Author:Fisch, Jill

If index funds underperform active funds, then assets will flow out from passives to actives.--Bill Ackman, CEO, Pershing Square Management (1)

Passive investors--ETFs and index funds--are the most important development in modern-day capital markets, dictating trillions of dollars in capital flows and increasingly owning much of corporate America. Neither the business model of passive funds, nor the way that they engage with their portfolio companies, however, is well understood, and misperceptions of both have led some commentators to call for passive investors to be subject to increased regulation and even disenfranchisement. Specifically, this literature takes a narrow view both of the market in which passive investors compete to manage customer funds and of passive investors' participation in the capital markets.

We respond to this failure by providing the first comprehensive theoretical framework for passive investment and its implications for corporate governance. To start, we explain that to understand passive funds, it is necessary to understand the institutional context in which they operate. Two key insights follow. First, because passive funds are simply a pool of assets, their incentives are a product of the overall business operations of fund sponsors. Second, although passive funds are locked into their investments, their shareholders are not. Like all mutual fund investors, shareholders in index funds can exit at any time by selling their shares and receiving the net asset value of their ownership interest. Consequently, the sponsors of passive funds compete on both price and performance with other investment options--including other passive funds as well as actively managed funds--for investor dollars. As we explain, this competition provides passive fund sponsors with a variety of incentives to engage with the companies in their portfolios. Furthermore, the size of the major fund sponsors and the breadth of their holdings affords them economies of scale that not only justify engagement economically but also enable them to engage effectively.

An examination of passive investor engagement in corporate governance demonstrates that passive investors behave in accordance with this theory. Passive investors are devoting greater sophistication and resources to engagement with their portfolio companies and are exploiting their comparative advantages--their size, breadth of portfolio, and resulting economies of scale--to focus on issues with a broad market impact, such as potential corporate governance reforms, that have the potential to reduce the underperformance and mispricing of portfolio companies. Passive investors use these tools, as opposed to analyzing firm-specific operational issues, to reduce the relative advantage that active funds gain through their ability to trade.

We conclude by exploring the overall implications of the rise of passive investment for corporate law and financial regulation. We argue that, although existing critiques of passive investors are unfounded, the rise of passive investing raises new concerns about ownership concentration, conflicts of interest, and common ownership. We evaluate these concerns and the extent to which they warrant changes to existing regulation and practice.

INTRODUCTION 19 I. A THEORY OF PASSIVE INVESTOR INCENTIVES 27 A. The Institutional Context of Passive Funds 27 B. Passive Fund Competition 31 C. Passive Funds and Governance 37 II. THE PASSIVE INVESTOR IN PRACTICE 43 A. Passive Investors and Governance 43 B. Passive Investors and Activists 52 C. The Role of Policy 54 III. THE IMPLICATIONS OF THE THEORY 55 A. Market Discipline 56 B. Concentration of Ownership 61 C. Conflicts of Interest 64 CONCLUSION 71 INTRODUCTION

Passive investors, or more accurately the large mutual fund complexes that manage most of the assets invested in passively managed funds, are the new power brokers of modern capital markets. (2) Drawn by the lower costs of these products as well as a literature reporting that even savvy money managers cannot consistently beat the market, (3) an increasing number of retail investors invest through indexed mutual funds and exchange-traded funds (ETFs) (4) (collectively, index funds or passive funds)--funds that do not make information-based trading decisions. This shift has concentrated a growing portion of publicly traded equity in the hands of the sponsors that operate these index funds, particularly the Big Three--BlackRock, Vanguard, and State Street. (5) Although the extent to which index funds will continue to grow remains unclear, some estimates predict that by 2024 they will hold over 50% of the market. (6)

Commentators have expressed concern, even alarm, over the growth of passive investors and its implications for capital market efficiency and corporate governance. (7) This literature, however, largely misconstrues or ignores the institutional structure of passive funds and the market context in which they operate. (8) As a result, it fails accurately to reflect the incentives of passive investors. Moreover, by marginalizing passive investors with assertions of apathy or collusion, the literature has failed to appreciate the serious implications of the rise of passive investment for corporate law and governance.

We respond to that deficit. In this Article, we provide the first comprehensive theoretical framework for passive investment. We use this framework to explore the role of passive funds in corporate governance. We then explore the overall implications of the increasingly influential role enjoyed by passive funds for corporate law, including the allocation of power between management and shareholders, the regulation of voting, and the concentration of economic power.

Commentators focus their criticism on two key attributes of passive funds. First, passive funds, by virtue of their investment strategy, are locked into the portfolio companies they hold. They cannot exploit mispricing or other informational advantages through trading, nor can they follow the Wall Street Rule and exit from underperforming companies the way traditional shareholders, particularly active funds, can. (9) Second, passive funds compete against other passive funds that track the same index, not on the basis of the performance of their portfolio (because the funds hold the same index), but primarily on cost. (10) Firm-specific research is costly, and because they have committed to track the returns of an index, passive funds cannot exploit information-based trading to improve their returns. Critics therefore argue that it is irrational for passive investors to research and monitor their portfolio companies. (11)

We challenge this portrayal of the passive investor business model as incomplete and offer a more nuanced approach. To start, while the term passive fund is widely used, it is frequently misunderstood. Although a passive fund is a fund that is managed to track an index, there are a wide variety of indexes, meaning that there is substantial variation among passive funds. The construction and management of the index is not passive but entails a form of managed investing, if not by the passive funds themselves, then by the index providers. Moreover, although a large number of funds track some popular indexes like the S&P 500, other funds track a bespoke index created just for that fund. (12) In addition, some nominally passive funds afford their managers a degree of discretion in choosing among the stocks on the index or deviating from that index. (13) Finally, although many passive funds have very low fees, those fees vary substantially. (14)

We next explain that, to understand passive funds, it is necessary to understand the institutional context in which they operate. The existing literature analyzes the behavior and incentives of passive investors at the level of the individual mutual fund but overlooks the fact that an individual mutual fund is simply a pool of assets. (15) The mutual fund's actions are undertaken by third parties who have a contractual relationship with the fund. (16) These third parties--whom we term "passive investors" to distinguish their actions from those of the fund itself--are the fund sponsor, which establishes the fund, and the investment adviser, which makes the fund's operational decisions and is typically a related entity. (17)

The institutional context of passive funds can therefore vary widely, depending on the structure and incentives of those who operate the funds. In the case of Fidelity, for example, Fidelity Investments, the fund sponsor, is a privately owned company which, in addition to offering over 500 mutual funds, designs and administers employer-sponsored retirement plans and offers brokerage and other investment services. (18) Fidelity Management & Research Company is the investment advisor for Fidelity's family of mutual funds. (19) Conversely, BlackRock, Inc. is a publicly traded corporation that is the sponsor of the BlackRock mutual funds, and its funds are managed by BlackRock Capital Investment Advisors LLC. (20) For simplicity, we will generally refer collectively to the fund sponsor and the investment adviser as the sponsor, but it is worth noting that they are independent entities with differing incentives. (21)

The incentives of sponsors, rather than merely those of the pool of assets, drive fund behavior. Most significantly, sponsors normally manage an entire family of funds, and the family usually includes a mixture of passive and actively managed funds. The sponsor's business model involves maximizing the revenue from the entire family. (22) That revenue, in turn, is a product of both assets under management and fund fees. To illustrate this principle at the passive investor level, the competition is between Fidelity and Vanguard, not between Fidelity's Large Cap index fund and the Fidelity Magellan Fund. (23)

Similarly, it is important to distinguish between a...

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