Document Type

Article

Publication Date

2018

Abstract

American investors have begun to embrace the reality that academics have been championing for decades — that a broad-based, passive indexing strategy is superior to picking individual stocks or investing in actively managed funds. But there are several reasons to believe that the rise of passive investing will have harmful consequences for firm governance, shareholders, and the economy. First, because passive funds seek only to match the performance of an index — not outperform it — they lack a financial incentive to ensure that each of the companies in their very large portfolios are well-run. Second, passive funds face an acute collective action problem: any investment in improving the performance of a company will benefit all funds that track the index equally, while only the activist fund incurs the costs. Third, governance interventions are especially costly for passive funds, which do not generate firm-specific information as a byproduct of investing and thus must expend additional resources to identify underperforming firms and evaluate interventions proposed by other investors. Such expenditures would undo the cost savings that attracted investors to the passive fund in the first place.

For these reasons, many passive funds are likely to leave company performance to the invisible hand of the marketplace. Even if a fund does choose to intervene, it will rationally adhere to a low-cost, one-size-fits-all approach to governance that is unlikely to be in the company’s best interest. The scope of this problem is potentially immense: as investors continue to flock toward passive investment vehicles, the institutional investors that dominate the passive fund market will increasingly influence and even control the outcome of shareholder interventions — from shareholder votes to those proposed by hedge fund activists — creating widespread economic harm. For that reason, this Article proposes that lawmakers consider restricting passive funds from voting at shareholder meetings. Doing so would reduce the influence of passive funds in governance and also preserve the role of informed investors as a force for managerial discipline.

Disciplines

Business Organizations Law | Law | Securities Law

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