Passive Investors, Not Passive Owners

TL;DR: In this paper, the authors examine whether and by which mechanisms passive investors influence firms' governance, exploiting variation in ownership by passive mutual funds associated with stock assignments to the Russell 1000 and 2000 indexes.

Abstract: Passive institutional investors are an increasingly important component of U.S. stock ownership. To examine whether and by which mechanisms passive investors influence firms’ governance, we exploit variation in ownership by passive mutual funds associated with stock assignments to the Russell 1000 and 2000 indexes. Our findings suggest that passive mutual funds influence firms’ governance choices, resulting in more independent directors, removal of takeover defenses, and more equal voting rights. Passive investors appear to exert influence through their large voting blocs, and consistent with the observed governance differences increasing firm value, passive ownership is associated with improvements in firms’ longer-term performance.

Summary

1. Introduction

• While there is considerable evidence that institutional investors influence the governance and policies of firms (e.g., Aghion, Van Reenen, and Zingales, 2013; Brav et al., 2008), this evidence primarily focuses on the role of activists that accumulate shares and make demands upon managers or active fund managers that exit positions when managers perform poorly.
• Second, passive investors might be less able to exert influence over managers.
• To overcome this challenge and to assess whether passive investors affect firms’ governance and performance, the authors exploit variation in ownership by passive mutual funds that occurs around the cutoff point used to construct two widely used market benchmarks, the Russell 1000 and Russell 2000 indexes.
• This benchmarking by passive funds leads to a sharp difference 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 even though these stocks are otherwise similar in terms of their overall market capitalization.
• The authors also analyze vote outcomes, such as the average support for management and governance-related shareholder proposals, which could be directly related to a potential mechanism by which passive investors can exert influence—their ability to exercise “voice.”.

2. Sample, data sources, and descriptive statistics

• The authors merge stock-level mutual fund ownership data and Russell equity index membership with firm-level governance, proxy voting, accounting, and executive compensation data.
• The authors now briefly describe each data source and their sample.

2.1. Mutual fund holdings and Russell 1000/2000 index membership

• The authors use the S12 mutual fund holdings data compiled by Thomson Reuters and available from Wharton Research Data Services (WRDS) to compute mutual fund holdings in a stock as a percent of its market capitalization.
• Before May 2004, funds were required to report holdings only twice a year using Form N-30D, but many mutual funds voluntarily reported holdings in the other two quarters.
• Thanks to Denys Glushkov at WRDS for assistance with S12 holdings.
• To generate variables for mutual fund ownership disaggregated into these three categories, the authors compute the percentage of each stock’s market capitalization that is owned by passive, active, and unclassified mutual funds at the end of each quarter.
• The authors obtain data for the Russell 1000 and 2000 indexes from Russell, and they start the sample at 1998 because this is the first year Russell provides us with its proprietary, float-adjusted market capitalization, which is used to determine the rank (i.e., portfolio weight) of each security within an index.

2.2. Governance, voting, accounting, and compensation data

• Governance and voting data are mainly from Institutional Shareholder Services (ISS), formerly known as Riskmetrics, which provides information on several aspects of corporate governance for firms in the S&P 1500.
• The authors also construct several variables related to 6.
• The authors use the voting results database from ISS to calculate the average percentage of shares that vote in support of management proposals at annual meetings and in support of shareholder-initiated governance proposals for each firm between reconstitutions of the Russell indexes (i.e., between July of year t and June of year t+1).
• Shark Repellent provides historical information on firms’ most recent poison pill, such as when the poison pill was renewed, withdrawn, or allowed to expire.
• Annual accounting data are from Compustat, and the authors use executive compensation data from Execucomp.

2.3. Sample and descriptive statistics

• For their main analysis, the authors restrict their sample to stocks in the 250 bandwidth around the cutoff, as determined using the end-of-June Russell-assigned portfolio weights for stocks within each index.
• Table 1 reports summary statistics for their main sample.
• The average level of mutual fund ownership (as a percentage of shares outstanding) is around 25%.
• Support for management proposals is high (85%), consistent with the notion that many of the issues addressed by these proposals are routine in nature, while support for shareholder-initiated governance proposals is considerably lower (36%).
• Independent directors make up 65% of the total number of directors for firms in the sample.

