Khaosai Wongnatthakan
As ESG enters the political realm, it’s not a question of “if” we should have policies that restrict the voting shares of fund companies, but “which one.”
“The politicization of American investing just reached a new low,” states Eric Pan, head of mutual fund and ETF industry organization ICI.1 He was referring to Texas pushing back on fund companies that use environmental, social and governance (ESG) factors in their investment strategies and proxy voting. Politicians, Mr. Pan says, should stay out of the business of fund companies.
I disagree. Fund companies now own large percentages of U.S. corporations, and this concentration of power is absolutely a matter of public policy.
The success of index funds and ETFs has led to a few fund companies each owning 10% of many U.S. corporations, and sometimes their combined ownership exceeds 30%. Accordingly, fund companies can tell these investee companies what to do by voting proxies or electing directors who reflect their views. Larry Fink, the CEO of BlackRock, has been explicit in how he would push companies. In his 2018 letter, Fink wrote that companies needed to do more than make profits – they also needed to contribute to society to receive BlackRock’s support.2 With BlackRock’s $10T+ of assets, this “support” Fink refers to could be interpreted as slightly more heavy handed than a gentle tap on the back.
It has been U.S. policy for 100 years to disperse concentrations of corporate power. In some cases, this has meant restricting anti-competitive practices or even breaking up companies, such as Standard Oil and AT&T (T). In banking, regulatory oversight and restrictions are triggered for 25% owners to counteract the power of nationwide commercial banks. Securities laws have also required disclosure of all holdings of institutional investors (even if only 0.001%) or of any investor’s ownership level over 5%.
Even in the recent, weak anti-trust era, prosecutors have reviewed concentrations of power and fair trade abuses. Thus, suggesting that politicians stay away from this issue of concentration of voting power is not only a mistake, it is also out of step with our multi-generational public policy of addressing concentrations of economic power. Rather, I think the asset management industry should engage with policymakers to suggest solutions.
Many commentators have worried about this concentration of power in index companies. Poignantly, fund industry titan John Bogle, the founder of Vanguard, wrote about this topic in his last WSJ piece before he passed away.3 In his November 2018 column, Mr. Bogle offered a list of potential solutions. Some he ruled out as impractical, but most are worth reviewing.
Disclosure of index fund communications is a first potential solution. This would require “timely and full public disclosure by index funds of their voting policies and public documentation of each engagement with corporate managers.” As the amount of interaction between proxy voters and company management has skyrocketed, Mr. Bogle’s point about engagement is particularly important. However, calibrating which communication would be required seems difficult. Who would determine whether a policy was too abstract? Proxy voting policies including ESG policies are already disclosed, yet this hasn’t restrained the exercise of power. At the other extreme, providing a transcript of every discussion would probably chill valuable interactions between companies and their owners.
Next, Mr. Bogle recommends “requir[ing] index funds to retain an independent supervisory board with full responsibility for all decisions regarding corporate governance.” However, as he noted, this raises the question: would this really improve the existing oversight provided by independent fund directors?
Another idea is to “enact federal legislation making it clear that directors of index funds… have a fiduciary duty to vote solely in the interest of the funds’ shareholders.” The problem with this solution is that it doesn’t really add protection, and there is no mechanism to stop the politicization of proxy voters.
Mr. Bogle finally addresses my preferred solution of capping the percent of shares that any index fund company could vote of a portfolio company’s voting shares – say, to 5%. The underlying philosophy of this cap is that shareholders who own funds that blindly follow index rules don’t deserve the same input into governance as other owners. There is, of course, no magic to this number, and arguments could be made for a lower or higher number. The extra votes held by a fund company could be either not voted, or voted in proportion to those of other investors. Alternatively, the index fund company could create a mechanism to transfer voting rights back to their largest clients, as BlackRock has done.
Mr. Bogle didn’t like this solution because he thought index funds were more deserving of corporate input than other shareholders. He saw index funds as desirable “long-term holders” and therefore presumably more virtuous. Other investors were, in his view, only “corporate stock renters.” I believe this is an oversimplification – neither passive/index nor active investors are per se better than the other. Many index funds track indices with high levels of turnover, which means that many index funds are not long-term holders. It is also unlikely that index fund buyers consider, much less are driven by, a fund company’s proxy policies. Index fund buyers are by definition buying baskets of stocks: why should they care about their input to specific companies? I don’t think looking into the hearts and intentions of index and active shareholders is necessary for our purposes. Rather, we are trying to address the public policy issue of the aggregation of these proxy votes into power.
The last solution would be to break up the index companies. Such a draconian breakup raises a lot of structural issues of how to do this and might undo the lower fees that investors have enjoyed from competition among index fund companies.
The capping proposal tries to reasonably limit index funds without affecting active investors. Limiting an index company’s vote to 5% of a company still respects the power of those index investors. 5% of a company is a lot.
The index capping solution also allows activist and other active investors to “do their thing” – launch takeovers and mergers, and conduct other types of proxy votes – just as before. It doesn’t inhibit shareholder activism or even prevent index companies from voting along with activists.
Capping can also relieve politicians from having to micromanage the inherently subjective ESG policies4. For example, it was “S” and “G” that caused Tesla (TSLA), one of the biggest “E” companies in the world, to fail to achieve a particular ESG ranking. According to the S&P 500 ESG Index, Tesla has a score of 22, the weakest ranking of the five U.S. auto companies in the index. S&P pointed to Tesla’s business conduct as justification for the lower score, identifying two separate events centered around claims of racial discrimination and poor working conditions at Tesla’s Fremont factory. As another example, should proxy voters be directing whether a particular factory should be built, i.e., making the tradeoff between “S” (i.e., jobs) and “E” (i.e., the environment)? Whatever proxy voters decide, their power would be limited under the capping proposal.
In sum, like the trust companies and monopolies of old, some index fund companies have become too large to be left unchecked. Rather than pretending that large index ownership has no policy implications, the investment industry should engage with policymakers to find the best solution. Policies to address the concentration of corporate power are coming one way or another. Without this critical input from the asset management community, we’ll be left without a seat at the table – and we may not like the outcome that the political system comes up with.
Important Disclosures
1 Real Clear Politics, Don’t Politicize Investing, in Texas, California, or Anywhere Else, September 8, 2022.
2 New York Times, BlackRock’s Message: Contribute to Society, or Risk Losing Our Support, January 15, 2018.
3 Wall Street Journal, Bogle Sounds a Warning on Index Funds, November 29, 2018.
4 Stanford Law professor Joseph Grundfest calls ESG “especially subjective guessing.”
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