Index Funds and Stewardship: A Practice Worth Encouraging
by Joshua Levin
March 25, 2019
Indexing, passive ownership, and the relative dominance of BlackRock, State Street, and Vanguard (the “Big Three”) have created a concentration of corporate power not seen since the Gilded Age in America.1See Dorothy S. Lund, The Case Against Passive Shareholder Voting, 43 J. CORP. L. 493, 506-10 (describing the rise of passive investing); see also Sarah Krouse, At BlackRock, Vanguard and State Street, ‘Engagement’ Has Different Meanings, WALL ST. J. (Jan. 20, 2018), https://www.wsj.com/articles/at-blackrock-vanguard-and-state-street-engagement-has-different-meanings-1516449600 (noting that the three firms combined to own “18.5% of the S&P 500 at the end of the third quarter, up from 14.7% five years earlier”); Jan Fichtner & Eelke Heemskerk, These 3 firms own corporate America, BUSINESS INSIDER (MAY 10, 2017), https://www.businessinsider.com/american-corporation-big-three-firms-2017-5 (discussing the huge magnitude of the shift toward indexing ownership). However, whether increased passive ownership is “good” or “bad” for companies and shareholders hinges largely on the activity of the three major indexing players. Are these firms doing too much, too little, or a Goldilocksian “just right” amount with their significant ownership of the United States equities market?2Of course, the Big Three are not generally the beneficial owners of the stock at issue, but they do exercise the voting rights of those shares.
On the side of “doing too much,” some argue that the concentration of power of institutional investors presents a risk of anti-competitive, cartel-like behavior.3See generally Eric A. Posner et. al., A Proposal to Limit the Anticompetitive Power of Institutional Investors, 81 Antitrust L.J. 669 (2017). As the size and concentration of institutional investors increase so too do the risks of such adverse behavior. Those who claim that passive investors are “doing too little” tend to focus on the lack of a financial incentive for index funds to monitor individual companies and the high rates of those funds voting with management.4Lund, supra note 1 at 494-498. Interestingly, both groups identify one identical solution: eliminating passive shareholder voting.5 Id.; Posner et. al., supra note 3.
Alternatively to these two viewpoints, the stewardship and engagement efforts of the “Big Three” index funds may be good from a corporate governance perspective.6See Edward B. Rock & Daniel L. Rubinfeld, Antitrust for Institutional Investors, 82 Antitrust L.J. 221, 277-78. This is possible since index fund managers have increased their focus on governance and stewardship.7See Madison Marriage, BlackRock, Vanguard and State Street bulk up governance staff, Fin. Times (Jan. 28, 2017), https://www.ft.com/content/657b243c-e492-11e6-9645-c9357a75844a; see generally BlackRock, BlackRock Investment Stewardship 2018 Annual Report (2018) (describing the goals, focus, and efforts of the stewardship group in 2018); Vanguard, Investment Stewardship 2018 Annual Report (2018) (same).Eliminating passive shareholder voting would erase these improvements because management have little incentive to heed non-voting shareholders. Because of this trend toward increased stewardship by passive investors, more information should be gathered before any regulatory changes are put in place.