3. Empirical framework

• Identifying the impact of passive investors on corporate governance and performance poses an empirical challenge.
• Cross-sectional correlations between passive ownership, governance, and performance might not reflect a causal relation because ownership by passive investors could be correlated with factors—such as firms’ access to capital, investment opportunities, or ownership by active investors—that directly affect corporate outcomes.
• Failure to control for such factors could introduce an omitted variable bias that confounds inferences.
• To overcome this challenge and to determine the importance of passive investors, the authors use stocks’ assignment to the top of the Russell 2000 index as an exogenous shock to ownership by passive mutual funds.
• The authors now describe their identification strategy.

3.1. Russell index construction and passive institutional investors

• Passive funds attempt to match the performance of a market index by holding a basket of representative securities in the particular market index being tracked in proportion to their weights in the index.
• The importance of index assignment for ownership by passive mutual funds is illustrated in Fig. 3, in which the authors sort stocks using their end-of-May CRSP market capitalization and plot the average share of firms in the Russell 2000 and average end-of-September ownership by passively managed funds.
• The end-of-May market cap reported by CRSP does not perfectly predict a stock’s index assignment because Russell makes a number of adjustments when calculating its proprietary market capitalization values such that these values, which are used to determine a stock’s index membership, do not perfectly match market capitalizations reported in sources such as CRSP.
• Because index assignment is determined by a stock’s market capitalization, and because market capitalization can directly affect a stock’s institutional ownership for reasons separate from index assignment, the authors also include a robust set of controls for stocks’ end-of-May market capitalization in their estimation.

3.3. First-stage estimation

• The authors report estimates of their first-stage regression of passive mutual fund holdings on membership in the Russell 2000 index plus additional controls.
• The results, reported in Table 2, confirm that mutual fund ownership is related to membership in the Russell, particularly for passive mutual funds.
• Using a bandwidth of 250 firms and varying the polynomial order of controls for market cap, the authors consistently find an increase in ownership by passive funds of about a half of a sample standard deviation (Table 3, columns 1–3).
• Additionally, the Kleibergen-Paap F-stat on the excluded instrument exceeds 10, providing further confidence that a weak instrument is unlikely to be a concern (Stock, Wright, and Yogo, 2002; Angrist and Pischke, 2009).
• The lack of an increase in either analyst or media coverage among firms at the top of the Russell 2000 bolsters their assumption that index assignment in their setting will only affects firms’ governance structure through its effect on passive ownership.

3.4. Why index assignment might matter

• A question that naturally arises is why index assignment might matter at all for firms’ passive ownership.
• While increasing an ownership stake for one stock at the bottom of the Russell 1000 might not significantly affect a fund’s tracking errors relative to a Russell 1000 benchmark, 20 a similar increase for a number of other stocks would.
• Achieving the same total increase in ownership stake can be prohibitively large for any one passive institution to achieve alone, and coordinating a combined ownership increase among multiple passive institutions might either be too costly or impose additional regulatory disclosure requirements these institutions wish to avoid.
• The authors now turn to analyzing whether passive ownership and index assignment affect firms’ governance structures and the potential mechanisms by which passive investors can exert influence.

4. How passive investors affect firms’ corporate governance

• To select the governance outcomes for their analysis, the authors start from a 2014 speech given by the Chairman and CEO of Vanguard, Bill McNabb, that summarizes the broad governance issues on which Vanguard focuses.
• Two other governance issues that were discussed in this speech, but are not as easily tested, are “Accountability” (of both the board and management) and “Shareholder engagement.”.
• 21 Street, and Barclays Bank when the filing of such policies was first required beginning on July 1, 2003.
• From these proxy-voting policies, it is clear that these four broad governance issues were also a focus of passive investors during their sample period.
• The authors will analyze their impact on the fourth issue, the level and structure of executive compensation, in Section 6.2.

