Passive Compliance: How Index Fund Ownership Affects Financial Reporting

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September 7 , 2023  |  By Jack Travis, Caleb Rawson

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The debate is always raging between institutional investors and stock market experts alike. With mutual funds, what’s the better bet when trying to beat the market — active or passive management? In 2022, a declining market put money management skills to the test. By ability or luck, nearly half of actively managed mutual funds outperformed the S&P 500, an increase from only 15% the previous year. While these numbers show the potential of active management, playing the market will always be a gamble. Passively managed mutual funds remain a reliable option for those attempting to place a safe bet. Empirical testing also points toward passive managerial styles inhibiting managers from being dishonest, adding to their security. 

Research has shed light on how the opposing managerial styles affect a fund’s integrity in its financial reporting to investors. In their study, “The power of not trading: Evidence from index fund ownership,” researchers Caleb Rawson and Stephen Rowe reexamine how index fund managers’ inability to make trading decisions influences bias in performance reports and the complexity of financial documents. 

Active vs. Passive Management 

Common ownership via index funds has grown steadily since the late 1990s. The total net assets of index funds increased from $384 billion in 2000 to $5.7 trillion in 2021. Analysts often attribute increasing interest to an index fund’s unique approach to portfolio management.  

As opposed to active managers, index fund managers face greater constraints and limitations when making trading decisions and deciding whether, and when, to enter or exit positions. Index fund managers aim to match the performance of a published index like the S&P 500. They buy and sell securities within the target index to maintain similar fluctuations. By creating a portfolio in correlation with an index, managers take a back-seat role. Active managers use their own judgement when making trading decisions.   

Stock market legends such as Warren Buffet and Burton Malkiel have long hailed index funds as being the safest way to invest. Academic research and popular media, however, have highlighted potential downsides of common ownership via index funds. These downsides could give potential investors pause. While lower fees and less associated risk make index investing a gateway for prospective traders, some may look for additional benefits before deciding to invest. 

Unlike other mutual funds, index funds operate in a way that naturally encourages high quality financial reporting and simple documentation. Common funds that do not follow an index make trading decisions based on information. Managers must monitor and engage with portfolio companies to gain insight into where the market is headed, which has proven to lead to bias in financial reports. Meeting earning benchmarks, alleviating career concerns, or other financial benefits could all motivate active managers to allow their financial reports to contain bias, regardless of the long-term effects their firm might face.  

Due to index funds seldom engaging with companies through trading, their financial documentation is uncomplicated. Fewer shareholders investigate financial reports when making trading decisions, and consequently, index fund managers logically encounter fewer incentives to misrepresent figures and overcomplicate fund related documents. Rawson and Rowe hand-collected and examined the information for approximately 7,000 funds during their study. By examining the fund objectives in prospectuses provided by firms and comparing firm information from Compustat, CRSP, IBES, Audit Analytics, and Thomson Reuters, the researchers could determine how index fund ownership and passive fund management affect financial reporting, providing valuable context to the discussion of financial transparency in general. 

The Reality of Fund Management  

Researchers and business reporters have previously tended to paint index fund ownership as having exclusively positive or negative effects. Despite index funds’ reputation for being safe investments, many financial analysts highlighted the potential downsides high levels of indexed ownership might bring. Specifically, could index funds owning large portions of public companies affect the corporations’ governance and the economy in general? Experts additionally fear earnings myopia, or near-sightedness, leading to unintended consequences. Rawson and Rowe noted both positive and negative implications of index fund ownership and expanded the conversation as index fund ownership continues to consume the market.   

Results from the study confirmed passive managers’ limited trading ability positively correlates to unbiased reporting and straightforward paperwork. Furthermore, the research has provided the first large-scale evidence that less trading by index funds has implications for financial reporting behavior of all types of public firms. The researchers also observed otherwise undocumented effects of both passive and active management during in their empirical testing. For example, while index fund management is positively associated with less bias in financial reporting, the researchers also found passive managers’ financial reporting to generally be of a lower quality.  

Throughout the study, the researchers aimed to strengthen the argument for and against index funds. They set out to expand our knowledge of index funds and how a passive management style affects fund communications with institutional investors. Now, those looking into mutual funds have more insight into the entire spectrum of common ownership. 

The Importance of Integrity 

As you search through endless amounts of ways to manage your wealth, index funds remain a reliable choice, but they are not without flaws. Any manager may solve a selfish, short-term issue by introducing bias into their financial reports, so investors therefore need to remain vigilant of both active and passive mutual fund managers attempting to exaggerate their ability at the expense of your money. Firms misrepresenting information in financial documents is disastrous and will be even more so if common ownership continues to increase

Mutual fund ownership is burgeoning, regardless of whether the fund follows an index or not. Investors traded over 9,000 mutual funds, holding $21.3 trillion in assets on U.S. exchanges during 2019. The independent investor must have as much information as possible about who is managing their money and how they might act while in charge of it.  

Through their study, Rawson and Rowe have expanded the context for investors considering purchasing stock in an index fund or any type of mutual fund. Furthermore, they have added even more fuel to the fiery deliberation between passive and active management. 

Caleb RawsonCaleb Rawson is an Assistant Professor of Accounting at the University of Arkansas, where he has been teaching financial accounting since 2018. He received his PhD in accounting from the University of Colorado Boulder in 2018, and his BS in accounting from Colorado Christian University in 2013. His research is largely in the areas of insider trading, index funds, and voluntary disclosure including examining how rising index fund ownership shapes manager decisions, how managers selectively use press releases to communicate to investors and promote the firm, and how local and national newspapers influence investors' perception and reaction to information. His research has been published in prestigious academic journals including The Accounting Review, Review of Accounting Studies, and Journal of Accounting Research and featured in media outlets such as Bloomberg, Arkansas Money & Politics, and Accounting Today.