Index-style investing is all the rage. Investors by the millions believe that funds do better by seeking to match the stock market rather than trying to beat it.

But what happens to companies with large blocks of shares owned by these “passive” investors? Are the mutual funds that control these shares serving as watchdogs, pressing to make the firms better through proxy votes and other activism? Or are the fund companies just sitting on the sidelines?

Fund companies heavy into passive investing, like Vanguard Group, State Street and Dimensional Fund Advisors, say they are active owners, constantly pressing the firms they own to do better. But there has been little academic work to make the case one way or another.

Until now. A new study by Wharton faculty members finds that passive investors have indeed pressed effectively for shareholder-friendly policies like increasing the number of independent directors and removing poison pills and dual-class share structures.

“Passive investors aren’t necessarily passive owners,” says finance professor Todd A. Gormley.

Index-style fund companies “are increasingly becoming more proactive in their proxy voting,” says finance professor Donald B. Keim. “Thus, passive institutional investors have a very important, yet unstudied and undocumented, influence on corporate governance. Our paper is the first to provide evidence on this important relationship.”

Gormley, Keim and their colleague, Wharton doctoral student Ian R. Appel, describe their work in the paper, “Passive Investors, Not Passive Owners,” which finds that an increase in company ownership by passive investors has a clear effect on governance policies. “For example,” the researchers write, “relative to the sample average, a 10% increase in ownership by passive investors is associated, on average, with a 9% increase in the share of directors on a firm’s board that are independent.”

“Passive investors aren’t necessarily passive owners.”–Todd A. Gormley

A Growing Role

The work underscores the growing role of passive, or index-style investing since the 1970s. Prior to that, the mutual fund industry almost exclusively used “active” fund management, with teams of analysts and stock pickers constantly buying and selling in a search for better-than-average stocks. In fact, the whole idea of a mutual fund was to hire experts so individual investors did not have to play the markets themselves.

Then in in 1970s Vanguard Group founder John C. Bogle produced an alternative, a fund that simply held the stocks in the Standard & Poor’s 500, an index of the 500 largest U.S. companies. Bogle’s research, and that of many to follow, showed that the typical active manager could not consistently pick enough winners to beat the overall market’s performance. The index fund would simply match the market’s returns and save money by buying and holding the stocks in the underlying index, eliminating all the research and trading costs racked up by active funds. While many actively managed funds charge annual fees of 1% or more of a fund’s assets, the cheapest index funds today charge less than one-tenth of that, a cost advantage that snowballs over time through compounding.

Over the years, millions of investors, including some institutions like pension funds, have embraced this approach, and by last October index funds held $3.2 trillion in assets, or 36% of the assets in funds owning U.S. stocks, according to Keim. Actively managed funds still hold the rest.

Because the fund companies have voting rights for the stocks they own, this stake held by passive funds represents an enormous amount of shareholder power. But do the funds use it? In a sense, it doesn’t matter whether a company in an index fund is well run, because the fund will track the index’s performance anyway. As long as the fund and index move in tandem, the fund has achieved its goal. And, of course, being an activist shareholder costs money.

Also, actively managed funds have an easy way to deal with a badly managed company: They can sell the stock. Index funds don’t have this option, lacking one of the key tactics for exerting leverage on a company’s management. On the other hand, being stuck with a poorly managed company gives the index fund a strong incentive to make the firm better.

“Passive institutional investors have a very important, yet unstudied and undocumented, influence on corporate governance.”–Donald B. Keim

“Because passive investors are unwilling to divest their positions in poorly performing stocks, which would lead to [fund] performance deviating from the benchmark, they may place an even greater weight than active fund managers on ensuring effective governance in the firms they own,” the researchers write, adding: “[Corporate] managers’ knowledge that these passive investors are not likely to sell their shares anytime soon may also give the views of passive investors greater weight than those of active fund managers.”

Though passive owners cannot pressure managers by threatening to sell, holding large blocks of shares gets managers’ ears, Keim says. “The size of passive investors’ ownership stakes may facilitate activist investors’ efforts to rally support for their demands,” he adds, referring to hedge funds and other investors who are aggressive in pressing for change. “Bringing just a few of these large passive investors on board can lend credibility to an activist campaign.”

Poison Pills and Special Meetings

Index fund companies claim the use their voting power and access to managers’ ears to press for improvements, but it has been difficult to tell how hard they try or whether they have any success. To find out, a study would need to compare companies that have a large percentage of passive ownership with similar firms that do not.

Appel, Gormley and Keim did this by looking at companies straddling the cutoff between the Russell 1000 and Russell 2000 indexes, both of which are tracked by numerous index funds. The Russell 1000 contains the 1,000 largest public U.S. companies as measured by market capitalization, or the share price times the number of shares. The Russell 2000 has the next largest 2,000 stocks. Members of each index are ranked by market cap, from largest to smallest, and funds tracking the index match the index weighting, putting lots of money into the largest stocks, and little into the smallest.

The study compared the smallest stocks in the Russell 1000 with the largest in the Russell 2000. Because these stocks are clustered around the cutoff between the two indexes, they were very similar in market cap. But a fund tracking the Russell 1000 would put little of its money in the smallest stocks in the index, while a fund based on the Russell 2000 would put lots of money into that index’s largest stocks. The stocks at the bottom of the Russell 1000 and top of the Russell 2000 are therefore similar in every way except that those topping the Russell 2000 have a 5% to 10% higher than average ownership by passive investors, a statistically significant difference.

“On average, a 10% increase in ownership by passive investors is associated with about a fifth of standard deviation increase in ROA.”

The researchers then looked at corporate governance practices involving shareholder rights. Rights groups, for instance, prefer “independent” corporate board members to “insiders” such as those who are also executives with the firm. And they oppose policies that make it difficult for a firm to be taken over or pressured to improve. That includes poison pills, which can flood the market with new shares to prevent a takeover, and restrictions on shareholders’ rights to call special meetings. They also oppose dual stock structures that give insiders more voting power than ordinary shareholders.

Appel, Gormley and Keim found a clear pattern: Firms with more passive ownership had more shareholder-friendly governance, indicating that passive investors do pressure firms effectively. The largest effect was the 9% increase in independent directors associated with the 10% increase in passive ownership. In addition, a one percentage point increase in passive ownership produced a 0.5% increase in the likelihood of removing a poison pill and reducing restrictions on shareholders’ right to call a special board meeting. While these may sound like modest numbers, they are significant because, overall, only about 4% of firms remove a poison pill each year, while just 0.7% ease restrictions on calling special meetings.

Reflecting Risk

How do passive owners exercise their clout?

“Our evidence suggests that a key mechanism by which passive investors exert their influence is through the power of their large voting blocks,” the researchers write. A 10% increase in passive ownership is associated with a 4% decline in support for management proposals and a 10% increase in support for proposals considered shareholder friendly.

Consistent with the observed differences in governance having a positive influence on firm value, the researchers also find that passive ownership is associated with improvements in firms’ longer-term performance. On average, a 10% increase in ownership by passive investors is associated with about a fifth of standard deviation increase in ROA. The researchers also find that ownership by passive investors is associated with reduced cash holdings, a higher dividend yield and suggestive decline in managerial pay, all of which have been associated with improvements in firm-level performance.