Rise Of Institutional Investors Research Articles

From Orchestra Conductor to Principal's Agent: How Internal Financialization of Top Management Has Enabled External Financialization of the Firm

ABSTRACT This paper analyzes the evolution of internal management work within large corporations from the end of the nineteenth century to the late 1960s. It argues that internal financialization is the prior condition for external financialization, as expressed notably in the shareholder value that is the focus of most theoretical and empirical analyses of financialization of corporate governance. Starting from the twofold nature of management work, our analysis examines how top managers of large corporations have become progressively disassociated from the production process. Through an exploration of the history of business accounting, we show how the evolution of management work has progressively financialized the functions of top managers. One of our main conclusions is that the alliance between shareholders and top managers around the nature and purpose of the firm is the result of an endogenous process. Therefore, the origin of shareholder-value-based corporate governance not only has to be situated before the rise of institutional investors and financial liberalization in the 1970s, but must also be seen as an internal process setting the conditions for the emergence of this management model.

The Rise of Institutional Investors in Bond ETFs

We examine the effect of bond Exchange‐Traded Funds (ETFs) on corporate bond liquidity. Using Propensity Score Matching and Difference‐in‐Differences techniques, we demonstrate that inclusion in ETFs is associated with a 10% reduction in transaction costs for high yield (HY) bonds and 4% reduction for investment grade (IG) bonds. The result holds during periods of market stress and is robust to different liquidity metrics. We find evidence that HY mutual funds use ETFs to manage their liquidity needs, contributing to the steady growth of HY bond ETFs. Increased HY ETF institutional ownership channels trading away from the underlying corporate bonds to the ETF shares and decreases bond aggregate liquidity, although in the cross‐section inclusion in ETFs improves liquidity. IG investors are not substituting ETF trading for bond trading and we conclude that the gains to liquidity accruing to ETF bonds in that market are a net benefit to investors.

The Agency Problems of Institutional Investors: Presentation Slides

The presentation slides in this document provide an overview of our study The Agency Problems of Institutional Investors, which was published in the Journal of Economic Perspectives in its summer 2007 issue. The slides build on our presentations at the 2017 ALEA annual meeting. Our study focuses on how the rise of institutional investors has transformed the governance landscape. The study analyzes the agency problems that the investment managers of institutional investors have 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. Our study 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.

The Conundrum of Common Ownership

The common ownership debate has become one of the most contentious issues in corporate law today. This debate is a by-product of major changes to capital market ownership structure, which have triggered concerns about the rise of institutional investors, the growth of index investing, and the rapid concentration of ownership in major international financial markets. Common ownership theory focuses on concerns about the incentives of large financial institutions holding widely diversified portfolios of shares in competing companies within a particular economic sector. Proponents of the common ownership theory argue that, even where institutional investors have relatively small ownership stakes, their collective holdings in competing companies produce anticompetitive effects. Other scholars, however, have challenged both common ownership theory and its regulatory prescriptions. Although common ownership theory began in the United States, it is now being discussed around the world. This article examines three conflicting narratives that emerge in this literature concerning institutional investors and common ownership theory. The article seeks to position these narratives within the context of the rising influence of institutional investors since the early 1990s and its relation to major international corporate governance developments. It analyzes aspects of common ownership theory in light of these contemporary corporate governance developments, and argues that drawing regulatory and policy conclusions from the current body of conflicting empirical findings on the effects of common ownership is premature.

