Index Fund Stewardship
Posted by Lucian Bebchuk, Alma Cohen, and
Scott Hirst (Harvard Law School), on Tuesday, June 12, 2018
In an article published in the American Economic
Association’s Journal of Economic Perspectives, The
Agency Problems of Institutional Investors (Bebchuk, Cohen and Hirst (2017)
or “BCH”), we put forward and applied an analytical framework for understanding
the monitoring and engagement decisions made by index funds. (Our article also
extend the framework to actively managed funds). In light of the current policy
discussions regarding the rise of index investing, this post discusses some of
the implications of our article’s results and conclusions for this discussion.
A significant body of recent work has
expressed serious concerns that the rise of indexing leads to increase
in “common ownership” that produces anti-competitive effects (e.g., Azar,
Schmalz & Tecu (2018), Elhauge
Scott Morton & Weyl (2017)). These writers worry that index funds,
which have substantial ownership in many companies that operate in a
given industry, can induce corporate managers to act in a more
anti-competitive fashion than they would do without such institutional
owners. We show that this line of work fails to take into account the
incentives of index fund managers that we analyze. As a result, it
makes implausible assumptions regarding the extent to which index fund
managers influence the business decisions of their portfolio
companies. Our incentive analysis should temper the concerns of
the same time, our incentive analysis should also temper the enthusiasm of those
who expect large governance benefits to flow from the rise of index investment.
On the view of index-fund-enthusiasts, because index funds do not have the
option of exit, they have a strong incentive to improve governance and thereby
improve value, and their substantial stakes in companies enable them to do so.
Indeed, the leaders of the largest index fund managers have made public
announcements stressing their commitment to stewardship and improving corporate
governance, and these fund managers have been expanding the number of staff that
are dedicated to voting and engagement.
governance commitments by index fund managers are encouraging, and we recognize
that well-meaning index fund managers may make stewardship decisions that are
superior to those predicted by an incentive calculus. However, a key premise in
the fields of corporate governance and financial economics is that incentives
matter. Our analysis sheds light on the structural incentive problems that
impede the ability of index funds to produce governance benefits.
give readers a sense of these problems we discuss below two structural factors
that sharply limit the benefits to index fund managers from bringing about
value-enhancing changes. (Among other things, our article also analyzed private
costs that index fund managers bear that discourage them from seeking governance
changes that the managers of portfolio companies resist; see BCH, pp.
101-104.) Our discussion below proceeds in three steps:
We first identify an
analytical benchmark, the actions that would be optimal from the perspective
of the beneficial investors in index funds;
We then analyze how
the tiny fraction of governance-generated gains captured by index fund
managers provides incentives to under-invest significantly compared to this
Finally, we analyze
how the competition for investment assets among rival index fund managers
provides no incentives to seek value gains.
Benchmark Scenario: Stewardship Decisions that Maximize Portfolio Value
focus is on the stewardship decisions of index fund managers. Such stewardship
can take various forms, including monitoring the managers of portfolio
companies, obtaining information relevant for assessing the governance of
portfolio companies, as well as proposals coming for a vote, and engaging
directly with company managers.
us consider an index fund in a hypothetical scenario where there are no agency
problems in the management of the fund. For instance, suppose that the index
fund manager owned all the beneficial investments in the fund. In this case, the
index fund manager would have an incentive to make stewardship decisions that
would maximize the total wealth of the index fund’s owners. Formally, suppose
that some stewardship activity would cost C and increase the value of the
index fund’s portfolio by ΔV. Then, in the benchmark no-agency-problems
scenario, the stewardship activity would be undertaken if C < ΔV.
large equity positions — like those that index fund managers hold in many
companies — this no-agency-problems scenario would often predict meaningful
investments in stewardship activities. FactSet data that we reviewed indicates
that each of the Big Three – BlackRock, Vanguard, and State Street Global
Advisors – holds positions exceeding $1 billion in value in a large number of
public companies. Consider an index fund that owns a $1 billion investment in a
given portfolio company, and suppose that investment in certain stewardship
activities would increase the value of the company by 0.1 percent. In the
no-agency-problems scenario, the index fund would have an incentive to spend up
to $1 million on stewardship to bring about this change.
Capturing Only a Small Fraction
of the Benefit
now turn to the decisions that index fund managers can be expected to find
privately optimal in such a situation. We initially take as given the level of
fees charged by investment managers and the size of the portfolio managed; we
then relax these assumptions below.
key source of agency problems is that index fund managers bear the costs of
stewardship activities, but capture only a small fraction of the benefits that
they create. For example, under their existing arrangements, if an index fund
manager were to employ staff fully dedicated to stewardship of a small number of
companies, or if an investment manager were to conduct a proxy fight in
opposition to incumbent managers, the index fund manager would have to cover
those expenses itself, out of the fee income it receives from investors.
the same time, the benefits from stewardship flow to the portfolio. Index fund
managers do not receive incentive fees on increases in the value of their
portfolio but only charge fees that are calculated as a percentage of assets
under management. Let α be the fraction of assets under management that an
investment manager charges as fees. Therefore, α is also fraction of the
increase in the value of a portfolio company that the index fund manager would
be able to capture, in present value terms, from additional fees.
