Index Funds and the Future of Corporate Governance: Theory, Evidence, and Policy

Abstract

Index funds own an increasingly large proportion of American public companies. The stewardship decisions of index fund managers-how they monitor, vote, and engage with their portfolio companies-can be expected to have a profound impact on the governance and performance of public companies and the economy. Understanding index fund stewardship, and how policymaking can improve it, is thus critical for corporate law scholarship. In this Article we contribute to such understanding by providing a comprehensive theoretical, empirical, and policy analysis of index fund stewardship. We begin by putting forward an agency-costs theory of index fund incentives. Stewardship decisions by index funds depend not just on the interests of index fund investors but also on the incentives of index fund managers. Our agency-costs analysis shows that index fund managers have strong incentives to (i) underinvest in stewardship and (ii) defer excessively to the preferences and positions of corporate managers. We then provide an empirical analysis of the full range of stewardship activities that index funds do and do not undertake. We analyze four dimensions of the Big Three's stewardship activities: the limited personnel time they devote to stewardship regarding most of their portfolio companies; the small minority of portfolio companies with which they have any private communications; their focus on divergences from governance principles and their limited attention to other issues that could be significant for their investors; and their pro-management voting patterns. We also empirically investigate five ways in which the Big Three could fail to undertake adequate stewardship: the limited attention they pay to financial underperformance; their lack of involvement in the selection of directors and lack of attention to important director characteristics; their failure to take actions that would bring about governance changes that are desirable according to their own governance principles; their decision to stay on the sidelines regarding corporate governance reforms; and their avoidance of involvement in consequential securities litigation. We show that the body of evidence is, on the whole, consistent with the incentive problems that our agency-costs framework identifies. Finally, we put forward a set of reforms that policymakers should consider in order to address the incentives of index fund managers to underinvest in stewardship, their incentives to be excessively deferential to corporate managers, and the continuing rise of index investing. We also discuss how our analysis should reorient important ongoing debates regarding common ownership and hedge fund activism. The policy measures we put forward, and the beneficial role of hedge fund activism, can partly but not fully address the incentive problems that we analyze and document. These problems are expected to remain a significant aspect of the corporate governance landscape and should be the subject of close attention by policymakers, market participants, and scholars.

The new permanent universal owners: Index funds, patient capital, and the distinction between feeble and forceful stewardship

“…From a corporate governance perspective, the rise of the Big Three presents a puzzle. The Big Three generally are not able to sell ('exit' in the vocabulary of Hirschman, 1970), because they are almost entirely passive asset managers (Bebchuk & Hirst, 2018).…”

“…We believe that the ongoing debates on the rise of passive investing (see for instance Braun, 2016;Bebchuk & Hirst, 2018;Haberly et al, 2019;Jahnke 2019aJahnke , 2019bPetry et al, 2019) do not yet fully appreciate the transformative and potentially disruptive undercurrent that comes with the money mass-migration into the Big Three as Permanent Universal Owners. For instance, a growing body of literature in the fields of law and economics is concerned with the increase in 'horizontal shareholding' (Elhauge, 2016) -which means that competing listed firms now often have the same 'common owners' (Schmalz, 2018;Backus et al, 2019), such as index funds or other large investors (e.g.…”

“…Institutions as well as private investors are increasingly shifting money from actively managed mutual funds to passively managed index funds (Bebchuk & Hirst, 2018Fichtner et al, 2017). Index funds replicate established stock indexes, such as the American S&P 500 or the British FTSE 100 while minimizing investor fees (Petry et al, 2019).…”

“…This is markedly different from the fragmented actively managed mutual funds industry characterized by centrifugal market forces -there is no significant advantage from being much bigger than the competitors. In contrast, first-mover advantage combined with powerful economies of scale and liquidity benefits of large index funds -centripetal market forces -make it unlikely that the dominant position of this trio of passive asset managers is going to be challenged in the near future (Bebchuk & Hirst, 2018Bogle, 2019). Haberly et al (2019) aptly characterize the Big Three as 'digital asset management platforms' that cause 'winner-take-all market share consolidation'.…”

Investing for long-term value creation

“…However, US evidence on proxy voting (Bolton et al 2019) indicates that mutual funds, including the large passive asset managers (Black-Rock, Vanguard and State Street), are more narrowly 'money conscious' investors that often vote with management, while pensions funds support a more social and environment-friendly orientation of the firm. Moreover, Bebchuk and Hirst (2019) show that mutual funds have an incentive to under-invest in stewardship, as they bear the full cost but only get a tiny part of the benefit. 4 For Europe, Dimson, Karakaş, and Li (2018) find that institutional investors, in particular pension funds, are active in coordinated engagement to influence firms on environmental and social issues.…”