4.1. Independent directors

• The authors first assess whether passive mutual funds exert influence on board independence.
• Increasing the percent of independent directors was a specific concern of many passive investors during their sample period and is one dimension of governance in which passive investors have a direct say via their proxy votes in director elections.
• At some level, this particular exclusion is not surprising since some passive institutions (e.g., Vanguard) have the same individual act as both CEO and Chairman, and consistent with passive investors not holding a view on this issue, the authors find no association between passive ownership and whether a company’s CEO serves as Chairman of the Board. 22 for market capitalization.
• The economic magnitude of the relation is sizable.
• The differences in the estimates across time periods are statistically significant at the 1% confidence level.

4.2. Takeover defenses

• The authors now consider the association between ownership by passive mutual funds and takeover defenses.
• The first-stage estimates in the smaller sample of observations with non-missing director data remain statistically significant at the 1% level.
• While Coates (2000) notes that essentially every firm has a “shadow pill” in place because a pill can be implemented by a board at any time without shareholder approval, having a poison pill in place is still thought to provide managers with advantages in fighting off hostile bids and unwanted activists.
• The authors find evidence that ownership by passive funds is associated with the removal of restrictions on shareholders’ ability to call special meetings.
• The statistically weaker results for classified boards could partially be an artifact of the time period of their sample; Guo, Kruse, and Nohel (2008) note that shareholder efforts to de-classify boards intensified significantly in 2003 following the passage of Sarbanes-Oxley.

4.3. Equal voting rights and dual class share structures

• Finally, the authors analyze whether ownership by passive mutual funds is associated with the voting rights of shareholders.
• The estimated coefficient is negative and statistically significant (at the 1% level) in all of the estimations; a one standard deviation increase in Passive% is associated with about a one standard deviation decrease in the likelihood that a firm has a dual class share structure.
• 20 Another voting rights issue that is discussed in the proxy-voting guidelines of passive investors is their opposition to cumulative voting.
• In unreported analysis, the authors do not find an association between passive ownership and whether firms have cumulative voting for directors.

5. Possible mechanisms by which passive investors influence governance

• A key mechanism by which passive investors might influence a firm’s governance structure is via their voice.
• In particular, passive investors can use their ownership stake and ability to vote to monitor firms and ensure conformity with their views on governance structures.
• Alternatively, it is also possible 20 Because adding a dual class share structure is typically not allowed by stock exchanges after a firm’s initial IPO, the observed difference in dual class structures is most likely driven by firms removing a dual class share structure rather than failing to add one.
• Instead, passive investors’ concentrated ownership might facilitate activism by others, such as hedge funds, by lowering the costs for other activists attempting to coordinate votes against management (Brav et al., 2008; Bradley et al., 2010).
• The authors investigate these two possible channels.

5.1. The power of passive investors’ “voice”

• To address whether passive investors exercise voice and influence firms’ governance through their large voting blocs, the authors first analyze support for management proposals.
• Consistent with an increased monitoring of managers and with passive investors exercising voice, the authors find that greater ownership by passive funds is associated with less support for management proposals (Table 8, columns 1–3).
• The estimated coefficients are negative and statistically significant (at the 1% level).
• A one standard deviation increase in ownership by passive funds is associated, on average, with about a 0.75 standard deviation decline in support for management proposals.
• The lack of difference in the composition of proposals suggests the lower support for management proposals is not driven by managers submitting a greater number of less-shareholder-friendly proposals.

5.2. No increased activism by others

• An alternative mechanism by which passive ownership might influence firms’ governance structure is by facilitating activism by other, non-passive investors.
• The point estimates are negative and statistically significant.
• The authors find that a one standard deviation increase in passive fund ownership is associated with a 0.13–0.16 standard deviation (i.e., 1.6–2.0 percentage point) decline in the likelihood of hedge fund activism.
• While the observed decline in activism by non-passive institutions is consistent with passive investors successfully affecting governance outcomes and reducing the need for activism by others, it does not negate the possibility that the concentration of passive institutions’ ownership stakes increases the threat of activism by others, or that this threat increases the influence of passive investors’ “voice.”.
• Anecdotal evidence suggests that informal discussions between passive institutions and managers, backed up with the threat of voice, are often used to exert influence.

