In an article published in the American Economic Association’s Journal of Economic Perspectives, The Agency Problems of Institutional Investors (Bebchuk, Cohen and Hirst (2017) or “BCH”), we put forward and applied an analytical framework for understanding the monitoring and engagement decisions made by index funds. (Our article also extend the framework to actively managed funds). In light of the current policy discussions regarding the rise of index investing, this post discusses some of the implications of our article’s results and conclusions for this discussion.
A significant body of recent work has expressed serious concerns that the rise of indexing leads to increase in “common ownership” that produces anti-competitive effects (e.g., Azar, Schmalz & Tecu (2018), Elhauge (2016); Posner, Scott Morton & Weyl (2017)). These writers worry that index funds, which have substantial ownership in many companies that operate in a given industry, can induce corporate managers to act in a more anti-competitive fashion than they would do without such institutional owners. We show that this line of work fails to take into account the incentives of index fund managers that we analyze. As a result, it makes implausible assumptions regarding the extent to which index fund managers influence the business decisions of their portfolio companies. Our incentive analysis should temper the concerns of index-fund-alarmists.
At the same time, our incentive analysis should also temper the enthusiasm of those who expect large governance benefits to flow from the rise of index investment. On the view of index-fund-enthusiasts, because index funds do not have the option of exit, they have a strong incentive to improve governance and thereby improve value, and their substantial stakes in companies enable them to do so. Indeed, the leaders of the largest index fund managers have made public announcements stressing their commitment to stewardship and improving corporate governance, and these fund managers have been expanding the number of staff that are dedicated to voting and engagement.
Such governance commitments by index fund managers are encouraging, and we recognize that well-meaning index fund managers may make stewardship decisions that are superior to those predicted by an incentive calculus. However, a key premise in the fields of corporate governance and financial economics is that incentives matter. Our analysis sheds light on the structural incentive problems that impede the ability of index funds to produce governance benefits.
To give readers a sense of these problems we discuss below two structural factors that sharply limit the benefits to index fund managers from bringing about value-enhancing changes. (Among other things, our article also analyzed private costs that index fund managers bear that discourage them from seeking governance changes that the managers of portfolio companies resist; see BCH, pp. 101-104.) Our discussion below proceeds in three steps:
- We first identify an analytical benchmark, the actions that would be optimal from the perspective of the beneficial investors in index funds;
- We then analyze how the tiny fraction of governance-generated gains captured by index fund managers provides incentives to under-invest significantly compared to this benchmark; and
- Finally, we analyze how the competition for investment assets among rival index fund managers provides no incentives to seek value gains.
READ MORE »
