The Agency Problems of Institutional Investors

Abstract

We analyze how the rise of institutional investors has transformed the governance landscape. While corporate ownership is now concentrated in the hands of institutional investors that can exercise stewardship of those corporations that would be impossible for dispersed shareholders, the investment managers of these institutional investors have agency problems vis-à-vis their own investors. We develop an analytical framework for examining these agency problems and apply it to study several key types of investment managers. We analyze how the investment managers of mutual funds-both index funds and actively managed funds-have incentives to underspend on stewardship and to side excessively with managers of corporations. We show that these incentives are especially acute for managers of index funds, and that the rise of such funds has system-wide adverse consequences for corporate governance. Activist hedge funds have substantially better incentives than managers of index funds or active mutual funds, but their activities do not provide a complete solution for the agency problems of institutional investors. Our analysis provides a framework for future work on institutional investors and their agency problems, and generates insights on a wide range of policy questions. We discuss implications for disclosure by institutional investors; regulation of their fees; stewardship codes; the rise of index investing; proxy advisors; hedge funds; wolf pack activism; and the allocation of power between corporate managers and shareholders.

Common-Ownership Concentration and Corporate Conduct

“…Their model thus shows agency conflicts between shareholders and managers do not necessarily weaken the predictions of the above theories. Instead, agency conflicts that may reduce incentives especially of passively diversified investors to engage in governance (Bebchuk et al 2017) can be the vehicle by which CoOCo reduces investment and output, and at the same time increases industry profits. Because shareholders design incentive contracts the manager takes as given, their model also clarifies that managers need not be aware of their and competitor firms' ownership structures for common ownership to affect corporate behavior.…”

“…Relatedly, some have argued that passive funds' competitive pressures imply their primary objective is cost reduction, leading to reduced incentives to engage to increase the value of the firms they beneficially own on behalf of their investors, see an informal discussion in Bebchuk et al (2017). The premise of this argument is disputed and appears to conflict with empirical facts, as discussed below.…”

Democracy in America at work: the history of labor’s vote in corporate governance

“…307 The largest five shareholders (mostly mutuals) owned an average 20.8% in the top-twenty corporations. 308 It has been found that mutual firms have already caused rising consumer prices. 309 This has been described as "the major new antitrust challenge of our time."…”

The Party Structure of Mutual Funds

“…shares. Moreover, active managers face somewhat stronger voting incentives than those of passive managers (Kahan and Rock, 2007;Shapiro-Lund, 2017;Bebchuk, Cohen, and Hirst, 2017). An active manager can improve their portfolio's return relative to competitors by taking actions that increase the value of a stock in which the manager is overweight relative to the market.…”