Asset Management, Index Funds, and Theories of Corporate Control

Matthew Mallow is Vice Chairman at BlackRock, Inc. This post is based on his recent paper. Related research from the Program on Corporate Governance includes The Specter of the Giant Three by Lucian Bebchuk and Scott Hirst (discussed on the Forum here); Index Funds and the Future of Corporate Governance: Theory, Evidence, and Policy by Lucian Bebchuk and Scott Hirst (discussed on the forum here); The Agency Problems of Institutional Investors by Lucian Bebchuk, Alma Cohen, and Scott Hirst (discussed on the Forum here); and The Future of Corporate Governance Part I: The Problem of Twelve by John Coates.

In our paper entitled Asset Management, Index Funds, and Theories of Corporate Control, we dispute the principal arguments of three papers addressing asset management, index funds and corporate control: “The Future of Corporate Governance Part I: The Problem of Twelve” by John C. Coates, IV; and “The Specter of the Giant Three” and “Index Funds and the Future of Corporate Governance: Theory, Evidence and Policy,” both by Lucian A. Bebchuk and Scott Hirst. We show that, while these theories are thought-provoking, they conflict with each other and miss the mark on several fronts.

Coates argues that, through increased voting power and engagement activities, the growth of index funds will afford asset managers too much influence over their portfolio companies. This, he asserts, may lead to the effective control of public companies by a few individuals. Conversely, Bebchuk and Hirst, looking at essentially the same facts as Coates, posit that index fund managers because of potential conflicts and disincentives do not, and will not, adequately exercise their voting power and potential influence through engagement. They claim that this will lead to increased deference to company managements and insufficient monitoring of companies.

Our paper seeks to ground the debate around asset managers, index funds and corporate control firmly in the practical context of the operation and regulation of asset managers. Acting on behalf of clients, asset managers are incentivized to engage with companies on issues that may affect long-term performance. As minority shareholders, however, they lack sufficient voting power to exercise control. Importantly, voting records exhibit variation in asset manager voting behavior, challenging the perception of coordinated voting blocs. Furthermore, thousands of actors are involved in corporate decision making, many better positioned to influence public companies than individual asset managers. Several studies have shown that the collective investment stewardship activities of asset managers have raised the bar on corporate governance and increased the focus of companies on long term sustainability.

We provide an introduction to the debate around asset managers and corporate control, and the popularity of index investment products. We argue that Coates overstates the level of control that asset managers have over portfolio companies through voting and engagement. At the same time, Bebchuk and Hirst understate the role of a diverse range of shareholders and various stakeholders and market participants. We also provide background on the asset management industry—the business, its size, and how it is regulated. Some have criticized asset managers for voting proxies in ways that are not in their clients’ best interests, but we show that this is not the case. When voting is delegated to the asset manager, the manager must make the substantive decision on how to vote the ballot item, as well as the mechanical implementation of casting the vote. Since asset managers are fiduciaries, they must cast their vote with the best economic interests of the client in mind.

We also consider the principal policy measures suggested by Coates and Bebchuk and Hirst and describe the possible impact they may have on the ability of index funds to continue serving diverse investors. We find that if institutional investors such as Vanguard, BlackRock, State Street, and others did not speak out and vote on behalf of their millions of clients, the already powerful voices of management, activists, and proxy advisors would be further augmented. We also note that these authors have visions for investment stewardship that are not currently shared by U.S. regulators.

Much of the academic research to date, including that of Coates and Bebchuk and Hirst, gives little account to the realities of the asset management business and speculates as to future events. We have provided data and context for the activities and incentives of asset managers which we hope will contribute a more robust foundation for future research on asset managers, index funds and corporate control. Without this, the present research risks promoting the premature adoption of public policies, policies that will harm ordinary investors.

The complete paper is available here.

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