Institutional investors own more than 70 per cent of U.S. public firms and passive funds have seen significant growth, from five per cent of mutual funds in 2000 to more than 30 per cent today, but the jury is still out on what this means for corporate governance.
Using a theoretical framework, a new paper digs into how passive ownership impacts the governance of U.S. firms. It highlights two incentives for asset managers to engage in governance initiatives: fees and the size of the stake in the corporation.
While some may be concerned that lower investment management fees will lead to less engagement and therefore lower firm value, the paper found that, in fact, passive fund growth may improve governance, even if fees are lower, because lower fees go hand-in-hand with increased assets under management. As such, passive firms can take a bigger stake in portfolio companies, which provides a greater incentive to engage with management.
Further, the paper said impact on governance may depend on whether passive funds replace retail investors or active fund managers.
“Our paper emphasizes that the key for the effect of passive fund growth on firm value is who they are replacing when their assets under management grow,” says Nadya Malenko, an associate professor of finance at the University of Michigan and one of the paper’s co-authors. “You can imagine there are three types of investors: there are passive funds, there are active funds, but there are also retail investors. And what we show is [it] really matters whether passive funds replace retail investors when they grow and become more available or whether they replace active fund managers.
“Because retail investors, traditionally, . . . have been passive, they have small stakes. They don’t have a lot of information. They don’t traditionally engage in governance. That means that, as passive funds grow, in those firms where they’re primarily replacing retail investors, we should expect governance to improve.”
On the flip side, when passive funds replace active funds, overall governance becomes worse and the firm’s value decreases, says Adrian Corum, an assistant professor of finance at Cornell University and another co-author of the paper. “This is because active funds have higher fees and therefore have stronger effects on governance. Therefore, if they are replaced, it has a negative effect on firm’s value, so who gets replaced is crucial.”
The paper also demonstrated that, while a rise of passive management can increase competition and lead to lower fees for investors, the lower fees could also decrease the incentive to engage with company management and be detrimental to governance.
Further, a trade-off exists between governance and the returns to fund investors. “If governance improves, that is often detrimental to the investors of the funds themselves and that, to me, . . . was quite surprising,” says Malenko.
In an efficient market, pricing already incorporates the expectation that fund managers will be engaging in governance and improving the value of portfolio companies, she adds. “And because [the] price is incorporated information, prices of assets increase, so stock returns go down and that hurts fund investors.”
Along with Corum and Nadya Malenko, Andrey Malenko, an associate professor of finance at the University of Michigan, is a co-author of the paper.
The paper was presented at the Northern Finance Association’s 2020 conference. The Canadian Investment Review is a proud partner of the NFA conference.