The Economics of Investor Engagement

Institutional investors play a critical role in monitoring the managers of their portfolio companies. In theory, there are three channels through which investors can affect corporate behavior: voting, exiting positions, and engaging directly with company management.  While a large number of papers examine the impact of voting and exiting, relatively little work examines engagement.  Our paper ‘The Economics of Investor Engagement’ offers the first detailed analysis of the costs and benefits of investor engagement.

Engagement by institutional investors can take several forms: by writing letters or emails to a company's management team, by communicating with corporate managers via phone calls, or by meeting with corporate managers in person or virtually.  One challenge to examining engagement is that it is difficult to observe these activities. However, recently, large institutional investors have started publicly reporting their engagement activities in their stewardship reports.  We hand-collect and process these reports to build a sample of engagement activities from 2019 to 2023.

Why do Investors Engage?

We start by examining the incentives to engage.  Because little is known about engagement, it is unclear why investors engage in the first place. For example, it could be that investors do not expect engagement to yield any benefits, they do it simply for marketing purposes.  Alternatively, it is possible investors expect engagement to yield tangible increases in firm value that ultimately benefits their investors.

To explore this, we examine the determinants of engagement.  We find that the most important determinant of engagement activity is the dollar value of each investor's position in a company.  In other words, investors focus their engagement activities on the companies in which they hold the largest positions. In our sample, institutional investors engage with 4.2% of the companies in which they hold $10 million or less, but they engage with 86% of the companies in which they hold $10 billion or more (see Figure 1, below).

Intuitively, this result makes sense. By focusing on their largest positions, investors can maximize the benefits their investors receive. The results provide strong support that investors use engagement to increase firm value and they focus their engagement activities on the companies that yield the largest expected benefit for their investors.

We then develop and estimate a discrete choice model to further explore the costs and benefits of engagement. Our discrete choice model is flexible and based on the framework developed in Lewellen and Lewellen (2022). In sum, the framework posits that investors choose to engage when it benefits their fund.  Specifically, there are two channels through which engagement can impact a fund.  First, raising the value of a portfolio firm via engagement will increase the value of a fund's assets under management. Because funds earn fees as a fraction of their assets under management, this will increase the fund's fee income.  Second, increasing a portfolio firm's value will also improve the performance of the fund, which could attract additional investors to the fund.  This could also result in additional fee income. 

By analyzing these factors, our discrete choice model sheds new light on the economic incentives driving institutional investor behavior. Our results also have broader implications for corporate governance and the economy.

Key Findings

Our discrete choice model shows that institutional investors behave as if $10,000 spent on engagement leads to a 0.3 basis point (bps) increase in firm value. Importantly, the results suggest investors do think engagement matters for firm value and, consequently, the fund’s investors.

We then show that the costs and benefits of engagement vary across institutions and firms. Passive funds, such as BlackRock, Vanguard, and State Street, engage less frequently than active funds, controlling for position size. This is primarily because passive funds have lower fees, so the fund internalizes a smaller fraction of the value created from engagement. In other words, passive funds have lower incentives to engage, so they engage less.  However, we find that passive funds are just as good as active funds at using engagement to increase firm value. 

We also find that smaller firms and those with weaker financial performance exhibit significantly higher returns to engagement (up to 5.5 bps per $10,000 spent). However, institutional investors often hold smaller positions in these firms, reducing their likelihood of engagement. Put differently, our results highlight a key tension: owing to their incentives, the private value of engagement is less than the social value of engagement.  As a result, funds tend to engage less than the socially optimal amount.

Finally, we explore the economies of scale and scope. In particular, we examine what happens as funds get larger. While Passive funds report flat economies of scale, active funds face diseconomies of scale, reducing their engagement efficiency as their AUM expands. In light of these findings, we then use counterfactual simulations to explore how the continued rise of passive investing could impact engagement, corporate governance, and firm value in the future.

The Rise of Passive Investing

We simulate a scenario where passive funds control 90% of mutual fund and ETF assets, reflecting the ongoing trend toward passive investing. Our simulation reveals several striking results:

First, as passive funds grow, they increase their engagement activities due to larger holdings, leading to greater value creation for their investors and society.

Second, as active funds shrink, they engage less due to shrinking holdings, however, they generate more value per engagement action. Thus, even though the active fund managers and investors in the found capture less value due to their declining market presence, overall firm value increases. In sum, the shift to passive dominance enhances societal value creation but poses challenges for active funds, highlighting a misalignment between private and social incentives in engagement practices.

Conclusion

Overall, our paper offers novel results on the economics of investor engagement. We find that engagement generates modest but tangible effects on firm value, and we show that funds respond to financial incentives when choosing their engagement targets, consistent with the idea that funds believe engagement matters for firm value. Finally, we show that as the investment landscape continues to evolve, with passive funds gaining more and more prominence, the dynamics of engagement are likely to shift.

Davidson Heath is Assistant Professor of Finance at the University of Utah’s David Eccles School of Business.

Daniele Macciocchi is an Associate Professor at the University of Miami Herbert Business School.

Matthew Ringgenberg is a Professor of Finance at the University of Utah.

The full paper is available here.