The Modern Corporation and the Public Interest

Video abstractIn this essay, I discuss the problems associated with the rise of institutional investors and the concentration of stock ownership. I seek to answer the question, What\t\t\t\t\t\t\tis the public interest that the modern corporation should serve? I provide solutions for achieving a modern capitalism that place fiduciary duty and the public interest first. \t\t\t\t\t\t\tDisclosure: The views expressed in this essay are solely those of the author and do not necessarily represent the opinions of Vanguard’s present management.Read the transcript

The Agency Problems of Institutional Investors

Financial economics and corporate governance have long focused on the agency problems between corporate managers and shareholders that result from the dispersion of ownership in large publicly traded corporations. In this paper, we focus on how the rise of institutional investors over the past several decades has transformed the corporate landscape and, in turn, the governance problems of the modern corporation. The rise of institutional investors has led to increased concentration of equity ownership, with most public corporations now having a substantial proportion of their shares held by a small number of institutional investors. At the same time, these institutions are controlled by investment managers, which have their own agency problems vis-à-vis their own beneficial investors. We develop an analytical framework for understanding the agency problems of institutional investors, and apply it to examine the agency problems and behavior of several key types of investment managers, including those that manage mutual funds—both index funds and actively managed funds—and activist hedge funds. We show that index funds have especially poor incentives to engage in stewardship activities that could improve governance and increase value. Activist hedge funds have substantially better incentives than managers of index funds or active mutual funds. While their activities may partially compensate, we show that they do not provide a complete solution for the agency problems of other institutional investors.

Does Institutional Ownership Matter for International Stock Return Comovement?

We study the link between international stock return comovements and institutional investment. We test the hypothesis that the rise of institutional investors as shareholders of corporations worldwide has increased cross-country correlations and decreased cross-industry correlations. Using stock-level institutional holdings across 45 countries during the period 2001-2010, we find that industry and global factors are relatively more important than country factors in explaining stock return variation among stocks with higher institutional ownership. Industry diversification strategies offer more benefits than country diversification benefits for stocks with high institutional ownership. Our findings show that cross-border portfolio investment is a powerful force of international capital markets integration and convergence of asset prices across countries.

Center-Left Politics and Corporate Governance: What Is the 'Progressive' Agenda?

For as long as corporations have existed, debates have persisted among scholars, judges, and policymakers regarding how best to describe their form and function as a positive matter, and how best to organize relations among their various stakeholders as a normative matter. This is hardly surprising given the economic and political stakes involved with control over vast and growing resources, and it has become commonplace to speak of various approaches to law in decidedly political terms. In particular, on the fundamental normative issue of the aims to which decision-making ought to be directed, shareholder-centric conceptions of the corporation have long been described as politically right-leaning while stakeholder-oriented conceptions have conversely been described as politically left-leaning. When the frame of reference for this normative debate shifts away from state law, however, a curious reversal occurs. Notably, when the debate shifts to federal political and judicial contexts, one often finds actors associated with the political left championing expansion of shareholders' powers, and those associated with the political right advancing more stakeholder-centric conceptions of the corporation. The aim of this article is to explain this disconnect and explore its implications for the development of U.S. governance, with particular reference to the varied and evolving views of the political left - the side of the spectrum where, I argue, the more dramatic and illuminating shifts have occurred over recent decades, and where the state/federal divide is more difficult to explain. A widespread and fundamental reorientation of the Democratic Party toward decidedly centrist national politics fundamentally altered the role of and related issues in the project of assembling a competitive coalition capable of appealing to working- and middle-class voters. Grappling with the legal, regulatory, and institutional frameworks - as well as the economic and cultural trends - that conditioned and incentivized this shift will prove critical to understanding the state/federal divide regarding what the progressive agenda ought to be and how the situation might change as the Democratic Party formulates responses to the November 2016 election. I begin with a brief terminological discussion, examining how various labels associated with the political left tend to be employed in relevant contexts, as well as varying ways of defining the field of corporate governance itself. I then provide an overview of progressive thinking about in the context of state law, contrasting those views with the very different perspectives associated with center-left political actors at the federal level. Based on this descriptive account, I then examine various legal, regulatory, and institutional frameworks, as well as important economic and cultural trends, that have played consequential roles in prompting and/or exacerbating the state/federal divide. These include fundamental distinctions between state law and federal securities regulation; the differing postures of lawmakers in Delaware and Washington, DC; the rise of institutional investors; the evolution of organized labor interests; certain unintended consequences of extra-corporate regulation; and the Democratic Party's sharp rightward shift since the late 1980s. The article closes with a brief discussion of the prospects for state/federal convergence, concluding that the U.S. system will likely remain theoretically incoherent for the foreseeable future due to the extraordinary range of relevant actors and the fundamentally divergent forces at work in the very different legal and political settings they inhabit.

