What the Snap brouhaha reveals about the modern stock market

Oh, Snap. On Tuesday, the designer of the insanely popular Snapchat smartphone app got kicked out of the S&P 500. At issues were some voting rights shenanigans tied to its IPO.

That news might sound like it has the makings of an interesting, but ultimately arcane squabble between Silicon Valley entrepreneurs and Wall Street investors, but it actually hints at a massive change in our economy's financial governance. And one that raises borderline-existential questions for capitalism.

Basically, when Snap went public back in March, it only offered stock with no voting rights, giving public shareholders little-to-no say in the governance of the company. Instead, Snap's two founders retained control of 90 percent of the votes all by themselves. Some of the major investment firms the S&P 500 works with were not happy about this. Wall Street shareholders like having voting rights, because they want to direct corporations to maximize profits — which in turn mean bigger payouts to shareholders. So the S&P 500 decided to bar companies that offer multiple classes of stock — like Snap's non-voting shares — from inclusion on its index.

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Now, other companies on the S&P 500 have offered multiple classes of stock in the past, like Facebook, Google, and Berkshire Hathaway. And it sounds like if they ever do it again, they'll likely be kicked off too.

So why did the S&P 500 care this time? The reason has less to do with Snap, and more to do with the evolution of the stock index itself.

A few decades ago, investing in companies was generally an active endeavor. Investors went out looking for companies to park their money in, weighing each firm's individual merits — or hiring someone to do it for them. Then we invented indexes like the S&P 500: A big collection of different companies, all of whom have various levels of market capitalization. Today, no less than one-third of all money directed by investment firms is simply invested in an index like the S&P 500 — a little bit goes into every company in the index, proportional to their capitalization at a given moment. It's essentially investment on auto-pilot, which is actually more lucrative over the long run for most investors than actively picking stocks.

Another big change, though less recent, is the dominance of Wall Street by very large investment firms, who manage huge portfolios across many companies. These firms can and do still engage in active investment. But the logistics of scale also push them towards mimicking passive index investment in spirit if not in letter — they're just too big to make real specific bets on specific companies.

Why does this matter? As economist J.W. Mason explained to The Week, the classic defense of capitalism is that competition between companies improves social welfare. To get bigger market share and bigger profits, companies must invent better goods and services and drive down their costs, undercutting competitors. The great paradox of capitalism is that this pursuit of higher profits by each individual firm is supposed to actually drive aggregate profits across an entire industry or sector to zero.

But that paradox rests on a crucial assumption: That the people who own stock in and control a company are only interested in pursuing profits for that specific company. We think of corporations as pursuing profits, but also as pursuing the interests of their shareholders. "And traditionally we think of these two statements as almost being equivalent," Mason said. "But that really changes when you get these institutional investors and index funds into the game."

Studies of the financial and airline industries, for example, have found that the same big investor firms own significant amounts of stock in all the major firms in the sector. As of March 2013, the investment firm BlackRock alone owned 8.3 percent of United, 4.7 percent of Delta, 4.5 percent of Southwest, and 6.6 percent of JetBlue. Even more remarkably, if you'd selected two random companies on the S&P 500 back in 1999, the chances that the same shareholder would own at least 5 percent of both companies was just 20 percent. Today, the chances are 90 percent. The same investor owning stock across whole sectors or even the whole economy has become far more common in just the last decade and a half.

That means more and more investors no longer think about maximizing profits from a particular firm. They don't see themselves or their money as bound up with a specific company and its efforts. Rather, they're thinking about maximizing profits from everyone.

The possible consequences of this are profound.

When businesses are ruled by the exact same investors, they will feel far less pressure to compete with one another. So instead of undercutting each other by offering a better deal, companies will just try exploit customers with higher costs and poorer service while depressing wages and benefits for workers. If you noticed that this pretty much describes the behavior of sectors like the airline industry, you're certainly not the first.

This brings us back to Snap. In a way, its offer of non-voting shares was a move back towards the old way of doing business. Index funds might be considered passive investment vehicles, but the firms that manage them still vote in all the companies they hold stock in. And what these firms generally push for is behavior that maximizes the amount of money coming from their holdings in the aggregate. So Snap's decision on non-voting shares ensured that the people who actually control the company are concerned with its profits alone, not the profits of its entire sector.

That certainly doesn't turn Snap and other Silicon Valley firms into angels: They often don't have anyone to compete with even if they wanted to. And Silicon Valley visionaries are still loath to share their wealth and power with their workers. But the rising use of non-voting shares does offer one possible wedge for breaking up — or at least slowing down — our economy's slide into a kind of de facto central-planning, directed by and for Wall Street.

That also makes the S&P 500's decision a shot across the bow: A warning to Snap — and to every other like-minded company — to quit what it's doing and get back with the program. Being barred from the S&P 500 index won't hurt Snap's business model; very few corporations ever rely on Wall Street investment to raise capital. But it does mean Snap's investors will likely make less money when they eventually decide to cash out their stock.

So whether or not that warning works depends on how much Snap's owners care about the company versus their own gigantic pay day.