A recurrent claim for the stock market’s value to the economy is that shareholders have an incentive to monitor and analyze the companies in their portfolios, and through this process play a vital role in corporate governance and in the health of the overall economy. However, in a classic 1932 book, Columbia law professor Adolf Berle and Harvard economist Gardiner Means explained that because a shareholder’s vote “will count for little or nothing … the stockholder is practically reduced to the alternative of not voting at all or else of handing over his vote” to the proxy committee, appointed by existing management, who can “virtually dictate their own successors.”
After Berle and Means highlighted the problem that widely dispersed ownership created for corporate governance, researchers theorized that other mechanisms, such as (1) the discipline of the market for corporate control or (2) price pressure due to the sale of shares in underperforming companies, would rectify the lack of shareholder engagement.
The Berle-Means dispersed-ownership problem has faded with the rise of institutional investors (e.g., pension funds, mutual funds, etc.) and index funds. Today, the “Big Three” fund management firms—Vanguard, Black Rock and State Street Global Advisors—are the largest shareholders in 90% of S&P 500 companies, and together they vote about 25% of the shares. With this increased share-voting dominance, these three fund managers have significant potential to improve corporate governance, increase the value of their portfolios and strengthen the economy. In addition to the large percentage of shares voted, index funds have no “exit” from their positions in portfolio companies, providing those companies remain in the index, resulting in a long-term perspective. Vanguard’s founder and creator of the first index fund, Jack Bogle, concluded that index funds “are the best hope for corporate governance.”
Are these fund managers realizing Bogle’s high expectations? Apparently not, a trio of Harvard economists and legal scholars argue in a December 2019 Columbia Law Review article. They summarize their investigation into the stewardship decisions of the Big Three index fund managers stating, “Our … analysis shows that index fund managers have strong incentives to (i) underinvest in stewardship and (ii) defer excessively to the preferences … of corporate managers.” They provide much evidence supporting their conclusions, to include the fact that “the Big Three devote a negligible fraction of their fee income to stewardship and that their stewardship staffing levels enable only … cursory” monitoring. Most striking is that the stewardship activities of the Big Three “pay limited attention to financial underperformance.”
These governance issues are likely to receive much more attention in the coming years, as index funds continue to grow. Rest assured that at J.V. Bruni and Company we work diligently to understand corporate issues in order to appropriately vote proxy shares, and to adjust client portfolios accordingly.