6. Do passive investors affect firm performance, compensation, or other corporate policies?

• Ownership by passive investors might also be associated with differences in firm performance, managerial compensation, or corporate policies.
• Overall performance or corporate policies might differ if the observed differences in governance associated with passive investors help mitigate managerial agency conflicts or if managers adjust corporate policies so as to preempt hedge fund activism campaigns that 21 We thank Alon Brav for making these data on hedge fund activism events available to us.the authors.the authors.
• For more information on how the database is constructed, please see https://faculty.fuqua.duke.edu/~brav/HFactivism_SEPTEMBER_2013.pdf.
• 23 Glenn Booraem, controller of Vanguard funds, notes that engagement with directors and management of companies is a key component of Vanguard’s governance program, and that Vanguard has “found through hundreds of discussions every year” that it is “frequently able to accomplish as much—or more—through dialogue” as through voting (see Booream, 2013).

6.1. Overall performance

• There is considerable debate about the value implications of various governance structures or whether the potential influence of passive investors will necessarily improve firm performance.
• Because greater board independence, fewer takeover defenses, and equal voting rights arguably increase shareholder rights, one might expect that passive ownership mitigates agency conflicts and is associated with improved performance.
• Likewise, the value implication of removing poison pills and other takeover defenses is debatable (e.g., Stein, 1988; Coates, 2000).
• Columns 1‒3), it is positively associated with firms’.
• ROA after adding controls for whether a firm switched indexes that particular year (columns 4‒6).

6.2. Executive compensation

• There has been much debate regarding managerial pay and whether its growth reflects an efficient market outcome or an agency conflict.
• To assess whether passive fund ownership affects CEO compensation structure, the authors examine total CEO pay, its composition, and the sensitivity of CEO pay to stock price movements.
• In unreported analysis, the authors find that while Passive% is negatively associated with total pay, the estimates are not statistically significant except in wider bandwidths.
• It is important to note that their sample predates the implementation of “Say on Pay” by the Dodd-Frank Act in 2010.
• This provision, which requires non-binding votes on executive pay packages, potentially provides an added mechanism for passive investors to influence compensation decisions.

6.3. Cash, dividend, financing, and investment policies

• There is an extensive literature addressing the relation between corporate ownership structure and corporate policies; for example, agency theories suggest that better monitoring by shareholders might lead to changes in leverage, acquisitions, cash levels, and payout policies (Jensen, 1986; La Porta et al., 2000).
• Importantly, their earlier estimates for governance and vote outcomes are unaffected by the inclusion of the additional controls for whether a firm switched indexes that year.
• These robustness tests are discussed in Section 7.1.
• The authors find relatively little evidence that ownership by passive funds is associated with corporate policies related to investment, capital structure, or cash holdings.
• In unreported analysis, the authors find that a one standard deviation increase in Passive% is associated with about a 0.15 standard deviation increase in firms’ dividend yield (significant at the 10% level in some specifications).

7. Additional robustness checks and choice of specification

• In particular, the authors demonstrate that their findings are not sensitive to how they measure end-of-May market caps, to adding additional controls, to varying the sample bandwidth around the threshold, to using alternative definitions of passive institutional ownership as their key explanatory variable, or to using end-of-May market cap rankings to select their sample of stocks each year.
• The authors also address the possibility of a selection bias around the Russell 1000/2000 threshold, particularly for the subsample of observations covered by ISS databases.

7.1. Robustness to choice of controls, choice of bandwidth, and placebo tests

• The assumption of their identification strategy is that after limiting the sample to stocks close to the Russell 1000/2000 threshold and controlling for the one factor that determines index membership (i.e., end-of-May market cap), index membership does not directly affect their outcomes except through its effect on passive ownership.
• Because Russell Investments uses a proprietary method to calculate firms’ total market caps, the authors are only able to 32 imperfectly control for the underlying market cap used to determine index assignment.
• The authors findings, however, are robust to using alternative ways to measure firms’ end-of-May market cap.
• See Mullins (2014) for more details regarding the likely sources for this noise.

