BU Law Professor Scott Hirst and coauthor Lucian Bebchuk study how index fund managers approach corporate stewardship.
Millions of Americans have invested retirement savings in index funds. But, according to new research by Boston University School of Law Associate Professor Scott Hirst, the managers of such funds may not be monitoring and engaging with the public companies they track to the best of their abilities.
Index funds, which are tied to the performance of the S&P 500, Russell 3000, or other specific stock market indexes, are the largest of all institutional investors. According to “The Specter of the Giant Three,” an article recently published in the Boston University Law Review by Hirst and coauthor Lucian A. Bebchuk, a professor at Harvard Law School, more than $3.4 trillion in assets flowed to such funds between 2009 and 2018. In the article, the coauthors show that the “Big Three” index fund managers—BlackRock, Vanguard, and State Street Global Advisors—cast approximately 25 percent of the votes at the shareholder meetings of S&P 500 companies. According to Hirst and Bebchuk, those three funds may control 40 percent of votes at most S&P 500 companies within the next 20 years.
And yet, despite that enormous potential influence, the Big Three seem to be taking a disproportionately passive role on matters of corporate governance. Although the funds often support certain shareholder proposals for governance reforms, they generally avoid putting forward such proposals themselves. According to Hirst, that passivity is a sign that the Big Three are punching below their weight.
Hirst and Bebchuk are quick to point out that they do not believe index fund stewardship is worse than the stewardship of individual investors. In fact, the large ownership stakes held by the Big Three enable them to be effective stewards; the coauthors just don’t think those funds are being as effective as they could be.
“We believe that the concentration of shares in the hands of institutional investors, including index funds, produces the possibility of substantially better oversight,” Hirst says. “Our interest is in seeing that potential realized to the fullest extent possible.”
In “Index Funds and the Future of Corporate Governance: Theory, Evidence, and Policy,” which will be published later this year by the Columbia Law Review, Hirst and Bebchuk examine how the Big Three are—and are not—using their power. In the article, the authors show some of the ways the interests of index fund managers might not align with the interests of index fund investors. Specifically, they argue that index fund managers under-invest in stewardship and defer excessively to the managers of the companies in which they invest, even when doing so is not in the best interests of the funds’ investors.
One problem Hirst and Bebchuk identify is that the very low fees index fund managers charge mean that the rewards to index fund managers don’t justify the effort and cost required to bring about real change in a company’s governance structure.
“Thus, the index fund manager would not have an incentive to employ a team of professionals to spend significant time on stewardship … even though such stewardship would be value maximizing” for investors, Hirst and Bebchuk write.
Hirst and Bebchuk provide evidence that, for each position of $1 billion that they hold, the Big Three funds invest less than $4,500 in stewardship each year. As a result, in 2019, the fund managers had no engagement with approximately 90 percent of their portfolio companies, on average.
Index fund managers also can be reluctant to take positions that oppose corporate managers because doing so might jeopardize business relationships they have with public companies or spur those companies to push for greater regulation of index fund managers.
Hirst and Bebchuk acknowledge that index fund managers have fiduciary duties to their investors and also may make good stewardship decisions out of a desire to do the right thing or maintain their reputation as responsible stewards. But those factors can’t “completely overcome the incentive problems,” Hirst says.
Instead, the coauthors propose policy reforms they believe could help overcome some of those problems. For instance, to reduce the risk of excessive deference to corporate managers, Hirst and Bebchuk suggest index funds refrain from offering business services to the companies they invest in. They also advocate for more transparency in the relationships between index fund managers and corporate managers.
The potential impact of greater stewardship is significant.
“How index funds monitor the companies in which they invest impacts the performance and the actions of those companies, which in turn affects everyone in our society. Millions of American families whose retirement savings are invested in index funds are directly affected,” Hirst says.
The research is already earning accolades. “Index Funds and the Future of Corporate Governance” has won three prestigious awards, including the 2019 Cleary Gottlieb Steen Hamilton Prize for Best Paper in the European Corporate Governance Institute Working Paper Series, the Jaime Fernández de Araoz Award on Corporate Finance, and the 2018 Investor Research Award from the Investor Responsibility Research Center Institute.
“The importance of institutional investors has been growing significantly,” Hirst says. “The fact that institutional investors now hold the great majority of shares in most large US companies has made their actions and incentives very important.”
By Rebecca Beyer
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