NBER Study Reviews Corporate Governance Implications of Indexing

As passive fund assets totaled $5.743 trillion in the U.S. in 2021, academic research explores how passive funds employ investment stewardship.

The concentration of stock ownership in the hands of passive managers could reduce the quality of governance among public companies, new research has found. However, because passive management has created a more concentrated shareholder base, it could also make it easier for an activist investor to obtain the necessary support from a big shareholder.

The big three index managers—BlackRock, State Street Global Advisors and Vanguard—alone control more than a quarter of shareholder votes of S&P 500 companies, according to a research paper released this month by the National Bureau of Economic Research, co-written by Alon Brav of the Fuqua School of Business at Duke University and Nadya and Andrey Malenko of the Ross School of Business at the University of Michigan.

The academic researchers, “conclude that the effect of passive fund growth on governance is non-monotonic [highly variable]: Initial growth in passive funds improves governance, but further growth eventually harms it.”

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The reasoning is that as passive funds control a higher portion of total assets than do active managers, capturing more capital due to lower managerial fees, they disincentivize shareholder activism overall.

“Since management fees are particularly low for index funds, [the argument exists that] index funds have strong incentives to underinvest in stewardship,” wrote the authors.

Likewise, passive fund activism differs greatly from active management activism. Passive funds are less likely to run activist campaigns in individual firms, but are more likely to make an impact by setting broad, market-wide governance standards. Directionally, passive funds, especially the big three firms, tend to support management more often than actively managed funds in proxy votes.

According to the research paper, if there is a takeaway for governance implications from the growth in passive funds over the past decades, it is that such growth

Fee structures, according to the report, impact the capture ratio of additional value created by corporate interventions; as such, due to their lower fee structures, index funds are economically less incentivized to engage in altering proxy votes.

Passive indexes, the authors write, “charge substantially smaller management fees than actively managed funds, [and] their large AUM and ownership stakes often offset the weaker incentives due to smaller fees. This suggests that empirical research should not treat all index funds in the same way.”

Vanguard literature about its investment stewardship philosophy reads, “We steward the Vanguard funds’ global equity index holdings by voting proxies; engaging with company directors and executives; and advocating for market-wide adoption of governance best practices.”

Vanguard spokespeople note it has a team of investment stewardship analysts for its funds and that it views “proxy voting [as] one tool we can use to effect positive change on behalf of the long-term interests of our investors,” with ESG factors and financial performance among the factors of influence.

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Why Bother With Active Management When Mechanistic Passive Does Best Historically?


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