The recent popularity of index investing and corresponding influx of assets into passively managed mutual funds has generated a large literature in law and in finance about the implications for securities markets, antitrust, corporate governance, and beyond. But few have explored the index landscape itself. Professor Robertson’s article is an important exception, and her findings—in particular, that indices are more diverse and dynamic than many would have expected—have implications for all of these debates.
I’ll focus on the conversation that I’ve participated in the most: how the rise in indexing could affect corporate governance at public companies. I have written elsewhere that the popularity of “passive” investing is likely to exacerbate agency cost issues at corporations because index funds are unlikely to be engaged and informed stewards of companies. Others—including the “Big Three” institutional shareholders that dominate the passive fund market—have vociferously denied that this is the case.
Professor Robertson’s analysis sheds light on this debate. She explains that “passive” investing is a misnomer, and by this she means that index investors aren’t doing away with portfolio management altogether—instead, they are delegating the activity of managing the portfolio to an index creator. I believe this delegation supports my view about index fund stewardship. It also introduces a new agency issue that deserves further study. I’ll discuss each of these points in turn.
Here’s why the delegation that Professor Robertson highlights is likely to compromise index fund stewardship. Traditionally, an individual investing in an actively managed mutual fund could expect that the portfolio manager who exercised the governance rights would be the same person who bought and sold the portfolio’s securities. As Professor Robertson shows, index fund investors get something different. Instead of executing trades based on future expectations of performance, the index fund portfolio manager seeks to track the index as closely as possible. This enables the portfolio manager to keep costs (and fees) low because there is no need to acquire firm-specific information. And yet, the right to cast investor votes and engage with companies remains with the index fund (in reality, the funds almost always pass their votes up to centralized stewardship groups, leading to other problems).
This delegated management has two implications for index fund stewardship. The first is that the firm-specific information necessary to cast informed votes in shareholder elections is housed elsewhere—with the index creator, rather than the fund. Although some indices are proprietary, Professor Robertson’s analysis reveals that often, funds license the index from elsewhere, which means that the information used to create the index sits elsewhere, too. The second implication is that index fund engagement with companies will not be backed by the threat of exit. Accordingly, any such engagement is less likely to result in meaningful changes: even if the index fund portfolio manager were to be unhappy with management, the exit decision is controlled by someone else.
In sum, the delegated management that Professor Robertson identifies suggests that the index funds are not as well positioned to exercise their governance rights as their actively managed fund counterparts. As Professor Robertson also recognizes, the delegation also results in a new agency issue, which is the second point I’d like to touch on. In an actively managed fund, investors entrust portfolio management to someone who is duty-bound to act in their best interests. The index creator, on the other hand, is not a fiduciary, and may not even be known to the investor. In addition, the index creator has a profit motive—they seek to maximize revenue by encouraging funds to license their indices. This can be accomplished by creating a very good index, perhaps by ensuring that the companies included in the index adhere to the best governance standards. But there are other ways to maximize revenue, such as marketing, or even by catering to institutional investor clients in various ways.
Take the recent debate over dual class stock as an example. After a wave of technology company IPOs with differential voting rights prompted public outcry, many major index providers (specifically, Russell FTSE, S&P Dow Jones, and MSCI) altered their methodology to exclude or reduce the weight of companies with differential voting rights. This may be an example of index creators stomping out a bad governance practice: again, if the index excludes badly governed companies, the index creator will benefit from having made a more desirable index (and the index fund’s investors will benefit too). But it’s unlikely that this was the only reason for the exclusion. There are other “bad” governance practices that are less controversial, such as overloaded and overpaid directors, that have not attracted attention from major index providers. Not only that, the indices that took action did so only partially. Major dual-class technology companies like Alphabet and Facebook were grandfathered into the indices—the S&P 500 could not claim to represent the large-cap equity market and exclude two of the ten largest companies in the world. So what motivated the partial exclusion decision? One factor may have been aggressive lobbying from the Council of Institutional Investors, which represents all of the largest U.S. asset managers and which has been campaigning against dual-class companies for years.
The agency issue created when portfolio management is entrusted to non-fiduciary index creators deserves further study, as do the overall implications for corporate governance (and a recent article by Scott Hirst and Kobi Kastiel provides an excellent starting point). As for the latter question, it may be that investors are no worse off—even despite the suboptimal incentives of the index funds themselves—if index creators have an incentive to ensure that their indices exclude badly governed companies, as well as the ability to influence corporate behavior. But these requirements cut in different directions. The larger indices—the ones that are more likely to be able to alter company behavior with standards for inclusion and exclusion—tend to be popular because they purport to neutrally capture the market. And as Professor Robertson’s data shows, the smaller indices that pick and choose companies based on different criteria (i.e., a music industry index, or even a good governance index) are unlikely to have sufficient clientele to affect company behavior.
Dorothy Lund is Assistant Professor of Law at the University of Southern California.
This post is part of a symposium on delegated investment management. The rest of the posts in this symposium can be viewed here.