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Since the financial crisis of 2008, the stock market has seen a remarkable migration of investor money away from active management and toward passive, or index, funds. As a result, the “Big Three” asset managers—BlackRock, Vanguard and State Street—have swiftly ballooned into behemoths. Taken together, they constitute the largest shareholder in more than 40% of publicly traded U.S. firms, and 88 percent of the S&P 500.
If those percentages got your attention, you’re in good company. Politicians, regulators, and researchers have expressed concern and curiosity about the possible long-term impact of Big Three dominance. Two accounting professors at the Donald G. Costello College of Business, Sebahattin Demirkan and Ted F. Polat, recently added to a critical corner of the debate. Their paper in Journal of Risk and Financial Management clears up some of the uncertainty around Big Three supremacy by concentrating on investees’ cost of equity, a key measure of risk perception.
“For individuals, if your credit rating is high, you can borrow with lower interest, and vice versa” Demirkan says. “The same idea applies to companies. If they are highly rated for transparency, disclosure, etc., the cost of capital will go down because banks are willing to lend money at a lower rate. And investors will demand less in terms of dividends—Amazon, for example, has never paid a dividend to shareholders.”
Demirkan and Polat wanted to know whether the Big Three owning a significant equity stake served as a red flag or a green light for the marketplace. They analyzed financial performance and ownership data for 4,836 U.S.-listed firms over the period 1997-2016.
Within the data-set, they isolated three areas of risk associated with cost of equity: agency risk (or poor corporate governance practices), informational asymmetry and liquidity risk. For the companies in the sample, increased Big Three ownership was correlated with higher agency risk. This isn’t so surprising, considering passive investors are less incentivised to try and improve company performance through attentive stewardship. They aim, after all, to match the market rather than beat it.
However, a larger share of passive ownership tended to reduce informational asymmetry and liquidity risk. This is
in line with prior research finding that large institutional investors use their leverage to pressure investee companies into being more open about disclosure. For example, they might push managers to issue more detailed and frequent management earnings guidance disclosures and 8-K filings with the SEC.
Taking these nuanced results into account, Demirkan says that the ultimate impact of Big Three ownership will depend on the company and its context. Broadly speaking, a moderate increase in passive ownership lowers equity costs for companies that are fairly liquid and transparent with investors. But the positive effect dwindles for low-liquidity firms.
This is especially important because passive ownership, in and of itself, reduces liquidity as a rule.
“This is a disadvantage of the Big Three investors,” Demirkan says. “On the one hand, it is increasing information. On the other hand, because there is less active buying and selling, it may generate liquidity issues. In bad times, it may protect the company, because trading volume will be down anyway. But in good times, companies cannot benefit.”
The power of the Big Three, then, can be a double-edged sword. Beyond a certain level of ownership, passive investors may create more volatility than stability for firms. For Demirkan, this is yet another concern to be added to the list from civil society, policymakers and industry observers about the rapidly mounting clout of the Big Three.
The researchers argue that corporate managers and policymakers alike should do everything possible to maximize the strengths of passive ownership—such as its long-term focus, which can be better for promoting environmental and social responsibility—while containing the downsides of its unrestrained growth.
“At the end of the day, we must think about the entire society, not only shareholders,” Demirkan says. “Imagine a world where only passive investors exist, there are no individual investors. The CEO and the management team for the Big Three will rule capital markets. Instead of a democracy, the market will become a kingdom.”