A profoundly insightful look at power in society.
From American Affairs Journal:
The New Power Brokers: Index Funds and the Public Interest
One of the most consequential phenomena affecting the financial markets over the past two decades has been the increased concentration of ownership in America’s public companies by a handful of institutional investors. Since 1998, the average combined stake in S&P 500 companies held by the “Big Three” institutional investment funds—Vanguard, State Street, and BlackRock—has quadrupled from 5.2 percent to more than 20 percent. During the last ten years, the number of firms in the S&P 500 index in which the Big Three hold 5 percent or more of the company’s equity has increased more than fivefold, with BlackRock and Vanguard each now holding positions of 5 percent or more of the shares of almost all the companies in the S&P 500. If current trends continue, the combined average ownership stake of the Big Three is estimated to rise to 27.6 percent by 2028, and to 33.4 percent of S&P 500 equity by 2038.1
The driving force behind this development has been the rise of index funds—investment funds that track the performance of particular market indices, like the S&P 500 or the Dow Jones Industrial Average. Index funds have gained popularity as more individuals and institutions have accepted the idea that few investors can “beat the market” and that buying a full array of available stocks generally earns the highest risk-adjusted return, particularly net of investment costs, such as advisory and management fees. This has come as a boon to institutional investment firms like the Big Three, which are among the largest index fund providers in the world.
The increased concentration in stock ownership that has resulted from index funds’ popularity has conferred on index fund providers significant voting power over U.S. public companies. Because the Big Three generally vote all of their shares, whereas not all of the non–Big Three public shareholders vote their shares, shares held by the Big Three represent an average of about 25 percent of the shares voted in director elections at S&P 500 companies. Assuming that past trends continue, the Big Three are expected to represent about 34 percent of votes cast in the next decade, and about 41 percent of votes cast within two decades.2
Is it good policy to permit a handful of index funds to exert this level of control over America’s public corporations? In recent years, a growing number of academics and business commentators have considered this question, but the frame of thinking that has characterized most analytical efforts has been myopic. Almost universally, scholars have avoided grounding their analysis in an examination of why and how index funds exert voting power in the first place. Instead, they have offered policy proposals focused on addressing specific problems posed by index funds’ increased prominence in shareholder voting—from breaking up the index funds in order to eliminate the anticompetitive effects of common ownership, to stripping index funds of their voting rights based on a view that they lack sufficient institutional incentives and capabilities to exercise those rights in a manner that promotes shareholder value.3 In doing so, scholars have boxed themselves into treating the increased voting influence of index funds as if it were an organic market phenomenon that only warrants attention from policymakers for certain negative externalities that it produces.
In truth, the increased prominence of index funds in the shareholder voting process is fundamentally a political problem. Index funds have acquired the ability to exercise voting rights with respect to the shares they hold not because those rights are something that they require in connection with the conduct of their business. Rather, index funds are deemed to be the technical owners of the shares comprising those funds under corporate law and thus the holders of the voting rights associated with those shares. The practical result is that index funds’ approach to making voting decisions has little connection to the implementation of their index investing strategy—instead, they make their decisions based on a generalized, frequently ideological view of what constitutes good governance. This view is usually shaped by a small group of organizations and institutional investors who have proximity to the relevant power centers at the major index funds.
While this approach to voting has given rise to many critiques of index funds in recent years, simply banning index funds from casting votes or breaking them up ignores the core problem. That problem is an accountability issue driven by corporate law’s default allocation of voting rights to entities whose intended function is nothing more than to direct capital from individual and institutional investors into prepackaged market indices. This accountability problem has particular social significance for two reasons. First, the dramatic growth in index fund assets over recent years has been substantially financed by the retirement savings of millions of Americans. In fact, a substantial amount, if not the majority, of those retirement savings have been directed into index fund investments. In other words, the question of what to do with the voting power represented in index fund assets is very much a question of who should speak for the interests of the public in the proxy voting process. Secondly, since index fund investments represent permanent investments in the health and integrity of the broader markets, the success of those investments hinges on the ability of the economy to deliver long-term and broad-based results, which in turn depends on a mindset towards governance that is informed and driven by the public interest. Given that today’s shareholder voting landscape is not just dominated by index funds, but also by other well-heeled institutional investors who vigorously advocate for their own agendas, direct government action is necessary to ensure accountability in index funds’ voting activities and to enable the public to express a meaningful voice in the proxy voting process.
Why and How Do Index Funds Vote?As a threshold matter, it is important to recognize that the ability of index funds to exert voting influence is entirely the product of law rather than the invisible hand of market forces. Since an index fund is nothing more than a collection of stocks that track a market index, the availability of voting rights has no relevance whatsoever to the ability of an index fund to execute an index investing strategy on behalf of its clients. All that index funds are tasked with doing is to function as intermediaries between individuals and institutions who want to invest in an index by investing that capital into a portfolio of stocks that conform to the specifications of the underlying index.
Index funds have the power to vote “proxies” in respect of the shares comprising their funds, however, because under the relevant corporate laws they—not the ultimate beneficiaries of the index funds—are deemed to hold those voting rights by virtue of their status as the technical owners of the shares. As custodians of their clients’ capital, they also have a fiduciary duty to make voting decisions in the best interests of their clients. Index funds have generally interpreted this duty to impose an affirmative obligation to vote all proxies, even though the law prescribes little guidance as to what it means to vote in the best interests of one’s clients apart from requiring that funds comply with certain steps and procedures in how they go about making their voting decisions. As is the case with many relationships governed by fiduciary law, this duty functions as a legal “gap filler” that establishes a general, undefined default standard for conduct among parties in circumstances under which they have not actually stipulated or contemplated specific rules of conduct to govern the relationship.
Notwithstanding this default legal standard, the economics of index fund investing significantly reduces the incentives of index funds to utilize their voting rights as a tool for enhancing the underlying economic value of their investments. Index fund managers are remunerated with a very small percentage of their assets under management. Thus any increase in the value of a portfolio company resulting from their voting activities would result in only a negligible increase in their fees, and the dedication of increased resources and attention to the voting function would raise costs, which would directly harm an index fund’s relative performance. At the same time, any increase in the value of a portfolio company would benefit rival index funds that track the same index (and investors in those funds), which would receive the benefit of the increase in value without any expenditure of their own.4
In other words, index funds’ ability to vote their shares has no relevance to their underlying investing strategy. Thus they have limited incentives to invest sufficient resources to individually evaluate, and thereby maximize the value of their investments in, their portfolio companies. The practical effect is that index funds do not approach the process of making voting decisions as an aspect of their investment function in the traditional sense. Instead, index fund sponsors end up minimizing costs by taking away the authority to make voting decisions from fund managers and vesting that authority in independent governance units that promulgate uniform voting decisions regarding a given matter on behalf of the entire fund complex, including the sponsor’s actively managed funds and other non-index-fund vehicles.5....
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