Passive Investors, Not Passive Owners

Ian Appel

University of Pennsylvania – Finance Department

Todd A. Gormley

University of Pennsylvania – The Wharton School

Donald B. Keim

University of Pennsylvania – Wharton School

Abstract:

Passive institutional investors are a growing and increasingly important component of institutional holdings. To examine whether and by which mechanisms passive investors influence firms’ governance structure, we use an instrumental variable estimation and exploit variation in passive institutional ownership that results from stocks being assigned to either the Russell 1000 or 2000 index. We find that an increase in ownership by passive institutions is associated with more independent directors, the removal of poison pills and restrictions on shareholders’ ability to call special meetings, and fewer dual class share structures. Passive investors appear to exert influence through their large voting blocs — passive ownership is associated with less support for management proposals and more support for shareholder-initiated governance proposals. While we do not find direct evidence that the increased presence of passive investors facilitates activism by other investors, we do find that ownership by passive investors is associated with corporate policies that are likely to mitigate the prospect of an activist campaign, including less cash holdings and higher dividend payouts. In contrast to conventional wisdom, our findings suggest that passive investors play a key role in influencing firms’ governance choices.

Passive Investors, Not Passive Owners – Introduction

There is much evidence to support the idea that institutional investors influence the governance and corporate policies of firms (e.g., Aghion, Van Reenen and Zingales (2013); Brav et al. (2008); Hartzell and Starks (2003)). This evidence, however, primarily focuses on the role of “activists” that accumulate shares and make demands upon managers or “active” fund managers that exit positions when managers perform poorly. Yet, active investors represent only a subset of institutional investors. Many institutions are instead “passive” investors that hold diversified portfolios of stocks with low turnover, thereby distinguishing themselves from “active” managers, and do not actively buy or sell shares to influence managerial decisions. The investment objective of such institutions is to deliver the returns of a particular market index (e.g., S&P 500) or “investment style” (e.g., large-cap value) with fees and expenses that are as low as possible. Although passive investors, like Vanguard and Dimensional Fund Advisors, and the diversified portfolios they manage, reflect a large and growing component of institutional ownership, and more broadly, U.S. stock ownership1, there is little research on their role in influencing firm behavior. This oversight likely stems from a common presumption that passive investors are passive owners that lack both the motives and mechanisms to monitor their large and  diverse portfolios. To address this presumption, we examine both whether and how such passive investors might influence firms’ governance structure.

At first blush, it is unclear why passive institutional investors would affect firms’ governance choices. Unwilling to accumulate or exit positions, which would lead to deviations from the underlying index weights, passive institutions lack a traditional lever used by non-passive investors to influence managers. Given their diversified holdings across hundreds of stocks, passive investors may also lack the resources necessary to research and individually monitor each stock in their portfolio. Moreover, it is unclear whether such institutional investors should even care about firm-specific policies or governance choices. Unlike actively-managed funds that attempt to outperform some benchmark, index funds and other non-index passive funds seek to deliver the performance of the benchmark, and any improvement in one stock’s performance will simply increase the performance of both the institution’s portfolio and the underlying benchmark. Consistent with these arguments, interviews with investment managers at a number of large U.S. institutions suggest that many passive investors do not closely monitor firms’ policy choices (Useem et al. (1993)), and recent evidence suggests passive investors have no effect on firms’ investment policies or innovation (Aghion, Van Reenan, and Zingales (2013)).

Passive Investors

See full PDF below.