Why Passive Investors Care About Audit Quality

In recent decades, the rise of index funds (or passive investors), has caused heated debates over the efficacy of their stewardship role in corporate governance. Passive owners cannot influence the governance of a firm by selling its stock because the index composition determines whether the stock is in the fund. This  may increase passive investors’s incentives to monitor, vote  with their shares, and engage behind the scenes with companies. On the other hand, some scholars and commentators have questioned whether index funds deliver on their promises because stewardship seems too expensive for low-cost, low-overhead index funds.

In a recent study, we examine the impact of passive investors on corporate governance by looking at financial statement audit quality. Financial reports that reflect a firm’s fundamentals provide essential information to shareholders, and, since the interests of shareholders and management may differ, high-quality audits are important to good corporate governance. However, the passive investment style of these index funds – they hold stocks for at least a year and reevaluate their positions based on index factors – may give them less of an incentive than ordinary shareholders to engage high-quality auditors, which could affect financial statement auditing.

In our study, we examine the impact of passive ownership on audit quality. We use audit fees as the primary measure of audit quality and index fund ownership a  proxy for passive ownership. Identifying the impact of passive ownership on firms’ audit quality is challenging. One reason is that factors that directly affect audit quality – such as managerial capacity and firm transparency – may affect passive ownership. To address the endogeneity concerns, we exploit variations in ownership by passive mutual funds around the Russell 1000 and Russell 2000 indexes.

Every year, Russell ranks all U.S. listed companies by size. The Russell 1000 and 2000 indexes include the largest 1,000 and next largest 2,000 firms, respectively. Russell assigns a value-weighted portfolio weight according to each stock’s market capitalization. For passively managed mutual funds that are benchmarked on the Russell 1000/2000 index, there is a sharp shift in fund ownership between the smallest firms in the Russell 1000 index and the largest firms in the Russell 2000 index, even though these firms are of similar market value. To identify the effect, we rely on the exogenous change in ownership around the Russell 1000/2000 cutoff to assess whether passive funds affect audit quality.

Our results show that passive ownership leads to higher audit fees. Specifically, a one percentage point increase in passive ownership leads to approximately 18 perecent higher audit fees. This suggests that passive investors play an active role in audit-related governance issues. We also use other proxies for audit quality (such as restatements) and passive ownership, and we obtain results consistent with our main findings.

We also examine the mechanisms through which passive investors influence audit-related governance issues. Anecdotal evidence suggests that passive investors engage with firm management to improve corporate governance, but archival evidence of this engagement is rare due to data limitations. Since we cannot observe behind-the-scenes engagements between investors and their portfolio companies, we use proxy voting – a crucial way for institutions to express their opinions about companies – to examine whether passive investors pay attention to audit-related governance issues. Our estimation shows that passive ownership is negatively associated with the percentage of shareholders who vote with management on auditor ratification.

Further, we find that passive ownership leads to a higher likelihood of auditor turnover. Since anyone with the power to hire or fire an auditor has control over whether the auditor maintains or compromises its independence, our results provide strong evidence that passive investors play an active and influential role in improving audit-related governance issues through “voice.”

Overall, our findings support the view that passive investing helps improve governance. Our study also shows that proxy voting is an important way for index funds to voice their views on financial statement audit quality. As many have argued, one limitation of passive investing is that fund managers cannot monitor every firm; thus, the one-size-fits-all approach to gauge governance practices may have its shortcomings. Prior literature suggests that index funds use a set of screening criteria to filter out target firms. Such an approach may lack focus on firm-specific strategy or performance. However, index funds may facilitate activist campaigns to push for better governance. The 2017 landmark shareholder victory – in which index funds cast the key votes – that pushed Exxon Mobil to disclose the impact of climate change on its business is a good example. Thus, the consequences of increased passive ownership may need to be examined from a broader perspective, and any regulatory intervention to index funds’ voting power should be considered carefully.

This post comes to us from professors Ting Dong at Stockholm School of Economics, Florian Eugster at the University of St. Gallen and the Swiss Finance Institute, and Antonio Vazquez at Stockholm School of Economics. All three authors are affiliated researchers at the Mistra Center for Sustainable Markets (Misum). The article is based on their recent paper, “Passive Investors and Audit Quality: Evidence from the U.S.,”  forthcoming in the European Accounting Review and available here.