Is the rise of indexing bad for corporate governance?

By LARRY SWEDROE

The active investment management community has been attacking indexing — and passive investing in general — for decades. The reason is obvious: Their profits (and for many firms, their very survival) are at stake. The attacks began almost from the moment John Bogle started the First Index Investment Trust (later renamed the Vanguard 500 Index Fund) on December 31, 1975. The criticism reached the absurd level when in March 2016, a team at Sanford C. Bernstein & Co. called it “worse than Marxism“.

Another critique against indexing came from a June 2017 op-ed in The Wall Street Journal. The author warned against the growth of indexing, arguing that passive index funds adopt a hands-off approach to governance and allow firm management to become progressively unchecked: “American investors are increasingly acting on the realisation that a broad-based indexing strategy is superior to investing in individual stocks or actively managed funds. That’s great news for investors, who will pay less and get better returns. But it has troubling implications for corporate governance. No passive investor cares much about governance of a particular company.”

A perceived lack of incentives for index funds to engage in governance fuels these concerns regarding the growth of indexing.

The other side of the story

What’s interesting to note is that one almost never hears the other side of the story. Index funds should have a strong incentive to monitor the firms in their portfolio because they are not always able to sell out of positions when they disagree with management. Thus, they may be more inclined to exercise their “voice” by voting, since “voting with their feet” through divesting shares is not always possible if those shares represent ownership in a company that is a member of the fund’s underlying index.

In addition, index funds have an incentive to engage in corporate governance in order to compete with active funds that have discretion over their holdings.

The voting record of passive funds

Joseph Farizo, author of the March 2020 study (Black)Rock the Vote: Index Funds and Opposition to Management, sought to determine if index funds do participate in active governance by voting, and how they vote their proxy shares. His data sample consisted of 654 index funds voting on 267,847 management-sponsored proposals at 5,155 firms for a total of 8.8 million fund-proposal observations over the reporting years 2006-16. Here is a summary of his findings:

Index funds in the sample are submitting votes on proposals at companies their family does not hold in its active funds 27% of the time.

Index funds and active funds do not differ greatly in their average rates of opposition to management, as the difference is 0.3% (t-stat = 0.89).

Index funds are more likely to vote proxy proposals against firm management on shares their fund family does not hold in active funds than on shares their family does hold in active funds.

Index funds do not appear to strictly rely on the advice of Institutional Shareholder Services (ISS), as their votes align with this proxy advisor’s recommendation only half of the time.

Funds oppose management 5.9% of the time. However, they appear friendlier to management when the fund family owns shares in both active and index funds (opposing management 5.5% of the time) than when the fund family’s active funds do not own shares (opposing management 9.0% of the time).

On non-contentious proposals, index funds vote against management 3.5% of the time, 0.5% more than actively managed funds, though this difference is not statistically significant (t-stat = 1.41).

A majority (nearly 54% of index funds in the sample) oppose management between 20% and 60% of the time on contentious issues. Thus, index funds do not always align with management or always align with ISS.

Index funds show an even higher level of engagement in proxy governance on shares their fund family only holds in its index funds than on shares their family has an active position in.

A lack of index fund support increases the likelihood a company proposal fails.

Proposals that index funds supported but failed to pass are associated with negative abnormal returns on the day of the election, while of the proposals that passed, those that were favoured most by index funds were more likely to be value-increasing. This indicates that investors value the governance choices of index funds.

Farizo concluded that the evidence “dispels the concern that index funds, at least in the aggregate, completely disregard voting responsibilities by either always siding with management or always siding with ISS”.

Passive investors aren’t passive owners

Farizo’s results are consistent with those found by Ian Appel, Todd Gormley and Donald Keim, authors of the 2016 study Passive Investors, Not Passive Owners, who found that index ownership at a firm is associated with more independent directors, removal of takeover defences, and more equal voting rights.

They are also consistent with the findings of Appel, Gormley and Keim in their 2018 study Standing on the Shoulders of Giants: The Effect of Passive Investors on Activism. They found that an increase in index ownership is associated with an increased use of proxy fights by activists and a higher likelihood that an activist obtains representation on the board of the target firm.

Just another myth

The bottom line is that the findings from the three studies demonstrate that the idea that index funds present a danger because they adopt a hands-off approach to governance and allow firm management to become progressively unchecked is just another myth created by Wall Street — one they want and need you to believe but simply is not true.

It’s also not true that indexing yields average returns. It earns market returns that are well above those of actively managed funds.