Are Active Mutual Funds More Active Owners than Index Funds?

Lucian Bebchuk is James Barr Ames Professor of Law, Economics and Finance, and Director of the Corporate Governance Program, at Harvard Law School. Scott Hirst is Associate Professor at Boston University School of Law. This post is based on their ongoing research on institutional investors. 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).

Recent literature has taken the view that the stewardship decisions of actively managed investment funds are generally superior to those of index funds. Indeed, one recent article believes that index fund stewardship is so inferior that index fund managers should be precluded from voting (Lund 2018). In an ongoing research project, which builds on the framework provided in our recent work on the agency problems of institutional investors (Bebchuk, Cohen, and Hirst 2017), we seek to provide a detailed analysis of the agency problems afflicting the stewardship decisions of active managers. This post draws from that work to inform the current policy discussions regarding active funds, and to caution against viewing the stewardship of such funds as being generally superior to that of index funds.

Before proceeding, we wish to stress that we do recognize the problem with the stewardship activities of index funds. In research papers that we expect to release this fall, we provide a comprehensive theoretical, empirical, and policy analysis of these problems. Our work shows that the managers of index funds have strong incentives both to under-invest in stewardship and to be excessively deferential to corporate managers. We explain how these problems have prevented index funds from delivering on the governance promise that has been expressed by leaders of the “Big Three” index fund managers (BlackRock, Vanguard, and State Street Global Advisors), as well as by supporters of index fund stewardship. We also put forward policy proposals for improving index fund stewardship.

However, while we recognize the current shortcomings of index fund stewardship, we caution against any approach that gives up on such stewardship and proposes to curtail the influence of index funds in favor of increased influence of actively managed funds. Such an approach fails to recognize certain disadvantages of active fund stewardship. This post draws from the systematic comparison of these two types of stewardship in our current research work to discuss three ways in which the stewardship of index funds—and in particular, that of the Big Three—is either superior to that of most actively managed funds or at least less inferior than is commonly assumed.

In particular, we discuss below three points. First, because the Big Three have larger stakes in portfolio companies than active fund managers, the portfolios that the Big Three manage can be expected to capture a larger fraction of value gains produced by stewardship, which increases the relative strength of the Big Three’s incentives to undertake such stewardship. Second, the incentives of active fund managers to increase the value of portfolio companies that result from active managers’ competition with rival funds are much weaker than they may appear. Third, because active managers make discretionary trading decisions, having access to the executives of portfolio companies could be valuable to active managers, and this could provide incentives to accommodate the interests of such executives.

(1) The Fraction of Value Increases Captured by Investment Managers

Stewardship can take various forms, including monitoring the managers of portfolio companies, obtaining information relevant for assessing the governance of portfolio companies and for proposals to be voted on, and engaging directly with portfolio company managers. As Bebchuk, Cohen, and Hirst (2017) analyze, investment fund managers have substantial incentives to under-invest in stewardship activities because they expect to capture only a limited fraction of any value increases that would be produced by their investment in those stewardship activities. As explained below, such problems are likely to afflict active fund families severely, and such fund families might well have incentives to invest even less in stewardship activities than the Big Three.

Suppose that some stewardship activity by a given investment fund with respect to a given portfolio companies would cost C and would increase the expected value of the portfolio company by ΔS. From an efficiency perspectives, the stewardship activity would be socially desirable if and only if C < ΔS.

Suppose now that the investment fund owns a fraction of the portfolio company, α. In this case, part of the value increase (1 – α) will be not be captured by the portfolio. Accordingly, a stewardship activity would not maximizing the value of the investment fund’s portfolio, even though it would be socially worthwhile, if α × ΔS < C < ΔS. This is the classic free-rider problem that results where value increases are not fully captured by the investors that produce them.

Furthermore, even if C < α × ΔS—that is, even if the stewardship activity would be desirable for the portfolio—the investment fund manager might not have an incentive to undertake the considered stewardship activity. Whereas the manager’s arrangements with the fund require it to bear the cost C, the benefit α × ΔS will flow to the portfolio, and only a small fraction will be captured by the investment manager. This is because most investment managers do not receive incentive fees on increases in the value of their portfolio but only charge fees that are calculated as a percentage of assets under management.

Let θ be the fraction of the increase in the value of a portfolio company that the manager would be able to capture, in present value terms, from additional fees. It would not be in the interests of the investment manager to spend an amount C that would produce a gain of α × ΔS to the portfolio if C is larger than θ × α × ΔS. This is the agency problem that is stressed by Bebchuk, Cohen, and Hirst (2017). Thus, the investment fund manager will have an incentive not to spend C on the stewardship activity if

θ × α × ΔS < C

Thus, whether the investment fund manager will have an incentive not to undertake the stewardship activity will depend on the value of α and θ. The smaller are α and θ, the less likely it is that the investment manager will have an incentive to undertake the stewardship activity.

Because index funds charge lower fees, the value of θ is smaller for the Big Three than for fund families that focus on active funds. However, the value of α for the Big Three index funds is likely to be several times higher than the value of α for most active fund families. The total value of equity assets under management is $3.4 trillion, $3.5 trillion, and $1.8 trillion for BlackRock, Vanguard, and State Street Global Advisors, respectively. By contrast, all but three of the 25 largest active fund families have equity assets under management below $600 billion. Data that we have gathered indicates that, for many of these active funds, the product of θ × α is likely to be lower than it is for all or at least two of the Big Three.

