Index Funds and Corporate Governance: Let Shareholders be Shareholders

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The largest institutional investors have become the de facto “deciders” of corporate law controversies. In this article, we take a close look at the financial incentives of the largest institutional investors with regard to the three core areas of shareholder involvement: high profile proxy contests between activist shareholders and boards; broad market wide governance standards; and routine monitoring of portfolio companies through “engagement.”

With regard to the highest profile contests that will likely affect firm value, the managers of the three largest index funds – BlackRock, Vanguard and State Street – have direct financial incentives to vote intelligently that are typically larger than any other shareholder, with the occasional exception of very large actively managed mutual funds. With regard to market wide governance standards, the Big Three are better positioned than any other shareholders to set the standards. With regard to routine monitoring, hedge funds and large actively managed funds will often be in a better position to monitor because of their firm-specific knowledge.

The Big Three’s financial incentives to become involved in corporate governance derive from their enormous scale and scope. This is important in several ways. First, scale increases the likelihood that their decisions will be pivotal. Second, even at a low percentage fee, their share of increases in firm value will be larger than almost any other shareholder. Third, their scope generates “spillover knowledge” that is valuable in setting market wide governance standards. Fourth, the scale generates reputational incentives to be seen as responsible stewards, both for marketing and to forestall regulation. For a variety of reasons, flow-based incentives are unlikely to be significant.

Although the Big Three’s scale and scope produce financial incentives to be responsible and informed “deciders,” their incentives and capacity to engage in general monitoring of portfolio companies are not as strong because of their business model and organizational structure. With regard to this sort of monitoring, hedge funds that seek out underperforming companies and large actively managed mutual funds with a pool of analysts and portfolio managers who pick stocks are both better positioned to identify firm-specific problems.

In light of the significant incentives that the Big Three have to play their current roles in corporate governance responsibly, we largely disagree with critics who would prevent them from voting or who view their involvement in corporate governance as reflecting significant agency costs.

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