Monitoring the Monitors

Disclosure is a fundamental pillar of our market-based financial system. When information is accurate and complete, asset prices can reflect both expected return and risk. Yet, having information is one thing; using it appropriately is something else entirely. To evaluate the relative merit of a large number of potential investments, most people (including us) rely on specialists to do the monitoring: Independent auditors vouch for the accuracy of financial statements. Credit rating agencies tell us about the riskiness of bonds. Various brokers and specialized firms rate equities. And, for mutual funds, there are several monitors, of which Morningstar is the most prominent.

But, when the specialists fail to do their jobs, disaster can strike. Examples abound: auditors failed in the case of Enron; equity analysts overvalued technology firms during the dotcom boom; and rating agencies’ inflated assessments of structured debt contributed substantially to the financial crisis of a decade ago (see here). So, there is cause for concern anytime we see evidence that key monitors are falling short.

This brings us to the recent work of Chen, Cohen and Gurun (CCG) on Morningstar’s classification of bond mutual funds. They argue that mutual fund managers are providing inaccurate reports, and that Morningstar is taking them at their word when better information from standard disclosures is readily available. In this post, we describe CCG’s forensic analysis, but we don’t need to postpone our conclusion: if we can’t trust the monitors, then markets will not function properly….

Steve Cecchetti and Kim SchoenholtzNovember 11, 2019Disclosure, Monitoring, Monitors, Mutual funds, Bond fund, Actively managed funds, Index funds, SEC

Common Ownership: Back to Basics

Do diversified investment vehicles―especially index funds―diminish competitive pressures in concentrated industries? There is an active (and contentious) debate among researchers, policymakers and practitioners about the costs and benefits of such “common ownership.”

In addition to a rapidly growing number of industry-level studies—looking at airlines (here and here), banking (here and here) and ready-to-eat cereals (Backus, Conlon and Sinkinson, forthcoming), or at broad groups of industries—other researchers have sought to link common ownership to macroeconomic phenomena, like the weakness of post-crisis investment. And, in response to anti-competitive claims, legal scholars propose using antitrust law to limit the holdings of institutional investors in oligopolistic industries. Against this background, competition authorities in Europe and the United States are taking the debate seriously (see, for example, the FTC hearing held in December at the NYU School of Law).

Our own view is that the discussion remains at a very early stage, and that it is likely to take years to resolve whether CO, especially through index-tracking mutual and exchange-traded funds, meets the cost-benefit test (for a skeptical view of CO, see here). Importantly, even if CO does reduce competitive pressures, we currently know far too little to about the scale or scope to identify remedies that would be most effective and least disruptive. Furthermore, should the case for broad-based anti-competitive effects become compelling, any response will need to consider the welfare trade-off between the very large consumer benefits arising from broad index funds and the consumer costs associated with a loss of competition in selected oligopolistic industries.

Against this background, we welcome two new papers (here and here) by Backus, Conlon and Sinkinson (BCS) that review the literature, provide new data to characterize the evolving pattern of share ownership, and suggest a back-to-basics approach for testing the CO hypothesis in specific industries. We hope that their work will spur a wave of CO research that will help us weigh the increasingly animated claims and counter-claims. In the remainder of this post, we highlight a few of the lessons from this recent research….

Commentary

Money, Banking, and Financial Markets