Reversing the Fortunes of Active Funds

In 2019, for the first time in the history of U.S. capital markets, passive funds surpassed active funds in terms of total assets under management. The continuous growth of passive funds at the expense of active funds is a genuine cause for concern. Active funds monitor the management and partake of decision-making in their portfolio companies. Furthermore, they improve price efficiency and managerial performance by engaging in informed trading. The buy/sell decisions of active funds provide other market participants reliable information about the quality of firms. The cost of active investing is significant and it is exclusively borne by active funds; the benefits, by contrast, are spread over all shareholders, including passive funds that free-ride on the efforts of their active peers. Therefore, the contraction of active funds threatens to set back the quality of corporate governance in U.S. firms.<br><br>This Essay proposes a way to reverse this trend. To preserve the benefits presented by active funds, we explore the possibility of employing tax mechanisms to help defray the extra cost borne by active funds. Perversely, at present, our tax laws exacerbate the problem. Since active funds trade more frequently than passive ones, they face a substantially heavier tax burden. We argue that taxation is the key to leveling the playing field in capital markets.Specifically, we establish a prima facie case for using tax credits to support active funds and enhance their market share. We focus on two types of tax credits: effort-based tax credits and result-based tax credits. Effort-based tax credits would be granted whenever an active fund undertakes prespecified measures to improve corporate governance irrespective of their success. Result-based tax credits would be contingent on the attainment of certain outcomes. The two types are not mutually exclusive and, as we will show, can be combined for maximal effect.<br><br>Our proposal has three potential advantages over competing initiatives that seek to induce passive funds to become more active. First, taxes constitute a highly effective tool for altering behavior as they transform the underlying motivations of the subject. Second, our proposal has the potential to create a virtuous financial cycle: the expected increase in tax revenues from the improved performance of firms generated by the tax credit should cover the cost of providing the credits. Third, and finally, from a political economy standpoint, our proposal, on account of its noncoercive nature, will not attract opposition from the investment industry and thus stands a realistic chance of being adopted.