J.B. Heaton (University of Chicago Law School) has posted All You Need is Passive A Response to Professors Fisch, Hamdani, and Davidoff Solomon on SSRN. Here is the abstract:
In a recent paper, Professors Jill Fisch, Assaf Hamdani, and Steven Davidoff Solomon argue that passively-managed funds have incentives to engage meaningfully with their portfolio companies because they compete for investors with actively-managed funds. Since passively-managed funds that track indices cannot trade out of the index, Professors Fisch, Hamdani, and Davidoff Solomon argue that passive funds will engage with portfolio companies to increase the companies' stock return performance. In this short response, I highlight four problems with their argument. First, their argument is premised on the assumption that active managers have a comparative advantage over passive funds – the ability to trade in and out of stocks – that passive funds must address, but the empirical evidence – unaddressed in the paper – is that passive investment consistently outperforms active, suggesting there is no such comparative advantage to overcome. Second, the authors ignore a crucial structural problem with their view of passive investment managers: the fund complexes that manage the largest passive funds also sell active management services to some of the largest active managers. This matters because the profitability of actively-managed strategies is an order of magnitude greater than the profitability of the passive strategies. Third, while it costs passive funds little to vote for corporate governance improvements, and while it might be good marketing or relationship-building with their institutional clients, there is no evidence that these improvements give the passive funds any advantage over their active competitors. Finally, but perhaps most importantly, the authors fail to address the fact that passive investing appears to beat active investing not because of interventions of the type they study, but because passive investment in broad-based indices dramatically increases the probability of capturing the gains of the handful of stocks responsible for most equity returns.