Passive investing may have slashed fund fees but corporates caught in the index vortex seem to be paying the price in higher debt costs, according to a new Bank of International Settlements (BIS) study.
The just-published BIS ‘Passive investors and loan spreads’ analysis found a clear correlation between index fund ownership of stocks and bank lending terms to respective underlying companies.
In a result that could’ve gone “in either direction”, the study shows companies with a large passive shareholder base face higher bank loan spreads than listed firms with a greater proportion of active owners.
“Using syndicated loan data, we find that loan spreads increase with passive ownership and provide evidence consistent with higher loan spreads reflecting increased risk due to reduced shareholder oversight,” the BIS report says.
The analysis tracked debt metrics of US companies transitioning between the Russell 1000 and 2000 indices over an almost 20-year period.
Under the methodology, “downgraded firms’ – firms that move from a lower weight in Russell 1000 to a higher weight in the Russell 2000 – are exposed to an increase in passive ownership, while ‘upgraded firms’ move from the Russell 2000 to 1000 and are exposed to a decline in passive ownership”.
The sample period from 2006 to 2022 also closely tracks the rise of the indexing phenomenon with passive funds now holding about 30 per cent of the S&P 500 benchmark, equating to US$7 trillion.
During the 18-year stretch, the median company in the BIS study “saw an increase in passive ownership from around 2.5% to almost 20%”.
Theoretically, a high proportion of passive ownership might improve loan terms but the report says banks appear to view index influence as negative for debt, partly due to reduced shareholder oversight.
“The evidence we find is consistent with the argument that passive investors engage in less shareholder monitoring. In particular, we find that the impact of increased passive ownership on loan spreads is more pronounced in firms with better corporate governance,” the paper says. “These results suggest that the shift toward passive ownership is particularly consequential when it displaces traditionally active shareholder monitoring in well governed firms. We find no systematic evidence that effects are stronger among firms with greater information asymmetries.”
And with fewer active owners holding passive-heavy corporates to account, the BIS study says banks tend to up their own due diligence efforts when lending to those firms in what can be an expensive exercise.
“… we find evidence consistent with the interpretation that part of the rise in the loan spread in response to a higher share of passive funds reflects banks’ enhanced efforts, and hence higher cost, of monitoring,” the report says.
Authored by BIS contributors Konrad Adler, Sebastian Doerr and Xingyu Sonya Zhu, the paper suggests that the surge in passive investing can have unexpected second-order effects.
“Index funds’ rapid growth raises questions about their influence on governance and monitoring, as well as the consequences for other stakeholders.”