Commentators have bemoaned their lack of financial incentives to ensure that the companies in their portfolios are well run and have suggested that index funds should not be allowed to vote the shares of the companies in their portfolio or should be subjected to special regulations.

In this article, we provide a systematic and differentiated analysis of the incentive and information structure within which advisers to index funds operate. Overall, the Big Three have among the strongest direct financial incentives to become informed. These incentives derive from their enormous scale and scope. This is important in several ways. First, scale increases the likelihood that their decisions will be pivotal. Second, even at a low percentage fee, their share of increases in firm value will be larger than almost any other shareholder. Third, they benefit from economies of scope in setting market wide governance standards. Fourth, the scale generates reputational incentives to be seen as responsible stewards, both for marketing and to forestall regulation. On the other hand, unlike advisers to active funds, advisers to index funds do not have indirect, flow-based incentives and have lesser access to company-specific information generated by analysts in the context of their investment activities.

The differences between advisers to active and advisers to index funds have different implications for the three core areas of engagement: high profile proxy contests between activist shareholders and boards; broad market wide governance standards; and monitoring of portfolio company governance and performance. With regard to the highest profile contests that will likely affect firm value, the strong direct incentives should assure that the Big Three will vote intelligently. With regard to market wide governance standards, the Big Three are better positioned than any other shareholders to set the standards: they enjoy economies of scope and analysts-generated information is generally not important. With regard to company specific monitoring of governance, the Big Three are similarly well positioned. By contrast, with regard to company specific performance – for which analyst-generated information tends to be important – hedge funds and advisers to large actively managed funds will often be in a better position to become engaged than advisers to index funds. On the whole, our corporate governance world would be poorer if index funds could not vote their shares and proposals singling out index funds for regulation are unwarranted.