Are Passive Investors a Challenge to Corporate Governance?

Abstract

Corporate governance theories generally suggest that institutional investors could effectively improve the quality of governance through intervention and threat to exit. However, passive institutional investors such as index funds and ETFs lack the ability to exit and may not have strong motivation to intervene, thus lowering the quality of governance of the firms they heavily hold. This paper provides empirical evidence supporting this hypothesis. It shows that higher ownership by passive investors is related to lower firm value measured by Tobin’s Q and weaker operating performance measured by return on assets. Further analysis suggests that passive investors negatively affect several aspects of corporate governance: they exacerbate the managerial myopia problem by discouraging long-term investment, weaken managers’ incentive scheme by lowering the pay-for-performance sensitivity and the probability of performance-based disciplinary turnover, and reduce the independence of the board by raising the probability of CEO-chair duality.

Keywords: Passive Investors, Corporate Governance, Firm Performance, Executive Compensation, CEO Turnover

JEL Classification: G23, G34