Plenty of people have warned that the rise of passive investment is not unequivocally positive for the market. However, these critics have tended to have an agenda for supporting active management and have inevitably been rather quieter about the benefits of lower-cost products – active or passive – for investors.
Yet the more independent research is conducted on index funds’ market impact, the more it seems that passive investment could in fact be adversely affecting public corporations.
For example, last year, Rüdiger Fahlenbrach and Cornelius Schmidt reported that increases in passive ownership among Russell 1000 and Russell 2000 constituents led to greater CEO power, fewer new independent director appointments, negative returns when new independent directors were announced and more destructive merger and acquisition activity.
Now, new work by Nan Qin of Northern Illinois University and Di Wang of the University of Maryland focuses on the relationship between increased passive ownership of a firm and its subsequent operational and financial performance. The academics explored 652 US equity index funds and ETFs, 723 past and present S&P 500 constituents, and 408 non-S&P 500 firms of comparable size owned by those passive funds.
Alarmingly, Qin and Wang discovered that higher passive ownership – defined as the annual average percentage of shares in a stock held by any passive fund – was in fact associated with weaker operating performance and lower firm value, measured respectively by return on assets and Tobin’s Q ratio for estimating the fair value of a company.
Specifically, an increase of 100 basis points in passive ownership led to decreases of 322 basis points in a stock’s Tobin’s Q ratio and of 22 basis points in its return on assets over the following year. This negative relationship persisted for at least two years after the increase in passive ownership.
On the other hand, higher ownership by active funds was linked with higher firm values and stronger operating performance. These findings held across several different calculations of firm value and return on assets, and also persisted when Qin and Wang restricted their sample to just S&P 500 names or excluded small caps.
So why should companies backed by passive shareholders behave so anemically? One simple explanation could be that passive funds disproportionately own distressed businesses, as value indices do, for instance. However, Qin and Wang rejected this thesis, since most passive money is held in traditionally market-cap weighted funds.
This means that conventional passive funds do not take firm characteristics into consideration when buying them, while mainstream indices typically add companies that have increased in value and remove those that have declined. ‘Such a selection preference of index providers could only lead to positive relationships between passive ownership and firm value and performance,’ they argued.
Keeping an active mind
So what is happening? Broadly, passive investors are too passive. Qin and Wang noted that higher passive ownership was also connected with lower R&D and capital expenditure at firms, suggesting that passive funds are not pushing executives to invest in their businesses for the long term. More passive ownership also reduced the sensitivity of chief executives’ total compensation and cash compensation to short-term stock performance and made it more likely that chief executives would also serve as their own chairman.
Furthermore, when Qin and Wang looked into recent changes of chief executive – including 184 for disciplinary and performance issues – they determined that bosses were less likely to be fired following poor performance if their firm was heavily owned by passive investors. Active ownership, on the other hand, increased the likelihood of chief executives being sacked for disciplinary reasons.
Pulling all of this together, Qin and Wang arrived at a worrying conclusion. ‘Consider the improbable and theoretical extreme case where passive ownership reaches 100%,’ they proposed. ‘The threat of [shareholder] exit as an effective tool of corporate governance will no longer exist as long as the firm stays in the index, and investors would have much less bargaining power to pressure the management effectively, not to mention their likely weak motivation to do so. This could profoundly weaken the competitiveness of US companies and the productivity of the US economy.’
Qin and Wang therefore suggested that ‘regulatory changes may be considered in order to reduce the negative externality of passive investment vehicles, while retaining their benefits to ordinary investors.’
Of course, past performance is not indicative of the future, and there have been signs that passive groups are starting to take their governance responsibilities more seriously. Recent high-profile steps include backing shareholder resolutions on climate change and offering gun-free funds.
Perhaps it’s time for those passive investors who have held out against active engagement so far to realize that resisting such steps could lead to exactly the long-term underperformance they hope to avoid.