Doing Too Much
Recently a group of financial economists, Azar et al., presented evidence of the anticompetitive effects of common ownership in the airline and banking industries.8José Azar, Martin C. Schmalz & Isabel Tecu, Anti-Competitive Effects of Common Ownership, 73 J. Fin. 1513 [hereinafter Azar, Common Ownership]; José Azar, Sahil Raina & Martin Schmalz, Ultimate Ownership and Bank Competition (July 23, 2016) (unpublished manuscript), www.ssrn.com/abstract=2710252. If index funds are providing an impetus for tacit collusion that harms consumers, then serious antitrust concerns might be raised by this analysis. Obviously, committing crimes and lessening competition would be an example of index funds doing too much and causing economic harm. But Azar et al. suggest a wide variety of mechanisms that create anticompetitive results.9 See Azar, Common Ownership, supra note 7, at 1553-57 (describing engagements, incentives, and voting as potential avenues for index funds to influence company management). Nevertheless, there is significant doubt that company managers are incentivized to engage in tacit collusion or that there is an appropriate mechanism that shareholders could use to push that preference on managers.10 Rock & Rubinfeld, supra note 6, at 238-40; Matt Levine, Index Funds May Work a Little Too Well, Bloomberg (July 22, 2015), https://www.bloomberg.com/opinion/articles/2015-07-22/index-funds-may-work-a-little-too-well.At least one of these two scenarios would be required for the theory to pose a credible threat. Furthermore, if managers were sacrificing individual firm value to benefit diversified shareholders, activist investors and actively managed funds would monitor for and arbitrage the potential tacit collusion-based losses in firm value through direct engagement.11Rock & Rubinfeld, supra note 6, at 250-51.
However, in oligopolistic industries, Einer Elhauge of Harvard Law argues that management is not oblivious to its shareholder base or their interests.12Einer Elhauge, Horizontal Shareholding, 129 Harv. L. Rev. 1267, 1307 (2016). Taking the Azar et al. conclusions as given, Elhauge argues further that the active engagement of passive funds with companies should subject them to liability under U.S. antitrust law.13 Id.; see 15 U.S.C. § 18; United States v. E. I. du Pont de Nemours & Co., 353 U.S. 586, 597-606 (1957) (describing the type of control that tended to be considered a Clayton Act violation); United States v. Dairy Farmers of Am., Inc., 426 F.3d 850, 859–60 (6th Cir. 2005) (noting that lack of control or influence does not necessarily eliminate liability under the Clayton Act when acquisitions serve to lessen competition); see also Rock & Rubinfeld, supra note 6, at 260-62 (explaining the connection between Elhauge and Azar et al. and Elhauge’s argument). However, after considering the applicable statutes, case law, and Department of Justice and Federal Trade Commission enforcement policy, the Big Three’s voting of approximately 6-8% of certain firms should not constitute a prima facie antitrust violation under current law.14See Rock & Rubinfeld, supra note 6, at 252-62. Ultimately, Elhauge’s position seems closer to a contention that (assuming the Azar et al. empirics are correct) index funds should be illegal, rather than that they are illegal under current law.15See Rock & Rubinfeld, supra note 6, at 262 (suggesting that, if empirically correct, it is likely that antitrust enforcement will come to regulate horizontal ownership); Levine, supra note 9 (describing the potential effects of modern portfolio theory on management thinking and action).
Assuming there is a problem of passive funds doing too much, Posner et al. suggest a solution.16Eric A. Posner, Fiona Scott Morton & E. Glen Weyl, A Proposal to Limit the Anticompetitive Power of Institutional Investors, 81 Antitrust L.J. 669 (2017). Namely, there should be no voting or engagement by widely diversified passive funds.17Id. at 708 (“No institutional investor or individual holding shares of more than a single effective firm in an oligopoly may ultimately own more than 1% of the market share unless the entity holding shares is a free-standing index fund that commits to being purely passive [i.e., not voting or engaging with portfolio firms].”) (emphasis in original). The authors take the position that their solution will generally benefit society: “By reducing the monopolization of markets, it should lower prices for everyone. The returns to investors would decline, but their losses would be much less than the gains to society from the price reductions.”18Eric Posner & E. Glen Weyl, Mutual Funds’ Dark Side, Slate (Apr. 16, 2015), https://slate.com/news-and-politics/2015/04/mutual-funds-make-air-travel-more-expensive-institutional-investors-reduce-competition.html. Posner et al. say this rule saves us from rising inequality and “save[s] markets from themselves.”19Id.