An Alternative Post-Keynesian Framework for Understanding Capital Flows to Emerging Markets

:This article contributes to the establishment of a framework for the analysis of international capital flows, with a specific focus on emerging markets. It is based on a “monetary” analysis of the economy, as well as on the works of Hyman Minsky and Jan Toporowski in particular. The key aspects of such an approach are the following. First, in a monetary economy, capital flows need to be understood as “flows of funds” that pertain to the realm of financial choices, as opposed to the traditional understanding of capital flows as based on “real” variables, such as saving and investment. A consequence of this is the need to focus on gross flows rather than capital flows. Second, liquidity preference considerations also apply at the international level, particularly in relation to the liquidity of emerging-market currencies that, in turn, depends on context-specific “Keynesian fundamentals.” Third, the rise of institutional investors is the key historical development in the financial system, shaping the current reality of cross-border capital flows, including to emerging markets. I argue that institutional investors’ liabilities, in light of the theories of Minsky and Toporowski, are one of the most important variables in determining these investors’ portfolio choices. I synthesize these elements by defining capital flows to emerging markets as the demand for emerging-market assets by institutional investors. I propose a framework to categorize the various channels that guide this demand.

The Agency Problems of Institutional Investors

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.

The Rise and Fall of Delaware's Takeover Standards

The takeover standards that we learn and teach in law school, Revlon, Unocal, Weinberger, and Blasius, appear to be in decline. In this chapter for the book The Corporate Contract In Changing Times: Is the Law Keeping Up? (eds. William Savitt, Steven Davidoff Solomon, Randall Thomas), we attempt to explain the rise and fall of jurisprudential takeover standards in Delaware. We theorize that these standards were created by Delaware courts in the mid-1980s to rectify a perceived failure in the corporate governance system, principally the apparent failure of directors to act responsibly in the corporate governance eco-system. These new standards successfully channeled takeovers into certain preferred forms, but also helped ameliorate the problematic practices of that period. These new standards collectively had another effect: encouraging the rise of private enforcement activities, initially by the raiders themselves, but once hostile transactions became a less significant force, through expanded shareholder litigation. In this new environment, private litigation became increasingly unnecessary, a fact which became quite apparent with the rise in litigation rates to 96% of all takeovers. At the same time, the rise of institutional investors, coordinating bodies such as proxy solicitors, hedge fund activism and corporate governance movements, as well as the expansion of federal securities law into areas like executive compensation and board independence/monitoring, occurred. The consequence was a largely justifiable relaxation of these standards.

Consistent Forecasting vs. Anchoring of Market Stories: Two Cultures of Modeling and Model Use in a Bank

ArgumentIt seems theoretically convenient to construe knowledge practices in financial markets and organizations as “applied economics.” Alternatively or additionally, one might argue that practitioners draw on economic knowledge in order to systematically orient their actions towards profit-maximization; models, then, are understood as devices that make calculative rationality possible. However, empirical studies do not entirely confirm these theoretical positions: Practitioners’ actual calculations are often not “framed” by models; organizations and institutions influence the choice and adoption of models; and different professional groups in financial markets have diverging attitudes towards model calculations. In order to account for this diversity, this article proposes the concept ofcultures of economic and financial expertise; the concept focuses on the patterns of knowledge practices and knowledge-related self-definitions of groups within financial organizations and markets; it also facilitates an analysis of the relations between and, more specifically, the hierarchies among different practices and identities. The article then goes on to explore the process of foreign exchange forecasting in a particular bank. The description immediately reveals that two groups are involved in this process: economists and analysts. These groups maintain quite different practices and self-descriptions in relation to models: While the economists in the bank use the models as organizational resources for consistent forecasting procedures and observe data with the help of simple model structures, analysts approach model forecasts from the perspective of critics: They see limits in the variable-centered, as opposed to a “thematic” approach and they disregard a model's imposed temporality. Nevertheless, analysts use model forecasts as anchors for developing their own “paths” and stories about possible future expectation changes in the markets. The specific division of labor between economists and analysts, and specifically the dominant role of analysts in the forecasting process, fit into a larger picture: The rise of institutional investors in the foreign exchange markets and their demand for genuine market knowledge for speculative investment projects has contributed to the rise and dominance of analysts’ culture.

