What happens when index funds run Corporate America?
Hedge fund activist Bill Ackman posed that question recently in his fund’s annual letter to investors. It’s a really good one. No one knows what consequences the boom of passive investment funds will have for the corporations they own. It’s something my coauthors and I explore in a forthcoming research paper, and our conclusion goes against the prevailing wisdom.
After all, since 1998 the share of assets held by passive institutional investors — mutual funds designed to track stock indices like the S&P 500 rather than actively picking winners — has tripled. Last year clients poured an additional $414 billion into U.S.-based, lower-cost index funds offered by Vanguard, BlackRock, State Street, and others. At the same time, clients withdrew $207 billion overall from actively managed funds, according to the research firm Morningstar. The assets of BlackRock alone are now larger than the GDPs of all but two countries.
The rise of mutual funds designed to mimic stock indices rather than outperform them seems destined to change the dynamic of company boardrooms and executive suites. Since passive investors have dramatically more assets under management, they might be expected to exert more influence over corporate decision making.
The question is, do they really? And if so, are they using that power?
Until now, the chief answer to both questions has been no. The prevailing wisdom in the ongoing debate has been that the shift in the ownership of publicly traded firms actually weakens corporate oversight.
Unlike high-profile activist hedge funds, which attempt to outperform the market, the primary goal of passive investors is to deliver returns that match a market index. That’s why critics say passive funds lack the power of exit, the selling of shares (or threatening to sell them) when managers perform poorly. It doesn’t make sense to drop a S&P 500 stock for poor performance when your fund is supposed to follow the S&P 500. In the same way, index funds don’t selectively buy more shares when managers perform well.
Still, these funds retain the power of voice, the ability to exert shareholder influence on management and governance-related proposals. But critics say passively invested funds, with their lower fees, lack the resources and often the will to monitor their large and diverse portfolios. The Economist calls them “lazy investors.”
Not everyone agrees. A growing number of passive investors insist they play a key role in corporate governance. Because they are unwilling to sell off their poorly performing positions, managers of passive funds say they place even greater weight on sound governance and compliance practices than their counterparts at active funds.
As F. William McNabb III, chair and CEO of the Vanguard funds, recently said, “We’re going to hold your stock if we like you. And if we don’t. We’re going to hold your stock when everyone else is piling in. And when everyone else is running for the exits. That is precisely why we care so much about good governance.”
My fellow researchers and I set out to test that claim. In our forthcoming research paper in The Journal of Financial Economics, we show that passive institutions do indeed positively shape firms’ governance policies. Our findings run contrary to the presumption that passive investors lack the willingness and ability to influence firms’ policy choices.
To do this analysis, we exploited the cutoff point between two widely used U.S. benchmark stock indices, the Russell 1000 and the Russell 2000. (The Russell 1000 comprises the largest 1,000 U.S. stocks by market capitalization, and the Russell 2000 comprises the next largest 2,000 stocks.) Since passive ownership is higher for stocks at the top of the Russell 2000 than the bottom of the Russell 1000, we were able to design our experiment to answer an important question: We wanted to know whether higher passive ownership actually leads to changes in corporate governance and performance, rather than resulting from a coincidence that passive investors simply tend to hold stocks that have these characteristics.
The results of our analysis suggests that passive investors affect firm governance in several ways. For example, we found that an increase in passive ownership is associated with a statistically significant increase in the share of independent directors on firms’ boards. In addition, firms with higher passive investor ownership were more likely to remove firm takeover defenses (for example, so-called “poison pills” and limitations on shareholders calling special board meetings). They were also less likely to have the unequal voting rights of a dual-class share structure.
Our findings suggest that passive institutions influence firm governance primarily through the power of their voice. An increase in passive ownership is associated with a decline in support for management proposals and a boost in support for shareholder proposals. Basically, when passive funds make up a larger percentage of the ownership, management appears to be confronted with a more contentious shareholder base.
So much for passive investors being passive.
There is evidence that passive investors are taking these actions with the belief that improved governance will eventually lead to improved performance and, ultimately, shareholder value. Specifically, we found that passive ownership is associated with higher profitability and firm value.
That’s not to say passive investors are acting like active or even activist investors; they seem to be choosing their battles. Overall, our findings are consistent with passive investors improving firm performance by advocating for proven governance reforms that require a low level of costly monitoring on their part.
While not active in the traditional sense, passive investors are not passive owners. Even without the power of exit they are leveraging the power of voice in their growing voting blocs to shape firms’ governance and policies.
So, to answer the question, what happens when index funds run Corporate America? We expect that the governance of publicly traded firms will increasingly align with the preferences of the large passive institutional investors: BlackRock, State Street, Vanguard, and the like.
Does this mean that traditional active funds are losing their own hands-on role in corporate oversight? My coauthors and I believe that’s unlikely. Instead, the clout of these active investors may rise, due to the large voting blocs of passive investors.
How? Actively managed funds do hold a declining share of a firm’s assets. But when they agitate for changes in governance, they may well find an ally in passively managed funds, a shareholder base that is increasingly concentrated. The support of large index-tracking mutual funds can lend credibility to activist campaigns, and therefore increase their likelihood of success.