One of the major shifts on Wall Street during the past 40 years is the growing influence of institutional investors, such as Fidelity and Blackrock.
In the late 1970s, firms like these owned about 30 percent of the market, while individual investors owned the rest. Today, those percentages are flipped, with institutions owning as much as 76 percent of U.S. stocks. Part of this is due to the rise of employers offering 401(k) retirement plans, which gave people a convenient way to invest. Another reason is that research has shown investing in index funds to be just as effective as picking individual stocks—while being far easier as well.
This evolution of ownership raises some important questions about corporate governance. For instance: shareholders, through voting rights, have some influence on how firms are governed. Historically, that influence was dispersed among thousands of individual investors. But now that a single institutional investor can own, say, five percent of United Airlines, how does that affect how such an investor tries to shape United’s handling of matters such as CEO pay, takeovers, and board structure?
In a new working paper, the husband and wife team of Jonathan and Katharina Lewellen approach this question by estimating the incentives institutional investors have to be actively involved in the firms they invest in.
They measure incentives as the increase in an institution’s cash flow (management fees) when a stockholding increases 1 percent in value. This considers both the direct effect of a value increase on assets under management and the indirect effect via the subsequent increase in fund flows. The methodology accounts for the fact that institutions compete with each other for fund flows and tend to be evaluated based on relative performance (so engagement by one institution often benefits other institutions).
The Lewellens find the incentives to be substantial: a 1 percent increase in the value of a stock held by an institution leads, on average, to an increase of $148,300 in an institution’s cash flow. This estimate ranges from $21,000 for small institutions (who hold more concentrated portfolios) to $343,000 for the largest institutions (with more diffuse holdings). For the large and arguably passive institutions, the incentives are comparable to those of many activist investors who find it profitable to engage actively with their portfolios firms.
On a more anecdotal level, these findings ring true. The Lewellens presented their research at a conference this spring where the keynote speaker was the head of the investment stewardship team at a large institutional investor. “His theme was that they absolutely want to be engaged, that there’s value in it,” recalls Katharina, an associate professor of business administration at Tuck.
This rise of institutional investors is strengthening the incentives to get involved in governance, so it actually may have a positive impact on corporate governance, and that should be good for everybody.
Concentrated stock ownership by institutions also raises another question. If institutions own large percentages of the major firms in one industry, does that lead to a weakening of competitive instincts among those firms? The logic in this question is based on a simple truth: companies (and therefore their investors) do better when all the firms in an industry are growing. In such a situation, however, it’s consumers who stand to be harmed by the high prices that can prevail with a lack of competition.
In their paper, the Lewellens call this potential phenomenon a “rival incentive”: how much institutional shareholders in one firm gain if rival firms in the industry increase in value. Industry observers have raised concerns about this possibility in recent years, but the Lewellens find “the rival incentives to be relatively modest,” says Jonathan, the Carl E. and Catherine M. Heidt Professor of Finance at Tuck. As they write in their paper, in concentrated industries, “rival incentives are positive but typically smaller than own-firm incentives,” which means that firms gain more if their own holdings increase by one percent, compared to if the value of every competitor also goes up by one percent.
The Lewellens’ paper upends years of speculation, in the media and in the academic literature, that institutional investors are passive investors. And, according to the co-authors, that’s good news. “This rise of institutional investors is strengthening the incentives to get involved in governance,” Jonathan says, “so it actually may have a positive impact on corporate governance, and that should be good for everybody.”