Friday, March 29, 2013

The Drone Corporation: Passive Investing and Indexed Companies

Passive Investing and Indexed Companies 
March, 2013

Executive Summary
Significant shifts in the stock ownership patterns of publicly traded companies have occurred over the past forty years. Of particular interest is the dramatic growth in the size and number of fully indexed companies, where ownership is so widely held that classical agency theory may no longer be meaningfully applicable. Largely unnoticed and poorly documented, the shift in the United States towards ever larger fully indexed corporations, which Bob Monks has called “drone corporations”, or “corporate drones”, appears to be accelerating rapidly among the most powerful and influential US companies, bringing an entirely new context to bear on the concept, “too big to fail.”

The Growth in Increasingly Indexed Companies 
For purposes of the current brief an “indexed company” is one whose ownership is so widely distributed that no single shareholder holds a principal position, which is defined by the SEC as 10% or more. In most cases the largest single position is likely to be less than half that amount, or it may be held by a shareholder this itself also widely held, such as a mutual fund company or a passive index fund; in the most extreme cases the largest single position may be less than one percent of the shares outstanding.  
These screens were applied to the companies that comprise the S&P 500 index, identifying the fully indexed companies in this group by excluding any companies where: 
  • There are one or more principal shareholders, which the SEC defines as those holding a position of 10% or more 
  • One or more company founders continue to play a key role in guiding the company as either CEO or Chairman, regardless of the size of this individual’s holdings 
  • Where family interests, in most cases linked to the company’s founder, are represented by active board members, regardless of the size of the family’s current holdings 
  • Where one or more known activist shareholders have taken an active position in in the company
Just ten years ago, in July of 2003, the first year for which GMI Ratings (formerly The Corporate Library) collected the necessary ownership data to make such an assessment possible*, indexed companies comprised just 36 percent of the S&P 500 by count, but already accounted for 51 percent of the total S&P 500 market cap. By July of 2012 the count had grown to 54 percent of the S&P 500, and accounted for 64% of its total market cap. Furthermore, while the average market cap of all S&P 500 companies rose from just under $16 billion in 2003 to more than $26.5 billion in 2012, the average market cap of an S&P 500 indexed company rose from $22.5 billion to $30.5 billion. The fully indexed company has not only become the dominant form among large cap US corporations, but these companies continue to grow, in size, in number, and in power.  
These screens are intended to exclude any companies where there were one or more vested owners, or more specifically shareholders whose holdings were of sufficient size and importance to warrant an active level of monitoring and participation in the affairs of the corporation. Exactly the same screens were applied for each of the two time periods under review, but closer examination of a few specific companies highlights the dynamic nature of this target group. In the case of Wells Fargo, for example, which Warren Buffett has begun to steadily increase his holdings, will soon approach the threshold for being excluded from this group, while Apple, since the death of Steve Jobs, is headed in the opposite direction.  
The rise of the modern index fund is clearly a major contributor to this development, but so too are the emergence of high speed, high volume digital trading standards, including modern derivative practices, and a steady trend towards the creation of ever larger and increasingly global corporate empires. 

While there are many smaller companies that meet this definition as well, the current brief is focused on the indexed companies that were identified as part of the S&P 500 as of July 15, 2012.  
Characteristics of the Indexed Corporation 
Indexed companies effectively “resolve” the agency problems inherent in the public corporate form by effectively removing vested owners from the agency equation, and by elevating the power and authority of the CEO and board accordingly. Absent the constraining influence of active, i.e. informed and involved, owners, and particularly in the context of CEO-selected and CEO-dominated boards, the elevation of the indexed company CEO in status and power has been considerable, and the normal ties between power and accountability effectively eliminated. In the absence of vested owners, the indexed company CEO and board asserts degree of power and authority that was previously associated with controlled companies, which are the polar opposite of the indexed company with regards ownership.  
Surprisingly, given their prominence and growing dominance of the US equity markets, while certain individual indexed companies have performed quite well, in terms of average investment returns to shareholders over the five year period between July, 2007 and July, 2012, the 269 indexed companies that comprise a majority of the S&P 500 as of July 2012 have consistently under-performed their non-indexed counterparts.  
The Summary Table at the end of this brief compares the indexed versus non-indexed S&P 500 companies as of July, 2012, and supports a number of equally surprising conclusions: 

