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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
!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!
*
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
