Passive Investors, Not Passive Owners via SSRN

Ian Appel

University of Pennsylvania – Finance Department

Todd A. Gormley

University of Pennsylvania – The Wharton School

Donald B. Keim

University of Pennsylvania – Wharton School

April 22, 2015


Passive institutional investors are an increasingly important component of U.S. stock ownership, and their influence on firm-level governance is widely debated. To examine whether and by which mechanisms passive investors influence firms’ governance structures, 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. Our findings suggest that passive investors play a key role in influencing firms’ governance choices; 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. Consistent with the observed differences in governance having a positive influence on firm value, we find that passive ownership is also associated with improvements in firms’ longer-term performance.

Passive Investors, Not Passive Owners – Introduction

While there is considerable evidence 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 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, such “active” investors represent only a subset of institutional investors. Increasingly, many institutions are instead “passive” investors that hold diversified portfolios of stocks with low turnover and do not actively buy or sell shares to influence managerial decisions.1 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 minimal fees and expenses. The rapid growth and large ownership stakes of such passive investors raises questions about how effectively managers are being monitored. Many worry that passive investors lack both the motives and mechanisms to monitor their large, diverse portfolios, and that the increasing market share of such “lazy investors” weakens firm-level governance and hurts performance (The Economist, 2015). However, others counter that passive investing does not equate with passive ownership.2 In this paper, we examine whether passive institutional investors influence firms’ governance structures, and ultimately, performance.

There are many reasons to suspect that the growth of passive investors weakens the governance of firms. First, such institutional investors may lack an incentive to monitor managers. 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. Second, such investors may be less able to exert influence over managers. Specifically, by seeking to minimize deviations from the underlying index weights, passive institutions lack a traditional lever used by non-passive investors to influence managers—the ability to accumulate or exit positions.

Third, given their diversified holdings across hundreds of stocks, passive investors may lack the resources necessary to research and individually monitor each stock in their portfolio.

And yet, there are reasons why passive investors may seek to improve firms’ governance choices and performance. If fund flows respond to absolute (rather than just relative) performance, passive managers will have an incentive to improve overall market performance because fund fees are based on assets under management, which will increase with both positive fund flows and positive performance (Black (1992)). Moreover, because passive institutions are less able to divest their positions in poorly performing stocks, they may place even greater weight than active fund managers on ensuring effective governance in the firms they own (Romano (1993), p.83). Finally, all institutional investors have a fiduciary duty to manage their funds and vote their proxies in the best interest of shareholders.

Passive Investors

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