Are Passive Index Funds Active Owners? Corporate Governance Consequences of Passive Investing
The popularity of index funds, which automatically track an index of stocks, is continuing to grow in the U.S, and, albeit less intensely, in the EU. Due to the high concentration of the index funds industry, the exponential rise of mutual funds designed to track stock indices has had significant corporate governance implications. Specifically, passive investing significantly impacts listed companies’ ownership on both sides of the Atlantic. The three leading passive fund managers (BlackRock, Vanguard and State Street) make up an increasingly important component of the shareholder base of listed companies, as they hold relevant stakes (usually not exceeding 5%) in thousands of American and European companies. Therefore, they are able to play a crucial role in shareholders’ meetings and to exert considerable influence over the board and management.
Whilst it is widely acknowledged that the rise of passive investing is beneficial for final investors, who take advantage of greater diversification and lower costs, many institutions and corporate governance experts contend that the ‘ETF-ization’ of listed company ownership can have negative corporate governance implications. Indeed, passive investors are deemed to also be passive owners, who are not interested in being actively involved in the corporate governance of investee companies. Even though index funds are, by definition, focused on the long term — as they are designed to track a market index automatically and are unable to sell the shares included in the tracked index — index fund managers are deemed to have even more limited incentives to engage with investee companies than other institutional investors. For passive funds, the potential downsides of engagement are considered to be greater than they are for actively managed funds, because in the passive fund industry the free rider problem is even more significant. As passive funds automatically track an index (e.g. S&P 500), the potential benefits resulting from corporate governance intervention are very limited (given the huge number of portfolio companies) and inevitably create an advantage for all competitors tracking the same index, as well as ‘active investors’ who hold a stake in (some of the) companies comprised in the index. Therefore, the rise of passive investing seems to clash with the aim pursued by many lawmakers and regulators of promoting more active involvement by institutional investors in the corporate governance of their investee companies.
Against this background, in a recent article, I provide a comprehensive analysis of available evidence and empirical studies concerning passive investors’ approach to voting and engagement, showing that passive investors seem to have a positive impact on corporate governance when the cost of intervention is low (such as, for instance, when voting according to pre-defined policies at annual meetings). By contrast, passive investors are deemed to be generally passive owners vis-a-vis high-cost governance activities such as the monitoring of mergers and acquisitions, or the choice of board members, albeit there is a growing reputational and regulatory pressure for leading passive index fund managers to play an active monitoring role.
Based on available evidence (even though it is still not sufficient to draw a final conclusion), and taking into account the fact that passive investors are by definition focused on the long-term, the rise of passive investing provides confirmation that the main disincentive for engagement by passive (and active) institutional investors is not short-termism but cost. Consequently, I outline an analytical framework of potential regulatory strategies aimed at reducing engagement-related costs in order to encourage passive index fund managers and, more generally, non-activist institutional investors to play a more effective oversight role over investee companies. More specifically, taking the current EU institutional investor-driven corporate governance strategy as a reference, I analyze the potential shortcomings of regulatory approaches to institutional shareholder engagement that are mainly focused on curbing short-termism. I argue that, in order to promote more effective passive investor engagement, there is a need for regulatory action aimed at tackling cost-related issues more effectively. Chief among these issues, the facilitation of collective engagement seems capable of promoting more effective involvement by institutional investors in the corporate governance of investee companies. Instead of attempting to reduce the costs of engagement, it is preferable to promote the redistribution of these costs between active and passive institutional investors. In this regard, the incentivizing of collective engagement could be key. This means that engagement costs would be shared between the institutional investors that collectively undertake engagement activities, thereby overcoming possible collective action problems.
This proposal does not seek to change the engagement practices of passive investors radically. These investors would continue to adopt standardized voting policies and rely largely on proxy advisory services in relation to routine matters. On the other hand, the redistribution of costs favored by collective engagement may promote more proactive engagement by them in non-routine issues, such as proxy contests or M&A and related-party transactions. In addition, by favoring the sharing of the related costs, collective engagement can incentivize both passive and active institutional investors to give adequate scrutiny to activists’ proposals. In this way, interaction between activist and non-activist investors can render shareholder engagement more effective.
Giovanni Strampelli is Associate-Professor of Business Law at Bocconi University, Milan.
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