Should Passive Funds Be Active?

Once people come to see that some of their money is being spent on activities that have nothing to do with performance we may engender some genuine competition between index funds.
November 14, 2017 • Commentary
This article appeared on The Weekly Standard on November 14, 2017.

Investment companies that run index funds—which merely seek to replicate the ups and downs of a broader market index and that entail no investment strategy by any managers—are becoming ever more popular, with a greater proportion of our retirement savings are going into them. Forty percent of all stock is currently held in such passively managed funds, and three large investment companies with popular index funds—Vanguard, BlackRock and State Street—together hold nearly $13 trillion in assets.

Index funds can be great investments for the middle class, since management fees are low that means net returns are higher, and in the long run they tend to outperform nearly every actively‐​managed stock market fund offered. The SEC recognizes the benefits they deliver and it has simpler filing requirements for investors that do not seek to exert an active control over a company.

However, these behemoths do manage to exert their influence over the companies they invest in via their proxies. Given their size,​they each control​a significant percentage of each company in the S&P 500, which means they have the potential to tip the scales on contentious proxy proposals by voting together on shareholder proposals to change corporate governance.

In the last decade they have begun to exert their growing, collective influence in an attempt to improve corporate behavior and procedures companies, with some success: The ten‐​year poison pill is nearing extinction, there are many fewer classified boards these days, and nearly 90 percent of companies in the S&P 500 have majority voting requirements.

However, of late these funds have been increasingly using their proxies to vote for proposals that are tangential to corporate governance, and some these hold the potential to hurt the bottom line of the companies being targeted. First and foremost of these, of course, is the increasing predilection for activists to introduce proposals to force the company to do more about climate change than would be prudent if they were to follow their fiduciary duty. For instance, earlier this year, Vanguard CEO F. William McNabb III released a letter to public companies outlining the priorities of its investment stewardship group, with specific reference to climate change.

With index funds increasingly likely to support such proposals it is likely that we will see more of these in the coming years, the result of which will do nothing to reduce climate change but will increase the cost of doing business for companies large and small.

Another increasingly common proposal has been to force companies to review their charitable giving, with an eye towards potential human rights issues—defined broadly—that might be affected through such giving.

The increasing support that index funds have been giving proxy proposals peripheral to a company’s bottom line (and potentially deleterious to its stock price) may be a manifestation of the greater indexation of the U.S. stock market. A point that Bloomberg’s Matt Levine has made in myriad ways in his always‐​informative daily column Moneystuff is that if fund managers are paid largely based on performance relative to their peers, then the sole motivation for index fund “managers” is to reduce their fees.

What happens to any individual stock is of no consequence to them, since it impacts their index fund peers equally. As a consequence it is easy to conceive of them agreeing to pursue strategies that might not be best for their clients whose money they “manage” but that give them some sort of nonpecuniary satisfaction—like the admiration of their friends or laudatory coverage in the press for their prescience or “courage.”

Fixing this potential moral hazard is tricky: Most people would probably agree that, presently, the benefits of indexation currently outweigh its potential drawbacks, so outlawing index funds doesn’t make sense for the foreseeable future and is probably impossible to boot.

But one thing we could potentially do would be to request that these funds provide more information to their millions of passive investors informing them of the extent and cost of the activities they undertake with regards to proxy voting. We might consider allowing investors with money in these funds to ask why they vote the way they do, or why they choose to vote at all on these peripheral proxies.

Once people come to see that some of their money is being spent on activities that have nothing to do with performance we may engender some genuine competition between index funds.

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