value of α is likely to be small for index fund managers, as the asset-weighted
average net expense ratio for US equity index funds is on the order of 10 basis
points (see, e.g., Oey
and West, 2016). It would not be in the interests of the investment manager
to spend an amount C that would produce a gain of ΔV to the
portfolio if C is larger than α × ΔV. Thus, agency problems would
lead to underspending on stewardship, precluding efficient expenditure,
α × ΔV < C <
illustrate this wedge, reconsider the example above of an index fund that holds
a $1 billion investment in a portfolio company whose value would increase by $1
million if certain stewardship activities are undertaken. Assume that the index
fund manager would expect additional fees with a present value of 0.5 percent
from the $1 million increase in the value of the investment. In this case, the
index fund manager would be willing to undertake these stewardship activities
only if their cost were below $5,000. The expected private benefit to the index
fund manager, and correspondingly the maximum that the fund manager would be
willing to spend end on the stewardship activities, is tiny compared with the
$1 million in the no-agency-costs scenario.
The Limits of Competition
far our analysis has assumed that index fund managers take their fees and their
assets under management as given. We now relax this assumption. This enables us
to consider whether the desire to attract additional funds might counter the
distortions identified above – and thereby lead index fund managers to make
additional investments in stewardship that would enhance the portfolio value.
Investors wishing to invest in index funds can choose among options offered by
different index fund managers. It is therefore crucial to understand how such
competition affects the incentives of index fund managers.
index fund manager were to increase its spending on stewardship at a particular
portfolio company and thereby increase the value of its investment in that
company, the manager would also increase the value of the index. As a result,
the expenditure would not lead to any increase in the performance of the index
fund relative to the performance of rivals of the index fund manager that follow
the same index. Any increase in the value of the corporation would also be
captured by all other index funds investing according to the index, even though
they had not made any additional expenditure on stewardship.
if the index fund manager were to take actions that increase the value of the
portfolio company, and therefore also the value of the portfolio that tracks the
index, doing so would not result in a superior performance that would enable the
manager to attract funds currently invested with rival index fund managers. Such
decisions would also not enable the index fund manager to increase fees relative
to rivals tracking the same index, as such rivals would offer the same gross
return without the increased fees. Accordingly, for index fund managers, a
desire to improve relative performance would not provide any incentives
that could counter tendencies that the manager might otherwise have to
underspend on stewardship.
might be argued that the inability of index funds to attract additional
investors by increasing stewardship spending implies that the existing
equilibrium is optimal. However, this argument is incorrect. Our analysis
indicates that this equilibrium exists due to a collective action problem.
beneficial investors of an index fund would be better served by having the fund
increase stewardship spending up to the level that would maximize the portfolio
value, even if the fund were to increase its fees to fund this spending.
However, if the index fund were to raise its fees and improve its stewardship,
each individual investor in the fund would have an incentive to switch to rival
index funds. That is, a move by any given index fund manager to improve
stewardship and raise fees would unravel: the fund’s investors would prefer to
free-ride on the manager’s efforts by switching to another investment fund that
offers the same indexed portfolio but without stewardship or higher fees.
Taking Incentives Seriously
above analysis suggests that index fund managers have incentives to under-invest
substantially in stewardship relative to what is optimal for their beneficial
investors. Our article also showed that index fund managers have excessive
incentives to go along with the preferences of corporate managers (BCH, pp.
101-104), as do active fund managers. Both factors are impediments to the
ability of index fund managers to bring about governance gains.
our article explained, while index fund managers are in the process of expanding
the resources they dedicate to stewardship, their current expenditures are
consistent with our incentives analysis (BCH, p. 100). According to Krouse,
Benoit, and McGinty (2016), in 2016 Vanguard employed about 15 staff for
voting and stewardship at its 13,000 portfolio companies; Blackrock employed 24
staff for voting and stewardship at 14,000 portfolio companies; and State Street
Global Advisors employed fewer than 10 staff for voting and stewardship at its
9,000 portfolio companies.
figures imply that the amount of personnel time that each of these major index
funds devoted to each portfolio company was, on average, less than one
person-workday per year. This seems to be very little investment of
personnel time for the tasks involved in monitoring and engaging with portfolio
companies, which include (a) reviewing and assessing (i) the company’s annual
report and proxy statement, (ii) the performance of the directors and the
performance of the company with respect to the long-term plans whose importance
index fund stress, (iii) the company’s executive pay arrangements, (iv) all
management proposals, including proposals regarding option plans, and all
shareholder proposals that go to a vote, as well as (b) reviewing proxy advisor
assessment on these matters, and (c) all engagements that the manager undertakes
with the company during the year.
effects of incentives on behavior are rich and complex, and depend on a number
of dimensions. In our current work we explore ways of improving the stewardship
activities of index fund managers so they contribute to governance significantly
more than they do currently. In the meantime, we hope that the framework of
incentive analysis that our article provided will be useful for helping both
index-fund-alarmists and the index-fund-enthusiasts to re-examine their
complete article is available
Harvard Law School Forum
on Corporate Governance and Financial Regulation
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