Aurora Borealis
24 October 2019 CFA Institute Journal Review

Standing on the Shoulders of Giants: The Effect of Passive Investors on Activism (Digest summary)

  1. Clifford S. Ang, CFA

This is a summary of “Standing on the Shoulders of Giants: The Effect of Passive Investors on Activism,” by Ian R. Appel, Todd A. Gormley, and Donald B. Keim, published in the Review of Financial Studies, vol. 32, no. 7.

The authors investigate the relationship between growth in passive ownership and growth in investor activism. They find that higher passive ownership leads to more ambitious activist goals, an increase in confrontational tactics, and activists seeking more board seats. The authors’ results suggest that growth of passive ownership leads to an increase in activists’ willingness to engage in costly, value-enhancing forms of monitoring.

What Is the Investment Issue?

The authors analyze whether growth in investor activism and growth in stock ownership by passive institutional investors are related. Specifically, they analyze whether the increasingly large and concentrated ownership stakes of passive institutional investors influence the types of campaigns undertaken by activists, the tactics they use, and their eventual outcomes.

How Did the Authors Conduct This Research?

Using S12 mutual fund holdings data compiled by Thomson Reuters, the authors compute mutual fund holdings in a stock as a percentage of its market capitalization. Their sample covers securities on the NYSE, Amex, and NASDAQ as well as Toronto and Montreal common stocks. To identify passively managed funds, the authors determine whether the fund’s name includes a string that identifies it as an index fund or the CRSP Mutual Fund Database classifies the fund as an index fund. All other mutual funds that can be matched to the CRSP Mutual Fund Database are classified as active funds, and the remaining funds that cannot be matched are left unclassified.

The authors obtain corporate activist campaign data from SharkWatch (FactSet), which collects the information from company/activist filings and press releases, news/trade publications, and company websites. They classify activist campaigns into four mutually exclusive categories based on their primary goal:

  1. campaigns seeking board representation
  2. campaigns seeking to maximize shareholder value by advocating for specific policy changes
  3. all other campaign goals
  4. 13D filings with no explicit activist intent

The most common tactics used by activists (e.g., proxy fights, drafting shareholder proposals, and lawsuits) and the most common outcomes of activist campaigns (e.g., results from a proxy settlement, increased dividends/payouts) are identified. The main sample covers the period 2008–2014.

The authors regress activism outcomes on passive ownership percentage plus certain control variables. The main empirical challenge in this model is that the potential cross-sectional correlation between passive ownership and activism outcomes may not reflect a causal relationship. Instead, the ownership of passive investors could be correlated with factors that directly affect activism. Failure to control for this issue could introduce omitted variable bias that confounds inferences. To overcome this problem, the authors use the inclusion of firms in the Russell 2000 as an “instrument” (i.e., a variable that is added to the right-hand side of the regression equation that allows one to better estimate the true correlation between the dependent and independent variable) to isolate an exogenous source of variation in passive fund ownership.

What Are the Findings and Implications for Investors and Investment Professionals?

The authors have several findings that could be of interest to investors. First, they find that passive mutual funds significantly affect activists’ strategic choices because activists set relatively more ambitious goals when more of a company’s stock is held by passive investors. Second, they find that increased passive ownership is associated with the increased use of confrontational tactics by activists. The authors document a shift in the likelihood of using hostile tactics to gain board seats when passive ownership is higher. Third, the authors find an increase in the total number of board seats sought when passive ownership is higher. These results suggest that the presence of passive institutions increases activists’ willingness to engage in costlier but more value-enhancing forms of monitoring.

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