Passive Investors, Not Passive Owners

The following post comes to us from Ian Appel, Todd Gormley, and Donald Keim, all of the Department of Finance at the University of Pennsylvania.

In our paper, Passive Investors, Not Passive Owners, which was recently made publicly available on SSRN, we examine whether passive institutional investors, like Vanguard and Dimensional Fund Advisors, influence firms’ governance structure. Although passive institutional investors, which seek to deliver the return of a market index with expenses that are as low as possible, reflect a large and growing component of U.S. stock ownership, there is little research on their role in influencing firm behavior.

The lack of research on passive institutional investors likely stems from a presumption that such investors lack both the resources and motives to monitor their large and diverse portfolios. For example, unwilling to accumulate or exit positions, which would lead to deviations from the underlying index weights, passive institutions lack a traditional lever used by non-passive investors to influence managers. Moreover, it is unclear whether passive institutional investors should even care about firm-specific policies or governance choices. Unlike actively-managed funds that attempt to outperform some benchmark, passive funds seek to deliver the performance of the benchmark, and any improvement in one stock’s performance will simply increase the performance of both the institution’s portfolio and the underlying benchmark.

And yet, there are many reasons to expect that passive investors play a key role in affecting firms’ governance choices. Because passive investors are unwilling to divest their positions in poorly performing stocks, which would lead to performance deviating from the benchmark, they may place even greater weight than active fund managers on ensuring effective governance in the firms they own. As F. William McNabb III, Chairman and CEO of the Vanguard funds recently stated, “We’re going to hold your stock if we like you. And if we don’t. We’re going to hold your stock when everyone else is piling in. And when everyone else is running for the exits. That is precisely why we care so much about good governance.” Additionally, if fund flows respond to absolute performance, passive managers will have an incentive to improve overall governance and market performance because fund fees are based on assets under management, which will increase with both positive fund flows and positive performance.

There are also many mechanisms by which passive investors might influence firms’ governance. First, institutions that manage passive funds often own a sizable proportion of a firm’s shares and actively make their views on issues related to governance known to managers. 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. Second, the size and concentration of passive investors’ ownership stakes may facilitate activist investors’ efforts to rally support for their demands. Bringing just a few of these large investors on board can lend creditability to an activist campaign. Finally, passive institutional investors may be more effective at monitoring managers than retail investors that directly hold stocks.

To identify the impact of passive investors on firms’ corporate governance and other policies, we exploit variation in ownership by passive institutional investors (from SEC 13F filings) that occurs around the cutoff point used to construct two widely used market benchmarks, the Russell 1000 and Russell 2000 indexes. A stock’s index assignment has a significant impact on the extent of ownership by passive institutions that use the Russell indexes as benchmarks. For example, the 750th through 1,000th largest stocks (in terms of market capitalization) will be included in the Russell 1000 and be given very small portfolio weights within the index since they represent the smallest firms in their index, while the 1,001st through 1,250th largest stocks will be included in the Russell 2000 and be given weights in that index that are an order of magnitude larger because they represent the largest firms in their index. Because there is a comparable amount of passive assets benchmarked to each index, there is a sharp jump in ownership by passive institutional investors for stocks at the top of the Russell 2000 relative to stocks at the bottom of the Russell 1000.

Contrary to the presumption that passive investors lack the willingness and ability to influence firms’ policy choices, we find that passive investors have a significant impact on the aspects of governance structure they explicitly mention as being important in their proxy voting guidelines. In particular, we find that an increase in ownership by passive investors is associated with an increase in the share of independent directors on a board, the removal of poison pills and restrictions on shareholders’ ability to call special meetings, and fewer dual class shares. The economic magnitudes are sizable.

Our findings suggest that a key mechanism by which passive investors influence firm governance is through a combination of their large voting blocs and strong views on what constitutes effective governance for the average firm. Rather than engage in costly, firm-specific interventions for each stock in their large, diversified portfolios, passive investors seem to exert influence by voting (or withholding management support) according to general proxy voting guidelines regarding basic aspects of governance. In particular, we find that higher passive institutional ownership is associated with less support for management proposals and a greater support for shareholder-initiated governance proposals. While we do not find direct evidence that ownership by passive investors increases activism by other investors, like hedge funds, we cannot exclude the possibility that the observed differences in governance are also partly driven by an increased threat of activism by others.

The influence of passive investors is not limited to firms’ governance structures. We find that ownership by passive investors is also associated with reduced cash holdings, a higher dividend yield, and lower managerial pay. We find no evidence, however, that passive ownership is associated with meaningful differences in firms’ overall performance or value, which is consistent with earlier evidence regarding the value implications of shareholder activism related to governance.

The results of this paper provide new insights into the determinants of firms’ governance structures and the mechanisms that allow large shareholders to influence managerial decisions. Importantly, we show that institutional influence over corporate actions is not limited to active institutions and their unconstrained flexibility to buy and sell positions, but extends to passive institutions as well. While passive investors are not “active” in the traditional sense, their significant voting blocs and ability to engage in voice are powerful tools used to shape the governance structure of firms and influence some aspects of corporate policy.

The full paper is available for download here.

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