Shareholder Governance through Disclosure

The following post comes to us from Jordan Schoenfeld of the Department of Accounting at the University of Michigan.

Index fund sponsors today oversee about 18% of all mutual fund and ETF assets (or $2.3 trillion), but their ability to govern is hampered by a pressing need to keep expense ratios low (ICI, 2013). Thus traditional governance channels, such as evaluating and guiding project selection by managers (intervention), are foreclosed to them. Neither can these fund sponsors strategically trade in response to private information, because they must hold the index. Nonetheless, index fund sponsors would still like to govern their portfolio companies, because high index returns mean more inflows into their funds and fees. In my paper, Shareholder Governance through Disclosure, which was recently made publicly available on SSRN, I conjecture that index fund sponsors govern by asking management of firms to disclose more about their activities. These disclosures can facilitate the monitoring activities of all stakeholders and increase firm value, thus benefiting the index fund sponsor. For example, more disclosure enhances other blockholders’ monitoring activities and makes stock prices more informative about management’s actions. In addition, eliciting such disclosures about current projects undertaken by management does not require the index fund sponsor to invest in and acquire specific skills about how to run the business. This feature of disclosure makes it particularly attractive to index fund sponsors, who compete by keeping their expenses low.

The demand for disclosure by index fund sponsors contrasts the demand for disclosure by other large owners. Other large owners, even the passive ones, have incentives to gather firm-specific information privately and act on it either by intervention or by trading (e.g., Admati and Pfleiderer, 2009). Thus, their desire for public disclosure depends on the type of news (good or bad) as well their dynamic trading or intervention strategy. Index funds, on the other hand, can neither strategically trade nor intervene. Therefore, I conjecture that, on average, an exogenous entry of index funds should lead to increased overall disclosure over the subsequent years.

I use S&P 500 index inclusion as the key economic phenomenon to test whether index fund sponsors demand more disclosure from management for governance purposes. Index inclusion generates two kinds of ownership variation: the percentage ownership stake that index funds take in the firm, and the weight of that firm as a percent of index fund assets under management (AUM). These ownership measures are exogenous from a given firm’s manager’s perspective because he cannot directly control index fund AUM, nor can he directly control the performance of all other firms in the index, which affects his firm’s designated weight in the index. The index fund ownership stakes determine the power that index fund sponsors have over management, as well as the benefits index funds receive when they exert governance over management. Each treatment firm can also be closely matched to a control firm, and exploiting each inclusion firm’s behavior pre and post inclusion relative to the matched control firm results in a difference-in-difference (D-in-D) regression setting that eliminates time varying effects common to both firms, any inclusion effect common to all inclusion firms, and all firm fixed effects.

I use a sample of 368 S&P 500 index inclusion firms (and 368 control firms) over the period of 1994-2010. I find that for a one standard deviation increase in index fund shareholdings, 8-K filings increase by 17.81%, 8-K document counts increase by 31.12%, and supplementary financial statement filings increase by 8.90%. These results suggest that index fund sponsors are more effective at eliciting disclosure when they buy a larger stake in a firm. Forcing management to disclose more is also costly for index fund sponsors. I therefore conjecture that these fund sponsors will focus their efforts on firms that form a greater portion of their portfolio. Accordingly, I find that when the weight of the firm as a percent of index fund AUM increases by one standard deviation, 8-K filings increase by 10.27%, 8-K document counts increase by 18.19%, and supplementary financial statement filings increase by 12.71%. If management is entrenched, I conjecture that index fund sponsors may be less effective in their goal of eliciting more disclosure. I find that less entrenched managers provide more disclosure for the same amount of increase in index fund shareholdings and the weight of the firm as a percent of index fund AUM.

I next measure the effect of the increase in disclosure. I first show that analyst forecast errors decrease relative to control firms in a D-in-D manner when the treatment firm, i.e., the firm joining the index, gets a larger ownership stake from index funds. These firms also experience lower bid-ask spreads (again in a D-in-D setting). This reduction in bid-ask spreads may be unrelated to the improved disclosure environment, but could occur simply because of increased uninformed trading resulting from index fund rebalancing and liquidity needs. I use a structural model to separate the disclosure effect and the trading effect of index fund ownership on bid-ask spreads, and find that the disclosure effect is significant.

To further establish that my results relate well to industry practice, I showcase them in the context of BlackRock. BlackRock is one of the largest index fund sponsors, the largest shareholder in over 20% of publicly traded U.S. companies, and the manager of over $4 trillion in assets (Craig 2013). BlackRock’s Global Corporate Engagement website provides several relevant insights, three of which I provide here: (1) BlackRock engaged with roughly 1,500 public companies in 2012; (2) “The reporting and disclosure provided by companies forms the basis on which shareholders can assess the extent to which the economic interests of shareholders have been protected and enhanced and the quality of the board’s oversight of management”; and (3) “Where company reporting and disclosure is inadequate or the approach taken is inconsistent with our view of what is in the best interests of shareholders, we will engage with the company and/or use our vote to encourage better practice.” In addition, BlackRock acknowledges that they retain the proxy advisory firms Institutional Shareholder Services (ISS) and Glass Lewis, which offer several services focused on getting additional disclosures out. For example, Glass Lewis’s “Proxy Talk” service allows index fund sponsors to directly question management, which “[fosters] improved disclosure of the relevant facts,” according to Glass Lewis’s website.

My study makes two contributions to the literature: first, I show how index fund sponsors govern, a subject that has not received due attention in the literature. For example, Mullins (2014) shows that firms that get included in the Russell 1000 index make fewer diversifying acquisitions and are more likely to face resistance from shareholders to management proposals. He interprets these changes as an index inclusion effect. My study, on the other hand, uses the index inclusion setting to identify my hypothesis that index fund sponsors govern by eliciting more disclosure from firms. Second, theory suggests that disclosure can alleviate agency problems and improve governance (Verrecchia, 2001; Bond, Edmans, and Goldstein, 2012). I show that this theory can be usefully applied to passive and cost-conscious owners such as index fund sponsors. Most important, prior studies such as Lang and Lundholm (1996), Healy et al. (1999), and Bushee and Noe (2000) show that disclosure is associated with institutional investor shareholdings. Those studies use these associations to argue that certain institutional investors are attracted to firms with certain disclosure practices, and that management may adopt disclosure practices to attract such investors. Index funds have no such leeway to choose their portfolio firms. Using an exogenous shock to represent causality, I show that index fund sponsors use disclosure as a mechanism to govern their portfolio firms.

The full paper is available for download here.


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