7.2. Robustness to alternative definitions of passive ownership

• For their analysis above, the authors measure the ownership stake of passive investors by summing up the ownership of mutual funds they classify as passively managed.
• A disadvantage of the fund-level data, however, is that it misses the holdings of passive institutional investors that do not manage mutual funds or Exchange Traded Funds (ETFs).
• To illustrate this, the authors obtain data on institutional holdings from the Thomson Reuters Institutional Holdings (13F) Database.
• As further evidence that only passive investors adjust their holdings to index assignment, their first-stage estimates only detect an increase in “quasi-index” ownership (which includes some of the largest passive investors, like Vanguard, State Street, and Barclay’s Bank) and no increase in “transient” or “dedicated” ownership.
• In particular, the 2.3 percentage point increase in quasi-index holdings found in Table 11, column 2 corresponds to about a 0.14 standard deviation change in Quasi-index%, which is considerably smaller than the 0.5 standard deviation change detected when using a more precise measure of passive holdings.

7.3. Robustness to alternative sampling choices

• In their main analysis, the authors select their sample to be the 250 stocks with the smallest portfolio weights in the Russell 1000 and the 250 stocks with the largest portfolio weights in the Russell 2000.
• In particular, the authors can instead rank stocks based on their end-of-May market cap, as calculated using CRSP, and select the sample for each year of the sample using firms ranked 750th through 1,250th that year.
• An advantage of this latter approach is that it eliminates the risk that Russell’s float-adjusted reweighting of stocks within an index affects their findings.
• A disadvantage of this approach, however, is that the authors are no longer necessarily comparing the very bottom firms of the Russell 1000 against the very top firms of the Russell 2000, which is where they would expect to find the biggest difference in passive ownership (and hence, outcomes) to occur.
• This sampling choice, however, has little impact on their IV estimates.

7.4. Ruling out potential sample selection biases

• One potential concern with their analysis is the possibility of systematic differences (beyond 36 market capitalization, which the authors control for) in the type of stocks on the two sides of the Russell 1000/2000 threshold.
• If present, such difference could cause a violation of the exclusion restriction.
• Moreover, the authors do not find evidence of a significant difference in either the lagged stock return or lagged change in stocks’ end-of-May market cap ranking between the stocks on either side of the Russell 1000/2000 threshold for the sample observations covered by ISS.
• Because their analysis is limited to the subsample of firms covered by ISS, their estimates indicate that among firms covered by ISS, more passive ownership is associated with a firm being less likely to have a dual class share structure.

8. Conclusion

• Institutions that manage passive funds, like Vanguard and State Street, are an increasingly important component of U.S. stock ownership, and the impact of their growth on firm-level governance is widely debated.
• There are multiple reasons why passive investors might have a vested interest in affecting firms’ governance structures and performance and why their large ownership stakes might make them an influential voice in decisions pertaining to firms’ governance structures.
• Benchmarking to these indexes leads to about a 66% difference in passive ownership for stocks at the top of the Russell 2000 relative to stocks at the bottom of the Russell 1000.
• The authors instrumental variable estimation relies on the assumption that after conditioning on firms’ market capitalization, which determines index assignment, inclusion in the Russell 2000 index does not directly affect their governance or corporate outcomes except through its impact on ownership by passive investors.
• The authors findings, however, do not resolve the ongoing debate regarding the value implications of various governance structures, including board independence, takeover defenses, and equal voting rights for shareholders, and whether the optimal governance structure might vary across firms in ways that do not always conform to the proxy-voting guidelines of the largest passive institutions.

