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About Index Funds, Complacent Managers, and Destruction of Shareholder Value

Posted by
Swiss Finance Institute
Friday, December 8, 2017 - 08:00

Passively managed index funds are on the rise. But do institutional investors actually have the capacity and interest to monitor the corporations they are invested in? And what is the impact of passive institutional ownership for shareholders?

To find out, SFI Professor Rüdiger Fahlenbrach (Ecole Polytechnique Fédérale de Lausanne) and Cornelius Schmidt, SFI PhD, focused on examining two areas of corporate governance that may rapidly be influenced by executives after a change in a firm’s ownership structure: the accumulation of titles on the board of directors and the turnover at the board level, as a measure of directors’ power within the organization. The coauthors then measured shareholder reactions—were the returns on such board announcements positive or negative?—and, finally, the effect of more passive shareholder structures on firms’ M&A transactions.

While passive institutional investors insist on executing their duties concerning corporate governance, it is not clear how actively they really perform in that regard. Many institutional investors actually seem to mechanically follow the voting recommendations they are provided with—which actually leads to consistent votes at annual meetings and hence positively affects corporate governance. However, in their research paper «Do Exogenous Changes in Passive Institutional Ownership Affect Corporate Governance and Firm Value?», the authors find evidence that corporate executives use the shift toward a more passive shareholder base to influence corporate governance and advance their personal interests: the more passive owners a firm has, the more power the CEO gets, and his or her likelihood of becoming chairman or president increases significantly, while board turnover decreases so that the directors serve longer—and that seems to be bad for the shareholders. Furthermore, returns on M&A announcements seem to decrease when passive ownership increases, which results in a meaningful reduction of monetary shareholder value. And indeed, firms held by more passive investors seem to undertake worse M&A deals compared to their peers with a more active shareholder base. All these results are clear signs that passive investors such as index funds mean higher agency costs for the shareholders and lead to empire building for personal gains by corporate executives.

The authors first examined the existing academic literature and studies on the topic concerned to derive their hypotheses. Then they conducted empirical analysis, using numerous data sources.

Fahlenbrach and Schmidt’s research paper has been accepted for publication in the Journal of Financial Economics and has been discussed in a post on Bloomberg’s Money stuff blog. They have also summarized their insights in a blog post on the Harvard Corporate Governance and Financial Regulation forum

Would you like to learn more about corporate governance or managing institutional investments? We offer courses—for example the CAS in Asset Management, the CAS in Corporate Banking, or the SFI Spotlight Course Corporate Governance & Strategy.