Monday, July 10, 2017

Governance: The Growing Concentration of ETF (and mutual fund) Voting Power

Something that doesn't come up in casual conversation but may be important.
From the Columbia Law School's Blue Sky blog:

Mutual Fund Advisors’ “Empty Voting” Raises New Governance Issues
The creation of the mutual fund will go down as one of the greatest innovations in financial history. It has provided tens if not hundreds of millions of unsophisticated and uninformed stock market investors with easy access to low cost portfolio diversification. Moreover, for those investors who do not want to spend time and money searching for portfolio managers who can earn excess risk-adjusted returns, passively managed index funds provide tremendous value.

But mutual funds also have their downside. They generate what Ronald Gilson and Jeffrey Gordon would call the “agency costs of agency capitalism.” Mutual funds generate these costs through the industry practice of delegating voting rights to mutual fund advisors. These advisors are also the ones who are contracted to manage the investments of the mutual funds. This delegation of voting rights allows for a stock market phenomenon that is rarely discussed in the press or in academic papers, the “empty voting” of mutual fund advisors. Empty voting is when persons or entities obtain “voting rights greater than their economic interest.” The risk is that empty voting will lead to a reduction in overall shareholder wealth as the empty voter uses its voting power to act opportunistically at the expense of shareholders. For example, a hedge fund that owns a significant number of shares in a company could also own so many put options on the company’s stock that it would have “negative economic ownership” and vote according to its negative economic interest.

The potential agency costs of this practice have only increased as voting power has become concentrated with the rise of the mega-mutual fund advisor: Blackrock, Vanguard, State Street Global Advisors, and Fidelity, etc. These mega-fund advisors now control, without having any economic interest in the underlying shares, the voting rights associated with trillions of dollars worth of equity securities. For example, as of December 31, 2016, Blackrock had over $5.1 trillion of assets under management, with a little over half of those assets being equity securities.

In a recent op-ed piece in the Wall Street Journal, Todd Henderson and Dorothy Shapiro Lund discuss how an activist hedge fund, acting with the support of the two leading proxy advisors, was allegedly impeded in moving forward on its proxy contest because several mega-mutual fund advisors balked at voting to support the hedge fund’s director nominees for fear that doing so would “threaten their ability to retain that company as a client for corporate retirement fund assets.” This conflict of interest, the desire not to offend management for fear of losing business, encompasses the conventional wisdom of how mutual fund advisors may use their empty voting power opportunistically and has been the subject of empirical study.

But there may be more to this empty voting story than just conventional wisdom. It can be argued that mega-mutual fund advisors have been drawn into an alliance with the shareholder empowerment movement on the issues of proxy access and dual class share structures created through IPOs like Snap Inc.’s, which resulted in a class of non-voting shares, simply because of the business opportunity such an alliance represents. That opportunity is to attract or retain the business of public pension funds and union related funds (which control approximately $3 trillion in assets), the institutional leaders in the shareholder empowerment movement, which are shifting their portfolios away from high cost, actively managed mutual funds and hedge funds to low cost indexed funds, the kind of funds that the top 10 largest mutual fund advisors dominate in terms of market share.

The shareholder empowerment movement advocates shifting corporate decision-making authority to shareholders, and thus away from boards of directors and executive management, without regard to the impact on the decision-making of public companies. Shareholder empowerment, not shareholder wealth maximization or enhanced company performance, is the objective of this movement. Therefore, this alliance cannot be understood as being wealth maximizing for mutual fund investors....

HT: Professor Bainbridge: "Sharfman on an alliance between mutual funds and activist shareholders".

For a light-hearted romp here's BlackRock's "Open-End Fund Proxy Voting Policy Procedures Governing Delegation of Proxy Voting to Fund Adviser Effective Date July  1, 2017"