Passive Investors

Passive Investors

Jill Fisch, Assaf Hamdani, Steven Davidoff Solomon

September 24 2018

Passive investors, such as Vanguard or Blackrock, that track an index and have no discretion over their investments own a growing fraction of publicly-traded securities around the world. Our paper develops a comprehensive framework for passive investment and its implications for corporate governance. 

The potential ability of passive investors to influence decision-making at public companies through their engagement and voting power has led some commentators to call for them to be subject to increased regulation and even disenfranchisement. Critics have focused on two key attributes of passive funds. First, passive funds, by virtue of their investment strategy, are locked into the portfolio companies they hold.  Unlike traditional investors, particularly actively-managed funds, passive funds  cannot increase their investment in underpriced companies or follow the Wall Street rule and exit from overpriced companies.  Second, passive funds compete against other passive funds primarily on cost. As a result, passive investors arguably will be unwilling to incur the costs of firm-specific research and monitoring of their portfolio companies.

We challenge this portrayal of the passive investor business model as incomplete as a matter of both theory and real-world experience.  Instead, we offer a more nuanced approach. We first explain that the claim that index funds compete for investors only against other index funds tracking the same index is naive. Rather, index funds compete, on an ongoing basis, both with other index funds and with actively-managed funds, and they compete along several dimensions – most importantly performance – as well as price. Passive fund sponsors therefore have an incentive to take measures to neutralize the comparative advantage enjoyed by active funds, that is, their ability to use their investment discretion to generate alpha. Because passive investors cannot compete by exiting underperforming companies, they must use voice to prevent asset outflow and, more importantly, to reduce the risk that the companies in their portfolio that are not subject to monitoring by active investors will underperform. 

Second, the existing literature simplistically analyzes the behavior and incentives of passive investors at the level of the individual mutual fund.  Mutual funds are, however, simply a pool of assets, and a true understanding of their incentives requires analysis at the level of the fund sponsor.  Most fund complexes include a mixture of active and passive funds with different fee structures, knowledge bases and investment strategies. This mixture creates the potential for efficient cross-subsidization due to the differing expertise of active and passive funds. Finally, passive funds’ substantial holdings give them both economies of scale and, in many cases, the power to determine the outcome.  Passive funds’ status as pivotal investors not only increases their voting leverage but also reduces their cost of monitoring.

Although proposals to disenfranchise passive investors due to governance concerns appear to be misguided, the rise of passive investors raises other potential concerns.  In particular, the growth of passive investment has led to an increasing concentration of public company ownership in the hands of a small number of sponsors. In addition, the business models of these sponsors raise novel concerns about the incentives for sponsor influence as well as creating potential conflicts of interests. While these concerns should not alter the fundamental balance of power between shareholders and management, they may require courts and lawmakers to reexamine corporate law’s traditional deference to shareholders and consider measures to ensure the integrity of shareholder voting.

Authors

Real name: 
Steven Davidoff Solomon
BERKELEY CENTER FOR LAW AND BUSINESS
Real name: 
Research Member, Board Member
University of Pennsylvania Law School