Figures

Table 2 Impact of index assignment on mutual fund ownership

Fig. 2. Portfolio weights in the Russell 1000 and 2000 indexes by within-index ranking for the year 2006. This figure plots the portfolio weights of the bottom 500 firms in the Russell 1000 index and the top 500 firms in the Russell 2000 index for the end-of-June 2006. Observations are ordered by their within-index ranking such that rankings of 1 and 1,000 represent the firms with the largest and 1,000th largest portfolio weight in the index, respectively. The portfolio weights are given as a percent.

Table 3 First-stage estimation for ownership by passively managed funds

Table 7 Ownership by passive investors and dual class share structures

Table 11 Impact of index assignment on institution-level (13F) stock ownership

Fig. 3. Market capitalization, index assignment, and passive ownership by market capitalization rankings for the bottom 500 firms of Russell 1000 and top 500 firms of Russell 2000. This figure plots the average end-of-May Ln(Market capitalization), fraction of firm-year observations in the Russell 2000, and passive mutual fund ownership (%) by ranking, where ranking is determined using end-of-May market capitalization, as reported in CRSP. The sample includes the bottom 500 firms of the Russell 1000 and the top 500 firms of the Russell 2000, as determined using end-ofJune Russell-assigned portfolio weights for each index. Passive mutual fund ownership is calculated as of September each year, and all averages are calculated using bins of ten firms and data from 1998–2006. For the passive ownership panel, we scale the vertical axis to report a standard deviation on each side of the sample mean.

Table 10 Ownership by passive investors and firms' return on assets

Table 5 Passive ownership and board independence, pre- versus post-2002 rule change

Table 12 Robustness of IV estimates to using passive indicator based on institution-level (13F) stock ownership

Table 9 Ownership by passive investors and hedge fund activism

Table 1 Summary statistics

Table 4 Ownership by passive investors and board independence

Fig. 1. Growth of passive investors, 1998–2014. This figure plots the estimated percent of all U.S. equity mutual fund assets under management between 1998 and 2014 that are held in passively managed funds and the estimated percent of total U.S. market capitalization held by passively managed mutual funds. We construct the figure by matching the S12 mutual fund holdings data compiled in the Thomson Reuters Mutual Fund Holdings Database to market caps reported in CRSP and fund names in the CRSP Mutual Fund Database. We use a name-parsing procedure along with the index fund identifier from the CRSP Mutual Fund Database to classify mutual funds as passively managed. Our procedure is described in Section 2.1 of the text. Holdings and market cap are calculated each year at the end of the third quarter.

Table 8 Ownership by passive investors and shareholder support for proposals

Full text

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Passive Investors, Not Passive Owners
*
Ian R. Appel
†
, Todd A. Gormley
‡
, and Donald B. Keim
§
February 6, 2016
Journal of Financial Economics, forthcoming
Passive institutional investors are an increasingly important component of U.S. stock
ownership. To examine whether and by which mechanisms passive investors influence
firms’ governance, we exploit variation in ownership by passive mutual funds associated
with stock assignments to the Russell 1000 and 2000 indexes. Our findings suggest that
passive mutual funds influence firms’ governance choices, resulting in more independent
directors, removal of takeover defenses, and more equal voting rights. Passive investors
appear to exert influence through their large voting blocs, and consistent with the
observed governance differences increasing firm value, passive ownership is associated
with improvements in firms’ longer-term performance.
(JEL D22, G23, G30, G34, G35)
Keywords: corporate governance, institutional ownership, passive funds, performance
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*
For helpful comments, we thank Bernard Black, Alon Brav, Alan Crane, Sevinc Cukurova,!David Denis, Ran
Duchin, Alex Edmans, Vyacheslav Fos, Erik Gilje, Stuart Gillan, Vincent Glode, Robert Jackson, Wei Jiang,
Charles Jones, Oğuzhan Karakas, Borja Larrain, Doron Levit, Craig Lewis, Inessa Liskovich, Michelle Lowry,
Nadya Malenko, Pedro Matos, David Matsa, Sebastien Michenaud, David Musto, Christian Opp, Ed Rice, Michael
Roberts, Dick Roll, Luke Taylor, Paul Tetlock, Jeremy Tobacman, James Weston, and seminar participants at
Boston College (Carroll), Columbia Business School, Florida Atlantic University, FTSE World Investment Forum,
University of Pennsylvania (Wharton), University of Washington (Foster), U.S. Securities and Exchange
Commission, NBER Summer Institute for Corporate Finance, Western Finance Association Meetings, ISB Summer
Research Conference, Drexel Conference on Corporate Governance, Ohio State University Corporate Finance
Conference, Society of Financial Studies Cavalcade, 9
th
International Finance UC Conference, and the NYU/Penn
Conference on Law and Finance. We also thank Alon Brav for sharing his data on hedge fund activism, Louis Yang
for his research assistance, and the Rodney L. White Center for Financial Research for financial support.
†
!Carroll School of Management, Boston College, 140 Commonwealth Avenue Chestnut Hill, MA, 02467. Phone:
(617) 552-1459. Fax: (617) 552-0431. E-mail: ian.appel@bc.edu
‡
The Wharton School, University of Pennsylvania, 3620 Locust Walk, Suite 2400, Philadelphia, PA, 19104. Phone:
(215) 746-0496. Fax: (215) 898-6200. E-mail: tgormley@wharton.upenn.edu
§
Corresponding author. The Wharton School, University of Pennsylvania, 3620 Locust Walk, Suite 2400,
Philadelphia, PA, 19104. Phone: (215) 898-7685. Fax: (215) 898-6200. E-mail: keim@wharton.upenn.edu