Finally, in the discussion above we have implicitly assumed that a given stewardship investment can be expected to produce the same expected value gain in a particular portfolio company whether it is made by an active funds family or by one of the Big Three. However, in many situations it can be reasonably expected that the likelihood that a given stewardship investment will bring about an increase in value would depend on the size of the stake of the fund family making the stewardship decision. For example, the larger the stake that the fund family owns in the portfolio company, the greater the likelihood that the fund family’s vote would affect the outcome, and thus the larger the payoff to investing in improving the information on which the vote would be based. Because most active fund families have a much smaller stake in a given portfolio company than the Big Three they will have weaker incentives to invest in stewardship than the Big Three.

Accordingly, compared with the Big Three, active fund families do not have stronger incentives—and indeed might have weaker incentives—to invest in stewardship activities for their portfolio companies.

(2) The Limits of Competition-Generated Incentives

Investment managers compete with rival managers to attract additional assets and to retain existing assets. This competition could affect stewardship incentives. In the case of index fund managers, competition with rival index fund managers does not provide any incentives to invest in generating value increases in portfolio companies: any investment by an index fund manager that would increase the value of a portfolio company will increase the returns of rival index fund managers that track the same index precisely as much as it increases the returns of the index fund manager generating the improvement. However, as we described in Bebchuk, Cohen, and Hirst (2017), the extent to which competition incentivizes managers of active funds to invest in stewardship to generate value increases is much more limited than is commonly assumed.

To begin, it is important to recognize that there is evidence that many active funds are, to varying extents, “closet indexers” whose holdings substantially overlap with their benchmark index, deviating only by limited underweighting and overweighting of certain stocks (Cremers and Petajisto 2009). For an actively-managed fund that is a closet indexer, a desire to improve relative performance would provide no incentives to move stewardship decisions toward optimality for any of the portfolio companies where the company’s weighting in the investment fund’s portfolio is approximately equal to its weighting in the index; improving the value of those portfolio companies would not enhance performance relative to the index.

Furthermore, for all the portfolio companies that are underweight in the portfolio relative to the index, enhancing the value of the portfolio company would actually worsen the performance of the active manager relative to the index. For these portfolio companies, the possibility of increasing relative performance does not provide any incentive to try to enhance the value of the portfolio company; on the contrary, this consideration weighs against trying to do so.

Thus, the desire to improve performance relative to that of rival investment managers could only provide the manager of an active fund with incentives to improve value in those portfolio companies that are overweight in the portfolio compared to the index. Even for such portfolio companies, the extent to which improving the value of the corporation would improve fund performance will depend on the extent to which the corporation is overweight in the portfolio.

Consider a portfolio company that constitutes 1% of the benchmark index and 1.2% of the investment fund. In this case, any increase in the value of the portfolio company will be substantially shared by rival funds that track the index at least partly. Indeed, the increase in value of the portfolio company will worsen the performance of the investment fund relative to rival funds that are more overweight with respect to the portfolio company. Thus, even for companies that are overweight within the portfolio of the investment fund relative to the index, the impact of the desire to improve relative performance would be diluted by the presence of the company in the benchmark index and in the portfolios of rival funds.

Furthermore, as discussed above, in most cases actively-managed funds are part of mutual fund families composed of a number of mutual funds, and stewardship decisions are commonly made for all these investment funds by the fund family’s governance or proxy voting group. In such a case, the fact that a given actively-managed fund is overweight in a particular corporation might be offset by the fact that other actively-managed funds within the same fund family might be underweight. The investment manager of the fund family will have an incentive to bring about an increase in value in a particular company only if its actively-managed funds are on the whole overweight the company, and the incentive will be diluted to the extent that any gains will be shared by other mutual fund families.

(3) The Deference Incentives Produced by Active Trading

Our forthcoming work on index fund managers analyzes in detail certain incentives that such managers have to be excessively deferential toward the preferences and positions of the corporate managers of their funds’ portfolio companies. Here, however, we wish to note that the managers of active funds have another type of incentives to be deferential to corporate managers that does not apply to the managers of index funds.

Ke, Petroni and Yu (2008, p. 855) describe evidence that some active managers value “direct access to companies’ management.” These managers of active funds believe that, notwithstanding the limitations imposed by Regulation Fair Disclosure, being able to communicate with corporate managers of portfolio companies will improve the fund’s trading decisions. For active managers, trading decisions that change the weight of a portfolio company relative to its weighting in the index are likely to be the main determinants of their performance relative to their benchmark index. To the extent that active investment managers believe that making stewardship decisions that corporate managers disfavor might adversely affect their fund‘s access to such corporate managers, an interest in improving relative performance could provide incentives to avoid such stewardship decisions.

Note that, to the extent that managers of active funds get access to corporate managers and consequently make better trading decisions, the gains from such trading decisions will improve the investment manager’s performance relative to others, since rival fund managers will not share these trading gains. By comparison, gains from improving the value of particular portfolio companies will be shared substantially with rivals. Thus, an interest in improving relative performance could well lead active fund managers to place more weight on gains to their portfolios from access to corporate managers, relative to gains from increasing the value of particular portfolio companies, compared to what would be optimal for the investment funds’ beneficial investors.

By contrast, index fund managers do not have such trading-related incentives to defer to corporate managers. Because index funds do not trade based on perceived under- or over-valuations, they do not attach importance to having access to the executives of portfolio companies. Supporters of index fund stewardship have stressed that the trading behavior of active funds may give them a short-term perspective. The discussion above indicates another way in which the trading behavior of active funds adversely affects the active fund stewardship relative to that of index funds: the trading introduces incentives to be deferential to the preferences and positions of corporate managers.

* * * * *

The above discussion highlights the complexity of the analysis necessary to compare the stewardship of index funds and active funds. We expect to provide such an analysis in a future work. In the meantime, the above discussion counsels caution regarding possible conclusions that the power of index funds should be curtailed in favor of active funds.

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