The Case Against Passive Shareholder Voting

In the past few years, investors have begun to embrace the reality that academics have been championing for decades—that a broad-based passive indexing strategy is superior to picking individual stocks or actively managed mutual funds. As a result, millions of investors have abandoned actively managed mutual funds, or ‘active funds,’ in favor of passively managed funds, or ‘passive funds.’ This past year alone, investors in the United States withdrew $340 billion from active funds (approximately 4 percent of the total) while investing $533 billion into passive funds (growing the total by 9 percent).

This historically unprecedented shift in investor behavior is good news for investors, who benefit from greater diversification and lower costs. But the implications for corporate governance are ominous. Unlike active funds, which pick stocks based on their performance, passive funds—a term that includes index funds and ETFs—are designed to automatically track a market index. For this reason, I contend that the growth of passive funds will exacerbate agency cost issues at corporations.

That is because passive funds do not choose investment securities for their performance but automatically to match an index or part of the market. Accordingly, I argue that passive funds lack a financial incentive to invest in improving governance at portfolio companies for three reasons. First, passive funds tend to have very large portfolios and, thus, an investment aimed at improving governance at a single firm is especially unlikely to enhance the fund’s overall performance. Second, passive funds face an acute collective action problem, because any investment in improving governance equally benefits all funds tracking the index, while only the activist fund bears the costs. Third, interventions are especially costly for a passive fund—unlike active funds, passive funds do not generate information about firm performance as a byproduct of trading. Therefore, thoughtful governance interventions require the passive fund to expend additional resources gathering firm-specific information, as well as developing governance expertise. Such expenditures would eat away the cost savings that attracted investors to the passive fund in the first place.

Accordingly, as assets continue to flow into passive funds, managers of those funds will be less likely to engage thoughtfully with portfolio companies and discipline management. In addition, institutional investors that primarily invest in passive funds will cease to moderate hedge fund activism, which means not only that certain beneficial activist interventions will not occur, but also that certain detrimental interventions may garner substantial support. Instead, passive fund managers will adhere to low-cost voting strategies, such as following a proxy advisor or voting ‘yes’ to any shareholder proposal that meets pre-defined qualifications. And without a consensus about what constitutes good governance, there is reason to believe that the proliferation of an unthinking, one-size-fits-all approach to governance will make many companies worse off.

For now, the majority of mutual fund assets are invested in actively managed funds, which means that most institutional investors continue to have an incentive to ensure that their portfolio companies are well-governed. But today, some S&P 500 companies have passive fund ownership in excess of 20 percent and that number continues to rise. In addition, the institutional investors that dominate the passive fund market already have a substantial voice in corporate governance: together, Vanguard, BlackRock, and State Street Global Advisers, whose portfolios primarily consist of passive funds, constitute the largest shareholder of 88 percent of major U.S. companies. In other words, the passive institutional investors are beginning to crowd out the active investors.

In addition, I contend that the optimal amount of active participation in governance is greater than the amount that is necessary to keep stock market pricing efficient. So long as a few active funds police the market for underperforming stocks and use that information in their trading decisions, stock prices will rise and fall with company value. But a small percentage of informed investors cannot control governance outcomes. If passive funds own only 51 percent of a company’s stock, they will be able to determine the success or failure of shareholder proposals, proxy contests, and hedge fund activism, even in the face of total opposition from informed investors. And even with less than voting control, passive funds can still influence governance in many ways. This means that distortions will appear long before stock price inefficiencies do.

Of course, as long as institutional investors house passive funds and active funds under the same roof, the passive funds will be able to free ride off of information generated by active funds. Thus, when there is investment overlap between active and passive funds, those passive funds will catalyze interventions favored by informed investors. But active funds invest in a smaller number of companies than passive funds do and so investment overlap is not guaranteed. And as assets continue to flow out of active funds, there will be even fewer common investments, as well as less information generated by active fund managers.

What can be done to prevent the governance distortion created by the rise of passive investing? I offer a novel policy proposal: Restrict passive funds from voting at shareholder meetings. There is a compelling legal rationale for such a restriction. Passive funds lack governance expertise and firm-specific knowledge and so a thoughtful voting strategy would increase costs without meaningfully improving portfolio returns. Thoughtless voting is also likely to harm investors, as well as other shareholders, especially as passive funds grow in size and influence. In other words, pursuit of either approach would put the passive fund at risk of breaching its fiduciary duty to act in its investors’ best interest. A law restricting passive funds from voting would thus make both investors and fund managers better off. The restriction would also diminish the voice of passive investors in governance, reducing the risk of distortion and preserving the voice of informed investors as a force for discipline.

For more information, please see my recent article, ‘The Case Against Passive Shareholder Voting’ available here. This post has previously been published here.

Dorothy Shapiro Lund is a Harry A. Bigelow Teaching Fellow, Lecturer in Law at University of Chicago Law School.