Even individual retail investors who have been hearing the gospel of diversification for decades now might hold more than 30 stocks, and your idiosyncratic risk goes way down with no reduction in your expected return. Diversification is taught in every introductory investment class as a magic tool for eliminating unnecessary risk. I taught it myself for years without ever thinking about potentially negative economic consequences.
Exchange-Traded Funds
Now, the case that common ownership stifles competition is far from settled science. Antoinette Schoar, a finance professor at the Massachusetts Institute of Technology’s Sloan School of Management, expressed skepticism about Azar and Schmalz’s idea when we spoke at the American Economic Association’s annual meeting in Chicago this January. Schoar speculated that even if most of a company’s investors are big, well-diversified institutions and funds, it will always be a few highly motivated activist investors who drive corporate policy. Large diversified investors, she says, will simply get out of the way and let the activists, who care about the stock’s value, push managers to compete.
Schoar is definitely right about one thing. Namely, in order to establish a firm link between diversification and lack of competition, researchers must think carefully about the process by which investors actually pressure companies to compete with each other. One potential reason to be skeptical of Azar and Schmalz’s result is that it seems implausible that even the most concentrated investors would evaluate an airline’s routes one by one and pressure the board of directors to cut or raise prices on certain routes. Investors tend to exercise control over companies in much more long-term, indirect ways, like electing directors.
Nevertheless, Azar and Schmalz’s idea deserves a lot of attention and follow-up. Fortunately, policy makers are already starting to pay attention. For example, economist Jason Furman, an important policy adviser to Democratic politicians, has reportedly managed to convince Massachusetts Senator Elizabeth Warren that common ownership represents a threat to the workers of America.
That’s good news. Instead of simply resolving to tax the rich more, politicians should think about how the structure of the economy can be reformed to reduce inequality while also boosting productivity. Increasing competition would be good for workers, but it would also be good for the economy.
This Bloomberg View column does not necessarily reflect the opinion of the editorial board or Bloomberg LP and its owners.