Do Passive Index Investment Enhance Market Monitoring Functions?

The issuance of the CSI A500 ETF has shifted market attention towards passive investment strategies.ETFs,as a well-established passive investment tool,have garnered increasing attention due to their unique and innovative trading attributes.This paper investigates whether passive index investment tools enhance market monitoring functions from the perspective of ETF ownership.The findings reveal that a higher proportion of ETF ownership in individual stocks significantly reduces the prevalence of shareholder equity pledging.An exploration of the underlying mechanisms suggests that higher ETF ownership mitigates information delay and offsets existing noise trading,thereby improving stock price information efficiency.This enhanced efficiency generates a monitoring effect,ultimately reducing equity pledging by shareholders.In terms of ownership characteristics,the monitoring effect is more significant in firms where the largest shareholder holds a higher ownership stake or in non-SOE enterprises.Further,the improvement effects brought about by ETFs are more pronounced in firms with lower levels of information disclosure quality.The results of the study remain robust after undergoing various tests,including instrumental variable analysis.The conclusions of this study provide important insights for improving market efficiency,strengthening market monitoring functions,and fostering a virtuous governance cycle. We primarily examine the enhancement of market monitoring functions from the perspective of ETF ownership,using equity pledge as a measure of the effectiveness of market supervision.The interaction between institutional investors and corporate governance generally operates through three mechanisms:active governance,“voting with their feet”,and market-based information mechanisms for indirect supervision.Given the diverse investor base and dispersed composition of ETFs,we argue that the third mechanism predominantly underpins their market monitoring role.We investigate whether an increase in the proportion of ETF holdings can reduce equity pledging,thereby curbing corporate tunneling behaviors and enhancing effective monitoring.We identify improvements in stock price information efficiency as the primary channel through which ETFs exert their supervisory function.Key factors influencing stock price information efficiency include the speed of information transmission,liquidity depth,and the proportion of noise trading.Our empirical analysis demonstrates that the introduction of ETFs accelerates information transmission,offsets existing noise trading,and enhances the efficiency of stock price information.This,in turn,creates capital market pressure that imposes supervisory constraints on equity pledging by shareholders,although we find that the liquidity channel appears less significant.Further analysis reveals that the supervisory effect of increased ETF ownership is more evident in firms where the largest shareholder holds a higher proportion of shares or in non-state-owned enterprises,as these firms often exhibit stronger incentives for tunneling.We also find that the effects of ETFs are more pronounced and significant in firms with weaker information disclosure practices.To address potential endogeneity concerns,we leverage the exogenous increase in passive ownership resulting from index reconstitutions,referring to changes in the bottom constituents of the Russell 1000 Index and the top constituents of the Russell 2000 Index.Similarly,in the Chinese market,we use changes in the CSI 300 and CSI 500 indices,and construct an instrumental variable based on newly added top-tier constituents in the CSI 500 Index.Our results remain robust,thereby ensuring the reliability of our findings. The primary contributions of this paper are as follows:1)Expanding the understanding of the impact of passive index investment tools from the perspective of ETFs:While existing literature on ETFs largely focuses on their influence on the characteristics of capital markets,there is a lack of in-depth exploration of their effects on corporate governance.Our findings provide a robust interpretation of the role ETFs play in corporate governance,demonstrating how ETF ownership influences equity pledging through its effects on the informational environment.This contribution offers new insights and evidence regarding how financial instruments can address corporate governance issues via information mechanisms.2)Augmenting research on the factors influencing equity pledging:Prior studies on equity pledging have predominantly focused on its consequences or subsequent abnormal behaviors,leaving the determinants of equity pledging relatively underexplored.By adopting the unique perspective of ETFs,our study identifies how different informational environments affect equity pledging decisions,filling an important gap in the literature.3)Exploring the channels through which ETFs exert influence:We show that ETFs play a role in corporate governance by reducing information transmission lags and mitigating noise trading.This enriches the understanding of the mechanisms through which passive index investment tools operate.Given the growing scale of ETF investments,our findings highlight the practical importance of examining how ETFs shape the ecological dynamics of capital markets.Overall,the results of this study have significant implications for future research on passive index investment tools.They contribute to a deeper understanding of how such tools enhance market efficiency and foster greater market depth,offering valuable guidance for both academic inquiry and practical application.