Index Funds and the Cost of Engagement

Institutional ownership of companies has grown to the point that institutions today own approximately 80 percent of the market value of U.S. stocks.[1] Recent academic research explores this rising ownership concentration and debates the growing importance of “passive” or “index” investors.[2] This literature raises concerns that asset managers in general, and index funds in particular, may be becoming too powerful, while also exhibiting conflicts of interests. Some commentators, therefore, suggest that index funds have become so powerful, they will cast the deciding vote on any proxy battles between activist investors and corporate management. Others see a conflict of interest resulting from asset managers seeking to gain incremental assets from corporate pension funds, with the result that they will vote mainly with management, thereby inhibiting the corrective influence of activist investors.

As I explain in a new paper, the growing assets of index funds also offer an opportunity to help guide corporate conduct. Fears that index funds will underinvest in governance, while justified in the past, are less so now. The reason is that the Big Three asset managers have grown to the point where their economies of scale mean that the costs of retaining a well-resourced corporate governance team have fallen to negligible levels (see Facebook example below). Indeed, governance should be considered a cost of doing business.  All of the Big Three are today household names, and social and environmental activists are aware of them and their power. The consequence is that the Big Three will increasingly see their social license to operate challenged and, in an effort to avoid stricter regulation, will be required to show that they have a balanced, active approach to corporate governance.

This is not to diminish  the valid concern that the growth of the Big Three risks creating a Giant Three that in 20 years cast votes representing as much as 40 percent of all the shares of U.S. corporations.[3] What I am challenging is the notion that the standard of governance will drop to the lowest permissible.

More than 50 interviews with institutional investors, corporate issuers, and their advisers from Europe and the U.S.  inform my understanding of the quality of the dialogue between institutional investors and corporations. The key findings are (a) engagement is still maturing on both sides and resources are being added by investors, (b) engagement by the largest institutions shows a focus on domestic companies with large capitalization or on otherwise high-profile controversies (non-U.S. and smaller companies reported frustration at a lack of engagement from the Big Three), (c) engagement by investors occurs mainly when there are problems (lack of attention from investors is often misconstrued by corporations as a lack of interest), (d) activist investors are learning to engage and work around mutual funds, which helps explain why the rising ownership of the Big Three has not resulted in a decline in activist campaigns, (e) companies have a substantial fear that the Big Three could be heavily influenced by either social or financial activists, and (f) there is virtually no engagement by smaller index fund companies.

To illustrate why I believe index funds have an incentive to engage in corporate governance, consider the following Facebook example from March 2018 and the resulting sell-off in U.S. equities (wiping $245 billion of market value off the S&P 500).

Such significant stock moves can affect the size of the assets under management (AuM) of asset managers in two ways. First, there is the stock-specific drop in AuM and, second, there may be a wider stock market sell-off if the affected stock is big enough. A rough calculation illustrates the potential financial impact. In Q1 of 2018, BlackRock, Vanguard, and State Street held approximately 146.2 million, 173.6 million, and 87 million shares, respectively. On Friday, March 16, 2018, Facebook stock closed at $185.09 a share. Following the news of the data scandal, the stock price closed $12.53 lower, or $172.56 a share, on Monday, March 19, and continued to fall by approximately $20 over the following days. The initial first-day move equates to a decrease in AuM of $1.83 billion, $2.18 billion, and $1.09 billion for the Big Three, respectively. Assuming an average management fee of 0.1 percent of assets (across passive and active), the loss in revenue would be $1.83 million, $2.18 million, and $1.09 million, respectively. However, this is not a one-time loss, but it lowers the AuM of asset managers in perpetuity. There are several ways to estimate this. One could, for example, treat the $2 million as a negative perpetuity that is discounted with an interest rate to arrive at a present value. Alternatively, one could approximate the loss in income by looking at its negative effect on the valuation of the asset manager itself. Asset managers are typically valued at between 1-2 percent of their AuM. In the case of the Facebook example, the $1.83 billion reduction in AuM for BlackRock would equate to a loss of between $18.3 million and $36.6 million.

But the above calculation covers only the stock-specific loss in AuM; there is also the wider market sell-off it triggered. Prior to the Facebook announcement, the S&P 500 had a market capitalization of approximately $24 trillion. On March 19, 2018, the S&P 500 subsequently lost 1.17 percent in value. Assuming an average valuation of 1 percent of AuM for the Big Three, and a mean holding of 17.6 percent of S&P companies, implies that these three asset managers lost as much as $718 million in market value as a result of the S&P 500 move on March 19, 2018.[4] The fewer scandals occur, the safer equities appear, and the more assets the passive managers can attract. And while the Big Three might have to pay for it, they also receive a large portion of the inflows.

