• Funmilayo Fenwa

Should Large Index Funds Invest More Assets in Engagement and Stewardship?

Background


Index funds replicate existing stock indices by buying shares of the member firms of a particular index, and holding them “forever”, unless the composition of the index changes. Today, the index fund industry is dominated by three index fund managers – BlackRock, Vanguard and State Street, which are popularly referred to as the “Big Three”. The Big Three manage over $5 trillion of the U.S. corporate equities, constitute the largest shareholder in 88% of the S&P 500 companies and each own a position of 5% or more in a vast number of public companies.


Given the large share of corporate equities held by index funds in U.S. public companies, Bebchuck and Hirst argue that the way in which these large index funds – particularly the Big Three – engage with, monitor and vote in portfolio companies has a major impact on the governance and performance of public companies and the economy.


It is common practice for large index fund managers to stress the importance of responsible stewardship, and their supposedly strong commitment to it, given their large stakes and long-term commitment to the portfolio companies. For instance, Blackrock’s CEO Larry Fink stated that “our responsibility to engage and vote is more important than ever” and that “the growth of indexing demands that we now take this function to a new level.” This article addresses why, in reality, large index funds underinvest in engagement and stewardship and seeks to provide insights on whether increased stewardship by large index funds would be beneficial to the portfolio companies and/or the fund investors.


Definition of Stewardship and Current Levels of Stewardship by Large Index Funds


BlackRock defines investment stewardship as “engagement with public companies to promote corporate governance practices that are consistent with encouraging long-term value creation for shareholders in the company.” Stewardship by index funds comprises of three components: monitoring, voting and engagement.


Monitoring involves evaluating the operations, performance, practices, and compensation and governance decisions of portfolio companies. Voting in portfolio companies is a key function of index fund managers. Shareholders vote on a number of actions including the election of directors, charter and bylaw amendments, mergers, dissolutions, and other fundamental changes in the corporation. These votes are generally cast by index funds, and the fund managers determine how their funds vote. Engagement is defined as a direct communication between investors and companies, or direct contact between a shareowner and an issuer (including a board member).


Empirical evidence suggests that large index funds are not delivering on their promise of stewardship and engagement. As Bebchuck and Hirst note, the stewardship budgets of the Big Three are less than one-fifth of 1% – only 0.2% – of the estimated fees that each of the Big Three charge for managing equity assets.


Why Do Large Index Funds Underinvest in Engagement?


This article discusses three reasons put forward by Bebchuck and Hirst on why large index funds currently underinvest in engagement.


First, large index funds underinvest in engagement and stewardship because of the tiny fraction of value increases captured in the index fund managers’ fees from stewardship. In this regard, there is a gap between the interests of the index fund managers and those of the beneficial investors in their funds. Index fund managers generally cover the cost of investments in stewardship from the stream of fee income that they receive over time from investment funds. However, the increase in the present value of fee revenues they can expect to receive is only a fraction of the expected value increase from stewardship. Unlike hedge fund managers who utilize the so-called “2-and-20” compensation arrangements which enables them to capture a meaningful proportion of any governance gains they bring about, index fund managers capture only a fraction of the governance gains they produce. Thus, it is no wonder that hedge fund managers (unlike index fund managers) are more involved in stewardship, which has led to rise of hedge fund activism in the past decade.


Second, competition with other index funds tracking the same index gives large index funds zero incentive to invest in engagement and stewardship for any of their portfolio companies. Similar to other businesses, an index fund manager faces clear and direct competition with other index fund managers. This is particularly the case in the index fund market where multiple managers track the same or similar index. To illustrate this, consider a situation where an index fund manager invests in stewardship that increases the value of a particular portfolio company. This increase will be shared with all other investors in the company, including rival funds that replicate the same index.


Third, index fund managers have incentives to be excessively deferential to the portfolio companies’ managers in order to avoid private costs of nondeference, resulting in underinvestment in stewardship. A key consideration here is the gap between the interests of the index fund managers and the index fund investors. One way in which this comes to play is the fund managers’ financially significant business ties with corporate managers. An important source of investment manager revenue that has received a lot of attention relates to defined contribution plans, commonly referred to as “401(k) plans". In this regard, index fund managers derive a substantial portion of their revenues from 401(k) plans, in two ways: (i) by providing administration services to such plans; and (ii) by having their index funds included in the menu of investment options available to plan participants. As a result, index fund managers can reasonably expect that the extent to which corporate managers view them favorably might influence their revenues from 401(k) plans.


Would Increased Engagement by Large Index Funds Be Beneficial to Portfolio Companies or Fund Investors?


One thing is sure, increasing investments in engagement and stewardship will put a burden on portfolio companies. The management teams and boards of portfolio companies are tasked with leading their corporations with their best judgment. One may argue that the market currently provides a substantial check on their activities, and managers are keenly aware of the threat of activist investors who may seek to induce changes. Thus, index fund managers should not seek to micromanage their portfolio companies, especially given index fund managers’ long-term investment horizons. To have to speak to a company’s several largest shareholders after minor dips in stock performance would be another distraction to the company’s management.


Interestingly, large index fund managers are also aware that their substantial and growing power puts them at risk of public and political backlash. The backlash could lead to the imposition of considerable legal constraints on the power and activities of large index funds. Fund managers therefore have a significant interest in reducing the risk of such backlash.


Given the considerations above, it is difficult to categorically say that increased engagement by large index funds will benefit the portfolio companies or the fund investors. As I see it, micro-managing the management teams of various portfolio companies is likely to place an undue burden on the portfolio companies, which may actually not result in increased performance.


Funmilayo Fenwa is a Corporation LL.M. candidate at NYU and serves as a Graduate Editor of the NYU Journal of Law & Business. Prior to attending NYU, Funmilayo worked as an M&A and Project Finance lawyer for over three years at Olaniwun Ajayi LP, a top tier commercial law firm in Nigeria. She graduated with first class honors in law from Nottingham Trent University, England.

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