The Posner et al. rule would impose costs on investors if the Big Three wanted to keep voting, which they generally see as their fiduciary duty. As a response, the Big Three may lower diversification or increase administrative expenses, a troubling, but natural, result.20Full disclosure: the author of this paper keeps his retirement account invested in Vanguard index funds.There is also a likely unintended consequence of the Posner et al. proposal. Combining the lack of a financial incentive (discussed more infra) for index fund engagement with the inability to follow through (i.e., vote) to express their preferences, beneficial engagement between index shareholders and companies would likely stop entirely; funds would reduce administrative costs and therefore save money.21See Rock & Rubinfeld, supra note 6, at 266-67.If policy makers believe encouraging input from long-term shareholders is a benefit for the long-term sustainability and viability of companies, then antitrust law and policy should not create barriers to the growing engagement between index providers and their portfolio companies.
Doing Too Little
Dorothy S. Lund argues that passive funds do not have the financial incentive, governance expertise, and form-specific knowledge necessary to discipline company management.22Lund, supra note 1, at 496-97. In essence, she argues passive investors do too little with respect to firm oversight and therefore too much with respect to voting. These issues are exacerbated in competitive industries; there are simply not enough hours in the day to collude across a significant number of firms. Alternatively, Lund argues actively managed funds have the right incentives to identify underperforming firms and push for value creating change.23Id.; see generally Marcel Kahan & Edward B. Rock Hedge Funds in Corporate Governance and Corporate Control, 155 U. Pa. L. Rev. 1021 (2007) (discussing the potential for active funds and activists to be a positive force in corporate governance). So, they should be the ones doing the voting.24Lund, supra note 1, at 497. While she acknowledges the concern, her article generally does not discuss the issue of potential misalignment of incentives as between active managers and “regular” investors.25Id. at 495; Leo E. Strine, Jr., Can We Do Better by Ordinary Investors? A Pragmatic Reaction to the Dueling Ideological Mythologists of Corporate Law, 114 Colum. L. Rev. 449, 458– 59 (2014) (noting the potential misalignment of interests between institutional investors and “regular” investors). Lund argues further that actual, genuine engagement on the part of index funds could increase costs or thoughtless voting could hurt company performance, potentially resulting in a breach of fiduciary duties to investors in the index fund.26Lund, supra note 1, at 497.
Others argue that conflicts of interest and lack of transparency with respect to the relationship between institutional investors, proxy advisory firms, and portfolio companies present significant concerns for shareholders interested in long-term value maximization.27See Ike Brannon & Jared Whitley, Corporate Governance Oversight and Proxy Advisory Firms, Harv. L. Sch. F. on Corp. Governance And Fin. Reg. (Sept. 17, 2018), https://corpgov.law.harvard.edu/2018/09/17/corporate-governance-oversight-and-proxy-advisory-firms/ (describing the reliance of institutional investors on proxy advisory firms, the potential conflicts, and the transparency solution); see also Gretchen Morgenson, Dubious Corporate Practices Get a Rubber Stamp From Big Investors, N.Y. Times (May 19. 2017), https://www.nytimes.com/2017/05/19/business/gretchen-morgenson-arconic-activist-investors.html (describing the failure of institutional investors in holding management to account as illustrated by Arconic’s recent experience as an activism target); Gretchen Morgenson, Your Mutual Fund Has Your Proxy, Like It or Not, N.Y. Times (Sept. 23, 2016), https://www.nytimes.com/2016/09/25/business/your-mutual-fund-has-your-proxy-like-it-or-not.html (highlighting potential conflicts and their impact on executive compensation and independence of board chairmen/chairwomen). Even though Gretchen Morgenson made such arguments, she has had to contend with evidence that institutional shareholders appear to vote with management less frequently than individual shareholders.28Gretchen Morgenson, Small Investors Support the Boards. But Few of Them Vote., N.Y. Times (Oct. 6, 2017), https://www.nytimes.com/2017/10/06/business/small-investors.html; see also Cydney Posner, Are Shareholder Proposals on Climate Change Becoming a Thing?, Harv. L. Sch. F. on Corp. Governance And Fin. Reg. (June 21, 2017), https://corpgov.law.harvard.edu/2017/06/21/are-shareholder-proposals-on-climate-change-becoming-a-thing/ (describing the importance of BlackRock and Vanguard voting against management recommendations in passing climate related shareholder proposals).She attributes the difference to the difficulties retail shareholders face in casting their votes.29Morgenson, supra note 28. While she is correct that institutional investors voted approximately 90% of their shares compared with retail investors’ rate of about 30%, her explanation is not the only possible (or even plausible) one.30Broadridge & PircewaterhouseCoopers, ProxyPulse 2018 Proxy Season Review at 2, (2018), https://www.broadridge.com/_assets/pdf/broadridge-2018-proxy-season-review.pdf. Perhaps retail shareholders are just less engaged in managing their portfolios than index managers who owe fiduciary duties to their clients. After all, there is an opportunity cost to managing one’s own proxy voting: it costs time. Whatever the reason, it is clear that retail shareholders are unlikely to discipline management through the proxy voting process as currently instituted. Since institutional shareholders vote with much greater frequency and are more likely to vote against management, they are likely a better candidate than retail owners to act as a check on management.