  • While the average tenure of indexed company CEOs is more than two years shorter than at non-indexed companies, the indexed company CEO is far more likely to be a “company man”**, who rose up through the ranks of the company by way of more junior positions. 
  • Despite their shorter average tenure, the indexed company CEO is more than 50% more likely to be named Chairman of the Board. 
  • Indexed companies are more likely to have other corporate CEOs on their boards, and in particular on their compensation committees. 
  • Non-executive director shareholdings at indexed company boards average less than half the dollar value of their non-indexed counterparts. 
  • Despite their poorer average returns to investors, indexed company CEOs took home last year, on average, approximately $1.25 million more than their non-indexed counterparts.
Looking even further afield, and comparing these groups using data from other readily available sources yielded even more startling possibilities:  
  • Indexed companies, on average, laid off nearly 50% more workers, for exactly the same reporting period***. 
  • In terms of regulatory and related fines and settlements paid over the past 20 years, the indexed companies were more than twice as likely to make such payments, and account for almost 85% of the total amount paid, totaling more than $80 billion in all****.  
The fully indexed companies are not only becoming larger and more dominant, they have also begun to exhibit a number of characteristics, and engage in corporate behavior, which could ultimately have a very negative impact on the health and well-being of the US equity markets. In his book, Citizens DisUnited*****, Bob Monks takes an even closer look at this trend and its implications in this larger context, and identifies those key shareholders who could make all the difference in reversing it.  

Questions for Further Research 
The rise of the fully indexed corporation appears to have escaped the attention of most academic researchers, and perhaps even a majority of investors. Based on the findings of  this preliminary brief and its supporting data, and the even more far reaching conclusions highlighted in Citizens DisUnited, certain questions seem particularly important: 
  1. What are the exact mechanisms that have encouraged the growth in indexed companies that has occurred in the US markets over the past five years? How likely is the continued expansion of this trend, and what will be its likely impact on the US economy? Are we creating an “ownership deficit”, from which we might never recover? 
  2. What other shifts have occurred or are occurring with regards the ownership of large multinational corporations? For example, what impact has the growth in derivative trading, or the concept of borrowed voting rights, had on management accountability? Do we have any means for evening tracking such impacts? 
  3. If the fully indexed corporation delivers on average inferior investment returns, then why is this form growing so rapidly both in size and in number? What other factors come into play here, and just how important are they? For example, only one or two of the world’s largest shareholders – BlackRock, for example – have truly embraced the concept of responsible ownership, while a majority remain resolutely mute and passive when it comes to addressing the rights and responsibilities of equity ownership. Should limited liability also be taken to mean limited accountability, particularly when corporations perform sub-optimally, or when they engage in externalizing behaviors that carry a high societal price-tag? 
  4. For many of the current crop of indexed company CEOs it appears that their appointment as CEO is less of a career pinnacle challenge and more of an honorarium for past contributions, and the often criticized out-sized pay levels awarded to these individuals more about simple reward than competitive necessity. This seems particularly true in light of the relatively poor performance of so many of these companies. Why have the boards that oversee these individuals and approve such pay packages allowed this situation to get so out of hand – and why have shareholders done so little to stop them? 
  5. In the current political environment in the US, where forty plus years of steady corporate, financial and securities trading deregulation have been accompanied by a concomitant rise in corporate and CEO power and influence, is the growing disconnect between ownership and management of the very largest US corporations described here a viable and acceptable trend?
Ric Marshall, Chief Analyst at GMI Ratings 
March 2013 
The views and opinions expressed in this brief are entirely my own. 


* Unless specifically indicated otherwise, all data citations included in this study are based on data collected by GMI Ratings or its predecessor company, The Corporate Library, and has been compiled from public sources based on information filed by the companies themselves. The Corporate Library, and now increasingly GMI Ratings, are among the most widely cited sources for such data regarding US corporate governance. 

** For purposes of this brief the “company man” was defined as any CEO who came into that office with at least ten years of credited pension history. The actual list is included in the supporting data file in Table 6, CEO Characteristics. 

*** Based on data compiled by the Forbes Layoff Tracker, at 

**** Based on data compiled by George Draffan of and available at 

***** Citizens DisUnited:  Passive Investors, Drone CEOs, and the Corporate Capture of the American Dream by Robert A.G. Monks is available at and also in Kindle format via The book was published by Minerva Press in March of 2013.