June’s Complaint, October’s Answer
In June, I bemoaned that “Index Funds Have Too Much Voting Power.” That index funds have excessive control of corporate America is indisputable. For example, Vanguard, BlackRock BLK, and State Street STT own a combined 16% of Microsoft MSFT, mostly through index funds. Such funds are accidental shareholders. Whatever they think about Microsoft, those who run index funds won’t change their trade requests. Thus, they are not the appropriate people to oversee corporate managements.
Solving the problem is harder than identifying its existence. I followed that article with, “3 Solutions for Index-Fund Voting,” and offered the following suggestions: 1) ban index funds from voting altogether; 2) shift their votes downstream, so that they are cast by the funds’ underlying shareholders, or 3) let index funds continue to vote, but have them openly proclaim their views, so that investors may choose the index fund that most closely reflects their personal voting preferences.
The third option was my favorite. It seemed to me that BlackRock had already adopted such an approach through its public backing of environmental, social, and corporate governance principles. Although they do not always realize it, shareholders of BlackRock’s index funds are, at least to an extent, ESG investors. (While historically BlackRock’s commitment to ESG investing has been more smoke than fire, in 2021 the company has matched its words with action.) Presumably, prospective investors who like ESG investing will seek BlackRock’s index funds, while those who disapprove of the movement would avoid them.
My preference, it turns out, is not BlackRock’s. As reported by Morningstar’s Leslie Norton, BlackRock will implement my second suggestion, by permitting the shareholders of institutional index funds to vote on corporate actions. Should they so desire, those investors may vote on corporate actions, in proportion to the percentage of the fund that they possess. Thus, if an index fund owns 1% of a company, and an institutional investor 2% of the fund, then that institution would vote 0.02% of the company’s shares.
BlackRock has several good reasons to begin with its institutional shareholders. Many have political affiliations, such as funds sponsored by state governments or labor unions. Such institutions may have strong views about corporate governance that they wish to exercise directly rather than delegate to an index-fund manager. They are squeaky wheels, as their complaints are likelier to reach BlackRock executives than are those from everyday investors. Finally, collating institutional investors’ requests is simpler, as there are fewer of them.
However, BlackRock has strongly hinted that although it has started with institutions, it will not end with them. In its announcement, the company stated "Our ambition over time is to continue to develop new technologies and new capabilities to increase proxy voting choice across even more of our investment products." This has been widely interpreted as implying that BlackRock will eventually give investors the same voting ability--an interpretation that appears to be correct, as the company has not challenged statements to that effect.
The company’s decision makes sense. I thought that BlackRock might opt for my third suggestion, by branding itself as the ESG investor’s index fund, but I realize now that would have been a mistake. As the world’s largest investment manager--Vanguard is the biggest mutual fund company, but BlackRock holds more assets overall--BlackRock can’t afford to adopt a niche strategy. It must appeal to all index-fund investors, including those who dislike the ESG approach.
How meaningfully this approach will change how index funds vote in corporate actions remains to be seen. The major institutional investors will seize the opportunity. They have the staffing power to research corporate proposals. However, smaller institutions will be less enthusiastic. Typically, when provided the opportunity to vote, they farm out that right to proxy-voting services. Most will either treat their index-fund shares similarly or abstain, thereby handing their responsibility back to the fund company.
The concern is greater yet for individual investors. In June, when considering the possibility that index funds pass their voting rights through to their underlying shareholders, I wrote, “The real question is whether index-fund investors would avail themselves of the 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.” That is a legitimate concern.
Nevertheless, BlackRock’s announcement represents progress. The current arrangement is openly flawed: Not only are index-fund chiefs ineffective corporate stewards, as they possess neither carrot nor stick, but they also are inappropriate for the task. When they vote in corporate actions, they vote shares that they do not possess. The legal owners of those shares--who are therefore the rightful owners of the votes--are those who invested in the index fund. If they wish their voices to be heard, they should be permitted the privilege.
Active Funds, Too?
Indeed, I will extend the argument: The same principle should apply to most actively managed equity funds. Not all. The managers of some funds lobby corporate executives, seeking to change their business strategies and/or governance policies. They hope to improve the company's results through their involvement. Those are activist funds, and they deserve their votes. Those who invest in such funds implicitly delegate their votes to the portfolio manager.
Most managers of actively managed funds, though, vote with their feet, not with ballots. If they like a company’s prospects, they hold its shares. If not, they sell. Their involvement with a company starts and ends with their trade requests. So, why give those managers complete control over the fund’s votes? Some of their shareholders will care more about the result of corporate initiatives than they do. And all will have a stronger claim for the right to vote. It is their money, after all.
I ran this column past two colleagues who specialize in evaluating company stewardship. Leslie Norton responds that I have understated the level of engagement that fund companies have with corporate America. Even though index managers cannot punish companies that ignore their advice by selling their stocks, they can and do vote against company proposals. In addition, while only a few active managers--the activists--spend significant time twisting corporate executives' arms, many managers offer their views.
For her part, Morningstar's Jackie Cook believes that even if index funds universally adopt BlackRock's approach, that doesn't mean that my third suggestion can't also be adopted. She writes, "Stewardship will continue grow in importance as a point of differentiation for asset managers, even if more asset managers take BlackRock's path of extending voting choice to institutional clients--and possibly to individual fund investors down the road."
“Markets and clients benefit from asset managers conducting proxy research, offering a default voting approach, and engaging on behalf of all assets under management. Rather than watering down asset managers’ influence, I believe that clients that have a strong position on specific issues or their own in-house proxy-voting approach will strengthen the voice of asset managers in engagement and likely challenge asset managers on key points of oversight.”
Fair enough. Although in principle fund shareholders should vote on corporate affairs, as they are the companies’ owners, in practice most will delegate that responsibility. Even if BlackRock’s approach is universally adopted, investment managers will continue to hold a great deal of voting power.
John Rekenthaler (firstname.lastname@example.org) has been researching the fund industry since 1988. He is now a columnist for Morningstar.com and a member of Morningstar's investment research department. John is quick to point out that while Morningstar typically agrees with the views of the Rekenthaler Report, his views are his own.
The opinions expressed here are the author’s. Morningstar values diversity of thought and publishes a broad range of viewpoints.