Institutional ownership has grown tremendously over the last decades, rising to more than 70% of US public firms. The composition of institutional ownership has also changed, with a remarkable growth in passive funds: The fraction of equity mutual fund assets held by passive funds has increased six-fold from around 5% to 30%. The Big Three index fund managers alone now cast about 25% of votes in S&P 500 firms. How active and passive asset managers monitor and engage with their portfolio companies has thus become of utmost importance for the governance and performance of public firms. In 2018, the SEC chairman Jay Clayton encouraged the SEC Investor Advisory Committee to examine ‘how passive funds should approach engagement with companies’, and during the 2018 SEC Roundtable on the Proxy Process, Senator Gramm noted that ‘what desperately needs to be discussed [in the context of index fund growth] ... is corporate governance.’
There is considerable debate among academics and policy makers about the governance role of asset managers and passive funds in particular. The critics of passive funds are concerned that they may not have sufficient incentives to invest in stewardship, while the proponents believe that these critiques are unfounded. The empirical evidence is also mixed, with some studies finding positive and others finding negative effects of passive funds on governance.
Motivated by these ongoing academic and policy discussions, our recent paper provides a theoretical framework to analyze the governance role of asset managers. We are interested in the following questions. How does competition among funds affect fund managers’ incentives to engage in governance? What are the effects of passive fund growth? And what are the potential effects of policy proposals that have been put forward to improve the governance role of asset managers?
In our model, fund investors decide how to allocate their capital by choosing between active and passive funds and making private savings. Passive funds are restricted to investing their assets under management (AUM) in the market portfolio, whereas active funds invest strategically to exploit mispricing. Each fund can engage with its portfolio companies, which involves direct interaction and engagement with the company’s management, informed voting, and other tactics that could improve governance and increase firm value.
The reason fund managers have incentives to engage is that by increasing the value of their portfolio companies, they increase the value of their AUM and, thereby, the fees they can collect. The higher is the fund’s stake in the firm, the more its AUM increase in value due to engagement, giving the fund stronger incentives to engage. Likewise, the higher are the fees charged by the fund to its investors, the more is captured by the fund from this increase in value, increasing the fund’s incentives to engage.
Our paper has several important implications.
Passive fund growth may improve governance even if it leads to lower fund fees.
A common concern is that the growth in passive funds is detrimental to governance due to the lower fees that passive fund managers charge and, thereby, their lower incentives to stay engaged. We show that while passive fund growth indeed decreases fund fees, it may nevertheless be beneficial for governance. The reason is that fund fees do not decrease in isolation: lower fees are accompanied by higher AUM, allowing funds to take larger stakes in their portfolio companies. These larger stakes, in turn, give funds stronger incentives to engage, which may counteract the negative effect of lower fees.
It matters whether passive funds replace retail investors or active funds in firms’ ownership.
More generally, we show that the effect of passive fund growth crucially depends on whether passive funds replace retail investors or actively managed funds in firms’ ownership structures. In the former case, passive fund growth is beneficial for governance: even though their fees are relatively low, passive funds have stronger incentives and ability to engage than the retail investors they replace. In the latter case, however, passive fund growth can hurt governance: since active funds charge higher fees to their investors, they internalize a larger part of the benefits from their engagement and thus may have stronger incentives to engage than the passive funds that replace them. Moreover, the competition for investor funds reduces active asset management fees and this, in turn, decreases even active funds’ incentives to engage. Overall, our results imply that the effects of passive funds can be heterogeneous across firms, which can help reconcile the conflicting empirical evidence about their impact on governance.
There can be a trade-off between governance and fund investors’ well-being.
Our paper points out that as passive funds grow, there can be a trade-off between funds’ engagement in governance and fund investors’ well-being. Intuitively, fund investors benefit from passive fund growth if it increases competition among funds and substantially decreases asset management fees. But lower fees decrease funds’ incentives to engage and hence are detrimental to governance. Put differently, effective fund manager engagement requires that funds earn sufficient rents from managing investors’ assets, which comes at the expense of fund investors.
Investments in stewardship have both positive and negative effects.
A common concern about passive funds is that they do not have sufficient resources to monitor and engage with their portfolio companies. Given this concern, it is natural to suggest policies inducing passive funds to increase investments in their stewardship teams. We show that such policies have both positive and negative effects. On the one hand, increasing funds’ investments in stewardship induces them to engage more, which increases the value of their portfolio firms. On the other hand, since financial markets rationally anticipate the effects of increased engagement on firms’ valuations, the overall market valuations go up, reducing the expected returns of new fund investors. As a result, such regulations are not necessarily beneficial to all investors despite their positive effects on governance. Likewise, fund managers do not always benefit from increasing their stewardship teams. In particular, since such stewardship investments may lead to a decline in future expected equity returns due to higher valuations, the fund may experience outflows and thereby a reduction in its asset management fees.
Overall, our paper adds to the academic and policy debate on the governance role of passive funds. In addition to the arguments presented in that debate, our findings point to other important effects of passive fund growth and proposed policy regulations that need to be taken into account.
This post was originally published on the Columbia Law School Blue Sky Blog and is based on the authors’ article ‘Corporate Governance in the Presence of Active and Passive Delegated Investment’, recently published in the European Corporate Governance Institute (ECGI) - Finance Research Paper Series.
Adrian Aycan Corum is an assistant professor at the Samuel Curtis Johnson Graduate School of Management, Cornell University.
Andrey Malenko is an associate professor of finance at the Stephen M. Ross School of Business, University of Michigan.
Nadya Malenko is associate professor of finance at the Stephen M. Ross School of Business, University of Michigan.