Concern about the proliferation of passive investors is growing, but no one has yet called for eating babies as a solution to this overpopulation.
Although none of the responses so far have been as extreme as Jonathan Swift’s satirical proposal to solve 18th century Irish poverty, some of the charges against the rising passive tide have been as deadpan.
‘Are index funds evil?’ asks an article in the September issue of The Atlantic, citing research indicating that competition between companies in an industry declines when they are owned by the same passive managers.
At the end of July, Elliott Management founder Paul Singer warned that ‘passive investing is in danger of devouring capitalism.’ He argued that ‘what may have been a clever idea in its infancy has grown into a blob which is destructive to the growth-creating and consensus-building prospects of free-market capitalism,’ given that ‘the biggest shareholders have no – repeat, no – skin in the game’.
And last year, analysts at Sanford C. Bernstein claimed that ‘passive investing is worse than Marxism’ and sets economies on a ‘silent road to serfdom’ because indexers don’t attempt to allocate capital efficiently.
The downside of passive aggression
So what is to be done about this passive threat to the economic order? In a forthcoming essay for the Journal of Corporation Law, the University of Chicago’s Dorothy Shapiro Lund advocates a novel policy: stop passive investors from exercising their shareholder voting rights.
Shapiro Lund highlights several factors that are likely to deter passive managers from intervening in their holdings’ corporate governance.
First, because passive providers don’t have to employ any corporate-governance watchdogs or portfolio strategists, the costs must either be borne by the asset manager or passed on to clients. With low fees a primary attraction of the passive option, this is unappealing.
Second, as passive funds typically hold many more stocks than active mandates – around 500 for an S&P 500 tracker, versus an average of fewer than 100 for large-cap mutual funds according to one study – indexers have far less incentive to make this investment in corporate reform since any portfolio benefits will be heavily diluted.
Third, if any passive manager does take a stand and force positive change, its rivals will benefit as free riders because they own the same stocks.
‘In sum, the rise of passive investing exacerbates agency and collective-action problems associated with intermediated finance – although investors desire good governance, they are not willing to pay the fees necessary to secure it and would instead prefer to free ride on the investments of others,’ Shapiro Lund argued.
‘The same is true for passive fund managers, who will not invest in improving firm governance because any such investment will harm the fund’s competitiveness. Therefore, unlike active funds, passive managed funds have no financial incentive to monitor management or invest in governance interventions.’
Silence the passive
Passive titans such as BlackRock, Vanguard and State Street will naturally counter that they do invest in corporate governance, but Shapiro Lund maintained that ‘a closer look induces some skepticism about these claims.’ In her opinion, the teams devoted to these tasks within the asset managers are simply too small to discharge their responsibilities effectively over the tens of thousands of companies they oversee.
So how does Shapiro Lund justify her severe remedy of stripping passive investors of their votes? ‘A key benefit of restricting passive funds from voting is that doing so enhances the voting power of informed active investors, thus preserving the market for influence as a force for discipline.’
Shapiro Lund offered some evidence to demonstrate active managers’ role: one study has linked value-destroying acquisitions and dividend cuts to unengaged institutional investors, and another discovered lower risk-adjusted returns at companies that followed compensation recommendations from the proxy advisers many passive funds hire.
For Shapiro Lund, then, passive funds should either be banned from voting or should be required to pass their voting rights through to their end investors directly.
‘More study is necessary to determine the best option, but it appears that a rule restricting passive funds from voting would offer the most benefits and create the fewest costs,’ she concluded.
‘Active fund analysts are the primary drivers of meetings with management and the board; as their number decreases, institutional investor engagement will become less frequent and less effective. Accordingly, fewer battles will be settled in backroom conversations, as many are now, and a greater number will be resolved in expensive proxy battles. Thus, by restricting passive funds from voting, the law would reduce the risk of governance distortion created by the rise of passive investing.’