Lund suggests two possible “remedies” to the problems created by uninformed or conflicted voting by passive investors: (1) eliminate their vote entirely or (2) pass-through votes to beneficial owners.31Lund, supra note1, at 528-33. Her solutions fail to address some noteworthy considerations for those shareholders. First, it is not clear that the right incentives for long-term growth are provided by active fund managers.32See Strine Jr., supra note 25. Second, as Lund notes, her solutions impose direct costs on investors who prefer indexing strategies and want their fund managers to engage in governance stewardship.33Lund, supra note 1, at 530-31. Lund claims this is a feature, not a bug.
Getting to the Goldilocks “Just Right” Amount
Index investors are generally locked-in, long-term shareholders. Their incentives are properly aligned for engagement by the Big Three to focus on long-term returns and sustainability of firms. But the Big Three and passive fund managers generally will need to address the challenges presented by the “doing too little” status quo. The Big Three cast thousands of proxies every year despite stewardship teams numbering only in the tens.34Id. at 515-20 (describing the number and extent of engagement as reported by BlackRock and Vanguard in 2015).The funds are generally committed to growing these teams and have made efforts to do so.35Marriage, supra note 7; see also BlackRock, BlackRock Investment Stewardship 2018 Annual Report, supra note7, at 2-3 (describing the growth of the BlackRock stewardship group and a goal to double team size by 2020). However, their reliance on proxy advisors’ recommendations raises the concern that potential conflicts among proxy advisors may result in negative returns for shareholders.36See Brannon & Whitley, supra note 27; Lund, supra note 1, at 516-17. Additionally, the funds want to win pension management accounts from companies and thus have an incentive to accommodate portfolio company management of the same companies.37See Lucian Bebchuk et al., The Agency Problems of Institutional Investors, 31 J. Econ. Persp. 89 (2017). Finally, and perhaps most importantly, there is a collective action and freerider problem for individual index funds: costs of engagement are born by the firm doing the work, while the benefits are distributed across the market. How can passive fund providers transparently increase governance engagement despite seeming to lack a financial incentive?
