Common ownership, institutional investors, and welfare

• Author: Rune Stenbacka,Oz Shy
• Published date: 01 July 2020
• Date: 01 July 2020
• DOI: http://doi.org/10.1111/jems.12380

J Econ Manage Strat. 2020;29:706–723.wileyonlinelibrary.com/journal/jems706

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© 2020 Wiley Periodicals LLC

Received: 15 April 2019

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Revised: 3 December 2019

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Accepted: 4 May 2020

DOI: 10.1111/jems.12380

ORIGINAL ARTICLE

Common ownership, institutional investors, and welfare

Oz Shy

1

|Rune Stenbacka

2

1

Research Department, Federal Reserve

Bank of Atlanta, Atlanta, Georgia

2

Department of Finance and Economics,

Hanken School of Economics, Helsinki,

Finland

Correspondence

Rune Stenbacka, Department of Finance

and Economics, Hanken School of

Economics, P.O. Box 479, 00101 Helsinki,

Finland.

Email: Rune.Stenbacka@hanken.fi

Abstract

This study evaluates the effects of institutional investors' common ownership

of firms competing in the same market. Overall, common ownership has two

opposing effects: (a) it serves as a device for weakening market competition,

and (b) it induces diversification, thereby reducing portfolio risk. We conduct a

detailed welfare analysis within which the competition‐softening effects of an

increased degree of common ownership is weighted against the associated

diversification benefits.

1|INTRODUCTION

Recent studies have attracted attention to the increasingly important phenomenon of common ownership of publicly

traded firms (e.g., Azar, Schmalz, & Tecu, 2018; Backus, Conlon, and Sinkinson, 2019b; Gilje, Gormley, and Levit, 2017;

Schmalz, 2018; Seldeslachts, Newham, and Banal‐Estanol, 2017). In particular, institutional investors often hold

ownership stakes in competing firms belonging to the same industry. He and Huang (2017) present evidence that the

proportion of U.S. public companies with common institutional ownership has increased from below 10% in 1980 to

about 60% in 2014. These public companies include institutional owners that simultaneously hold at least 5% of the

common equity of rival firms in the same industry. Azar (2017) reports a similar trend by reference to a finding that

the share of S&P 500 firms with overlapping owners holding at least 3% ownership stakes in firms belonging to the same

industry has increased from 25% to 90% during the period from 2000 to 2010.

From a theoretical perspective, common ownership can be expected to soften competition because managers, who

maximize the returns to their shareholders, internalize the effects their product market decisions have on rivals. This is the

central mechanism developed in the model of overlapping intra‐industry ownership by O'Brien and Salop (2000). Several

empirical studies have recently estimated the effects on competition of common ownership in different industries. Azar et al.

(2018) present evidence to support the conclusion that common ownership raised airfares by relating these prices to

measures of concentration which are adjusted to take common ownership into account. Further, Azar, Raina, and Schmalz

(2016) show similar effects of common ownership on spreads and fees for banking products.

1

Newham, Seldeslachts, and

Banal‐Estañol (2018) explore the effects of common ownership on entry. They employ data from the pharmaceutical industry

to empirically establish that common ownership with the incumbent brand firm reduces the probability of generic entry.

In this analysis, we focus on a configuration where consumers can allocate their savings into one of two competing

institutional investors. The institutional investors channel their funds to acquire ownership in product market firms

operating in a duopolistic industry. We can think of these institutional investors as pension funds. We initially show

that an increased degree of common ownership relaxes the intensity of product market competition. However, an

increased degree of common ownership also reduces the risks in the intra‐industry portfolios of the institutional

owners. Therefore, an increased degree of common ownership defines an interesting tradeoff between relaxed com-

petition in the product market and improved risk diversification in the asset market for risk‐averse savers. A detailed

welfare analysis associated with this tradeoff is the main contribution of our study.

