News

Passive index funds dominate the U.S. equity fund market. With nearly $21 trillion in assets, index funds control more money than actively-managed funds and make up nearly half the $45 trillion total net assets managed by U.S. investment companies including the “Big Three” — BlackRock, Vanguard, and State Street Global Advisors. 

Together, those three firms own about a quarter of the equity — and voting rights — in every exchange-traded company in the U.S. But that concentration of ownership in a handful of institutional investors has become a hot-button issue in Washington, where policymakers are considering several proposals to reform index fund proxy voting and limit the outsized power index fund managers and their proxy advisors have over corporate governance.

Until now, there’s been little research on how those proposals would actually impact corporate votes. A new paper by Duke Law School Professor Robert E. Bishop and co-authors Edwin Hu and Frank Partnoy provides that data in the first large-scale empirical study showing how changing index fund votes under various hypothetical reform proposals would have changed the outcomes of some 645,000 corporate votes taken over a 20-year period.

In a presentation to the SEC’s Investor Advisory Committee, Bishop explained how the researchers retabulated the historical votes under each of four proposed index voting reforms:

• Abstaining from voting
• Voting indexed shares with management 
• Voting indexed shares on the recommendations of Institutional Shareholder Services and Glass Lewis, the two dominant proxy advisors who provide institutional investors with voting recommendations
• “Mirroring” the votes of indexed shares on a pro rata (proportional) basis to the rest of the market — votes cast by non-indexed shares

They found that of the four scenarios, pro rata voting of indexed shares to the votes of non-indexed shares was the least disruptive to corporate voting — flipping the outcome on only 12 items out of 645,000 — fewer than 0.002% of votes. Those 12 items involved “contentious” issues such as executive pay where management and the proxy advisor disagreed, Bishop said. It also avoided the drawbacks of some of the other reforms such as abstention, where excluding indexed votes would have caused a failure to meet a quorum in one out of ten shareholder meetings. 

“We’re not advocating for one method over another, but people are putting a lot of ideas forward and I would prefer to have a good smart policy than a dumb policy,” Bishop said. 

“Of all of the proposals being considered, mirror voting doesn't create a sea change. It’s the one that would be least disruptive to the system but still allows for quorums to be met to allow regular corporate business to proceed.”

Planning for the rise of passive investing and governance power 

If switching to mirror voting wouldn’t flip the outcome of many votes, why change? And why has index fund voting become a contentious policy issue to begin with? 

Bishop points to two reasons. One is political interest in limiting institutional investor influence over corporate voting, especially on controversial matters such as ESG (environmental, social, and governance), which could lead to increased regulation. Congress is considering several bills, such as the INDEX Act, that would curb their power. 

The second is the expected increase in cash pouring into index funds by the 76 million American households who invest through investment companies, giving their votes even more power. Inflows into passive investment vehicles have outstripped inflows into actively managed funds for several years, with no sign of reversal. 

“Some are concerned that votes are being cast in a way that matches the political views of the index fund manager, rather than necessarily the views of the underlying beneficial owner,” Bishop says. “Mirror voting is pretty neutral — it doesn't appear to empower one interest group over another.”

“And with what we foresee as a continued rise in index investing, it also helps head off the concern that the outcomes of basically all corporate elections in America are going to end up being decided by, essentially, a dozen people who are not actually picking the stocks that they hold.”

Bishop explains that because so many corporate issues are put up for vote every year, investment companies such as Vanguard that manage large index funds can’t possibly research them all in deciding how to cast shareholder votes. And that can be a lot of votes. 

Vanguard’s Total Stock Market Index, the largest U.S. mutual fund with about $2.3 trillion in total assets under management, invests in thousands of companies across the U.S. equity market. But it does so at low cost, with an expense ratio of 0.04% compared to an average expense ratio of 0.72% compared to similar funds. Investors in passive index funds not only give these companies power over how their money is invested, but the vast majority delegate the power to vote on their behalf when corporate issues are put up for shareholder vote. So companies like Vanguard employ stewardship teams to cast shareholders’ votes on thousands of corporate matters each year, often on the recommendations of proxy advisory firms.

“The teams are relatively small because the whole point of index funds is to minimize the costs,” Bishop explained. “Obviously it's not realistic to go through and research all the individual proposals, so what they do instead is come up with voting guidelines, and then they basically try to match the vote to those guidelines as close as they can.”

As policymakers consider ways to limit the outsized power and influence investment managers hold over corporate governance, Bishop said his goal isn’t to make recommendations, but to fill knowledge gaps so policymakers can make the most informed decisions.

“One of the things that I try to do with my research agenda is bring a novel empirical study to important regulatory issues,” he said. “We're not advocating for mirror pro rata voting over any other policy to strip or redirect institutional voting power. We're simply describing the outcomes of what would happen.”