The New Titans of Wall Street: A Theoretical Framework for Passive Investors

51 Pages Posted: 6 Jun 2018 Last revised: 19 Mar 2019

See all articles by Jill E. Fisch

Jill E. Fisch

University of Pennsylvania Law School - Institute for Law and Economics

Assaf Hamdani

Tel Aviv University Faculty of Law

Steven Davidoff Solomon

University of California, Berkeley - School of Law; University of California, Berkeley - Berkeley Center for Law, Business and the Economy

Date Written: March 1, 2019

Abstract

Passive investors — ETFs and index funds — are the most important development in modern day capital markets, dictating trillions of dollars in capital flows and increasingly owning much of corporate America. Neither the business model of passive funds, nor the way that they engage with their portfolio companies, however, is well understood, and misperceptions of both have led some commentators to call for passive investors to be subject to increased regulation and even disenfranchisement. Specifically, this literature takes a narrow view both of the market in which passive investors compete to manage customer funds and of passive investors’ participation in the capital markets. We respond to this failure by providing the first comprehensive theoretical framework for passive investment and its implications for corporate governance. To start, we explain that, to understand passive funds, it is necessary to understand the institutional context in which they operate. Two key insights follow. First, because passive funds are simply a pool of assets — their incentives are a product of the overall business operations of fund sponsors. Second, although passive funds are locked into their investments, their shareholders are not. Like all mutual fund investors, shareholders in index funds can exit at any time by selling their shares and receiving the net asset value of their ownership interest. Consequently, the sponsors of passive funds must compete on both price and performance with other investment options — including both other passive funds and actively-managed funds — for investor dollars. As we explain, this competition provides passive fund sponsors with a variety of incentives to engage. Furthermore, the size of the major fund sponsors and the breadth of their holdings affords them economies of scale enabling them to engage effectively. An examination of passive investor engagement in corporate governance demonstrates that passive investors behave in accordance with this theory. Passive investors are devoting greater sophistication and resources to engagement with their portfolio companies and are exploiting their comparative advantages — their size, breadth of portfolio and resulting economies of scale — to focus on issues with a broad market impact, such as potential corporate governance reforms, that have the potential to reduce the underperformance and mispricing of portfolio companies. Passive investors use these tools, as opposed to analyzing firm-specific operational issues, to reduce the relative advantage that active funds gain through their ability to trade. We conclude by exploring the overall implications of the rise of passive investment for corporate law and financial regulation. We argue that, although existing critiques of passive investors are unfounded, the rise of passive investing raises new concerns about ownership concentration, conflicts of interest and common ownership. We evaluate these concerns and the extent to which they warrant changes to existing regulation and practice.

Keywords: Law and economics, corporate governance, securities law, passive investing, mutual funds, ETFs, corporate finance, institutional investors, shareholder activism, capital markets

JEL Classification: G11, G23, K22

Suggested Citation

Fisch, Jill E. and Hamdani, Assaf and Davidoff Solomon, Steven, The New Titans of Wall Street: A Theoretical Framework for Passive Investors (March 1, 2019). University of Pennsylvania Law Review, Forthcoming 2019; U of Penn, Inst for Law & Econ Research Paper No. 18-12; UC Berkeley Public Law Research Paper; European Corporate Governance Institute (ECGI) - Law Working Paper No. 414/2018. Available at SSRN: https://ssrn.com/abstract=3192069 or http://dx.doi.org/10.2139/ssrn.3192069

Jill E. Fisch (Contact Author)

University of Pennsylvania Law School - Institute for Law and Economics ( email )

3501 Sansom Street
Philadelphia, PA 19104
United States
215-746-3454 (Phone)
215-573-2025 (Fax)

Assaf Hamdani

Tel Aviv University Faculty of Law ( email )

Ramat Aviv
Tel Aviv 69978, IL
Israel

Steven Davidoff Solomon

University of California, Berkeley - School of Law ( email )

215 Boalt Hall
Berkeley, CA 94720-7200
United States

University of California, Berkeley - Berkeley Center for Law, Business and the Economy ( email )

Berkeley, CA 94720-7200

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