The Agency Problems of Institutional Investors

Abstract

We analyze how the rise of institutional investors has transformed the governance landscape. While corporate ownership is now concentrated in the hands of institutional investors that can exercise stewardship of those corporations that would be impossible for dispersed shareholders, the investment managers of these institutional investors have agency problems vis-a-vis their own investors. We develop an analytical framework for examining these agency problems and apply it to study several key types of investment managers. We analyze how the investment managers of mutual funds - both index funds and actively managed funds - have incentives to under-spend on stewardship and to side excessively with managers of corporations. We show that these incentives are especially acute for managers of index funds, and that the rise of such funds has system-wide adverse consequences for corporate governance. Activist hedge funds have substantially better incentives than managers of index funds or active mutual funds, but their activities do not provide a complete solution for the agency problems of institutional investors. Our analysis provides a framework for future work on institutional investors and their agency problems, and generates insights on a wide range of policy questions. We discuss implications for disclosure by institutional investors; regulation of their fees; stewardship codes; the rise of index investing; proxy advisors; hedge funds; wolf pack activism; and the allocation of power between corporate managers and shareholders. This paper is part of a larger project on the incentives of investment managers that also includes Index Funds and the Future of Corporate Governance: Theory, Evidence, and Policy and The Specter of the Giant Three. Presentation slides for this paper are available on SSRN here.