Passive Institutional Investors and Corporate Innovation

Abstract

We study the effects of passive institutional investors on corporate innovation. The existing literature has shown a negative relation between the two, and in some cases, no relation. When we apply an instrumental variable approach based on Russell 1000/2000 index reconstitution to explore an exogenous variation of passive institutional ownership, we find that higher passive institutional ownership leads to more corporate innovation measured in terms of both patent quantity and quality. These results are in line with the evidence established in the existing literature that passive institutional investors play a key role in influencing corporate governance choices. In addition, we show three more channels: first, passive institutional investors are passive monitors in the sense that their increased presence allows more flexibility and transfers more power to the firm’s management; second, passive institutional ownership reduces the likelihood of CEO turnover especially for firms that are outperforming their industry peers; third, greater passive institutional ownership is associated with a wider adoption of non-executive employee stock options, which helps incentivize innovative activities.

Keywords: Corporate Innovation, Investment, Institutional Investors, Quasi-Indexers

JEL Classification: G23, G30, O31