Our welfare analysis reveals that the socially optimal degree of common ownership is importantly influenced by two

factors: (a) the degree of risk aversion and (b) the relative weight society assigns to consumption of the final product

versus that assigned to returns on savings via institutional investors. A low relative weight assigned to consumption of

the final product can be interpreted as a society that encourages savings for retirement and discourages excessive

consumption. We characterize in detail how the socially optimal degree of common ownership with risk neutrality

depends on the relative weight placed on consumption of the final good. In particular, we find that under risk neutrality

complete ownership specialization, that is no common ownership at all, is socially optimal as long as the relative weight

on consumption of the final good is sufficiently high. Further, we show analytically that with risk aversion, and for the

class of utility functions with constant relative risk aversion (CRRA), an increase in the degree of risk aversion increases

the socially optimal degree of common ownership. The intuition is that the institutional investors offer more diversified

investment portfolios to their savers if there is a higher degree of common ownership, and the value savers attach to

diversification is increasing as a function of the degree of risk aversion.

Our analysis is linked to a category of theoretical models which have characterized the effects of common own-

ership or overlapping ownership on market performance by applying industrial economics approaches. This category of

models includes O'Brien and Salop (2000), López and Vives (2019), and Shy and Stenbacka (2019), and it is broadly

surveyed in Vives (2019) as well as Section 2of Schmalz (2018). Our present analysis extends this approach to a welfare

analysis within which the competition‐softening effects of an increased degree of common ownership can be weighted

against the associated diversification benefits.

The recent advances in the analysis of the effects of common ownership have initiated an intense debate among

economists and legal scholars regarding policy implications. Elhauge (2016) and Posner, Morton, and Weyl (2017) have

proposed the introduction of rules to restrict the ability of institutional owners to hold ownership stakes in several firms

operating in the same industry. Other researchers, such as Lambert and Sykuta (2018) and Ginsburg and Klovers

(2018), have forcefully raised arguments against such restrictions. The debate has also entered the policy arena. For

example, in its resolution, dated April 19, 2018, in response to the European Commission's annual report on compe-

tition policy, the European Parliament calls on the Commission to “take all necessary measures to deal with the

possible anticompetitive effects of common ownership”and to “investigate …the effects of common ownership on

European markets, particularly on prices and innovation.”

2

Our welfare analysis could be viewed as a central com-

ponent in arguments required to derive effects‐based policy implications because it highlights the tradeoff between

competition‐relaxing effects and diversification benefits associated with an increased degree of common ownership.

It should be pointed out that intra‐industry common ownership is by no means the only way in which institutional

investors in general, and pension funds in particular, can diversity their portfolios. Of course, diversification can also be

accomplished by mixing equity from different industries as well as fixed income obligations without owning multiple

competing firms within the same industry. However, as frequently observed, investors can further diversify their

portfolios by acquiring stocks of competing firms within the same industry, and it is the focus of the present study to

analyze this particular aspect. To achieve this goal, we characterize the welfare tradeoff induced by an increased degree

of common ownership as we balance the competition‐relaxing effects against the associated diversification benefits. In

fact, our study matches the priorities suggested in Backus, Conlon, and Sinkinson (2019a) who argue that the most

fruitful direction for future research on the competitive effects of common ownership could involve attempts to

measure those effects within a single industry, “with a focus on pairwise profit weights rather than market‐level

concentration measures as the variable of interest”(p. 25).

This study is organized as follows. Section 2designs a static duopoly model to measure how the share value of

institutional investors varies with the degree of their common ownership in firms competing in the same product

market. Section 3solves for the equilibrium profits of the firms and investors as functions of the degree of common

ownership. Section 4analyzes how common ownership affects investors' portfolio risk. Section 5conducts the welfare

analysis of common ownership. Section 6explores several extensions of the model. Section 7presents concluding

comments. Appendices provide algebraic derivations.

2|DUOPOLY COMPETITION, INSTITUTIONAL INVESTORS, AND

COMMON OWNERSHIP

Following Shy and Stenbacka (2019) we introduce institutional investors into a modified duopoly model with two firms

competing based on production decisions in the product market. The two producing firms are owned by two

SHY AND STENBACKA

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