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Academics See Few Incentives for Index Fund Managers to Invest in Stewardship

An article by Harvard academics analyzes agency problems related to the rise of institutional investors and their increasing concentration of shareholdings in portfolio companies. The authors write that both “index fund alarmists,” i.e, academics who worry that the rise in common ownership from index funds is producing anti-competitive effects in the market, and index fund enthusiasts, who expect large governance benefits to flow from the rise of index investment, are not properly accounting for the structural incentive problems that limit index funds’ ability to produce governance benefits. In their academic paper, the authors discuss factors that affect the decisions of investment managers of either passive index funds, active mutual funds, or both. They find that: (1) investment managers generally capture only a small fraction of the benefits that results from their stewardship activities while bearing the full cost of such activities; (2) competition with other investment managers is typically insufficient to eliminate these agency problems; and (3)  investment managers may be further influenced by private incentives, such as their interest in obtaining business from corporations, that encourage them to side excessively with managers of corporations. The authors conclude that index funds have poor incentives to engage in stewardship activities that could improve governance and increase value for companies. They write: “[W]hile the rise of index funds benefits investors and the economy by reducing the costs of financial intermediation, this trend also has systemwide adverse consequences on governance.”