The Influence of Capital Structure on Strategic Human Capital

Strategic human capital research has emphasized the importance of human capital as a resource for sustained competitive advantage, but firm investments in this intangible asset vary considerably. This article examines whether and how external pressures on firms from capital markets influence their human capital strategy. These pressures have increased over the past three decades due to banking deregulation, technological innovation, and the rise of institutional investors and new financial intermediaries. Against this backdrop, this study examines whether a firm’s capital structure as measured by share turnover, shareholder concentration, and financial leverage is associated with firm investment in strategic human capital. Based on survey and objective financial data from 221 establishments in the United States and Canada, our analysis indicates that firms with greater share turnover, higher shareholder concentration, and higher levels of financial leverage are less likely to invest in human resource systems that create strategic human capital. Differences in national financial systems also lead to differential effects for U.S. and Canadian firms.

Proposal: Does Institutional Ownership Matter for International Stock Return Comovement?

The study of the determinants of stock return comovements is central to the international finance literature. In a classical contribution, Heston and Rouwenhorst (1994) argue that country-specific factors are more important drivers of volatility than cross-country industry factors. While international capital and trade barriers have fallen in the last decades, many other studies confirm these findings (Griffin and Karolyi (1998), Rouwenhorst (1999), Bekaert, Hodrick and Zhang (2009), among others). In this paper, we directly examine the increasing role of institutional investors, which invest worldwide, as potential agents of financial globalization. We test whether the rise of institutional investors as shareholders of corporations worldwide has been associated with increased cross-country correlations. For this purpose, we use new 2001-2010 data from FactSet/LionShares with portfolio holdings from over 5,700 institutions in over 20,000 stocks in 49 countries, with positions exceeding a total of US$18 trillion as of December 2010. As these professional investors pursue more industry or global focused portfolio strategies, we expect that asset pricing factors become more integrated across country boundaries. Thus, we test whether global and industry factors matter more for firms with higher institutional ownership, and conversely country factors matter less. We expect to find that the effect to be stronger for stocks held by foreign-based institutions which, by definition, exhibit less “home bias” (French and Poterba (1991)). The overall objective of this research project is to examine whether cross-border portfolio investment by institutional investors is a force of international capital markets integration.

Institutional investors and the reproduction of neoliberalism

Despite their increasing prominence within the contemporary financial system, the collective impact of institutional investors (i.e. mutual, pension and hedge funds) and, in particular, their role in the reproduction of neoliberalism has received little attention among scholars. The argument of this article is that a focus on institutional investors is necessary in order to develop a more complete understanding of the shift towards neoliberal social relations of production. More precisely, it argues that institutional investors possess specific characteristics which are serving to reproduce neoliberal restructuring in both coercive and consensual ways. In terms of the former, it argues that the rise of institutional investors has led to a centralization of investment decision making and to a situation in which neoliberalism is being reproduced in a coercive fashion. In terms of consent, this article argues that the specific characteristics of institutional investors are serving to link a broad range of interests in civil society to those of financial institutions. Taken as whole, this analysis contributes to the growing international relations scholarship which identifies the increasing power of non-state actors in the international system and their role in the contemporary process of restructuring.