Shareholder Value(s)
Professor David Webber and coauthors examine the role of index funds, driven by millennial investors, in advancing board diversity and corporate sustainability.
Photo by Francesco Gallarotti on Unsplash
Shareholder Value(s)
Professor David Webber and coauthors examine the role of index funds, driven by millennial investors, in advancing board diversity and corporate sustainability.
The following is excerpted from “Shareholder Value(s): Index Fund ESG Activism and the New Millennial Corporate Governance” (93 Southern California Law Review 1243, 2020). In a survey of scholars conducted by Corporate Practice Commentator, the paper was chosen from more than 320 submissions as one of the top 10 corporate law articles of the year.
Recently, the attention of business law scholars, corporate law practitioners, executives, and corporate directors has turned to the role of giant index mutual funds as the most important shareholders in many large companies. Together, the “big three,” BlackRock, Vanguard, and State Street (SSGA), control a staggering 25 percent of the shares of all S&P 500 companies, and this share is growing. Across the pages of top law reviews, at prestigious roundtables, and in board rooms around the world, commentators have debated whether index funds, which seek only to track the market at low cost and not to outperform it, will nevertheless invest the resources necessary to be vigilant shareholders.
In broad strokes, the debate over index funds as shareholders has resolved into camps. Critics argue that index funds, as cost-conscious, passive investors, have essentially zero incentive to ensure that the companies they invest in are well-run. Since index funds hold the same companies as their competitors, investing in improving the value of their portfolio will not provide a competitive advantage, and might upset managers who could in turn direct their firm’s retirement savings to other funds. These critics point to evidence showing that across a range of governance issues, index funds take a “don’t rock the boat” approach. They rarely challenge executives, lag other institutions in promoting corporate governance best practices, never bring shareholder proposals, and tend to side with incumbent managers in contested elections. Relative to their portfolio size, the big three have tiny corporate stewardship teams that, purely as a matter of personnel, can dedicate little time to individual companies.
To be sure, scholars and index fund advisors themselves identify some reasons that index funds might worry about firms’ success, such as advising fees and competition from active funds. Even those scholars and fund advisors who defend index funds’ stewardship, however, argue that index funds are likely to undertake only those interventions with the potential to have wide and significant impact on firms’ value. Furthermore, both sides largely agree that index funds have disincentives to actively promote governance improvements against management interests. While the debate is vigorous, there is reasonable consensus that index funds are mostly reticent, largely docile shareholders, except maybe with respect to interventions with a dramatic effect on firms’ value.
To win the millennial generation, index funds have turned their attention not simply to share price—the conventional marker of shareholder value—but to the social issues that millennial investors care about: shareholder values.
This article makes several contributions to the literature. We first show that the consensus view of index fund stewardship is both factually and theoretically incomplete: when it comes to environmental, social, and governance (ESG) issues, index funds are far from docile. With respect to these salient social issues, this article shows that index funds boldly challenge managers, vote out directors, and demonstrate vocal leadership in thought and deed—activities that are sharply at odds with the conventional account of index fund passivity. Importantly, index fund activism on these issues is not just cheap talk, rather, they targeted problematic firms systematically, voted against their board members and generated notable effects. In 2017, for example, after State Street announced its objection to all-male boards in its portfolio firms, the index fund voted against 400 of the 476 firms in its portfolio that did not have any female directors. By the end of 2018, more than 300 of these firms added a female director. Accordingly, that in July 2019 the last all-male board in the S&P 500 added a woman to its ranks reflects the outspoken and confrontational efforts of the big three, and BlackRock and State Street in particular.
Our second contribution is to show that, in contrast to conventional wisdom, funds compete aggressively with each other in escalating their ESG policies. For example, in pressing for increased representation of women on corporate boards, index funds have voted against directors, proactively publicized these votes, and used the media to highlight their confrontations with management. State Street and BlackRock have engaged in a pattern of escalating demands with respect to board diversity. As a result, these asset managers are currently well ahead of other corporate governance institutions, like Institutional Shareholder Services (ISS), in pressing this issue. Similarly, while efforts on the environmental front were initiated with a general request for companies to address “sustainability,” BlackRock has recently announced a significant push related to climate change, including divesting its active funds from coal stocks. While index funds are generally thought to keep a low profile to avoid backlash from managers or regulators, we show that funds have pressed ahead despite political backlash to some of these interventions. Consequently, we argue that on ESG issues, index funds are far from reticent shareholders—they are perhaps more active and influential than institutional shareholders have ever been.
Our third contribution is to offer an explanation of why index funds’ actions with respect to ESG issues bear so little resemblance to their activities on more traditional matters of shareholder stewardship. The former cannot be explained within the literature’s existing theoretical framework, which approaches shareholder stewardship largely as a trade-off between asset management fees and the fear of management retaliation. While index funds might fear management retaliation, we show that a more potent concern is on the horizon: in the next two decades, somewhere between $12 trillion and $30 trillion will pass to the millennial generation in what BlackRock CEO Larry Fink has called “the largest transfer of wealth in history.” This staggering wealth, which dwarfs the cumulative assets under management of the big three, is the prize sought by asset managers across the economy as the millennial generation begins to enter its wealth accumulation phase. To win the millennial generation, index funds have turned their attention not simply to share price—the conventional marker of shareholder value—but to the social issues that millennial investors care about: shareholder values.
