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You get what you pay for: The rise of the index fund and exploration in R&D

Subject

Strategy and Entrepreneurship

Publishing details

Working Paper

Authors / Editors

Troyer C;Ahuja G

Biographies

Publication Year

2021

Abstract

We take on the debate about whether institutional ownership can remediate agency problems in public corporations by examining how a specific type of institutional investor, the index fund, affects a key outcome that is a locus for potential conflict between shareholder and manager interests: R&D exploration. Drawing on exploration and decoupling theories, we argue that managers will only pursue R&D exploration if shareholders provide the kind of costly oversight that insulates managerial reputation from the risks that exploration poses to short-term performance, yet index funds have neither the incentives nor the ability to do so given their competitive imperative to minimize costs while managing large portfolios. We use multiple approaches including within-firm effects, IV estimation, and alternate measures of index ownership to find that index ownership constrains R&D exploration in R&D-intensive industries. Thus, while index funds are hailed as the investment vehicle of choice for the retail investor, our study suggests that the same features that make index funds effective financial instruments—low expense ratios and broad portfolios—limit their efficacy as providers of corporate governance. You get what you pay for: the strong commitment to low expense ratios limits investment in stewardship, which ultimately constrains exploration by their portfolio firms.

Series

Working Paper

Available on ECCH

No


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