Lucian Bebchuk is the James Barr Ames Professor of Law, Economics, and Finance, and Director of the Program on Corporate Governance, at Harvard Law School. Scott Hirst is Associate Professor at Boston University School of Law and Director of Institutional Investor Research at the Harvard Law School Program on Corporate Governance. This post is based on their recent study. Related research from the Program on Corporate Governance includes The Agency Problems of Institutional Investors by Lucian Bebchuk, Alma Cohen, and Scott Hirst (discussed on the Forum here).
Index funds own an increasingly large proportion of American public companies, currently more than one fifth and steadily growing. Understanding the stewardship decisions of index fund managers—how they monitor, vote, and engage with their portfolio companies—is critical for corporate law scholarship. In a study that we recently placed on SSRN—Index Funds and the Future of Corporate Governance: Theory, Evidence and Policy—we seek to contribute to such understanding by providing a comprehensive theoretical, empirical, and policy analysis of index fund stewardship.
We begin by putting forward an agency-costs theory of index fund incentives. Stewardship decisions by index funds depend not just on the interests of index fund investors but also the incentives of index fund managers. Our agency-costs analysis shows that index funds have strong incentives to (i) under-invest in stewardship, and (ii) defer excessively to the preferences and positions of corporate managers.
We then provide the first comprehensive and detailed evidence of the full range of stewardship activities that index funds do and do not undertake. This body of evidence, we show, is inconsistent with a no-agency-costs view but can be explained by our agency-cost analysis.
We next put forward a set of policy reforms that should be considered in order to encourage index funds to invest in stewardship, to reduce their incentives to be deferential to corporate managers, and to address the concentration of power in the hands of the largest index fund managers. Finally, we discuss how our analysis should reorient important ongoing debates regarding common ownership and hedge fund activism.
The policy measures we put forward, and the beneficial role of hedge fund activism, can partly but not fully address the incentive problems that we analyze and document. These problems are expected to remain a significant aspect of the corporate governance landscape, and should be the subject of close attention by policymakers, market participants, and scholars.
Below is a more detailed account of our study:
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