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The increasing percentage of the modern capital markets owned by passive investors – index funds and ETFs – has received extensive media and academic attention. This growing ownership concentration as well as the potential power of passive investors to affect both corporate governance and operational decision-making at their portfolio firms has led some commentators to call for passive investors to be subject to increased regulation and even disenfranchisement. These reactions fail to account for the institutional structure of passive investors and the market context in which they operate. Specifically, this literature assumes that passive investors compete primarily on cost and that, as a result, they lack incentives to engage meaningfully with their portfolio companies.

We respond to this failure by providing the first theoretical framework for passive investment and its implications for corporate governance. Our key insight is that although index funds are locked into their investments, their investors are not. Like all mutual fund shareholders, investors in index funds can exit at any time by selling their shares and receiving the net asset value of their ownership interest. This exit option causes mutual funds – active and passive – to compete for investors both on price and performance. While the conventional view focuses on the competition between passive funds tracking the same index, our analysis suggests that passive funds also compete against active funds. Passive fund sponsors therefore have an incentive to take measures to neutralize the comparative advantage enjoyed by active funds, that is, their ability to use their investment discretion to generate alpha. Because they cannot compete by exiting underperforming companies, passive investors must compete by using “voice” to prevent asset outflow.

We show that passive investors behave in accordance with this theory – their engagement with portfolio firms continues to grow, and they are devoting increasing resources to that engagement. Passive investors also exploit their comparative advantages – their size, breadth of portfolio and resulting economies of scale -- to focus on improving corporate governance, efforts that reduce the underperformance and mispricing of portfolio companies. Passive investors thus seek to reduce the relative advantage that active funds gain through their ability to trade.

We conclude by exploring the overall implications of the rise of passive investment. Significantly, although existing critiques of passive investors are unfounded, the rise of passive investing has the potential to raise concerns about ownership concentration, conflicts of interest and corporate law’s traditional deference to shareholders.