What the Rise of Indexing Means for Corporate Governance

The amount of assets that passive (index) funds have under management has grown significantly in recent decades. Domestic passive funds and ETFs now manage more than half of all assets under management (AUM) of domestic equity mutual funds and ETFs, and the Big Three passive fund managers (BlackRock, State Street, and Vanguard) cast over a quarter of the votes in S&P 500 companies. The growth in the voting power of passive funds has attracted the attention of market participants, academics, and regulators. For example, concerns about their outsized influence have led a group of senators to propose the INDEX Act, which would require passive funds to vote in accordance with the instructions of fund investors.

The question of how the rise in passive ownership affects the corporate governance landscape is very much unsettled, with different papers reaching contrary conclusions. There is also a significant debate about whether passive funds have a financial incentive to engage with companies on governance matters.[1]

In a new paper, we present an economic framework for the incentives of institutional investors to engage in governance, review the existing empirical evidence in the context of this framework, and highlight directions for future research.

We first discuss the benefits to institutional investors of monitoring and engaging with their portfolio companies. Building on the framework in Lewellen and Lewellen (2022) and Corum, Malenko, and Malenko (2022), we highlight two types of incentives for a fund manager to engage: direct incentives and flow incentives.[2]

1. Direct incentives. If engagement increases the value of a portfolio company, the total value of the fund’s assets under management (AUM) increases, allowing the fund manager to collect higher fees. This gives the fund manager a direct incentive to engage. However, the manager does not capture the entire rise in value, for two reasons. First, the fund does not own 100 percent of the firm, so the benefits from engagement are shared with other stockholders. This is the standard free-rider problem, relevant to the engagement by any shareholder. Second, the fund manager only captures a part of the value increase through the fees it collects and shares the rest with the fund’s investors. This second type of free-rider problem implies that, other things equal, passive funds have less incentive to engage than actively managed funds, given their typically lower fees.

We emphasize, however, that low asset management fees do not necessarily mean low incentives to engage:

  • First, low fees often come with large ownership stakes: low fees attract investor capital, increasing the fund’s AUM and thus its stakes in portfolio firms. Thus, the negative effect of low fees on engagement incentives is often counteracted by the positive effect of high ownership stakes. Moreover, large ownership stakes may also imply greater effectiveness of engagement, given that large shareholders have more voting power. As a result, large passive asset managers, such as the Big Three, may have relatively strong incentives to engage (e.g., Kahan and Rock, 2020; Lewellen and Lewellen, 2021; Corum, Malenko, and Malenko, 2022), even though they and many other funds merely track the index and collect low fees.
  • Second, a one-time increase in the value of a portfolio firm results in a stream of higher management fees in subsequent years, so the benefit of engagement is the present value of all these fee increases. As we discuss, this implies that the second type of free-rider problem is less severe than may appear at first; that incentives coming from management fees can be comparable to incentives coming from performance fees in hedge fund managers’ contracts; and that funds’ incentives to engage are likely to vary over time and across firms due to a variation in discount rates.

2. Flow incentives. The second type of incentive is investment flows into a fund. By engaging, the fund manager may attract more flows, further increasing fees. If flows result from the fund’s superior performance relative to other funds, then flow incentives for passive funds are likely to be small: Since other passive funds tracking the same index have the same return on their portfolios, there is no relative outperformance. However, flow incentives can be large even for passive funds if either (1) fund flows result from raw returns rather than only relative returns or (2) fund investors have non-monetary preferences and are attracted to funds that engage on environmental, social, and governance issues (e.g., Fisch, Hamdani, and Solomon, 2019; Sharfman, 2022).

We also highlight that any discussion of flow-related incentives should carefully consider the sources of flows: If, by engaging, an institution attracts capital from other institutional investors, then those other investors’ AUM, and hence their direct incentives, are likely to decrease. It is thus important to think about the aggregate effects of fund flows, taking into account which types of institutional investors are crowded out, and how this affects all shareholders’ combined incentives to engage.

Relatedly, the overall governance effects of passive fund growth are likely to depend on where flows to passive funds come from. If passive funds attract flows by crowding out investors’ direct investing in the stock market, then the likely primary effect of passive fund growth will be the replacement of retail investors as shareholders. Since retail investors typically have low incentives and little ability to engage, this crowding out may improve governance. Instead, if passive fund growth comes at the expense of investors’ allocations to actively managed funds, the likely key effect of passive fund growth is that it will crowd out active funds from firms’ ownership. This may negatively affect governance if active funds’ incentives to engage are stronger given their higher fees (Corum, Malenko, and Malenko, 2022).

