Corporate ownership has undergone a seismic shift in the past two decades. As we illustrate, the rise of ETFs has dramatically altered the investor landscape, positioning them as one of the largest shareholders in US corporations.
The dramatic shift from active investing to passive ETFs has sparked a full debate among academics and practitioners about its implications on corporate governance.
Specifically, there is a growing concern that due to the complete passivity of indexing strategy, ETFs pose significant risk for corporate governance.
For example, a Wall Street Journal article titled Index Funds Are Great for Investors, Risky for Corporate Governance described ETFs as threats to corporate governance since passive investors do not care about governance of a particular company.
It proposes ETFs should abstain from voting altogether because ETFs, as they are uninformed, are incapable of voting in their investors’ best interest. This sentiment is echoed in academia.
According to a study titled Do Index Funds Monitor? conducted by professors from University of Utah, University of Miami and University of Hong Kong, index institutions are not effective monitors of corporations due to lack of necessary resources and incentives.
If ETFs do not fulfil their fiduciary duty, it is a wake-up call for regulators who are mindful about monitoring corporate America.
On the contrary, our study, titled ETF and Corporate Reporting, shows ETFs do not worsen corporate governance, but improve it. While practitioners, academics and regulators have only focused on the passiveness of ETFs, in our study, we pay close attention to the low churn rate of ETFs.
Specifically, we hypothesise that the low churn rate of ETFs mitigates corporate myopia. The US capital market has become increasingly myopic over the past decades.
According to an article in Harvard Business Review by Barton, titled Capitalism for the long term, the average holding period for US equity in 1970 was about seven years, which fell to seven months in 2011.
This short-term investing behaviour puts tremendous pressure on firms to deliver good short-term results. For example, according to a 2005 survey by professors Graham, Harvey, and Rajgopal, 78% of executives responded that they are willing to sacrifice long-term value to report good quarterly earnings.
Hillary Clinton famously coined the term ‘quarterly capitalism’, criticising this myopic behaviour. Ironically, due to their passiveness, ETFs do not churn their portfolio based on short-term earnings. Instead, this passive investment style makes ETFs long-term capital providers.
As ETFs do not trade based on quarterly earnings, firms with high ETF ownership are relieved from the myopic pressure to report good short-term earnings and can focus on long-term values.
How do ETFs mitigate managerial myopia?
When a firm misses its quarterly earnings target, its stock price collapses significantly, as investors penalise the firm by selling their shares in the company.
This significant penalty for missing earnings target has made corporate America increasingly myopic. However, our research documents that the penalty for missing quarterly earnings expectations is much smaller when ETF ownership is high.
While the average penalty – drop in stock price – for missing quarterly earnings target is about 4.9%, the penalty is 2.1% lower – about 43% smaller than the average penalty – for firms with high ETF ownership.
On the other hand, firms with high active mutual fund ownership face 1.6% higher penalty – 33% higher than the average – for missing earnings target. This smaller penalty associated with ETFs is due to their low turnover – and vice versa on all counts for active mutual funds.
We find that after a firm misses its earnings target, active mutual funds significantly reduce their position in the firm, while the positions held by ETFs are unaffected. This evidence suggests that ETFs are patient capital providers, being less sensitive to quarterly earnings.
ETFs reduce financial misstatements
Since firms with high ETF ownership are relieved from the pressure to meet the short-term earnings target, they have less incentive for altering financial statements to report better quarterly earnings.
It is well-known that corporations engage in ‘earnings management’ to avoid worse-than-expected earnings.
Examples of earnings management are to report higher receivables by recognising unrealised sales or lower payables by omitting purchases on credit.
Our research reveals firms with high ETF ownership are less likely to use these tricks, suggesting that their financial statements are more reliable and transparent.
Thus, contrary to the concerns raised by the media and academic research, when it comes to financial reporting, ETFs improve corporate governance.
Firms with high ETF ownership do not cut investment to report good earnings
Additionally, corporations can conduct earnings management by cutting valuable discretionary expenditures, such as R&D and advertising expenses. However, cutting these expenditures comes at a cost.
While it boosts short-term earnings, it sacrifices the firm’s long-term value as a valuable investment for the future is foregone.
Our research provides evidence that firms with high ETF ownership do not reduce these important expenses even when they are close to missing the earnings target.
In other words, corporations choose sustainable long-term growth over short-term earnings when ETF ownership is high.
Thus, this finding suggests that ETFs exert a positive influence on corporations so that they relinquish myopic behaviour and focus on long-term value.
These findings underscore the importance of considering the unique characteristics of ETFs in regulatory and policy discussions.
As ETFs continue to reshape the investment landscape, their role as patient capital providers offers a promising antidote to the short-termism that has plagued corporate America.
For regulators and policymakers, understanding and leveraging the strengths of ETFs could be key to fostering a more stable and forward-looking corporate sector.
This article was authored by Namho Kang, assistant professor of finance at Bentley University and In Ji Jang, assistant professor of finance at Bentley University.
This article first appeared in ETF Insider, ETF Stream's monthly ETF magazine for professional investors in Europe. To read the full edition, click here.
