Tangible steps

Last week’s column discussed index-fund voting. A handful of major fund companies—most notably, Vanguard, BlackRock, and State Street —possess enough shares of corporate America to swing close proposals their way, should those organisations vote in unison. And the power of index-fund providers is steadily increasing, thanks to their ongoing business success.

That situation strikes many observers as a problem. It’s one thing for a handful of major shareholders, or even one owner, to command the fortunes of an individual company (as, for example, with Morningstar (MORN) founder Joe Mansueto). It’s quite another for a single small group to control everything. That seems dangerous, even if the group’s intentions are pure and its decisions informed.

That article posed the concern; today’s instalment presents three potential solutions, each submitted by the previous column’s readers. They are: 1) legal restrictions, 2) investor empowerment, and 3) fund construction.

Just say no

The simplest way to curb the power of index funds is to remove their voting rights, on the logic that passive managers shouldn’t intrude into active affairs. After all, index funds buy everything that comes their way, at the behest of others (that is, those who purchase their funds). Why should accidental shareholders partake? Reserve that opportunity for those who earned the privilege.

If that argument is accepted, the answer is straightforward: Ban index funds from voting. Corporate actions would then be settled solely by active shareholders. Alternatively, index funds could be allotted a partial vote, for example a 25 per cent weighting of their shares. Such a policy would let them participate in elections, but without dominating.

Disenfranchising index funds seems radical. But so too is today’s policy. If index funds did not exist, and somebody proposed that by investing indiscriminately with other people’s money, three companies would end up controlling 20 per cent of corporate America, the idea would be considered preposterous. Through familiarity, the extreme has become mundane.

Opening the doors

A second option is for index funds to involve their shareholders. Currently, index funds shut their investors out of the process. James McRitchie, publisher of the website CorpGov.net, points out that funds are required to disclose their proxy votes only once each year, and “in a way that requires investors to subscribe to services like Bloomberg, FactSet, or ProxyInsight to decode the filings.” Understandably, few index-fund investors take such steps.

McRitchie proposes that index funds reveal their votes in “something close to real-time,” in a user-friendly format. To that end, he has filed a petition with the SEC. (Strictly speaking, the petition requests such disclosure among all funds, including those that are actively managed.) At least one SEC commissioner, Allison Herren Lee, has taken up the cause.

Armed with such information, suggests Morningstar’s Jackie Cook, index-fund investors could be given a voice. At the least, funds could establish opinion polls, not only to judge what shareholders thought of their recorded votes, but also potentially to influence the funds’ future decisions. At the most, index funds could install pass-through voting, thereby permitting their owners to vote their wishes directly.

Until recently, administering such a process would have been too costly. But technology has altered the math; while such programs do carry meaningful setup costs, they can be cheaply operated once in place. The real question is whether index-fund investors would avail themselves of their voting opportunity, or would overwhelmingly abstain, preferring to free-ride the efforts of others. If the latter were to occur, then this solution would exist more in theory than reality.

31 flavours

The third option is the most provocative. A reader argues that no fix is required, because over time, an index fund’s voting practices will become part of its offering. That is, when investors choose a fund, they will do so partially because of how it will vote. After all, he writes, that already occurs with BlackRock’s index funds, which reliably support BlackRock CEO Larry Fink’s views on climate change.

I wouldn’t go that far ... yet. Many BlackRock fund shareholders do not closely follow business affairs, and thus are unaware of Fink’s preferences. In addition, even those who are aware of BlackRock’s inclinations may not realize that the company advances those views through its index-fund proxy voting. To date, BlackRock’s preferences shape its corporate marketing, but not those of its funds.

However, there’s no reason that approach cannot change. Indeed, adding variety to index funds makes a great deal of sense. There are no practical differences between today’s major index funds. They have similar costs, similar managements, and similar returns. They are commodities like barrels of oil, bushels of wheat. Not so they if signalled their voting intentions. Select this index fund to support environmental, social, and governance initiatives. Select that fund if you wish to block them.

That is merely an example; corporate elections involve more than ESG principles. The point is that advertising their voting habits would give index funds the chance to differentiate their wares while also permitting shareholders to implement their views. Adopting this approach would also eliminate the agency problem. No longer would index-fund managers sometimes contradict the wishes of their funds’ investors. The views of caretaker and owner would be consistently aligned.

There are practical difficulties. Presumably, the largest index-fund providers would not wish to chase away existing customers by taking controversial stands. (“Republicans buy sneakers, too.”) Also, funds might struggle to present their voting policies in a fashion that can be easily understood. At the least, though, it certainly seems like an idea that a smaller index-fund provider would wish to test.

Worse yet

For index-fund providers, none of these ideas will appeal. For them, the current system works well. Why change? My response: Eventually, the government’s patience will cease. It accepts today’s situation, with three companies controlling 20 per cent of corporate America. But as that figure continues to increase, as it has done steadily over the past two decades, policymakers will at some point take action.

And that action could be more aggressive yet. For example, University of Chicago law professor Eric Posner has proposed that index funds be limited to holding a single company within an industry. In comparison, this column’s suggestions are relatively benign.