Opt-In Stewardship: Toward an Optimal Delegation of Mutual Fund Voting Authority

Corporate ownership in the U.S. has been re-institutionalized. Individual investors are now much less likely than they once were to hold shares of corporations directly. Instead, individuals now typically invest through mutual funds, especially index funds. As a result, mutual funds now own about one-third of the total U.S. stock market, and the “Big Three” fund families—Blackrock, Vanguard, and State Street—are the largest blockholders in the vast majority of large publicly traded companies. The big mutual funds have thus become a central locus of power in American corporate governance.

Mutual fund voting presents both problems and solutions. On the one hand, mutual fund voting is problematic because it contradicts a basic axiom of good corporate governance: the union of voting rights with economic returns. Mutual funds separate economic returns (which go to the investors) from voting rights (which go to the fund), thus introducing the potential for a divergence of interests. This realization has raised concerns about how mutual funds will use their massive economic and political power, leading to congressional hearings and regulatory reform initiatives.

At the same time, mutual fund voting promises a solution to the problem of rational investor apathy. Rational apathy refers to the set of the information and incentive problems that make individual investors lax monitors of corporate governance. An earlier wave of academic commentary put engaged institutional ownership forward as the solution to rational apathy. Unfortunately, it didn’t work out that way. Most institutional investors were no better at monitoring than individuals.

Things are different now. Mutual funds now emphasize the importance of proxy voting. The largest fund families now allocate voting authority to internal “stewardship groups.” These groups manage voting on an industrial scale. In the 2018 proxy season, for example, Vanguard voted on over 168,000 proposals at over 19,000 meetings for more than 12,000 companies.

Will the stewardship of large asset managers finally solve the rational apathy problem and realize the ideal of engaged monitoring? Or will it further weaken investor power as individual and institutional incentives diverge? I address these questions in a forthcoming article in the Texas Law Review, Opt-In Stewardship: Toward an Optimal Delegation of Mutual Fund Voting Authority.

My article articulates a theory of delegated voting to answer the essential questions of whether, when, and how mutual funds should vote on behalf of their investors. Along the way, it addresses questions such as: What should investors expect from mutual fund voting? What should mutual funds be able to presume about their investors’ interests? Over what kinds of matters should funds exercise discretionary voting authority? And how should they vote when they do?

The core of my argument is that a rational investor’s decision to delegate voting rights depends upon two considerations: information and purpose. A rational investor will delegate voting rights to an intermediary if and only if the intermediary possesses a comparative advantage in acquiring or analyzing the information necessary to vote intelligently. This comparative advantage in information is the basis for scholars’ belief that institutional investors can solve the rational apathy problem.

The second essential consideration, purpose, is often neglected. A rational investor will delegate voting rights to an intermediary if and only if the intermediary shares the investors’ purpose. Both elements are necessary. If the intermediary’s purpose is somehow opposed to the investor’s, the delegation of voting rights does not make sense even if the intermediary has an information advantage.

My article uses these two basic considerations—information and purpose—to analyze each of the paradigmatic issues on which shareholders vote. The principal situation in which mutual funds ought to exercise voting discretion is in “contests”—that is, proxy fights and M&A. In contests, meaningful information is produced, and the mutual fund has a comparative advantage over ordinary investors in analyzing this information. As importantly, in contests, the mutual fund intermediary can assume a common interest on the part of its investors.

The opposite situation is presented by environmental and social proposals. There mutual funds are not presented with meaningful information nor are they able to assume a common purpose on the part of their investors. Fortunately, unlike contests, there is no reason to suppose that management is conflicted in assessing environmental and social proposals. Mutual funds should therefore defer to management’s recommendation when voting on environmental and social issues. However, investors with differing objectives should be given an opportunity to opt out, either ex ante (through special funds) or ex post (through a form of pass-through voting).

Governance issues are distinguishable from both contests and from environmental and social proposals. Like contests (and unlike environmental and social issues), mutual funds can assume a common investor purpose with respect to governance. Investors will favor governance reforms that increase corporate value and oppose governance changes that decrease it. Also like contests (and unlike environmental and social issues), a manager’s recommendation with respect to governance reforms may be tainted by her own interests. Managers can be expected to disfavor governance reforms that restrict their authority or reduce their tenure. However, considering the unproven link between governance and performance, mutual funds do not have a comparative informational advantage in voting intelligently on governance. Therefore, in the absence of meaningful information concerning the effect of a given governance reform on the performance of a specific firm, mutual funds should abstain from voting on governance proposals. Instead, the votes should either be passed-through to investors or not voted at all.

My theory of delegated voting seeks both to ground scholarly debate and to guide policy-makers considering revisions to the proxy voting system. It provides a clear rubric for ensuring that mutual fund voting serves investor interests. However, given the potential of mutual funds to use voting to serve their own interests over those of their investors, regulators should act to reset the default allocation of voting authority between mutual funds and their investors.

The complete article is available here.