The Role of Passive Investors in Corporate Governance: An Empirical Analysis of the Influence of Passive Institutional Investors In the U.K.

Kristian Uldall Skov Pedersen & Simon Sebastian Hjorth Lorenzen

Student thesis: Master thesis


This thesis investigates the association between equity ownership by passive investors, firm performance, and corporate governance quality. In order to examine this, we use a sample of 737 UK firms from 2010-2016. This is complementary to previous research, which has been centered around the U.S. The previous results have determined that index funds may not be as ‘passive’ as expected, with them actively influencing firm governance instead, by exercising their voice. However, the results regarding whether the effect of passive investor ownership is negative or positive have been ambiguous.
Following existing theory, we propose that passive investors are incentivized to positively impact the performance and corporate governance quality of firms, and have the ability to do so through standardized, low-cost mechanisms. We formulate a number of hypotheses to test if, and by which mechanisms, passive institutional investors influence firm governance and performance. To test the influence on the overall corporate governance quality, we use ESG Governance metrics as a proxy, while performance is measured by Tobin’s Q and ROA.
To examine our hypotheses, we rely primarily on linear regression to investigate the impact of firms having a high (above 5%) versus low level of ownership by passive investors on different measures. In order to increase the reliability and reduce the endogeneity concerns, we leverage the matching data processing technique, using Coarsened Exact Matching (CEM). This allows us to match firms on a number of firm characteristics, testing the effects of the ‘treatment’ (passive institutional investor ownership), for similar firms in terms of size, industry, and age. In addition to that, we use a number of control variables.
Our findings suggest that passive investors do exert influence on firms through voice. We find that passive investor ownership is positively and significantly associated with the market-based performance measure, Tobin’s Q, but insignificantly so with the accounting performance measure ROA. Furthermore, we find no significant association between passive ownership and the overall ESG governance quality measures. For our board measures, our findings suggest that corporate governance committees are not influenced by passive investor ownership, but that they do lead to a higher probability of having a compensation committee, and in extension, also more likely to have CEO compensation linked to stock performance. Furthermore, passive investor ownership is also found to be positively and significantly associated with board independence. Finally, we have ambiguous results for our measures of takeover defenses, as passive investor presence is related to having more equal voting rights and lower prevalence of dual class stocks, but does not significantly influence the overall number of takeover defenses or shareholder rights to call special meetings.
Overall, this thesis attempts to advance the understanding of the influence of passive institutional investors on corporate governance. Our research suggests that passive investors exercise their voice, and participate more in the governing of firms than expected and promote standardized good governance measures across the market.

EducationsMSc in Applied Economics and Finance, (Graduate Programme) Final Thesis
Publication date2018
Number of pages108
SupervisorsAleksandra Gregoric