Passive Institutional Investors and Corporate Innovation

Using an instrumental variable approach that exploits an exogenous variation of passive institutional ownership caused by Russell 1000/2000 index reconstitution, we find that greater passive institutional ownership leads to improvement in corporate innovation measured by patent quantity and quality. Our results are robust to alternative setup of regression discontinuity design and a refinement to improve the approximation of the end-of-May market capitalization that Russell uses for index assignment. We identify three channels for such effect: first, the increased presence of passive institutional investors transfers more power to the manager; second, passive institutional ownership reduces the likelihood of CEO turnover especially for firms that outperform their industry peers; third, greater passive institutional ownership is associated with a wider adoption of non-executive employee stock options, which helps incentivize innovative activities.