This is the second entry in a two-part series on the rise of index funds in U.S. equities markets. This post is for the intrepid reader interested in a thorough survey of the empirical and theoretical literature concerning the implications of institutional investors. In the first entry of this series, I disputed the mechanisms by which index funds are argued to exert an outsized influence on the firms within their portfolios. But in this second entry, I will instead grant this key premise of the anti-trust advocates’ argument: index funds, either individually or as a group, have a significant degree of influence over major decisions made by the firms in their portfolio. But the anti-trusters then go on to argue that index funds will deploy this power to induce these firms’ management to restrict intra-industry competition. While management at any given firm in an industry will be unwilling to unilaterally disarm, the fact that index funds are simultaneously invested in all of the publicly-traded incumbents in an industry allows for a solution to the prisoners’ dilemma dynamic which would otherwise thwart efforts at oligopolistic collusion.
In this post I will grant the premise that index funds, as the plurality shareholders of a given firm, will be able to select for a management team and board of directors willing to pursue their preference for maximizing total industry profits instead of individual firm profits. In this sense, we have a principal-agent model in which the principal (index funds) keeps its agent (the firm’s management) on a tight leash. This power indeed presents the potential for index funds to diminish the value of the individual firm, thereby harming the other shareholders. Yet this same governance dynamic which allows for the possibility of such speculative, thinly substantiated harm to shareholders<, similarly offers a corrective for a much greater and empirically ever-present agency cost which confronts all publicly traded firms: managerial rent-seeking.
Since the publication of Berle and Means’ The Modern Corporation and Private Property in 1932, the Ur-text of corporate governance theory, scholars have elaborated on and formally modeled the profound asymmetry between a corporation’s relatively small and cohesive management team and its dispersed shareholders (Manne 1964; Clark 1986; Easterbrook and Fischel 1991). Shareholders face a collective action problem vis-a-vis the managers who allocate their capital on their behalf: no individual shareholder is sufficiently incentivized to incur costs monitoring the management to ensure these funds are being directed toward their profit-maximizing use, because any gains which accrue from such monitoring must be distributed amongst the shareholders pro-rata, and cannot be internalized by the individual who does the monitoring.
Compounding the asymmetries which inhere in the ownership vs. control relationship are a variety of state and federal laws which increase the collective action costs faced by shareholders when attempting to replace bad management. In two highly influential law review articles, Bernard Black discusses a variety of legal impediments to coordinated shareholder action, ranging from costly SEC disclosure requirements, encumbrances on proxy campaigns, and legislation such as the Williams Act which regulate tender offers. A more recent analysis by Gilson and Gordon (2013) indicates that many of these regulatory frictions persist. Whenever transaction costs to takeovers are raised, the market for corporate control becomes less liquid, allowing for a firm’s management to extract greater wealth transfers from a firm’s creditors and shareholders. Alan Schwartz put the effects of such legislation bluntly in his 1986 article Search Theory and the Tender Offer Auction which predated the rise of index funds: “Capital markets cannot overcome the inefficiency the Williams Act creates”.
Between their structural disadvantage as monitors and the institutional deformities introduced by the political process, shareholders face a severe principal-agent problem vis-a-vis management. A massive literature, known as the “Managerial Power Perspective”, has emerged to document the ways in which corporate charters and compensation practices have in practice been disproportionately shaped by CEOs and other senior executives (see Bebchuk and Fried’s 2004 book Pay Without Performance, as well as Bebchuk, Cohen and Ferrell 2009, for an excellent overview). Exorbitant salaries, golden parachutes, and poison pills are some of the many ways in which, according to this perspective, corporate governance in practice deviates in a pro-management direction from the “optimal contract” which would otherwise obtain in a competitive, low-transaction cost landscape of symmetrically informed arms-length deals between management and shareholders. Indeed, many of the same progressive concerns, such as income inequality, which animate the anti-trust proposals of the “common ownership” paradigm are similarly leveled against the menacing figure of the rent-seeking, imperial CEO.
It is ironic, then, that the rise of index funds is likely to be ameliorative of this very principal-agent problem. The “common ownership” paradigm argues that index funds have perverse incentives insofar as they will induce management to reduce intra-industry competition, thereby harming the firm’s other shareholders. This amounts to an intra-shareholder wealth transfer. However, even according to this perspective, index funds will not be willing to abide the classic example of a wealth transfer from shareholders to management. Such managerial rent-seeking can come in many forms: salary in excess of marginal product of labor, personal consumption of perquisites, “empire building” which entrenches management by raising its replacement cost, and so on ad infinitum. In such instances, index funds will not countenance this non-profit-maximizing behavior, because it is not in pursuit of maximizing total industry profits. Instead, index funds will be incentivized to minimize managerial rent-seeking, the benefit of which will redound to all of the firm’s shareholders. I will now discuss both the theoretical and empirical literature which demonstrates that index funds can, and do, leverage their role as large institutional investors to combat managerial malfeasance, misfeasance, and general misbehavior.