Empirical evidence. We next review the empirical evidence on passive fund engagement and voting. Papers in this literature often come to contrary conclusions about the governance effect of greater passive ownership. While several empirical studies find that it is associated with less managerial power, other studies show the opposite.[3]One potential explanation for these differences is that the methodologies are different: There is an ongoing debate in the literature on passive funds about the right methodology. A complementary way to reconcile the conflicting evidence is by analyzing whether higher passive ownership in a given study results from lower retail or lower active ownership: Studies that document a positive (negative) governance effect of higher passive ownership show no corresponding changes (significant decreases) in active ownership. We also highlight that policymakers should be careful in using the existing studies to understand the governance effects of passive fund growth over the last decades. First, the type of investors that are crowded out by passive funds over time may be very different than in the existing empirical studies, which often rely on variation in ownership due to index reconstitutions. Second, differently than in the existing studies, changes in ownership structures over time are accompanied by changes in funds’ AUM and asset management fees, all of which affect shareholders’ combined incentives to engage.

We next discuss the evidence on proxy voting by institutional investors. Several papers show that the votes of passive funds, including the Big Three, are more pro-management than the votes of active funds.[4] However, as we discuss in the paper, there are several reasons why this is not necessarily evidence of a passive approach to voting or of excessive deference towards management. There also seems to be a difference between the Big Three and smaller passive fund families. The Big Three appear to perform more governance research and vote more independently from proxy advisers, which is consistent with their larger ownership stakes and thus potentially stronger incentives to increase value. Further research is therefore needed to provide a more definite and precise interpretation of the evidence on funds’ votes. In addition, research may benefit from explicitly distinguishing between the voting practices of the Big Three and smaller passive asset managers.

Overall, the literature has made important progress in understanding and quantifying passive funds’ incentives to engage, their monitoring activities, and their interactions with other shareholders. Based on the findings in the literature, there is no clear answer to whether passive fund growth has been beneficial or detrimental for governance, and there are important questions remaining. We therefore conclude our paper by discussing several directions for future research in this area.

ENDNOTES

[1] E.g., Bebchuk, L. A., and S. Hirst (2019). Index Funds and the Future of Corporate Governance: Theory, Evidence, and Policy, Columbia Law Review 119, 2029-2146; Fisch, J. E.; A. Hamdani, and S. D. Solomon (2020). The New Titans of Wall Street: A Theoretical Framework for Passive Investors. University of Pennsylvania Law Review 168, 17-72; Kahan, M., and E. B. Rock (2020). Index Funds and Corporate Governance: Let Shareholders be Shareholders. Boston University Law Review 100, 1771-1815; Lund, D. C. (2018). The Case Against Passive Shareholder Voting, Journal of Corporation Law 43, 493-536; Sharfman, B. S. (2022). Opportunism in the Shareholder Voting and Engagement of the ‘Big Three’ Investment Advisers to Index Funds.” Journal of Corporation Law, forthcoming.

[2] Lewellen, J., and K. Lewellen (2022). Institutional Investors and Corporate Governance: The Incentives to Be Engaged, Journal of Finance 77, 213-264; Corum, A. A., A. Malenko, and N. Malenko (2022). Corporate Governance in the Presence of Active and Passive Delegated Investment, Working paper.

[3] Appel, I. R., T. A. Gormley, and D. A. Keim (2016). Passive Investors, Not Passive Owners, Journal of Financial Economics 121, 111-141; Appel, I. R., T. A. Gormley, and D. A. Keim (2019). Standing on the Shoulders of Giants: The Effect of Passive Investors on Activism, Review of Financial Studies 32, 2720-2774; Filali Adib, F. Z. (2019). Passive Aggressive: How Index Funds Vote on Corporate Governance Proposals. Working paper; Heath, D., D. Macciocchi, R. Michaely, and M.C. Ringgenberg (2022). Do Index Funds Monitor? Review of Financial Studies 35, 91-131; Schmidt, C., and R. Fahlenbrach (2017). Do Exogenous Changes in Passive Institutional Ownership Affect Corporate Governance and Firm Value? Journal of Financial Economics 124, 285-306.

[4] Brav, A., W. Jiang, T. Li, and J. Pinnington (2022). Monitoring Through Voting by Passive Funds:  New Evidence from Proxy Voting. Working paper; Heath, D., D. Macciocchi, R. Michaely, and M. C. Ringgenberg (2022). Do Index Funds Monitor? Review of Financial Studies 35, 91-131; Boone, A. L., Gillan, S., and M. Towner (2020). The Role of Proxy Advisors and Large Passive Funds in Shareholder Voting: Lions or Lambs? Working paper.

This post comes to us from professors Alon Brav at Duke University’s Fuqua School of Business, Andrey Malenko at the University of Michigan’s Stephen M. Ross School of Business, and Nadya Malenko at the University of Michigan’s Stephen M. Ross School of Business. It is based on their recent paper, “Corporate Governance Implications of the Growth in Indexing,” available here.

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