“We’re going to hold your stock when you hit your quarterly earnings
target. And we’ll hold it when you don’t. 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.”
—!F. William McNabb III, Chairman and CEO of the Vanguard funds
1. Introduction
While there is considerable evidence that institutional investors influence the governance and
policies of firms (e.g., Aghion, Van Reenen, and Zingales, 2013; Brav et al., 2008), this evidence
primarily focuses on the role of activists that accumulate shares and make demands upon managers or
active fund managers that exit positions when managers perform poorly. Yet, such active investors
represent only a subset of institutions. Many institutions are instead passive in that they do not actively
buy or sell shares to influence managerial decisions. The investment objective of such institutions is to
deliver the returns of a market index (e.g., Standard & Poors (S&P) 500) or investment style (e.g., large-
cap value) with low turnover, diversified portfolios, and minimal expenses. As shown in Fig. 1, passive
investors have grown significantly in recent years; the share of equity mutual fund assets held in passively
managed funds tripled over the 1998‒2014 period to 33.5%, and the share of total U.S. market
capitalization held by passively managed funds quadrupled to more than 8%. However, the growth of
passive investors raises questions about how effectively managers are being monitored. Some worry that
passive investors lack the motives and resources to monitor their large, diverse portfolios, and that the
increasing market share of such “lazy investors” weakens firm-level governance and hurts performance.
1
Others counter that passive investing does not equate with passive ownership.
2
In this paper, we examine
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1
An example of this viewpoint was expressed in The Economist (2015) on February 7. As it stated, “A
rising chunk of the stock market sits in the hands of lazy investors. Index funds and exchange-traded funds mimic
the market’s movements, and typically take little interest in how firms are run; conventional mutual funds and
pension funds that oversee diversified portfolios dislike becoming deeply involved in firms’ management.”
2
For example, the title of this paper, “Passive Investors, Not Passive Owners,” was the title for an article
written by Glenn Booraem, controller of Vanguard, in April 2013 highlighting the care Vanguard takes when voting
proxies. See https://personal.vanguard.com/us/insights/article/proxy-commentary-042013. Similar views regarding
the distinction between being a passive investor, but active owner, were espoused by Rakhi Kumar, head of
corporate governance at State Street Global Advisors in The Financial Times on April 6, 2014 in an article titled,
“Passive investment, active ownership,” and by David Booth, chairman and co-founder of Dimensional Fund
Advisors, in the New York Times on March 16, 2013 (Sommer, 2013) in an article titled, “Challenging management
(but not the market).”
1