If you are inclined to believe them, the major index fund providers claim governance engagement and stewardship are parts of their fiduciary duty.38See BlackRock, supra note 6, at 1; see also BlackRock, The Investment Stewardship Ecosystem at 6-7 (July 2018), https://www.blackrock.com/corporate/literature/whitepaper/viewpoint-investment-stewardship-ecosystem-july-2018.pdf. Alternatively, being “good on governance” is just one way the fund providers can compete for assets.39See Hortense Bioy & Alex Bryan, Passive Fund Providers Take an Active Approach to Investment Stewardship, Morningstar at 6-10 (Dec. 2017), https://corporate1.morningstar.com/ResearchLibrary/article/839413/passive-fund-providers-take-an-activeapproach-to-investment-stewardship—-full-report/) (describing increased investor interest in stewardship by funds). Lund suggests investors might prefer index providers that do focus on governance—provided the investors are not the ones bearing the cost.40Lund, supra note 1, at 512. It follows that investors might choose funds that do serve governance purposes. Increased engagement costs might well be covered by increased fees received from an uptick in assets under management. Being the “Good on Governance” fund provider may well become a competitive advantage in attracting assets from investors. This is especially true for the Big Three as individual retail investors and pension funds are increasingly focused on Environmental, Social, and Governance performance of firms.41See Georg Kell, The Remarkable Rise Of ESG, Forbes (July 11, 2018), https://www.forbes.com/sites/georgkell/2018/07/11/the-remarkable-rise-of-esg/#f16f72016951 (describing the growth of and interest in ESG factors for investors including how institutional investors came to see an ESG focus as commensurate with their fiduciary duties). This may, in turn, provide the financial incentive to monitor that detractors of institutional shareholder voting identify as lacking. Cynicism would suggest that what passive funds are actually incentivized to do is create the appearance of being good on governance while doing very little in order to dupe investors and keep costs down.42See Lund, supra note 1, at 132-33. Whether that story is credible depends on the extent to which good faith is presumed on behalf of index funds and, more importantly, how much disclosure they make with respect to their governance efforts.
The State of Play
Regardless of the motivation, engagements are increasing. BlackRock, for example, engaged with portfolio companies 2,049 times in 2018 as compared to 1,421 times in 2015, as identified by Lund.43See Lund, supra note 1, at 519-20; BlackRock, supra note 7, at 20. Importantly, companies appear to be responding to the calls for better disclosure, more engagement, and improvements to environmental, social, and governance measures.44See, e.g., Vanguard, supra note 7, at 11-31 (describing a variety of engagements and their outcomes). Ernst & Young’s 2018 proxy season review notes the top four key takeaways as: “1. More companies voluntarily enhance board composition disclosures, 2. Push for gender diversity advances, 3. Environmental and social shareholder proposals gain traction [and] 4. Investor engagement continues to grow[.]”45Ernst & Young, 2018 proxy season review (2018), https://www.ey.com/Publication/vwLUAssets/EY-cbm-proxy-season-review-2018/$FILE/EY-cbm-proxy-season-review-2018.pdf. It is not likely a coincidence that these issues track closely with the stewardship priorities of the major passive funds.46See BlackRock, supra note7, at 5-6; Vanguard, supra note 7, at 3. Perhaps in support of Morgenson’s critique, the fifth takeaway was that “Say-on-pay gets steady support in wake of pay ratio disclosures[.]”47Ernst & Young, supra note 45. Alternatively, it may just be the case that engagement among active funds, passive funds, and companies has resulted in changes to compensation policy that earned positive votes from index providers.48See Vanguard, supra note 46, at 17 (describing how an engagement with a company changed executive compensation practices).Again, it is difficult if not impossible to say for certain what proportion of the generally overwhelming support for executive compensation49Broadridge & PricewaterhouseCoopers, supra note 30, at 5. is the result of engagement or acquiescence by passive funds.