A critical assumption underlying the Berle-Means managerial dominance paradigm is a set of shareholders dispersed such that no individual shareholder is sizable enough to internalize a sufficiently large pro-rata share of the gains to monitoring the corporation’s management. Yet this Olsonian dynamic is challenged by the presence of institutional investors, who would in fact be properly incentivized to do so. A large empirical literature notes the active involvement of institutional investors in overseeing managerial initiatives, consistent with their theoretical ability to internalize a sufficient portion of the gains which accrue from such activity: “A recent survey found that 63 percent of very large institutional investors have engaged in direct discussions with management over the past five years, and 45 percent had had private discussions with a company’s board outside of management presence” (also see: Edmans 2009; Edmans & Manso 2011; Bharath 2013; McCahery et al 2016).
Moreover, the transaction costs involved in mounting a formal shareholder challenge to management (e.g. voting on a resolution or a change in the board of directors, or soliciting votes in a proxy contest) are substantially lowered when the concentration of said shareholders increases. Concentration lowers these costs by, for example, making intra-shareholder communication much easier (Appel et al 2017). Between their individual incentives to monitor management and their role in reducing coordination costs to challenging it, institutional investors are capable of being a key counterweight to managerial rent-seeking and inefficiency. Indeed, the same empirical literature which raises the specter of rent-seeking CEOs simultaneously notes the strong and negative correlation between the presence of institutional investors and pro-management corporate charters, as measured by an “entrenchment index”:
[The index consists of] four constitutional provisions that prevent a majority of shareholders from having their way (staggered boards, limits to shareholder bylaw amendments, supermajority requirements for mergers, and supermajority requirements for charter amendments), and two takeover readiness provisions that boards put in place to be ready for a hostile takeover (poison pills and golden parachutes).
Other comprehensive studies surveying both the U.S. and Europe have similarly discovered an inverse relationship between institutional shareholders and such value-destroying provisions (Bebchuk, Cohen and Wang 2008; Edmans 2013), as well as institutional investors’ greater likelihood of voting against management instead of obeying the much-lamented “always vote with management” rule of thumb which prevails amongst passive investors (Appel et al 2015, 2017; He, Huang and Zhao 2017).
But not so fast, say the theorists of “common ownership”. Index funds are unlike other institutional investors: their portfolios are diversified such that incurring costs in monitoring any given firm’s management will almost certainly exceed the benefits which accrue as a result. They will instead be content to broadcast their preference for managers and directors willing to soft-peddle intra-industry competition, carefully husbanding their oversight resources so as to scrutinize managers’ performance on that particular metric. Any managerial rent-seeking detected in the process will be purely incidental to their primary goal of monitoring for aggregate industry profit-maximization.
Even granting this premise, it remains true that index funds qua common owners will be incentivized to punish managerial rent-seeking when detected. Thus, there is the potential for an institutional complementarity between these passive owners, with a latent preference for managerial competence and fidelity, and activist shareholders.
The modus operandi of an activist investor is to scour the market for a firm whose existing capital could be allocated more profitably in the hands of a more competent or less rent-seeking management. Then, a move to acquire a controlling stake in the firm is attempted by either purchasing a sufficient number of shares directly or by initiating a proxy battle whereby non-activist shareholders’ votes are recruited for the purposes of replacing the incumbent managers and/or directors. The lower the transaction costs involved in this process, the more liquid the market for corporate control, meaning that capital will flow into the hands of managers most capable of profitably deploying it (Fischel and Easterbrook 1989). Yet there are a variety of statutes and regulations which coagulate this market (as described in Part I of this post). Onerous SEC disclosure requirements triggered by acquiring a certain percentage of outstanding shares, the Williams Act and its restrictions on tender offers, and many other legal frictions raise the transaction costs involved in waging a corporate takeover.
Moreover, these political costs merely compound the difficulty which inheres in such an activist campaign when faced with widely dispersed, passive shareholders. Grossman and Hart articulated the free-rider problem facing an activist shareholder making a tender offer in their seminal 1980 article. Each individual shareholder is willing to hold out against accepting a tender offer if 1) their share is individually insufficient to effectuate a transfer in control and 2) the offer price is lower than the expected share price post-transfer. The communication costs involved in soliciting proxy votes are similarly prohibitive when shares are highly dispersed and turnover at a rapid rate.
Institutional investors, including index funds, thereby present a more concentrated shareholder landscape to activist investors seeking to oust bad management. The coordination costs of corralling a few key shareholding blocs, rather than a dispersed herd, may be surmountable if the management is sufficiently incompetent or extractive. Moreover, assumption 1 of the Grossman and Hart model is now violated. By lubricating the market for corporate control in this way, index funds may potentiate the influence of activist arbitrageurs. This large group of inert shareholders may not proactively sniff out rent-seeking managers, but may nonetheless serve as a transmission vector for an activist determined to do so.
Given that the less fragmented shareholder structure brought about by index funds increases the returns to activist investing, we would expect such investors to disproportionately target firms with a higher percentage of their shares held by institutions. Indeed, the empirical evidence overwhelmingly affirms this to be the case. To quote from one of the most recent such studies:
We analyze whether the growing importance of passive investors has influenced the campaigns, tactics, and successes of activists. We find activists are more likely to pursue changes to corporate control or influence when a larger share of the target company’s stock is held by passively managed mutual funds. Furthermore, higher passive ownership is associated with increased use of proxy fights and a higher likelihood the activist obtains board representation or the sale of the targeted company. Our findings suggest that the large ownership stakes of passive institutional investors mitigate free-rider problems and ultimately increase the likelihood of success by activists.
