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E-MailDaniele Macciocchi is Assistant Professor of Accounting at the University of Utah Eccles School of Business; Davidson Heath is Assistant Professor of Finance at the University of Utah Eccles School of Business; Roni Michaely is Professor of Finance at the Geneva Finance Research Institute – University of Geneva; and Matthew Ringgenberg is Associate Professor of Finance at the University of Utah Eccles School of Business. 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 Forum here); Index Funds and the Future of Corporate Governance: Theory, Evidence, and Policy by Lucian Bebchuk and Scott Hirst (discussed on the forum here); and The Specter of the Giant Three by Lucian Bebchuk and Scott Hirst (discussed on the Forum here).
Over the last three decades, the rise of passively managed index funds has transformed how Americans invest. In 1990 less than 1% of all mutual fund assets were held by passively managed index funds. By 2017 index funds held over $6 trillion, more than 29% of all mutual fund assets. While the flow of assets continues as investors heed the call of lower fees and better average performance, the implications of this fundamental shift in investing remain unclear. The rise of passive investing may have consequences for corporate governance, regulation, and the future of the U.S. stock market.
Our paper, Do Index Funds Monitor? examines whether index funds monitor the firms in their portfolios and hold corporate managers accountable to the same extent that actively managed funds do. If a shareholder disagrees with firm management, she has three options. First, she can voice her opinion by voting against management proposals and in favor of shareholder proposals—including her own. Second, she can engage with firm management and convince them to change corporate policy. Third, she can sell her shares (the “Wall Street Walk”), which will express her lack of confidence in the firm’s future value, and possibly drive the share price down. We examine each of these three monitoring channels using comprehensive data on U.S. equity mutual funds from 2004 to 2017. We find that relative to active funds, index funds are weak monitors that cede power to firm management.
First, the voting behavior of index funds differs sharply from that of active funds. On contentious agenda items (items for which firm management recommended that shareholders vote one way while the proxy advisor ISS recommended the opposite way), index funds voted with firm management 55.5% of the time, while active funds voted with firm management 46.2% of the time. In other words, compared to active funds, index funds are less likely to disagree with firm management. On a wide variety of agenda items pertaining to board elections, corporate governance, disclosure, and executive compensation, index funds were between 9.5% and 13.5% more likely than active funds to vote with firm management. Thus, across the board, index funds cede power to firm management.
Second, we examine funds’ decision to exit by selling the stock. A majority of large index funds do not hold all the stocks in their benchmark index, instead they statistically replicate the index by holding a representative subset. Thus, they could credibly threaten to exit a stock. Yet index funds still exit much less often than active funds, and do not use exit to express dissatisfaction with firm management: Index funds do not exit a position after losing a shareholder vote, whereas active funds do.
Third, we examine the possibility that index funds engage with their portfolio firms “behind the scenes”. We find that index funds never file a Schedule 13D with the SEC, which signals that they do not intend to affect firm policy (Bebchuk and Hirst 2019). Moreover, when index funds hold more of a firm’s stock, we see no change in either the number or type of proposals that are tabled at the annual shareholder meeting. These findings suggest that index funds do not engage with firm management in order to affect corporate policies at their portfolio firms.
Doubts about the role of index funds in corporate governance have prompted a flurry of discussion in the media. Top executives from Blackrock and Vanguard publicly affirmed their commitment to good governance—indeed, they claimed that index funds can be better stewards than active funds. Yet, at the same time, Vanguard’s official voting policy states: “We will give substantial weight to the recommendations of the company’s board, absent guidelines or other specific facts that would support a vote against management.” In theory, passive investors with large positions should have strong incentives to monitor their portfolio firms (Fisch, Hamdani, and Davidoff Solomon, 2018). However, the economics of index investing—low expense ratios and the objective to replicate a benchmark index—suggests that index funds may lack both the incentive and the resources to monitor (as discussed in a paper by Bebchuk, Cohen and Hirst, 2017). On this side, both Richard Weil, a prominent active-fund manager, and a pair of academic researchers recently made the case that because index funds are doomed to be poor monitors, they should voluntarily disenfranchise themselves by committing not to vote. On the other end of the spectrum, other academics proposed tenure voting systems, in which voting rights increase with the length of time that the investor holds their shares. Since index funds exit much less frequently than active funds do, such a system would tilt voting power even more toward index funds.
Our findings speak to this controversy and show that the governance of public corporations is changing. As the rise of passive investing continues, we are moving from a world in which mutual funds provide a check on managerial power to a world in which mutual funds defer to firm management.
The complete paper is available for download here.
