Why Passive Investing Increases Corporate Activism by Knowledge@Wharton
If there’s a rap on passive, index-style investing it is this: Despite being big shareholders, mutual fund firms that use this autopilot approach to investing have no incentive to prod companies to do better.
“I think the common wisdom is that they just don’t care about governance,” says Wharton finance professor Todd A. Gormley. “In fact, some activists have come out and said that they think the growth of passive investing is actually bad for governance.”
But it isn’t necessarily so. In a 2015 paper, “Passive Investors, Not Passive Owners,” Gormley and two colleagues — Wharton finance professor Donald B. Keim and Ian R. Appel from the Carroll School of Management at Boston College — showed that the mutual fund firms which focus on passive investing do indeed cast their shareholder votes to press for change, and do it effectively.
Now, in a follow-up paper using a similar technique, the three researchers show how passive investing also leads to more aggressive shareholder activism than there would be otherwise, as passive fund firms add their clout to campaigns waged by activist investors. Their paper is titled, “Standing on the Shoulders of Giants: The Effect of Passive Investors on Activism.”
“We’re asking whether two recent trends in U.S. stock ownership — the rise of activism and the growth of passive investors — are related,” Gormley says. “Might the rise in passive ownership actually, somehow, be facilitating activism?”
About 400 activist campaigns are launched per year, the researchers write, a large upswing in recent years, and activists have become more ambitious in their goals, and more successful. Activists have various demands, such as getting more outsiders on corporate boards, changing policies on anything from environmental or labor issues to dividend payments, or eliminating poison pills that discourage takeover battles that can push up stock prices.
“Some activists have come out and said that they think the growth of passive investing is actually bad for governance.”–Todd A. Gormley
As shareholders, fund firms with passive, or index-style funds, can have enormous clout — if they care to use it.
“Passively managed mutual funds … have quadrupled their ownership share of the U.S. stock market over the last 15 years and now account for more than a third of all mutual fund assets,” the researchers write. “Furthermore, the institutions that offer these funds, like Vanguard, State Street and Blackrock, are now often the largest shareholders of U.S. companies.”
Mutual funds that use a passive approach simply buy and hold the stocks in an underlying index such as the Standard & Poor’s 500, Russell 1000 or Russell 2000, avoiding the costly process of searching for market-beating stocks. Many studies have shown that over the long term, passive investing produces better returns than active investing, because of cost savings and the fact that few active managers can find enough market-beating stocks year in and year out.
But because an index fund must own certain stocks regardless of their prospects, many market observers have assumed these fund firms don’t bother with the difficult, expensive and often fruitless business of pressing CEOs and board members for change. In fact, the work by Appel, Gormley and Keim shows the opposite: Since these funds are stuck with stocks in their underlying indexes, they have an extra incentive to prod those companies to do well. Actively managed funds, in contrast, can simply dump stocks in firms they think are poorly run.
The earlier paper showed, for instance, that firms with more shares owned by passive investors had more independent directors — outsiders more likely to be gadflies than board members who were among the company’s executives.
The newer work uses a similar technique, covering the period from 2008 to 2014, to compare companies that are much the same except for the amount of passive ownership. It focuses on companies near the cutoff point for being included in the Russell 1000 index, which has the 1,000 largest U.S. companies ranked from biggest to smallest, and the Russell 2000, which has the next largest 2,000 firms, also ranked from large to small.
“We see more proxy fights when there is more passive ownership.”–Todd A. Gormley
Because index funds allocate their money on the basis of each firm’s size, based on market capitalization, the companies at the bottom of the Russell 1000 have little passive-fund ownership, while those at the top of the Russell 2000 have a lot. But those two groups of firms are of similar size and represent a cross section of industries.
“During our sample period, the ownership by passively managed mutual funds is about 40% higher, on average, for stocks at the top of the Russell 2000 index relative to stocks at the bottom of the Russell 1000 index,” the researchers write.
The companies with more passive ownership — those at the top of the Russell 2000 — were no more likely, overall, to be targets of activist campaigns than the firms with less passive ownership, but neither were they less likely to be targeted. That challenges the common wisdom about passive ownership weakening shareholder interest in governance.
Proxy Fights and Hostile Takeovers
They key finding, though, was the difference between the types of activist campaigns waged against the two groups of firms.
Those with more passive ownership were more likely to be targets of activist campaigns to replace board members, a type of campaign that can be particularly difficult.
“We see more proxy fights when there is more passive ownership,” Gormley adds. Hostile takeover attempts also increase alongside passive ownership, he says. And with more passive ownership, those attempts tend to be more successful. In many cases, activism results in a negotiated settlement with management rather than a showdown in a proxy fight.
“We also see a shift toward more aggressive and expensive tactics,” Gormley says.
“Most of the larger passive institutions have built fairly extensive in-house governance groups that are particularly cognizant of governance issues in their larger holdings.”–Donald B. Keim
The rise in passive ownership, Gormley explains, has caused a greater concentration of ownership in public corporations. In the past, an effort like a proxy fight might require contacting legions of individuals who own the company’s shares. But now individual investors are more likely to own shares through mutual funds, which can cast votes on behalf of the funds’ investors.
“It’s much less costly to organize a campaign” when ownership is concentrated, Gormley says.
Passive funds merely seek to duplicate the performance of their underlying indexes, and are generally judged on how well they do this. Hence, an index fund is successful even if it loses money in a given period. Nonetheless, the passive fund companies do have a financial incentive to see the companies in their indexes perform well, since that will attract more investors, Gormley says, explaining why passive funds care about governance issues.
While index fund firms pride themselves on keeping costs as low as possible, many have clearly determined that working to improve corporate governance is worthwhile, says Keim.
“Most of the larger passive institutions have built fairly extensive in-house governance groups that are particularly cognizant of governance issues in their larger holdings,” Keim adds. “Because of this, I suspect it is relatively inexpensive to commit to join activist efforts in problem cases among these stocks.”
Passive funds, he adds, don’t often launch activist efforts themselves, but lend their clout to campaigns begun by others. Certain money managers and hedge funds, for instance, make a practice of accumulating large blocks of shares and then pressing for change.
“To the extent that we believe these activists are creating value, and the passive investors are helping them do this, this is good for investors,” Gormley notes.