Index Funds Help Create Positive Change At Public Companies

Index Funds Help Create Positive Change At Public Companies

According to an April 23rd article from [email protected], a new study by Wharton faculty members determines that passive investors like large index funds have pressed effectively for shareholder-friendly policies and enjoyed significant success.

Wharton professors Todd T. Gormley, Donald. B. Keim and Wharton doctoral student Ian R. Appel describe their research in the paper, Passive Investors, Not Passive Owners, which finds that passive investors often have a positive impact on governance policies. “For example,” the authors note in their paper, “relative to the sample average, a 10% increase in ownership by passive investors is associated, on average, with a 9% increase in the share of directors on a firm’s board that are independent.”

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Statement from lead author

Index-style fund companies “are increasingly becoming more proactive in their proxy voting,” says finance professor Keim. “Thus, passive institutional investors have a very important, yet unstudied and undocumented, influence on corporate governance. Our paper is the first to provide evidence on this important relationship.”

History of passive index funds

Back in the mid-1970s Vanguard Group founder John C. Bogle created the first index fund, a fund that just held the stocks in the S&P 500, a representative group of the 500 biggest U.S. companies. Bogle believed that the typical active manager could not consistently pick winners enough to outperform market indices. An index fund would get the same return as the overall market and save money by cutting out the research and trading costs borne by active funds.

index funds

Of note, many actively managed funds charge annual fees of 1% or greater of a fund’s assets, and the least expensive index funds have fees less than 10% of that a cost savings that adds up over time through compounding.

The growth in index funds was slow for the first few years, but the industry continued to expand over time. Index funds have become increasingly popular over the last couple of decades, and as of October 2014, index funds held $3.2 trillion in assets, or 36% of the assets in funds owning U.S. stocks (64% owned by actively managed funds).

How passive investors influence public companies

The researchers point out that: “Because passive investors are unwilling to divest their positions in poorly performing stocks, which would lead to [fund] performance deviating from the benchmark, they may place an even greater weight than active fund managers on ensuring effective governance in the firms they own.” They also add: “[Corporate] managers’ knowledge that these passive investors are not likely to sell their shares anytime soon may also give the views of passive investors greater weight than those of active fund managers.”

index funds

While it’s true that passive owners cannot effectively pressure company execs by threatening to sell, holding a big stake in a firm gets executives to at least listen to what fund managers say. Keim notes: “The size of passive investors’ ownership stakes may facilitate activist investors’ efforts to rally support for their demands,” he continues, in reference to investors who are pressing for improved corporate performance. “Bringing just a few of these large passive investors on board can lend credibility to an activist campaign.”

See full PDF below.

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