Efficiency Loss: The Hidden Cost of Passive Investors' Governance

Abstract

While regulators stress the importance of passive investors' fiduciary duty in corporate governance, we argue that by fulfilling their fiduciary duty to increase a firm’s value, passive investors unintentionally create market inefficiencies.
In our model, investors acquire information, optimize portfolios, and affect a firm's value through governance. In equilibrium, bad firms are left governed by passive investors, a consequence of market clearing. Therefore, when passive investors increase a firm's value, they increase it more for bad firms, reducing information sensitivity and generating market inefficiencies. We offer unique empirical predictions and explore applications to ESG policies and product market competition.

Keywords: mutual funds, passive investment, corporate governance, information acquisition, strate- gic complementarities, conflict of interests