Increased engagement, however, does not cure the potential conflicts of interest passive fund providers face when voting in corporate elections.50See Bebchuk et al, supra note 37 (describing the conflict index funds face in competing for company’s pension management while engaging); Brannon & Whitley, supra note 27 (describing the potential conflicts of robo-voting and reliance of passive fund managers on proxy advisors). Until somewhat recently, the Securities Exchange Commission exacerbated these potential conflicts by both requiring investment managers to vote their proxies in the best interests of their investors and deeming their fiduciary obligations met if managers followed the voting recommendations of proxy advisory firms.5117 C.F.R. § 275.206(4)-6(a) (requiring investment advisors to vote their proxies in accordance with their fiduciary’s best interests and maintain certain records thereof); David McCann, SEC Move Could Lessen Proxy Advisers’ Influence, CFO (Sept. 18, 2018), http://ww2.cfo.com/governance/2018/09/sec-move-could-lessen-proxy-advisers-influence/ (describing the rescission of an SEC rule that provided a fiduciary duty safe harbor for outsourcing proxy decisions to proxy advisors). The SEC later rescinded the regulations. Getting rid of the delegation-is-sufficient approach to satisfying fiduciary duties is a good start. A better solution would be requiring complete disclosure of the voting policies and practices of index providers, including their relationship with companies (especially those that are also clients of the index providers) and their relationship with and reliance on proxy advisory firms.52To the SEC’s credit, the above rule does require some retention and disclosure of voting decisions. See 17 C.F.R. § 275.206(4)-6(b),(c); see also Brannon & Whitley, supra note 27. That way, investors can evaluate the policies and practices of different funds and make informed decisions as to which manager they would prefer have their proxy and voice. Those investors would then be able to express their displeasure with fund managers by moving their money to a different provider or, as Morgenson suggests, voting against the fund management in an effort to change the policies.53Morgenson, Your Mutual Fund Has Your Proxy, Like It or Not, supra note 27. These methods of addressing conflicts have the added benefit of providing more motivation for competition among index providers to be the best on governance. To the credit of the index providers, their voluntary stewardship reporting and proxy disclosures generally do provide significant insight into their approach to engagement and proxy voting.54See generally BlackRock, BlackRock Investment Stewardship 2018 Annual Report, supra note 7; Vanguard, supra note 46. Ultimately, the creation and fostering of transparent competition among index providers on the subject of governance has the potential to greatly benefit investors.
It must be noted that the solutions posited by detractors of passive investor voting identified include costs to investors in index funds.55Posner, Morton, & Weyl, supra note 16; Lund, supra note 1 at 528-31. In part, this assumes that it is a cost for investors if they want their money manager to cast their proxy in their interest and passive funds were no longer permitted to vote. In each instance, those authors justified the costs by suggesting that overall social welfare would increase. This should not come as much comfort to the investorswho end up footing the bill.56See Matt Levine, Index Funds May Work a Little Too Well, Bloomberg(July 22, 2015)(expressing concern about changes to the system based on the potential horizontal ownership/antitrust threat identified to the extent they might negatively affect the known benefits of diversification). Index funds are a powerful, useful, and widely used method for reaping the benefits of corporate productivity.57See, e.g., Ben Carlson, The Benefits of Using Index Funds, A Wealth of Common Sense (Feb. 13, 2013), https://awealthofcommonsense.com/2013/02/more-reasons-to-invest-using-index-funds/ (describing the benefits of investing through index funds). They are generally endorsed by well-regarded investment professionals, including Warren Buffet.58Trent Gillies, Warren Buffett says index funds make the best retirement sense ‘practically all the time’, CNBC (May 14, 2017) https://www.cnbc.com/2017/05/12/warren-buffett-says-index-funds-make-the-best-retirement-sense-practically-all-the-time.html. On the other hand, the magnitude of additional costs on index fund investors suggested by Lund and Posner et al. cannot be readily known—this alone should be cause for significant caution while considering the best path forward.
Before adopting proposals that would significantly limit or eliminate the oversight of companies by index fund providers (that, again, have the clear incentives to manage for the long-term and investors who are pressuring them to do just that), it is best to consider minor tweaks to regulation that will permit investors to make informed decisions about who manages their money. There are some challenges, particularly regarding the magnitude of the effort required to do a good job of governance oversight and the potential conflicts of interest discussed above. It would be a cause for concern and serious reevaluation if (1) index providers start to scale down their stewardship efforts, (2) fulsome disclosure is not made with respect to policies, practices, and conflicts of interest by index providers, or (3) further investigation and research raises serious evidence of anticompetitive effects of index fund engagement. Until any of these stumbling blocks presents itself, it is in the best interests of investors, regulators, and the economy generally to require disclosure by index providers that can foster competition in the investment stewardship space.
Joshua Levin is a Quorum Editor & J.D. Candidate, Class of 2019, N.Y.U. School of Law.