whether passive institutional investors influence firms’ governance structures, and ultimately,
performance.
There are various arguments for why the growth of passive investors could weaken the
governance and performance of firms. First, such institutional investors might lack an incentive to
monitor managers. In particular, passive funds seek to deliver the performance of the benchmark, and
unlike actively managed funds, they have little motive to improve an individual stock’s performance.
Second, passive investors might be less able to exert influence over managers. By seeking to minimize
deviations from the underlying index weights, passive institutions tend to lack a traditional lever used by
non-passive investors to influence managers—the ability to accumulate or exit positions. Third, given
their diversified holdings, passive investors might have insufficient resources to research and monitor the
corporate policies of each individual firm in their portfolio.
And yet, there are numerous reasons why the growth of passive investors might improve firms’
governance choices and performance. First, passive institutions might be motivated to monitor managers
and improve overall market performance because this increases the value of their assets under
management (Del Guercio and Hawkins, 1999). Moreover, because passive institutions are less willing to
divest their positions in poorly performing stocks, they might be more motivated than other institutions to
be engaged owners (Romano, 1993; Carleton, Nelson, and Weisbach, 1998). Second, institutions that
manage passive funds can use their sizable ownership stakes to wield influence. All institutional investors
have a fiduciary duty to vote their proxies in the best interest of shareholders, and managers might be
more inclined to consider the views of passive investors over more active investors, which tend to exhibit
higher turnover rates (Del Guercio and Hawkins, 1999). Finally, while passive institutions might lack the
resources necessary to monitor the detailed policy choices of every firm in their large, diversified
portfolios, they might be effective at engaging in widespread, but low-cost, monitoring of firms’
compliance with what they consider to be best governance practices (e.g., Black, 1992, 1998).
Identifying the impact of passive investors on firms’ corporate governance and performance can
be challenging. Correlations between passive investors and governance choices might not reflect a causal
2

Frequently asked questions

Q1. What are the contributions in "Passive investors, not passive owners" ?

In this paper, the authors examine whether and by which mechanisms passive investors influence firms ' governance, and find that passive ownership is associated with improvements in firms ' longer-term performance. 

Q2. What have the authors stated for future works in "Passive investors, not passive owners" ?

While some large passive investors do vary their voting strategies across firms in ways that are not consistent with such a one-size-fits-all approach to governance ( Davis and Kim, 2007 ), additional analysis regarding these questions would seem to be a promising direction for further research. 

Q3. What is the effect of a one percentage point increase in passive ownership on board independence?

But if the true increase in passive ownership for stocks assigned to the Russell 2000, after accounting for passive investors not accounted for in the mutual fund data, is instead 2.1 percentage points, then the true effect of a one percentage point increase in passive ownership on board independence would be 4.87/2.1 = 2.32 percentage points. 

Q4. What is the key mechanism by which passive investors exert their influence?

Their evidence suggests that a key mechanism by which passive investors exert their influence isthrough the power of their large voting blocs (i.e., voice). 

Q5. What is the effect of passive investors exercising voice?

In further support of passive investors exercising voice via their votes, the authors find evidence thatownership by passive funds is associated with an overall increase in support for governance-relatedshareholder proposals. 

Q6. What is the key mechanism passive investors use to influence a firm’s governance structure?

In particular, passive investors can use their ownership stake and ability to vote to monitorfirms and ensure conformity with their views on governance structures. 

Q7. What is the effect of passive ownership on the ability of shareholders to call special meetings?

”24The authors find evidence that ownership by passive funds is associated with the removal of restrictionson shareholders’ ability to call special meetings. 

Q8. What is the effect of passive investors on shareholder voting?

Consistent with passiveinvestors being active in monitoring managers, management appears to be confronted with a more contentious shareholder base when passive funds, which are less able to vote with their feet, make up alarger percentage of the ownership. 

Q9. What is the evidence of a greater activism by passive investors?

The authors find no evidence, however, that greater ownership by passive mutual funds is associated withmore activism by non-passive institutions; instead, the authors find evidence of less activism by non-passiveinstitutions, consistent with passive investors monitoring managers and reducing the need for activism byother investors.