In recent years there has been a marked increase in passive investing, consisting of investing in exchange traded funds and index funds. Widely dismissed when first launched in the mid-1970’s, index funds are now estimated to account for approximately 20% of global aggregate investment fund assets. In the next five years, they are expected to surpass actively managed funds in the United States. Proponents of passive investing hailed Warren Buffet’s win of a bet against a prominent hedge fund manager that his investment in an index fund would outperform the latter’s hand-picked investments over a 10-year period as another sign that the prime days of active money management are numbered.

While index funds continue to grow in popularity amongst investors, the growing significance of passive investing has caused concern amongst some market observers over its potential systemic effects. One concern frequently raised is that passive fund managers will also be passive owners, as they do not have adequate incentives to engage with and hold company management accountable. This decline in accountability is predicted to cause corporate governance standards to slide.

Observers who believe that passive fund managers lack incentive to challenge company management typically point to several factors. For starters, passive fund managers are unable to voice disagreement with company management by selling their shares in a particular company which could diminish their leverage over company boards. Further, because passive funds principally compete with one another on management fees and invest in hundreds of companies, they have a disincentive to hire analysts to track management performance in specific companies as it would be too costly with minimal benefit.

Passive fund managers argue that despite the perceived disincentive to participate in corporate governance matters, the reverse is true. They claim that their long-term outlook requires a greater focus on corporate governance issues compared to active managers. While they acknowledge that their inability to sell shares in a specific company creates unique challenges, they suggest that their long-term ownership of assets and growing importance in the markets provides them with a number of effective strategies to solve corporate governance issues. In a recent study, Jill Fisch, Asaf Hamdani, and Steven Solomon explore these strategies, three of which are outlined below.

First, passive funds can influence governance by voting at shareholder meetings. Traditionally, it was assumed that passive funds would either neglect to vote or would simply side with company management. However, evidence suggests that passive funds cast their votes and often have a swing vote in proxy contests. Over the last few years, a number of the largest passive investor groups have supported shareholder resolutions requiring greater disclosure related to climate change, executive compensation, and gender diversity.

Second, the size of passive funds allows them to engage directly with company management. Passive funds increasingly seek ongoing dialogue with management, allowing them to influence board decision-making behind the scenes while avoiding the reputational fallout that may accompany traditional shareholder activism. Given the extent of passive funds’ shareholdings, corporations tend to be responsive to these outreach initiatives.

Third, the importance of passive funds in capital markets gives them a platform from which they can influence broader conversations about corporate governance. Passive fund managers can promote their stance on corporate governance issues through annual letters, media appearances, discussions with regulators, and lobbying efforts.

As passive funds continue to grow in size, their role in shaping conversations on corporate governance issues will further expand. Market participants, particularly company boards and activist shareholders, will need to pay close attention to what they have to say.

The author would like to thank Felix Moser-Boehm, articling student, for his assistance in writing this legal update.