Index Funds Get a Bad Rap – Why That’s Wrong

Index funds have revolutionized investing. Once a niche strategy, indexing now dominates Wall Street, with giants like Vanguard, BlackRock, and State Street—the “Big Three”—holding significant stakes in most large U.S. corporations. Understandably, that’s made a lot of people nervous.

A big question looms over this new reality: Do index funds actually monitor the companies they own? A highly cited study by Heath, Macciocchi, Michaely, and Ringgenberg (2022)—let’s just call them HMMR—says no. Their conclusion is alarming: as index ownership rises, firm performance weakens, managers get paid more regardless of results, and corporate governance takes a hit.

But here’s the thing: they got it wrong.

In our new paper, we revisit the data and methods HMMR used and find that the scary headlines don’t hold up. Their study made a few key mistakes—mistakes that, once corrected, make the picture look very different.

So what went wrong?

HMMR use a popular strategy in finance research: comparing companies that just barely make it into one index (e.g., the Russell 2000) versus those that just barely stay in another (e.g., the Russell 1000). This index cutoff creates a natural experiment. Stocks on either side are pretty similar, except for one big thing: the ones that fall into the Russell 2000 get snapped up by more index funds. HMMR used these “index switchers” to estimate the effects of index fund ownership on firm outcomes.

But here’s the catch: their analysis introduces a fundamental mismatch.

HMMR tried to estimate how moving between these two indexes affects firm behavior by lumping all the “switchers” and “stayers” into one giant statistical model. Unfortunately, this introduced apples-to-oranges comparisons between firms that were in different indexes to begin with. The result? They were attributing performance differences to index funds when they were really due to the companies being fundamentally different from the start.

Fixing the framework

We took their data and their code and made just one simple fix: we made sure the companies being compared were truly similar at the outset. When we did that, the big, scary effects of index fund ownership vanished.

Managers didn’t suddenly start slacking off when index funds bought more shares. Pay-for-performance incentives didn’t deteriorate. Corporate governance didn’t weaken. And firm performance—measured by metrics like return on assets and Tobin’s Q—didn’t decline.

If anything, we found signs of better alignment between pay and performance.

More Than a Single Fix

We didn’t stop at that one correction. We also addressed other methodological oversights that further skewed HMMR’s results.

First, we account for whether a company’s index status changed again after the initial switch. HMMR’s model didn’t, meaning some “treated” firms may not have remained treated at all. Second, we control for firm size—a major driver of index assignments as well as executive pay, governance structure, and performance. Ignoring this factor makes it hard to isolate the impact of index ownership. Lastly, we implement a combined, corrected approach that leverages both types of index switches in one unified analysis. This not only boosts statistical power, but also helps researchers avoid cherry-picking results across subsamples.

None of these adjustments are exotic. They’re small, standard improvements that strengthen the reliability of any empirical study. But together, they paint a clearer picture—and that picture doesn’t look anything like the one HMMR drew.

Not all investors are created equal

One of HMMR’s central claims is that index funds displace active mutual funds, which presumably monitor companies more closely. If true, that might explain a decline in oversight. But we show that’s not what’s happening.

Instead, the rise in index fund ownership tends to come at the expense of smaller, more fragmented institutional investors—the kind that own tiny stakes and have little incentive or ability to monitor. In contrast, the Big Three tend to hold larger stakes, which means they have more to lose if a company underperforms—and more leverage to push for change.

That’s a big deal. It means the shift toward index ownership isn’t necessarily a move toward passivity. It might actually be a consolidation of influence in the hands of players with the most skin in the game.

Why this matters

The broader debate about index funds is often painted in black and white. Either they’re saviors of low-cost investing, or they’re silent enablers of corporate mismanagement. The truth is more complicated.

Our research shows that when you use the right tools and make the right comparisons, the data tell a very different story than the one HMMR presented. Index funds aren't dragging down governance or firm value. If anything, they’re holding steady—or even helping.

To be clear, this doesn’t mean index funds are perfect stewards. Real concerns remain about the concentration of ownership and how these firms exercise their influence. But if we’re going to shape policy or public opinion around these issues, we should do so based on sound evidence—not shaky comparisons. We owe it to the public, and to the markets, to get the evidence right.

Bottom line: The narrative that index funds are passive passengers doesn't hold up. They may be low-cost, but that doesn’t mean they’re low impact.

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By Todd Gormley (Washington University in St. Louis, NBER, and ECGI) and Hwanki Brian Kim (Baylor University)

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