Paul Hodgson: How to get the “Big Three” on the stewardship bandwagon

The news that the largest mutual funds’ support for the Center for Political Accountability’s (CPA) corporate political disclosure resolutions has risen but that the very largest institutional investors – Vanguard, Fidelity and BlackRock, in particular – continue to vote against such resolutions will come as no surprise to Lucian Bebchuk and Scott Hirst.

Support for the CPA motions increased in 2018 (to 53% from 45% in 2017) but the two academics have come up with a series of proposed reforms to encourage stewardship by large index funds in a paper called: Index Funds and the Future of Corporate Governance: Theory, Evidence, and Policy.

But first, let’s take a look at the CPA report itself. Based on an analysis by Jackie Cook’s Fund Votes [now part of Morningstar], it looked at the 46 largest asset managers.

It found that 12 supported every single political spending resolution (the likes of Pax, Calvert and Morgan Stanley).

Eleven supported none (such as T. Rowe Price, Goldman Sachs ETF and Dimensional). Some 25 of the 46 groups increased their support from 2017 to 2018, while nine decreased support.

Five groups—BNY Mellon, Janus Henderson, Eaton Vance, PIMCO and Lazard—increased their support by over 40 percentage points.

More importantly, average shareholder support reached a record level in 2018, at 34%, ranging between 25% and 47%. Of the total 115 fund groups studied, 60 increased their support for political spending disclosure resolutions between 2017 and 2018, compared to only 23 fund groups that decreased such support.

Part of the reason for the low level of support from some, especially ETF, funds is attributed by the Bebchuk and Hirst paper to strong incentives to “(i) under-invest in stewardship, and (ii) defer excessively to the preferences and positions of corporate managers”.

The measures the paper suggests to allow stewardship investment to grow fall under the following headings: stewardship costs, business relations with public companies, transparency with private engagements, and size limits.

Under the first heading, the paper suggests that, first, stewardship costs should be charged to the index fund because at present index fund managers must bear the costs of those investments while only benefiting from a tiny portion of the gains such investments would generate.

Second, “Policymakers should… facilitate the pooling of [stewardship] research, including having such research be undertaken by outside organizations on behalf of multiple index fund managers.”Thirdly, the paper recommends a requirement that all index fund managers allocate for stewardship an amount equal to at least 0.0005% or 0.001% of their indexed equity assets under management, which, though still a negligible amount, would still increase the amount of assets invested in such manner considerably.

Elimination of conflicts of interest that come from fund managers administering 401(k) plans for employers would also go a long way to prevent excessive deferral to corporate managers, as well as a requirement for index fund managers to disclose any such relationships. Further disclosure should be applied to private engagements, says the paper.

BlackRock and Vanguard, for example, are very proud of their engagement with companies and consider it a major channel for their stewardship. But while they publish reports discussing what issues they engaged on, very little is actually disclosed as to the nature of the engagement nor even which company it was with.

The paper says proper disclosure would both give information to all investors, rather than simply to those engaging, and it would lead to more meaningful engagement.

Concerns that ‘private’ engagements would suffer through being disclosed are dismissed by the note that State Street Global Advisors has been fully disclosing its engagements since 2014 without any detrimental effects.

Finally, the paper discusses placing limits on the fraction of equity of any public company that could be managed by a single index fund manager.

The growth of index funds’ holdings of corporate equities “makes it especially important to consider the desirability of continuing the Big Three’s dominance”.

If the sector does continue to grow, and index fund managers control 45% of corporate equity, the paper alleges that having a ‘Giant Three’ each holding 15% would be inferior to having what it refers to as a ‘Big-ish Nine’ holding 5% each.

It posits that having nine decision makers rather than three would “substantially reduce the risk of concentration, and concomitant legitimacy problems”.

The paper does not suggest a process by which holdings could be ‘redistributed’ though either regulations or a market intervention.

The paper concludes: “Although the policy measures we put forward would improve matters, they should not be expected to eliminate the incentive problems that we identify.”