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.
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