A Glimpse of a Future With True Shareholder Democracy

In the near future, giant index funds, the low-cost assets that have helped millions of people build nest eggs, will gain “practical power over the majority of US public corporations.”

This nightmarish vision emerged in a 2018 prescient paper by John Coates.

Mr. Coates was a professor at Harvard Law School when he set out his reasoning – one I share. Now he’s a policy maker. In February he became acting director of corporate finance for the Securities and Exchange Commission. Under the new reform-minded SEC chairman, Gary Gensler, Mr. Coates is able to address the issues he has so carefully analyzed.

Neither Mr. Coates nor Mr. Gensler were available for an interview, but in this paper Mr. Coates set out his views. Index funds that simply track the market and make no attempt to outperform it are so effective and cheap that they are preferred Investment vehicle for trillions of dollars in assets. However, under current rules, it is the index fund executives, not the millions of people who invest in them, who have the authority to cast voting proxies.

These voices are at the heart of a system designed to give investors a voice on critical issues such as: B. how much the managing director is paid or whether a company harms the environment.

As I wrote in December 2019, this lack of proxy ability leaves a large number of investors out of the equation and gives corporations undue power. Remember that roughly half of all American households, which comprise tens of millions of people, are involved in the stock market. But most of its own stocks indirectly through funds – mainly index funds.

This means that fund managers have decisive power over corporate governance, and the largest fund companies have sided with management in around 90 percent of cases.

As Mr Coates wrote in 2018, “control of most public corporations – that is, the richest organizations in the world with more revenues than most states – will soon be concentrated in the hands of a dozen or fewer people.” The title of his paper was “The Problem of the Twelve” and referred to the unelected leaders of the index fund business.

What’s worse, mutual fund companies are often at odds. Many receive income from publicly traded companies for providing financial services related to retirement plans, but are responsible for casting critical voices about how these companies are run. Scientists like Mr. Coates have been concerned about these conflicts for years.

A new study on proxy voting for mutual funds from January 2015 to June 2020 provides further evidence that large fund companies that receive corporate remuneration tend to be on the side of corporate governance more often than usual.

The study “Detecting Conflicts of Interest: Proxy Voting Data Shows Asset Managers Tend To Prefer Clients” was conducted by the As You Sow group, which submits proposals from shareholders on issues such as the environment, gender and racial diversity, as well as executive figures.

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May 21, 2021 at 8:22 p.m. ET

The group based its findings on an analysis of 9.6 million fund company proxies, as well as records from the Department of Labor showing how much fund companies were paid for pension plan services.

“The big fund companies have massive aggregation of power that results from the investments of their shareholders,” said Andrew Behar, managing director of As You Sow. “At least fund companies shouldn’t be allowed to vote if they have a conflict of interest.”

Such obvious conflicts are allowed under the applicable rules, as stated by Mr Coates in his 2018 paper. There are many possible regulatory solutions, but the basic remedy would be to remove proxy voting from fund companies and place them in the hands of millions of fund shareholders. This change would be particularly important for investors in broad index funds that reflect the stock market and cannot sell stocks of individual companies.

For example, let’s say you don’t want to put money into Exxon Mobil because you disagree with its approach to climate change. If you own shares in an S&P 500 index fund, you still have an indirect interest in Exxon. And if you keep the fund in a retirement account, you may be stuck. According to Morningstar, a research firm that rates funds, only 3 percent of 401 (k) plans contain investment options based on principles known in the industry as environmental, social and governance (ESG) principles.

Amid widespread climate change concerns, fund companies appear to be postponing some of their proxies, Morningstar said. BlackRock, led by Larry Fink, has called for a swift transition to a “net-zero economy,” and Vanguard adopted guidelines in April that could lead to more “ESG-friendly” voting, said Jackie Cook, director of investment stewardship research at Morningstar.

It doesn’t seem ideal to me to have to rely entirely on the judgment of fund managers for major proxy competitions across the corporate landscape.

However, I took a look at an alternative future.

An independent S&P 500 index fund based in Honolulu called INDEX has taken a small step that could have a revolutionary impact: this year it started asking shareholders how they would like to vote.

The fund has introduced what is known as “Index Proxy Polling,” an easy way for shareholders to express their preferences for proxy votes for S&P 500 companies. The aim is to demonstrate how shareholders in an index fund can express their opinion.

Only about 100 investors have participated so far, said Mike Willis, the fund manager, and current SEC regulations require him to make the final voting decisions on behalf of the fund. He hoped, however, that the SEC would eventually allow him “to move to real shareholder democracy and have a go-through ballot where shareholders say what they want and we only vote for them.”

I recommend Mr. Willis for his innovative approach, but note that this is not your typical index fund. It’s an equally weighted version of the S&P 500: it puts a lot of emphasis on big and small businesses, so it may lag behind the market for giants like the Apple boom and outperform the standard index for smaller companies. The 0.25 percent expense ratio is reasonable, but not as low as some of the giant funds.

If experiments like this catch on, they could help bring the markets closer to something resembling shareholder democracy. But lawmakers and regulators – people like Mr. Coates and Mr. Gensler – also have to weigh up if we are to avert a future in which investor voices are subdued and huge corporations are dominated by even more powerful index funds.

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