Corporate Governance Implications of the Growth in Indexing

Abstract

Passively managed (index) funds have grown to become among the largest shareholders in many publicly traded companies. Their large ownership stakes and voting power have attracted the attention of market participants, academics, and regulators and have sparked an active debate about their corporate governance role. While many studies explore the governance implications of passive fund growth, they often come to conflicting conclusions. To understand how the growth in indexing can affect governance, it is important to understand fund managers’ incentives to be engaged shareholders. These incentives depend on fund managers’ compensation contracts, ownership stakes, assets under management, and costs of engagement. Major passive asset managers, such as the Big Three (BlackRock, State Street, and Vanguard), may have incentives to be engaged even though they track the indices and their engagement efforts benefit all other funds that track the same indices. This is because such funds’ substantial ownership stakes in multiple firms can both increase the effectiveness of their engagement and create relatively large financial benefits from engagement despite the low fees they collect. However, there is a difference between large and small index fund families: the incentives of the latter are likely to be substantially smaller, and the empirical evidence appears to be consistent with this distinction. The governance effects of passive fund growth also depend on where flows to passive funds come from, which investors are replaced by passive funds in firms’ ownership structures, how passive funds interact with other shareholders, and how their growth affects other asset managers’ compensation structures. Considering such aggregate effects and interactions can help reconcile the seemingly conflicting findings in the empirical literature. It also suggests that policymakers should be careful in using the existing studies to understand the aggregate governance effects of passive fund growth over the past decades. Overall, the literature has made important progress in understanding and quantifying passive funds’ incentives to engage, their monitoring activities and voting practices, and their interactions with other shareholders. Based on the findings in the literature, there is yet no clear answer to whether passive fund growth has been beneficial or detrimental for governance, and there are many open questions remaining. These open questions suggest several important directions for future research in this area.