Monitoring Spillovers Between Competing Passive and Active Asset Managers

Abstract

The tremendous increase in ownership of US corporations by passive funds raises important issues for the corporate governance of firms. Passive funds primarily compete on both price and performance with other investment options—including active funds, direct investment, and risk-free holdings. There is an ongoing debate on whether this competition provides sufficient incentives to passive funds to invest in corporate governance. In this paper, we shed light on this debate by formally analyzing the monitoring incentives of passive and active funds when they compete with each other. We show that even passive funds find monitoring portfolio firms optimal in equilibrium. We further provide conditions for when passive and active fund monitoring are strategic complements, leading to monitoring of the same firms, or strategic substitutes, leading to monitoring of different firms. Overall, our results provide a more nuanced view of the role that passive funds play in firms' corporate governance.

Keywords: Active funds; Passive funds; Competition; Corporate governance

JEL Classification: D4, G11, G23, G34, K22