Index Funds and the Future of Corporate Governance: Theory, Evidence, and Policy
Forthcoming, Columbia Law Review, Vol. 119, 2019
Harvard Law School John M. Olin Center Discussion Paper No. 986
95 Pages Posted: 14 Nov 2018 Last revised: 17 Jul 2019
Date Written: May 31, 2019
Index funds own an increasingly large proportion of American public companies, currently more than one fifth and steadily growing. 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 policy-making can improve it, is critical for corporate law scholarship. This Article contributes 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 the incentives of index fund managers. Our agency-costs analysis shows that index funds have strong incentives to (i) under-invest in stewardship, and (ii) defer excessively to the preferences and positions of corporate managers.
We then provide the first comprehensive and detailed evidence of the full range of stewardship activities that index funds do and do not undertake. This body of evidence, we show, is consistent with and can be explained by our agency-costs analysis.
We next put forward a set of policy reforms that should be considered in order to encourage index funds to invest in stewardship, to reduce their incentives to be deferential to corporate managers, and to address the concentration of power in the hands of the largest index fund managers. Finally, we 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: Suggested Citation