Corporate Governance Consequences of Passive Investing

The popularity of index funds, which automatically track an index of stocks, is continuing to grow in the U.S, and, albeit less intensely, in the EU. Due to the high concentration of the index funds industry, the exponential rise of mutual funds designed to track stock indices has had significant corporate governance implications. Specifically, passive investing significantly affects listed companies’ ownership on both sides of the Atlantic. The three leading passive fund managers (BlackRock, Vanguard, and State Street) make up an increasingly important component of the shareholder base of listed companies, as they hold relevant stakes (usually not exceeding 5 percent) in thousands of U.S. and European companies. Therefore, they are able to play a crucial role in shareholder meetings and to exert considerable influence over the board and management.

While it is widely acknowledged that the rise of passive investing is beneficial for retail investors, who take advantage of greater diversification and lower costs, many institutions and corporate governance experts contend that the “ETF-ization” of listed company ownership can have negative corporate governance implications. That’s because passive investors are deemed to be also passive owners, who are not interested in being actively involved in the corporate governance of the companies they invest in. Even though index funds are, by definition, focused on the long term—as they are designed to track a market index automatically and are unable to sell the shares included in the tracked index—index fund managers are deemed to have even more limited incentives to engage with companies they invest in than other institutional investors.

For passive funds, the potential downsides of engagement are considered to be greater than they are for actively managed funds, because in the passive fund industry, the free rider problem is even more significant. As passive funds automatically track an index (e.g. S&P 500), the potential benefits of corporate governance intervention are very limited (given the huge number of portfolio companies) and inevitably create an advantage for all competitors tracking the same index and for active investors who hold a stake in (some of the) companies comprising the index. Therefore, the rise of passive investing seems to clash with the aim pursued by many lawmakers and regulators of promoting more active involvement by institutional investors in the corporate governance of the companies they invest in.

There are, however, several reasons why passive index funds could play an active role in the governance of those companies. First, since passive investors are long-term shareholders, they should have an incentive to monitor managers in order to improve the company’s performance. Second, as the biggest three fund managers “are simply too-big-to-be-passive,”[1] there is growing reputational and regulatory pressure for leading passive index fund managers to play an active monitoring role.[2] The SEC and the European Commission adopted disclosure-based regulatory strategy that prompted (albeit without imposing a duty) institutional investors to extensively vote all portfolio shares. In addition, creating the appearance of governance expertise can help passive funds managers win clients, especially institutional investors.[3]

Against this background, in a recent article, I provide a comprehensive analysis of evidence and empirical studies concerning passive investors’ approach to voting and engagement and show that passive investors seem to have a positive impact on corporate governance when the cost of intervention is low, such as when voting according to pre-defined policies at annual meetings. By contrast, passive investors tend to be passive owners in regard to high-cost governance activities, such as monitoring mergers and acquisitions or the selection of board members. [4]

Based on this preliminary evidence, and taking into account that passive investors are  focused on the long-term, the rise of passive investing confirms that the main reason for institutional investors not to   engage with companies is  costs. Consequently, I outline an analytical framework for regulations aimed at reducing engagement-related costs in order to encourage passive index fund managers and, more generally, non-activist institutional investors to play a more effective role in corporate governance.  I analyze the potential shortcomings of regulatory approaches to institutional shareholder engagement that are mainly focused on curbing short-termism and argue that, in order to promote more effective passive investor engagement, there is a need for regulations that would reduce costs.

Collective engagement is a promising way for institutional investors to become more involved in corporate governance. It would, for example, reduce the burden of costs by spreading them among many active and passive institutional investors and thereby eliminate any collective action problems.

This proposal does not seek to dramatically change the engagement practices of passive investors, who would continue to adopt standardized voting policies and rely largely on proxy advisers for routine matters. Yet the sharing of costs through collective engagement could encourage them to be more actively engaged in non-routine issues, such as proxy contests or mergers or related-party transactions. In addition, collective engagement could encourage all institutional investors to give greater scrutiny to activists’ proposals and make shareholder engagement more effective.

ENDNOTES

[1] See Luca Enriques & Alessandro Romano, Institutional Investor Voting Behavior: A Network Theory Perspective 15 (Eur. Corp. Governance Inst. (ECGI), Law Working Paper No. 393/2018, 2018), https://papers.ssrn.com/sol3/papers.cfm?abstract_id=3157708.

[2] See Morningstar, Passive Fund Providers Take an Active Approach to Investment Stewardship 3 (2017) http://www.morningstar.com/content/dam/morningstar-corporate/pdfs/Research/Morningstar-Passive-Active-Stewardship.pdf.

[3] See Dorothy S. Lund, The Case against Passive Shareholder Voting, 43 J. Corp. L. 493, 527-528 (2018).

[4] See e.g.  Cornelius Schmidt & Rüdiger Fahlenbrach, Do exogenous changes in passive institutional ownership affect corporate governance and firm value?, 124 J. Fin. Econ. 285 (2017).

This post comes to us from Giovanni Strampelli, associate professor of business law at Bocconi University, Milan. It is based on his recent paper, “Are Passive Index Funds Active Owners?  Corporate Governance Consequences of Passive Investing,” forthcoming in the San Diego Law Review and available here.

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