Chasing Profits at Others’ Expense Can Harm Investors
The mutual fund revolution is overturning a fundamental principle of finance that it’s in the interest of investors for CEOs to maximize profit over time. This principle depends on an increasingly fragile assumption – that most investors in a firm hold shares in relatively few other firms and thus benefit from actions that increase its profits regardless of the cost of those actions to customers and other firms. In a world of portfolio investors, this is no longer true.
The implications are profound. The practice of granting CEOs stock options may be creating incentives that diverge from the interests of investors holding broad portfolios of stocks. Granting CEOs options on broad market indices may better align their incentives with today’s owners. And fund managers may feel increasingly compelled to discourage tactics that raise profits while imposing much higher costs on others.
Claims that higher profit always benefits investors are pervasive. Among other things, they are used to justify:
high CEO compensation 1,
competitive strategies with high social costs 2,
anticompetitive mergers 3, and
attacks on public and union pension fund activism 4.
To have force, however, these claims must assume investors benefit from tactics that increase profits even when they are zero-sum or worse – even when they impose costs as great or greater than that increase on customers and other companies. CEO incentive compensation packages reward increased earnings, for example, whether it comes at the expense of customers, staff, suppliers, or competitors.
Milton Friedman made explicit the assumption that profits benefit investors regardless of their social cost in his assertion – still rehearsed every year in legal briefs and comment to the SEC – that the only social goal of business is profit. The assumption operates just as powerfully in the argument against antitrust enforcement in consolidating industries that rising prices reward innovation.
Attacks on union and public pension fund shareholder activism, finally, depend heavily on the assumption that profits matter to their members and plan participants regardless of the cost at which they are won. As recently as 2008, for example, the Labor Department issued an Interpretive Bulletin 5 suggesting it is a breach of fund managers’ fiduciary duty to consider anything other than investment returns – even their plan participants’ job security – in their investment activities.
This assumption matters because it is wrong. There’s a large class of investors who benefit only from strategies that increase profits at one firm without imposing comparable or greater costs on customers and other firms. People who invest mostly through broad market mutual and exchange-traded funds or who rely on widely diversified pension plans, in particular, have financial interests that are starkly different from those of investors in single companies.
Imagine you own a mutual fund – maybe an index fund – with investments across the U.S. stock market. Would you benefit from drilling by ExxonMobil off the California coast? You might try to get a rough estimate of the long-term increase in the company’s earnings per share that could lift its share price. But what about the companies in your fund that might suffer from more offshore drilling?
The list might be fairly long. Hospitality companies suffered from the 1969 Santa Barbara oil spill, of course. Events that harm the hospitality sector tend to harm travel companies, as well. Since California’s enormous agricultural sector is highly sensitive to groundwater contamination – not least its coastal specialty crops – so are food processors, distributors, CPG companies, and retailers.
Judging from the number of ads filmed there, recreational travel along the California coast drives significant demand for a wide variety of vehicles. Insurers hate drilling in heavily populated areas. And banks suffer when the credit quality of portfolios depending heavily on real estate deteriorates. California companies account for over 20% of the market cap of the Fortune 500 6. Imagine the boost ExxonMobil would need to offset even small declines across that.
The larger point is that the U.S. economy is highly interconnected. Initiatives that create value through price-lowering efficiency improvements, new products, new networks or platforms, and new ways to improve welfare are true triumphs. Tactics that extract profits at high cost to others, from a market-wide perspective, are not.
And yet that perspective is increasingly important. Mutual funds have given casual investors access to the growth potential of the stock market at levels of risk as low as diversification allows. And passively managed index funds have extended that access at a fraction of the cost – maybe a twentieth – of old-fashioned brokerage.
In short, most of us simply cannot afford to spend our savings on individual stocks. Increasingly, we are constrained to invest across the market. Indeed, mutual funds held over 30% of U.S. equity in 2017 7. Zero-sum profit-taking does not make us better off; destructive profiteering harms us. We might even be better off if firms paid CEOs bonuses in shares of mutual funds just as broad as ours.
In 1952, Harry Markowitz invented modern portfolio theory 8. The key insight was that stock prices depend only on the part of their risk they share with the entire market – the part of their risk that is irreducibly social. Now that most of us are portfolio investors, we shouldn’t be surprised the inverse is becoming true. The only profits that increase our wealth are the profits not canceled out by other firms’ losses – profits that are truly social. To most investors, the social costs of profits matter.
Bork, R. The Antitrust Paradox (Free Press, 1978), summarized here.