Index Funds and the Future of Corporate Governance: Theory, Evidence, and Policy

Forthcoming, Columbia Law Review, Vol. 119, December 2019

European Corporate Governance Institute (ECGI) - Law Working Paper No. 433/2018

Harvard Law School John M. Olin Center Discussion Paper No. 986

126 Pages Posted: 14 Nov 2018 Last revised: 4 Nov 2019

See all articles by Lucian A. Bebchuk

Lucian A. Bebchuk

Harvard Law School; National Bureau of Economic Research (NBER)

Scott Hirst

Boston University - School of Law; Harvard Law School Program on Corporate Governance

Date Written: May 31, 2019

Abstract

Index funds own an increasingly large proportion of American public companies. The stewardship decisions of index fund managers—how they monitor, vote, and engage with their portfolio companies—can be expected to have a profound impact on the governance and performance of public companies and the economy. Understanding index fund stewardship, and how policymaking can improve it, is thus critical for corporate law scholarship. In this Article we contribute to such understanding by providing a comprehensive theoretical, empirical, and policy analysis of index fund stewardship.

We begin by putting forward an agency-costs theory of index fund incentives. Stewardship decisions by index funds depend not just on the interests of index fund investors but also on the incentives of index fund managers. Our agency-costs analysis shows that index fund managers have strong incentives to (i) underinvest in stewardship and (ii) defer excessively to the preferences and positions of corporate managers.

We then provide an empirical analysis of the full range of stewardship activities that index funds do and do not undertake. We analyze four dimensions of the Big Three’s stewardship activities: the limited personnel time they devote to stewardship regarding most of their portfolio companies; the small minority of portfolio companies with which they have any private communications; their focus on divergences from governance principles and their limited attention to other issues that could be significant for their investors; and their pro-management voting patterns.

We also empirically investigate five ways in which the Big Three could fail to undertake adequate stewardship: the limited attention they pay to financial underperformance; their lack of involvement in the selection of directors and lack of attention to important director characteristics; their failure to take actions that would bring about governance changes that are desirable according to their own governance principles; their decision to stay on the sidelines regarding corporate governance reforms; and their avoidance of involvement in consequential securities litigation. We show that the body of evidence is, on the whole, consistent with the incentive problems that our agency-costs framework identifies.

Finally, we put forward a set of reforms that policymakers should consider in order to address the incentives of index fund managers to underinvest in stewardship, their incentives to be excessively deferential to corporate managers, and the continuing rise of index investing. We also discuss how our analysis should reorient important ongoing debates regarding common ownership and hedge fund activism.

The policy measures we put forward, and the beneficial role of hedge fund activism, can partly but not fully address the incentive problems that we analyze and document. These problems are expected to remain a significant aspect of the corporate governance landscape and should be the subject of close attention by policymakers, market participants, and scholars.

This paper is part of a larger project on the incentives of investment managers that also includes The Agency Problems of Institutional Investors (with Alma Cohen) and The Specter of the Giant Three.

Keywords: Index funds, passive investing, institutional investors, corporate governance, stewardship, engagement, monitoring, agency problems, shareholder activism, hedge fund activism

JEL Classification: G23, G34, K22

Suggested Citation

Bebchuk, Lucian A. and Hirst, Scott, Index Funds and the Future of Corporate Governance: Theory, Evidence, and Policy (May 31, 2019). European Corporate Governance Institute (ECGI) - Law Working Paper No. 433/2018; Forthcoming, Columbia Law Review, Vol. 119, December 2019; European Corporate Governance Institute (ECGI) - Law Working Paper No. 433/2018; Harvard Law School John M. Olin Center Discussion Paper No. 986. Available at SSRN: https://ssrn.com/abstract=3282794 or http://dx.doi.org/10.2139/ssrn.3282794

Lucian A. Bebchuk (Contact Author)

Harvard Law School ( email )

Cambridge, MA 02138
United States
617-495-3138 (Phone)
617-812-0554 (Fax)

HOME PAGE: http://www.law.harvard.edu/faculty/bebchuk/

National Bureau of Economic Research (NBER) ( email )

1050 Massachusetts Avenue
Cambridge, MA 02138
United States

Scott Hirst

Boston University - School of Law ( email )

765 Commonwealth Avenue
Boston, MA 02215
United States

Harvard Law School Program on Corporate Governance ( email )

1575 Massachusetts
Hauser 406
Cambridge, MA 02138
United States

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