ARTICLES INDEX FUNDS AND THE FUTURE OF CORPORATE GOVERNANCE: THEORY, EVIDENCE, AND POLICY by Lucian Bebchuk & Scott Hirst
I. AN AGENCY-COSTS THEORY OF INDEX FUND STEWARDSHIP
This Part develops our agency-costs theory of index fund
stewardship. We start by explaining the nature of index funds and the
stewardship activities they undertake in section I.A. We describe views
that have been expressed about the significant promise that the nature of
index funds holds for stewardship in section I.B. We explain that this is
the basis for the “value-maximization view” of index fund stewardship,
and we put forward our competing “agency-costs” view in section I.C. We
then develop the agency-costs view, showing how this view indicates that
index fund managers will have incentives to underinvest in stewardship
in section I.D, as well as incentives to be excessively deferential to
managers of portfolio companies in section I.E. Finally, we consider two
potential limits—arising from fiduciary norms and reputational
considerations—on the force of these incentives in section I.F.
A. Index Funds and Stewardship
1. Index Funds. — Index funds are a special type of investment fund.
Investment funds pool the assets of many individuals and entities and
invest those assets in diversified portfolios of securities. Actively managed
investment funds buy and sell securities of companies in accordance with
their views about whether those companies are under- or overvalued. By
contrast, index funds invest in portfolios that attempt to track the
performance of specified benchmark indexes, such as the S&P 500 or the
Russell 3000. The term “index fund” encompasses both mutual funds
and exchange traded funds (ETFs), or any other investment vehicle that
mechanically tracks an index. Well-known examples of index funds
include the Vanguard S&P 500 Mutual Fund, SSGA’s SPDR S&P 500
ETF, and BlackRock’s iShares Core S&P 500 ETF. While some index
funds also track indexes of debt securities, this Article focuses on those
that invest in equity securities.
As we analyze in detail in our recent empirical study, The Specter of the
Giant Three, the index fund sector is heavily concentrated and is
dominated by the Big Three. In that study we explain that such
concentration is to be expected and should be expected to persist. The
dominant incumbents have significant structural advantages that derive
from the economies of scale of operating index funds; the funds’
branding; and—in the case of ETFs—the liquidity benefits for funds with
large asset bases. In addition, there are no significant opportunities for
new entrants to attract business from the incumbents by introducing new
products that would be difficult for the incumbents to imitate.
2. Stewardship. — In the literature on institutional investors, stewards-
hip refers to the actions that investment managers can take in order to
enhance the value of the companies that they invest in on behalf of their