Tutorial 5:Discuss whether and by which mechanisms passive investors influence firms’ governance Flashcards
How may passive investors weaken corporate governance?
1) LACK OF INCENTIVE TO MONITOR MANAGERS –> passive investors e.g. index funds & ETFs aim to replicate mkt index returns (e.g. S&P 500) or investment style (e.g. large-cap value) via benchmark-tracking rather than actively selecting individual stocks to outperform mkt –> prioritise tracking overall index performance –> may have less incentive to actively monitor & engage w company management of individual firms compared to actively managed funds.
2) LESS ABLE TO EXERT INFLUENCE OVER MANAGERS –> passive investment strategies aim to replicate index composition–> passive investors have limited flexibility to accumulate or exit positions based on individual company performance, unlike active investors who can use their trading activity on specific stocks of firms as leverage to actively influence management decisions & corporate governance practices of those firms e.g. disciplinary effect.
3) INSUFFICIENT RESOURCES TO RESEARCH & MONITOR CORPORATE POLICIES OF EACH INDIVIDUAL FIRM IN PORTFOLIO –> passive investors hold highly diversified portfolios comprising large no. of securities to mirror underlying index composition to provide investors w broad market exposure & reduce individual/idiosyncratic stock risk –> passive investors have limited resources available for in-depth research & monitoring of corporate policies & governance practices on each individual company in their portfolio –> less able & willing to actively monitor & engage w company management of individual firms compared to actively managed funds.
How may passive investors improve corporate governance?
1) MONITORING INCREASES ASSET VALUE SO HAVE NO INCENTIVE TO EXIT TO SEEK DIVERSIFIED PORTFOLIOS –> may be motivated to monitor managers & engage w their corporate governance practices to improve overall mkt performance as it directly impacts value of their assets under management to meet objective of tracking mkt index returns –> passive institutions less inclined to divest their positions in underperforming stocks as they tend to focus on long-term overall mkt trends rather than reacting impulsively to short-term underperformance of individual stocks in their portfolio –> may feel greater sense of responsibility to engage w company management to address performance issues & drive improvements –> can max. long-term shareholder returns.
2) SIZABLE OWNERSHIP GIVES PASSIVE INVESTORS LARGE POWER E.G. BLOCKHOLDER –> institutional investors e.g. mutual funds & pension funds may hold significant ownership stakes in numerous companies which grants them substantial voting power & influence over corporate decisions e.g. board composition, executive compensation, & strategic decisions to advocate for shareholder interests within companies –> institutions have fiduciary duty to vote proxies (votes attached to shares) in best interest of investors whose money they manage –> managers may be more inclined to consider views of passive investors over more active investors, which tend to exhibit higher turnover rates due to their focus on short-term buying & selling.
3) MAY ENGAGE IN WIDESPREAD BUT LOW-COST MONITORING OF FIRMS’ COMPLIANCE W GOVERNANCE PRACTICES –> as passive investors typically have lower management fees & operating expenses compared to actively managed funds since they do not involve extensive research or active trading strategies –> could increase efficiency of monitoring firms’ corporate governance practices in best interest of shareholders.
This engagement can take the form of active voting on governance matters, participating in shareholder meetings, and advocating for changes that align with long-term shareholder value creation.
What were the findings: did passive investors improve or weaken corporate governance?
IMPROVED CORPORATE GOVERNANCE:
1) INCREASED BOARD INDEPENDENCE –> passive investors tend to support greater board independence within companies i.e. boards that are more autonomous & less influenced by management –> may lead to to better corporate governance & managerial decision-making in best interest of max. shareholder value.
2) OPPOSE REMOVAL OF TAKEOVER DEFENSES –> allows for mkt forces to ensure better corporate governance & managerial decision-making i.e. if acquiring company more able to act in best interest of shareholders & max. their returns.
3) REDUCTION IN UNEQUAL VOTING RIGHTS ASSOCIATED W DUAL CLASS STRUCTURE –> dual-class share structures give superior/inferior voting rights to diff. groups of shareholders –> indicates a preference of passive investors for equal voting rights among shareholders –> promotes fairness & reduction in conflicts of interest between diff. shareholders w diff. voting rights to allow management to conduct corporate governance in best interest of all shareholders.
–> LARGE VOTING POWER OF PASSIVE INVESTORS –> active participation in corporate decision-making processes by voting on shareholder proposals & proxy resolutions –> typically less supportive of management proposals & more inclined to support shareholder proposals that align w shareholder interests and good governance practices to max. their value –> companies w greater passive fund ownership exhibit improvements in long-term performance –> reduces need for activist investors’ engagement in corporate governance –> firms w blockholder institutional passive investors are less likely to be targeted for activism by a hedge fund.
