In 2015, index investing accounted for approximately 30 percent of mutual fund assets, and that percentage is continuing to grow. The rise of index investing creates many challenges for good corporate governance. Index funds are disincentivized from expending resources on improving the performance and corporate governance of the companies in which they invest, creating large blocks of stock held by disinterested holders. These large blocks can determine the outcome of corporate elections, and create a voting dead weight enabling management to entrench themselves at the expense of shareholders and market efficiency.
The Efficient Market Hypothesis and the Growth of Index Investing
The efficient market hypothesis (“EMH”) provides that share prices already reflect all relevant information, and thus it is impossible to “beat the market” by active trading. The belief in the EMH and empirical evidence of the net-of-fees performance of active managers has led to the growth of index investing; why would an investor pay high fees to an active manager who is not likely to outperform the index?
The “Free Rider Problem”
As a result of the EMH, the differentiator between index funds is NOT the absolute return of the index fund, but rather how closely the fund tracks the benchmark index. Thus, the most successful index fund would hold all of the securities in the index and have the minimum necessary expenses to run the fund. As a measure of societal and economic efficiency, we want shareholders to carefully evaluate the corporate governance of the companies they invest and to exercise the corporate franchise in a way that promotes their goals. However, an index fund that spends money to evaluate proxy voting issues at the index components (an “Engaged Index Fund”) in the hopes of improving index performance will actually place itself at a disadvantage relative to its peer funds (“Indifferent Index Funds”). Assuming that both an Engaged Index Fund and the Indifferent Index Funds efficiently track the underlying index, they will benefit equally from the Engaged Index Fund’s corporate governance engagement, but only the Engaged Index Fund will have incurred the related expense, and, all things being equal, the Engaged Index Fund will underperform the Indifferent Index Funds in tracking the underlying Index by the amount of those expenses. As a result, index funds are disincentivized from incurring expenses that would improve the performance of the index components. This is the “Index Fund Free Rider Problem.”
The Implication of the Free Rider Problem
For large public corporations that are index components, typically a majority of their shares are held by institutional investors and at least 30 percent of those are held by index funds. This creates large blocks of shares disincentivized from expending resources in evaluating corporate votes. As in the Innoviva case, these blocks can make the difference in a proxy contest.
The Regulatory Solution Doesn’t Work and Has Ceded Power to the Proxy Advisory Firms
To address the Index Fund Free Rider Problem, the SEC has adopted rules requiring mutual funds to publicly disclose their voting policies, as well as their actual votes. Even the briefest perusal reveals that the overwhelming majority of votes are in favor of incumbent management. The SEC rules have simply caused many mutual funds, including index funds, to largely rely on proxy advisory firms, such as Institutional Shareholder Services and Glass Lewis, to guide their voting decisions. As a result, the key to winning a proxy contest has become obtaining a favorable recommendation from those firms.
Both ISS and Glass Lewis publish extensive guidelines relating to their recommendations. These guidelines have almost become a form of shadow corporate governance regulation. If the proxy advisory firms in their unelected and unaccountable judgment require X for a favorable recommendation, it is essentially guaranteed that X will occur. While the firms have adopted guidelines and ethical rules, in a move reminiscent of the credit rating agencies in the mortgage crisis, at least one of these firms offers a service to issuers, for a fee, to help them navigate the guidelines to obtain a favorable recommendation. The reliance on proxy advisory firms does not solve the Index Fund Free Rider Problem; it simply substitutes the judgement of private parties, potentially subject to undue influence, for the judgement of the economic interest holders.
What is the solution?
For that you will have to read my next post. Please feel free to suggest yours in the comment section below.
Editor’s note: This blog post is intended as general information on the law and legal developments, and is not legal advice as to any particular situation. Under New York ethical rules, please note that this post may constitute attorney advertising.