Jill E. Fisch is Perry Golkin Professor of Law at the University of Pennsylvania Law School; Assaf Hamdani is Professor of Law at Tel Aviv University; and Steven Davidoff Solomon is Professor of Law at UC Berkeley School of Law. This post is based on their recent paper. Related research from the Program on Corporate Governance includes The Agency Problems of Institutional Investors by Lucian Bebchuk, Alma Cohen, and Scott Hirst (discussed on the Forumhere)
Passive investors are the new power brokers of modern capital markets. An increasing number of investors are investing through exchange traded funds and indexed mutual funds, and, as a result, passive funds—particularly the so-called big three of Blackrock, Vanguard and State Street—own an increasing percentage of publicly-traded companies. Although the extent to which index funds will continue to grow remains unclear, some estimates predict that by 2024 they will hold over 50% of the market.
In our paper, Passive Investors, we provide the first comprehensive framework of passive investment. We use this framework to explore the role of passive funds in corporate governance and the capital markets and to assess the overall implications of the rise of passive investment.
A number of commentators have expressed concern, even alarm, over the growth of passive investors. The literature to date, however, ignores the institutional structure of passive funds and the market context in which they operate. Prior criticism has focused on two key attributes of passive funds. First, passive funds, by virtue of their investment strategy, are locked into the portfolio companies they hold. In particular, they cannot follow the Wall Street rule and exit from underperforming companies the way traditional shareholders, particularly active funds, can. Second, passive funds compete against other passive funds primarily on cost. As a result, critics argue that passive investors will be unwilling to incur the costs of firm-specific research and monitoring of their portfolio companies.
We challenge this portrayal of the passive investor business model as incomplete and offer a more nuanced approach. Our key insight is that although index funds are locked into their investments, the shareholders who invest in these funds are not. Like all mutual fund shareholders, investors in index funds can exit at any time by selling their shares and, when they do so, they receive the net asset value of their ownership interest. Moreover, because mutual fund inflows are driven by performance, passive investors risk losing assets if their returns lag those of actively-managed funds on a cost-adjusted basis. As a result, passive investors must compete for investors, and, because they cannot exit, they compete through engagement.
Understanding the business model of passive investors leads us to develop a comprehensive theory of their incentives and behavior. We show that active and passive funds compete for investors differently. Active funds compete based on their ability to generate alpha through the use of their investment discretion—choosing particular securities to under- and over-weight relative to their benchmark on the basis of firm-specific information. If active managers can generate substantial alpha on a cost-adjusted basis, fund investors will exit index funds in favor of actively-managed alternatives. Passive investors therefore seek to reduce the comparative advantage of active funds, i.e., their ability to exploit mispricing to generate alpha. Passive investors must do this by relying on voice, rather than exit. Importantly, because passive investors hold the market, their monitoring need not be and, as a practical matter, cannot be, firm-specific. Instead, passive investors can exploit economies of scale to improve governance across their portfolios.
Our theory finds support in practice. We document the emerging engagement by passive funds and their increasing influence with respect to individual and market wide firm governance. We show that passive investors have responded to the incentives to identify governance weaknesses that contribute to underperformance and mis-pricing and to seek to reduce governance risk. We also document how passive investors are coordinating with and mediating the efforts of shareholder activists. We note that recent empirical research shows that passive investor engagement appears to have a positive impact on governance.
Our theory has important implications for corporate law. Although, we show that recent proposals to disenfranchise passive investors due to governance concerns appear to be misguided, we note that the rise of passive investors raises other potential concerns. These concerns, which have thus far been overlooked, include new types of conflicts of interest, access to information and the concentration of economic power in the hands of a small number of fund sponsors and advisers. We delineate those concerns and the potential regulatory issues they raise.
While the role of passive investors continues to develop, and it is too early to determine the impact of passive investors on economic outcomes, our Article provides a theoretical framework for analyzing passive investor behavior and documents how current passive investor engagement is consistent with that framework. Our understanding of the institutional context that drives passive investor incentives will be critical in evaluating future policies to address their growing role in corporate governance.