A corroborating anecdote, cited in the above article:
For example, the activist hedge fund ValueAct was successful in obtaining a seat on Microsoft’s board with less than 1% of stock because Microsoft recognized that other large institutional investors backed the fund’s demand.
A comprehensive study of all attempts at activist takeovers in closed-end funds (CEFs) between 1988 and 2003 found:
We use three proxies for the ease of communication among the stockholders of a particular fund. The first is turnover, which measures the frequency at which the shares of the CEF change hands. A high turnover rate indicates greater costs of communication because frequent changes of shareholders make it difficult to locate and inform them of an activist’s intent. The second variable is the average size of trade in the fund’s shares. Larger trades indicate that, on average, shareholders hold bigger positions in the fund, and thus, the fund has fewer shareholders which are easier to communicate with.
The third variable is the percentage of institutional ownership in the fund. Institutional investors typically hold larger positions, are more informed, and are more likely to cast votes for shareholder proposals and proxy contests than retail investors (who are often blamed for apathy). Due to regulatory disclosure requirements (such as the quarterly 13F filings of holdings), they are also easier to locate and notify regarding an activist’s intent. The results of our empirical tests are consistent with the hypothesis that smaller costs of communication enhance activist arbitrage. (emphasis my own)
Two exhaustive literature reviews on activist investors and their effects (to be discussed below) by Alon Brav and coauthors note a consistent shareholder pattern among firms targeted by activists:
Activists rely on cooperation from management or, in its absence, support from fellow shareholders to implement their value-improving agendas. This explains why hedge fund activists tend to target companies with higher institutional holdings…
…the targets of hedge fund activism exhibit relatively high trading liquidity, institutional ownership, and analyst coverage. Essentially, these characteristics allow the activist investors to accumulate significant stakes in the target firms quickly without adverse price impact, and to get more support for their agendas from fellow sophisticated investors.
Having established that index funds structurally facilitate activist takeovers, the debate over the effects of index funds now supervenes on the effect of the activists. Although such hedge funds, leveraged-buyout artists and private equity investors have been pejoratively labeled as “vultures”, the balance of the literature strongly suggests net positive effects on firm share price, both in the short term and in the long term. The above-cited reviews by Alon Brav and coauthors, while noting that activists are particularly attracted to firms with a large concentration of institutional shareholders, focus primarily on the effects of such takeovers, which they summarize as follows:
The abnormal return around the announcement of activism is approximately 7%, with no reversal during the subsequent year. Target firms experience increases in payout, operating performance, and higher CEO turnover after activism.
The evidence generally supports the view that hedge fund activism creates value for shareholders by effectively influencing the governance, capital structure decisions, and operating performance of target firms.
In a more recent study, contra such claims that activists seek to “pump-and-dump” a target firm by extracting short-term profits at the expense of long-term profits, Bebchuk, Brav and Jiang adduce the following after examining the full universe of SEC Section 13D filings in the years 2001-2006:
We find no evidence that activist interventions, including the investment-limiting and adversarial interventions that are most resisted and criticized, are followed by short-term gains in performance that come at the expense of long-term performance. We also find no evidence that the initial positive stock-price spike accompanying activist interventions tends to be followed by negative abnormal returns in the long term; to the contrary, the evidence is consistent with the initial spike reflecting correctly the intervention’s long-term consequences.
In his The Problem of Twelve article warning of index fund managers’ influence, John C. Coates acknowledges that such control might depend on leveraging the threat of an activist:
When an index sponsor “engages” with a company, that company’s CEO knows that there is some material chance that a contest or activist campaign or merger will occur before that CEO’s tenure is over. CEOs listen with a keen ear in such moments.
But in arguing that an index fund might be facilitative in such an instance, he is implicitly conceding that it cannot be catalytic. That role falls to the activist- yet, crucially, the activist will only mount a campaign if he can increase that individual firm’s share value in so doing. The entire premise of the “common ownership” argument is that index funds want managers who will deprioritize the firm’s individual value. So, while it’s quite possible to leverage the threat of an activist against a rent-seeking management, it’s impossible to leverage this same threat against a competitive management, because an activist will only be interested if the post-takeover share price is greater than the pre-takeover price minus transaction costs. This incentive mismatch between index fund managers and activists renders this particular aspect of the ”common ownership” paradigm logically incoherent.
So, there we have it. The hypothetical, speculative harm of intra-industry collusion vs. the very real and endlessly documented threat of managerial rent-seeking. Moreover, the corporate governance mechanism by which this intra-industry collusion is said to be effectuated falls apart under careful scrutiny. Let’s wait until there are serious, demonstrable harms to shareholders before turning the coercive machinery of anti-trust law and the FTC against what is, on balance, a boon to shareholders and the broader economy.