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.