The Case Against Passive Shareholder Voting

Abstract

American investors have begun to embrace the reality that academics have been championing for decades — that a broad-based passive indexing strategy is superior to picking individual stocks or investing in actively managed funds. But there are several reasons to believe that this trend will have harmful consequences for firm governance, shareholders, and the economy. First, because passive funds seek only to match the performance of an index — not outperform it — they lack a financial incentive to ensure that each of the companies in their very large portfolios are well run. Second, passive funds face an acute collective action problem: any investment in improving the performance of a company will benefit all funds that track the index equally, while only the activist fund incurs the costs. Third, passive funds do not generate firm-specific information as a byproduct of investing and thus must expend additional resources to identify underperforming firms and evaluate interventions proposed by other investors. Such expenditures would undo the cost savings that attracted investors to the passive fund in the first place.

For these reasons, many passive funds will leave company performance to the invisible hand of the marketplace. And even if a fund does choose to intervene, it will rationally adhere to a low cost, one-size-fits-all approach to governance. The scope of this problem is potentially immense: as investors continue to flock toward passive investment vehicles, the institutional investors that dominate the passive fund market will increasingly influence and even control the outcome of shareholder interventions — from shareholder votes to those proposed by hedge fund activists — creating widespread economic harm. For that reason, this paper proposes that lawmakers restrict passive funds from voting at shareholder meetings. Doing so will reduce the influence of passive funds in governance and also preserve the role of informed investors as a force for managerial discipline.

Keywords: Corporate Governance, Corporate Law, Securities Law, Institutional Investors, Hedge Fund Activism, Shareholder Activism, Passive Investing, Index Funds, ETFs, Mutual Funds, Shareholder Voting, Market for Corporate Control, Agency Costs

JEL Classification: K22, G3, G23, G28, G20