The growth of the asset management industry, and its ownership concentration in particular, therefore poses both a major opportunity and significant challenge. More influential shareholders provide better oversight of corporate conduct. If investors do so only by constraining the ability for corporate executives to enrich themselves (principal-agent thinking), the increased influence of shareholders may be a net-positive for society. If, however, the increased influence comes at the cost of other stakeholder groups such as employees and consumers, recent trends in ownership concentration may raise societal concerns. The debates surrounding the desirability of share buybacks, investigations into common ownership, as well as the debates in the United Kingdom and the United States about adopting worker representation on company boards, are indicative of this.

For now, my arguably normative position is that challenging corporate power is the primary concern, while the means by which asset managers seek to exercise control over their investee companies is a secondary one. Limiting the voting rights of index funds would muzzle those shareholders with the deepest pockets and would eliminate the opportunity to employ them for the benefit of private governance alongside regulatory governance. Whether or not one considers the rise of institutional investors to be desirable will therefore depend in large part on one’s satisfaction with the level of corporate conduct. It will also be a reflection of the satisfaction one has with the quality and extent of domestic political and regulatory oversight.

Rather than the big asset managers exercising too much influence, there appears to be too little engagement beyond the domestic, high-profile, mega-cap companies. The future of engagement will depend, in part, on how the market share of passive managers develops in relation to active managers and how the market share of the Big Three develops within the passive market. If passive assets continue to grow faster than active assets and the Big Three continue to take the lion’s share of new inflows, then perhaps little will change as the voting degradation that comes with growing passive investing is counterbalanced by the fact that the majority of new passive assets are won by the comparatively well-resourced large houses. They may control the outcome of shareholder interventions, but it is likely they will do so from an informed position, at least as regards the largest proxy battles.


[1] Pensions & Investments, 25 April 2017, “80% of equity market cap held by institutions.”

[2] References:

  • Bebchuk, Lucian A., Alma Cohen, and Scott Hirst. 2017. “The Agency Problems of Institutional Investors.” Journal of Economic Perspectives 31 (3): 89–102.
  • Bebchuk, Lucian A., and Scott Hirst. 2018. “Index Funds and the Future of Corporate Governance: Theory, Evidence, and Policy.” ECGI – Law Working Paper, No. 433/2018.
  • Fichtner, Jan, and Eelke Heemskerk. 2018. “The New Permanent Universal Owners: Index Funds, (Im)patient Capital, and the Claim of Long-termism.”
  • Fichtner, Jan, Eelke Heemskerk, and Javier Garcia-Bernardo. 2017. “Hidden power of the Big Three? Passive index funds, re-concentration of corporate ownership, and new financial risk.” Business and Politics 19 (2): 298–326.
  • Gilson, Ronald J. and Gordon, Jeffrey N., The Agency Costs of Agency Capitalism: Activist Investors and the Revaluation of Governance Rights (March 11, 2013). ECGI – Law Working Paper No. 197
  • Lipton, Ann. 2017. “Family Loyalty: Mutual Fund Voting and Fiduciary Obligation.” The Tennessee Journal of Business Law 19 (175).
  • Shapiro Lund, Dorothy. 2017. “The Case Against Passive Shareholder Voting.” Coase-Sandor Working Paper Series in Law and Economics 829.
  • Serafeim, George, 2018. “Investors as Stewards of the Commons?” Journal of Applied Corporate Finance 30: 8–17.

[3] A point made by Bebchuk, Lucian A. and Hirst, Scott, The Specter of the Giant Three (May 9, 2019). Boston University Law Review, Volume 99, 2019

[4] The $718 million estimate is calculated as follows: $24 trillion (market capitalization of the S&P 500) x 1.17% (market move of S&P 500) x 17.6% (market share of Big Three) x 1% (typical valuation of asset managers). This estimate includes the stock-specific loss resulting from Facebook.

This post comes to us from Patrick Jahnke, a PhD candidate at the University of Edinburgh. It is based on his recent article, “Ownership Concentration and Institutional Investors’ Governance Through Voice and Exit,” available here.