Testing the Theory of Common Stock Ownership

Fiona Scott Morton is the Theodore Nierenberg Professor of Economics at Yale School of Management and Lysle Boller is a PhD student at Duke University. This post is based on their recent paper. Related research from the Program on Corporate Governance includes Index Funds and the Future of Corporate Governance: Theory, Evidence, and Policy by Lucian Bebchuk and Scott Hirst (discussed on the forum here); The Agency Problems of Institutional Investors by Lucian Bebchuk, Alma Cohen, and Scott Hirst (discussed on the Forum here); New Evidence, Proofs, and Legal Theories on Horizontal Shareholding by Einer Elhauge (discussed on the Forum here); and Horizontal Shareholding by Einer Elhauge (discussed on the Forum here).

In recent years, economists have become increasingly worried that the US (and perhaps global) economy is becoming less competitive. One possible reason relates to the changing ownership structure of US publicly-traded firms over recent decades. For half a century there has been a steady increase in institutional ownership in the US and a decline in the share of the average public company owned by retail investors. This changing ownership structure is closely related to the rise of diversified mutual funds, an invention that has been praised for providing consumers an inexpensive way to hold a set of diversified stocks. The broad availability of mutual funds has brought lower costs to savers, but there is a flip side to this coin—mutual funds (including index funds) often hold stakes in many competitors within the same industry. This pattern is referred to as “common ownership” or “horizontal shareholding.” The economics literature has long shown the potential for common ownership to be anticompetitive. A merger, for example, is a familiar setting where the same owner holds 100% of the two competitors; this purchase typically triggers a regulatory review due to concerns about possible declines in competition. A large institutional investor typically holds less, perhaps 4-7% of each rival, though there could be several similar investors of that size, making their total stake fairly large. For example, as of 2017, Vanguard held at least a 6% share in the six largest domestic airlines (Schmalz 2018), and Berkshire Hathaway held at least 7% in four of these same firms. The open empirical question this raises is whether there is a negative impact on product market competition from such institutional investor common ownership.

Mutual funds and other common owners have both the incentive and the ability to reduce competition between the competitors in their portfolios. The incentive derives from the financial benefit that owners and managers of stocks get from higher profits generated by lessened competition. The ability comes from the responsibility of a large owner to engage in corporate governance, oversee management, and their consequent ability to impact company strategy. If the management of a company therefore acts in order to maximize the value of the company’s owners’ portfolios, instead of just their own firm’s profits, theory shows that competition is reduced. In that setting, increases in common ownership might have important implications for the competitive environment of the economy. Indeed, in a recent paper also summarized in this forum, Backus, Conlon, and Sinkinson (2020) find that the change in incentives created by the rise of indexing is, in theory, large enough to explain some measures of increased markups over the same period. This is a theoretical result, however, that must be tested empirically.

A number of recent empirical papers have looked at individual industries to examine whether the incentives predicted by the theory of common ownership appear to be present, with mixed results. Our paper takes a different approach, allowing us to test for common ownership effects across a large number of industries. The intuition behind our test is simple—when firms enter an index (we focus on the S&P 500), institutional investors will purchase more of their stock because many index funds and mutual funds are tightly or loosely based on the index. This entry event therefore generates an increase in institutional and common ownership in the entering company’s competitors that are also members of the index. We examine several possible industry classifications, including the standard GICS industry classification and a sample of manually-classified competitors, and estimate the excess return of both the index entrant and its product market competitors in the three days following the announcement of an index change. We use a standard market model to control for market-level comovements. On average, the entering company experiences a large increase in its share price when the S&P announces the change. This is a well-known effect caused by increased demand for the stock and perhaps other factors unrelated to common ownership (see Afego 2017). While we replicate this “index bump” for the entrant, we also find that the event generates positive movement in the share prices of the product market competitors of these entrants. In other words, joining the S&P 500 is not only beneficial for the entering company, but it is also beneficial for its product market competitors who now have more overlapping owners with the entrant. This suggests that investors expect higher profits due to lessened competition.

Our findings are strengthened by two natural control groups in our data. First, if a new S&P 500 member was previously a member of a smaller S&P index (usually, the S&P MidCap 400), it experiences a much smaller change in institutional and common ownership upon entry, and there are no observable spillover effect to industry competitors upon its promotion to the S&P 500. Second, product market rivals that do not belong to the S&P 500 experience little change in common ownership upon entry and also do not exhibit an increase in their share price.

Finally, we calculate several measures of common ownership that have been put forth in the literature, and examine their relationship to the observed increases in competitor share prices. Measures that focus only on the “Big Three” index funds, or that focus only on large block shareholders, do not exhibit any relationship with observed returns. In contrast, more complete measures of ownership that include not only large common owners but also smaller institutional funds (“vector similarity” using both Cosine and Bray-Curtis measures) significantly predict abnormal returns of competitors in the index. This finding indicates that common ownership incentives may be present regardless of whether the fund industry is itself concentrated.

Our findings suggest that the common ownership hypothesis deserves both serious policy attention and further academic research, especially into the mechanisms that could be translating shareholder incentives into managerial action. Ederer, Gine, Tecu, and Schmalz (2018) provide one potential avenue, showing that common ownership may lead to a restructuring of executive compensation that puts less weight on competitive benchmarks. Crucially, high quality empirical research requires high quality data. This observation leads us to strongly oppose recent efforts to limit data collection on fund holdings, which could severely limit the ability of researchers to measure common ownership. We support calls to improve the quality of existing data collection and reporting methods for the same reason.

The complete paper is available for download here.

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