Carnegie Mellon University

Andrew Bird and Stephen Karolyi

July 01, 2017

“Passive investors” are Usually Anything But

Passive institutional investors are a rapidly growing segment of U.S. ownership, with the share of equity mutual fund assets held in passively managed funds more than doubling, to 33.5 percent, between 1998 and 2014.

But just how passive are they? That’s the question Andrew Bird, assistant professor of accounting, and Stephen Karolyi, assistant professor of finance and accounting, answer in research examining the role institutional investors play in how a corporation is governed.

Two papers — one published in the Review of Financial Studies in December 2016, the other in Accounting Review in January 2017 — fill a gap in prior research on corporate taxation, avoidance behavior, and public disclosure by companies.

Karolyi said, “There was a big hole in the literature. We couldn’t directly link the preferences of these institutional investors to the behavior of firms.” So he and Bird decided to investigate. Using data from Securities and Exchange Commission filings as well as Compustat — a database of financial, statistical and market information — Bird and Karolyi measured changes in corporate disclosure, which signaled a behavior change by the company — in this case, in response to passive investors’ demands.

Traditional thinking held that passive investors didn’t really participate in the way a business runs, Bird said, because they aren’t actively trading stock. But their research proved the opposite to be true. Institutional investors care about maximizing a company’s profit and cash flow.

“In fact, passive investors are very active, broadly, in doing corporate governance,” Bird said. They push for greater corporate transparency and want companies to optimize their tax planning, through the use of international tax havens, for example.

“The big-picture implication is that despite the fact that these passive owners cannot directly benefit from the new information that’s going to be disclosed, they must be getting some kind of indirect benefit by informing other investors who can trade the stock actively,” Karolyi explained. “That suggests they want to encourage other investors to participate in governing the firm.”

Bird and Karolyi began working on their research shortly after Karolyi joined the Tepper School faculty in 2014, often in collaboration with Thomas Ruchti, assistant professor of accounting.

“I think I walked in the door, and within three weeks, we started working on these projects together,” he said.