Index funds track the performance of an index passively to replicate the same returns. As the size and popularity of index funds grow, so too their influence on companies as they hold more equity. In the US, the “Big Three” index fund managers, BlackRock Inc, State Street Global Advisors and Vanguard Group currently hold around 25% of all shares in the S&P 500.
Given the large influence these fund managers have, stewardship decisions will impact governance and performance of public companies. A Harvard report – Index Funds and the Future of Corporate Governance: Theory, Evidence and Policy – explores the current voting and stewardship patterns undertaken by the big three fund managers.
The funds claim to devote the necessary resources to stewardship. Vanguard has an investment stewardship program that is “vibrant and growing” while BlackRock “intends to double to size of its investment stewardship team over the next 3 years”. The CIO of State Street Global Advisors has stated that their “asset stewardship program continues to be foundational to our [their] mission”.
The nature of an index fund would suggest better governance over time. Funds are invested with a long-term perspective. There is no “exit” unless the company leaves said index. Therefore, it would be in the fund’s best interest to ensure the company is not pursuing short-term gains at the expense of long-term value.
This might not hold water when taking into account the incentives of the fund managers.
The report uses an agency-cost framework to argue that fund managers do not have strong such stewardship incentives.
The research found that fund managers have strong incentives to underinvest in stewardship. Since they are remunerated with a very small percentage of their assets under management, any stewardship that increases portfolio value will be insignificant for remuneration increases.
Furthermore, increasing the value of a company would increase the value of rival index funds which leads to a free-rider issue. Each fund will believe the other will do the work and will not have to contribute their own resources
The business relationships between the fund managers and corporate managers lead to index funds being deferential in their voting patterns. Since the funds are invested in a large number of companies, taking non-deferential action would incur significant additional costs and paperwork. At the same time, taking more active action would put the fund managers in sight of a management backlash.
As the influence of index funds grows, there is “the risk that their potential stewardship activities could pose a threat to incumbents’ power and interests”. This may lead to a regulatory backlash as the public resists the concentration of financial power.
The research suggests that the income devoted towards stewardship is negligible, limiting ability to cursory stewardship for most companies. The research estimated that funds have less than 0.2% of the fees received directed to their stewardship departments. Engagement levels are also low, with an average of less than 4% of the portfolio companies subject to multiple engagements and over 90% of the portfolio companies not subject to any private engagements. While the funds do employ proxy advisors, they have stressed that the final decisions are made by themselves.
This lack of focus on stewardship reveals the aspects that the funds have failed to undertake adequately. They pay limited attention to business performance, the choice of individual directors and important characteristics of said directors. They fail to bring about improvements favoured by their own governance principles and are passive on governance reforms. Index funds have passed on all opportunities to influence consequential securities litigation, refraining from taking on lead plaintiff positions in security class actions, despite the fact they have substantial skin in the game.
The report proposes reforms that would increase incentives for index funds to be more active in stewardship. They do not see the value of stripping voting power altogether or transferring the voting rights to investors. A recommendation proposed would be to charge stewardship cost towards the index fund. This would remove the perception of the stewardship department as a cost centre and ensure costs are borne by investors.
To tackle the free-rider issue, the report puts forward the benefits of proxy advisors allowing fund managers to share in the costs. However, the additional filing would depend on a change in policy to encourage pooling. There can also be a policy to mandate minimum stewardship expenses, based on a fraction of the indexed assets under management. Regulators could also consider limiting or fully disclosing the relationships between fund managers and portfolio companies. This would ensure that information flows reach the public, creating more transparency on voting decisions and reducing information asymmetry. As their influence is expected to grow further, a limit on the ownership by any one fund would break up the sector. This would reduce the required filings and investment risks.
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