Are Passive Institutional Investors Engaged Monitors or Risk-Averse Owners? Both!

IMF Working Papers, June 4, 2021

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Study differentiates effects of passive institutional investors (mainly index funds adopting a passive portfolio strategy) on firms’ innovation activities and innovation strategies.
With larger passive institutional ownership:
- Firms’ countable innovation activities increase.
- Firms shift innovation strategies toward exploitation of existing knowledge instead of exploring new technology.
Enhanced monitoring by passive institutional investors through active votes could explain the positive effects on firms’ innovation activities.
Increasing risk aversion on the part of passive institutional investors appears to be the underlying force driving firms’ shift to incremental innovation.
The paper uncovers a subtle relation between institutional investors and innovation that earlier studies largely ignored.

Identification strategy relies on plausibly exogenous variation in passive institutional ownership generated by Russell 1000/2000 index reconstitutions.

Enhanced monitoring channel:
- Passive institutional investors engage via active votes, which may improve observable, countable innovation activities.
Risk-aversion channel:
- Passive investors’ increasing risk aversion leads firms to favor incremental (exploitation) innovation over exploratory (new-technology) innovation.

Institutional investor ownership composition affects not only the quantity of firm innovation but also the direction and risk profile of innovation strategies.
Policymakers and corporate boards should account for how ownership by passive institutional investors may encourage incremental innovation even as it increases measurable innovation activity.