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SSRN-id3148309.pdf - Are Passive Investors a Challenge to...

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Electronic copy available at: 1Are Passive Investors a Challenge to Corporate Governance?Nan Qin and Di Wang1This version: March 23, 2018AbstractCorporate governance theories generally suggest that institutional investors couldeffectively improve the quality of governance through intervention and threat to exit.However, passive institutional investors such as index funds and ETFs lack the ability toexit and may not have strong motivation to intervene, thus lowering the quality ofgovernance of the firms they heavily hold. This paper provides empirical evidencesupporting this hypothesis. It shows that higher ownership by passive investors is relatedto lower firm value measured by Tobin’s Q and weaker operating performance measuredby return on assets. Further analysis suggests that passive investors negatively affectseveral aspects of corporate governance: they exacerbate the managerial myopia problemby discouraging long-term investment, weaken managers’ incentive scheme by loweringthe pay-for-performance sensitivity and the probability of performance-based disciplinaryturnover, and reduce the independence of the board by raising the probability of CEO-chairduality.JEL classification: G23, G34Keywords: passive investors, corporate governance, firm performance, executive compensation,CEO turnover1Qin ([email protected]) is from the College of Business, Northern Illinois University, 236G Barsema Hall, 740Garden Road, DeKalb, IL 60115. Wang ([email protected]) is from University of Maryland, College Park, 3114Tydings Hall, 7343 Preinkert Dr., College Park, MD 20742.
Electronic copy available at: 2Are Passive Investors a Challenge to Corporate Governance?AbstractCorporate governance theories generally suggest that institutional investors couldeffectively improve the quality of governance through intervention and threat to exit.However, passive institutional investors such as index funds and ETFs lack the ability toexit and may not have strong motivation to intervene, thus lowering the quality ofgovernance of the firms they heavily hold. This paper provides empirical evidencesupporting this hypothesis. It shows that higher ownership by passive investors is relatedto lower firm value measured by Tobin’s Q and weaker operating performance measuredby return on assets. Further analysis suggests that passive investors negatively affectseveral aspects of corporate governance: they exacerbate the managerial myopia problemby discouraging long-term investment, weaken managers’ incentive scheme by loweringthe pay-for-performance sensitivity and the probability of performance-based disciplinaryturnover, and reduce the independence of the board by raising the probability of CEO-chairduality.

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Term
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Professor
DWDWD
Tags
Index fund, passive investors, passive ownership

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