Right Now | The Silent Shareholders
Passive Corporate Governance
Index funds—the low-cost mainstay of retirement accounts and college funds—are so popular that they now hold a surprisingly large share of U.S. corporations. These passive investment vehicles purchase shares of companies so that their holdings mirror common measures of market performance, such as the S&P 500, which is weighted by market capitalization. Now, a series of papers from the Law School’s Program on Corporate Governance sounds the alarm about the ways index-fund managers are using their expanding influence—or not. Ames professor of law, economics, and finance Lucian Bebchuk, director of the program, shows through empirical analysis that index funds often vote against the financial interests of investors. And Leo Strine, Scott lecturer on law and former chief justice of the Delaware Supreme Court, says index-fund managers are not doing enough to halt corporate political spending.
BlackRock, State Street Global Investors, and Vanguard, the so-called “Big Three” index-fund investors, collectively cast about 25 percent of proxy votes in all S&P 500 companies (a common benchmark for large, publicly held corporations), Bebchuk says, a percentage that he and his coauthor, legal scholar Scott Hirst of Boston University, expect to increase. “If trends of the past two decades continue for another two decades, the ‘Big Three’ will grow into what we term the ‘Giant Three,’” he says, projecting that they would cast up to 40 percent of such votes by 2040.
Bebchuk notes that the late Jack Bogle, the iconic founder of The Vanguard Group, once called index funds “the best hope for corporate governance,” suggesting that their vast holdings and the generally long-term investment horizons of the people who buy them to fund goals such as retirement enable these owners of shares in index funds to play a key role in company oversight. Yet the reality, Bebchuk says, is that index funds are “excessively deferential” to corporate management, even when this conflicts with investors’ needs or harms corporate performance. For example, he and Hirst analyzed votes on executive pay between 2012 and 2018 and found that the Big Three rarely voted down new pay packages. “We document that the frequency of ‘no’ votes by the Big Three is less than half and close to one-third of the frequency” seen in votes by the largest actively managed mutual funds (overseen by professional stock-pickers), Bebchuk explains.
He adds that index-fund managers are unlikely to intervene when a company’s financial performance lags. In one recent paper, Bebchuk writes: “[I]n the vast majority of companies in which a hedge fund activist is not agitating for change, the Big Three pay little attention to whether a company suffers from financial or business underperformance that might call for ‘fixing the management.’” Indeed, he and Hirst found, by analyzing data from research firm Morningstar, that index-fund managers spend relatively little time or money on stewardship activities, whether evaluating company performance or submitting shareholder proposals. By their estimates, BlackRock spends fewer than four days of employee time and less than $5,000 in stewardship costs per year for each billion-dollar investment the company holds, while State Street and Vanguard each devote fewer than two days, and less than $2,500 in stewardship costs, annually per billion-dollar holding.
Among his proposals to remedy the lack of oversight, Bebchuk suggests that index-fund companies not only pass the costs of research and other stewardship duties on to their investors, but also work together to create a shared research service to monitor companies in major indexes, with the aim of spotting those that underperform. “Index funds are under a lot of public scrutiny and they care about being viewed as good stewards,” Bebchuk notes. “We think that recognition of these problems would by itself contribute somewhat to improving matters.”
Strine, for his part, takes a broader view of the responsibilities index funds have toward their investors. He faults the Big Four investment companies (the Big Three, plus Fidelity) for operating without enough concern for the “worker investors” who rely on index funds and other mutual funds to finance college tuition and retirements. He applauds their efforts to begin paying attention to ESG issues (environmental, social, and governance concerns), but wants them to add another “E,” for “employees.”
Strine believes worker-investors are particularly affected by the Big Four’s lack of intervention focused on unchecked corporate spending for political purposes, another area of “total deference to management,” as he put it in a recent paper. He calls for all political spending by companies to be made public, and recommends a proposal first championed by Vanguard’s Bogle: that any political spending by public companies should require obtaining yes votes from 75 percent of the stockholders. Index-fund companies, he says, have the clout necessary to make such changes: “If Vanguard, BlackRock, State Street, and Fidelity voted to restrict political spending by public companies, it would happen.”