Institutional investors such as mutual funds, pension funds, and exchange traded funds (ETFs) play a prominent role in today’s economy. According to the CFA Institute, institutional investors now hold over $70 trillion in investable assets and thus wield immense influence over the corporations they invest in. But how do these institutions actually exercise their power?
The most nuanced and direct way for investors to interact with their portfolio firms is through shareholder engagement, where they communicate with corporate managers to share their perspective, suggest changes, or gather information. In a new study, we quantify the costs, benefits, and economy-wide impact of engagement by some of the largest institutional investors in the world.
Engagement activities range from writing letters to CEOs and joining meetings to pressing for better governance or environmental practices. Unlike voting or selling shares, engagement is a private dialogue, making it a less-easily observed but potentially more powerful and nuanced tool. By addressing issues directly with corporate leaders, investors aim to improve company performance – and, in turn, the value of their investments. The institutions in our sample each employs a dedicated stewardship team that engages with hundreds or even thousands of portfolio firms every year.
Despite its importance, we know surprisingly little about the economics of engagement. How much does it cost? What are the benefits? How much value does it create? Using novel data on investor engagement drawn from the yearly stewardship reports of eleven large institutional investors including BlackRock, Vanguard, State Street, and T. Rowe Price, we quantify these economic forces for the first time. We find that institutional investors act as if spending $10,000 on engagement increases a company’s value by 0.3 basis points (bps), or 0.003 percent, on average. While that may sound small, when scaled by trillions of dollars in market capitalization and assets under management, the potential benefits are significant. However, engagement isn’t free; the stewardship team requires significant resources to research the issues and conduct meetings with corporate leaders.
We find that both the costs and benefits vary depending on the firm being engaged. Smaller companies are slightly more expensive to engage with but offer much higher returns on engagement, an average 5.5 basis point expected increase in firm value. Yet institutional investors engage less with smaller firms because they hold smaller positions in those firms, limiting the potential payoff. We also find that engagement costs are higher for firms with entrenched management, where presumably resistance from leadership makes it harder to drive change.
The economics of engagement also depend on the type of fund that is engaging. Active funds – those that try to outperform the market by actively picking stocks – are more likely to engage than index funds, which simply aim to match the performance of an index like the S&P 500. Surprisingly, this difference isn’t because active funds are inherently better at engagement. In fact, we find that active and index funds create equal amounts of expected value when they engage. Rather, it’s a question of incentives. Index funds charge lower fees, meaning they capture a smaller share of the value created through engagement. As a result, despite their larger positions and more diversified holdings, they engage less.
Yet as passive investing continues to dominate the market, the role of these funds in engagement is becoming more pronounced. Index funds tend to hold larger stakes in companies simply because of their huge size, which increases their potential to create value when they do engage.
Using simulations, we examined what would happen if passive investing continued to grow, reaching 90 percent of all mutual fund assets. We find that index funds would engage more often, driven by their even larger holdings, and generate substantial value for both their investors and society. Our estimates suggest that index funds have flat economies of scale: Tracking an index does not become more difficult as the fund grows. As a result, the continuing rise of passive investing increases the total societal benefits of their engagement.
On the other hand, our estimates show that active investors face diseconomies of scale that limit their effectiveness as they grow. As an actively managed fund attracts more resources, it becomes harder to identify and act on profitable opportunities that move the needle. As Warren Buffett once said, “Anyone who says that size does not hurt investment performance is selling. The highest rates of return I’ve ever achieved were in the 1950s. I killed the Dow. You ought to see the numbers. But I was investing peanuts then. It’s a huge structural advantage not to have a lot of money.” Smaller active funds can engage more selectively and effectively. In our simulations, active funds actually create more value for society when they shrink. At the same time, active fund managers and investors certainly don’t want their funds to shrink, and we might expect them to fight this trend, for example by lowering their fees or introducing new active investing options.
Our findings add new dimensions to the debate about the future of investing and corporate governance. Engagement clearly has the potential to create significant value, but its benefits are unevenly distributed. Index funds, with their flat economies of scale, may increasingly fill the gap left by shrinking active funds, creating a system where the societal value of engagement could rise even if the payoff to individual funds and investors are smaller.
The study also highlights the challenges of aligning private incentives with social benefits. While active funds are more motivated to engage under current fee structures, index funds generate broader social gains as they grow. This mismatch creates a tension between what’s best for active fund managers and their investors and what’s best for the economy as a whole.
More broadly, our findings imply that engagement is a relatively hidden but powerful tool for increasing firm value – one that benefits not just large institutions, but the broader economy, too. As the balance between active and passive investing shifts, so will the dynamics of how institutional investors engage with the companies they own.
This post comes to us from professors Davidson Heath at the University of Utah’s David Eccles School of Business, Daniele Macciocchi at the University of Miami’s Herbert Business School, and Matthew C. Ringgenberg at the University of Utah. It is based on their recent article, “The Economics of Investor Engagement,” available here.