In three recent articles – The Agency Problems of Institutional Investors (co-authored with Alma Cohen), Index Funds and the Future of Corporate Governance: Theory, Evidence, and Policy, and The Specter of the Giant Three – we analyzed the stewardship choices of the three largest index fund managers, commonly referred to collectively as the “Big Three.” Our articles identified, analyzed, and documented two agency distortions that afflict these choices. These articles have attracted a number of responses and challenges, including from high-level officers of the Big Three and a significant number of prominent academics.

In our new article, Big Three Power and Why it Matters, which we recently posted on SSRN, we reply to these responses and challenges. In the course of our analysis, we present updated evidence on the substantial voting power of the Big Three and explain why it is likely to persist and, indeed, further grow. We also demonstrate that, due to their voting power, the Big Three have considerable influence on corporate outcomes through both what they do and what they fail to do.

We show that the attempts by responders to our earlier work to downplay either Big Three power and/or the problems with their incentives do not hold up to scrutiny. Our new article concludes by discussing the substantial stakes in this debate—the critical importance of recognizing the power of the Big Three, and why it matters.

Below is a more detailed account of the analysis in our new article.

The three largest index fund managers—BlackRock, Inc. (“BlackRock”); State Street Global Advisors, a division of State Street Corporation (“SSGA”); and the Vanguard Group (“Vanguard”)—collectively known as the “Big Three,” own an increasingly large proportion of American public companies. The nature and quality of Big Three stewardship have therefore been attracting increasing attention.

Under a traditional “value-maximization” account of Big Three stewardship, the stewardship decisions of index fund managers are premised to be largely focused on maximizing the long-term value of their investment portfolios, and agency problems are thus assumed not to be a first-order driver of those decisions. By contrast, in our earlier work we have sought to put forward an alternative “agency-costs” account of index fund stewardship. In Index Funds and the Future of Corporate Governance: Theory, Evidence, and Policy, we analyzed the incentives that shape, and the distortions that afflict, the stewardship choices made by the Big Three. In The Specter of the Giant Three, we provided empirical evidence on the rise of the Big Three and their likely future growth. Our work, and especially the incentive analysis of index fund incentives, built on the framework for analyzing the agency problems of institutional investors we had earlier put forward in a study with Alma Cohen, The Agency Problems of Institutional Investors.

In our new article, we seek to address a wide array of objections and challenges that have been put forward in response to our agency-costs view. Objections to our view from high-level officers of the Big Three were expressed in a keynote address by BlackRock’s then Vice Chairman Barbara Novick, a study issued by BlackRock’s then Vice Chairman Matthew Mallow, conference presentations by SSGA’s then Chief Investment Officer Richard Lacaille, and by Vanguard’s former CEO William McNabb, and responses to our work provided to the Financial Times and to The Wall Street Journal by SSGA, BlackRock, and Vanguard representative. A number of prominent academics have also taken issue with our agency-costs account of Big Three stewardship, including Professors Marcel Kahan and Edward Rock; Professors Jill Fisch, Assaf Hamdani, and Steven Davidoff Solomon; and Professor Jeff Gordon. Their work has not sought to downplay the power of the Big Three, as officers of the Big Three officers have attempted to do. However, they challenge our agency-costs account by putting forward a more favorable assessment of Big Three stewardship.

To responds to this wide array of objections and challenges, our new article provides additional analysis and evidence in support of the agency-costs account of Big Three stewardship. Our analysis reinforces the view that, despite the protestations of the Big Three senior officers, the Big Three have considerable power and influence on corporate decisions and outcomes. Furthermore, notwithstanding the claims of our academic critics, our analysis reinforces the conclusions that the stewardship decisions of the Big Three are substantially afflicted by distorted incentives. Our analysis proceeds as follows.

Big Three Voting Power

We begin by considering the arguments made by critics of our empirical analyses of the Big Three’s power. We put forward evidence showing that our conclusions regarding the Big Three’s substantial voting power remain intact after addressing the empirical issues and challenges raised by critics. We also update the estimates reported in our previous work; in particular, we estimate that, as of the end of 2021, the Big Three collectively held a median stake of 21.9% in S&P 500 companies, which represented a proportion of 24.9% of the votes cast at the annual meetings of those companies. In addition, we also engage with objections regarding the likely future growth of the Big Three, and we show that the power of the Big Three is likely not only to persist, but also to grow significantly.

Big Three Influence on Corporate Outcomes

Next, we examine how the Big Three’s voting power and their use of that power has important effects on corporate decisions and outcomes. This analysis is divided into two parts. The first part of this analysis considers how the Big Three’s voting influences actual and potential voting results. In response to the objection that the proxy solicitor Institutional Shareholder Services (“ISS”) exerts considerable influence on votes, we explain that the proportion of votes that ISS influences is less than the proportion of shares held by the Big Three. In response to the objection that the Big Three do not act as a cohesive voting bloc and often vote differently, we explain that the votes of the Big Three show significant correlation. Finally, in response to the objection that even a 10% voting block is unlikely to have significant influence because close votes are infrequent, we explain that there are significant situations in which index fund votes could determine whether a vote passes or not, both for proxy contests and for environmental, social, and governance (“ESG”) matters. And even where votes are not close, the outcome of votes can play an important part in influencing the behavior of corporate managers.

The second part of our analysis of the Big Three’s voting power analyzes how actual and potential voting outcomes, in turn, influence corporate decisions and outcomes. One objection raised against our analysis is that vote outcomes have a limited effect on corporate outcomes, because they are often advisory and because shareholder decisions are made by a collective group of thousands of different investors. In response, we explain that even advisory votes can influence the actions of corporate managers in important ways because, it is important for incumbent directors to retain large support from shareholders, and to avoid any visible disagreement with a substantial group of shareholders. Consequently, the voting decisions of shareholders holding large voting power, whether in advisory or binding votes, have substantial influence on corporate decisions.

Market Perceptions of Big Three Power

We next review how the power and importance of the Big Three is perceived and described by market participants. To the extent that market participants view Big Three positions as important, we explain, those views alone give the Big Three significant influence, irrespective of their actual ability to influence corporate elections. A belief in the power of the Big Three by corporate managers, even if misplaced, would make corporate managers make decisions that are influenced by the preferences of Big Three managers.

We document that management advisors indeed view the Big Three as very important. We also show how some of the communications by the Big Three themselves also reflect this perception. For example, communications by the Big Three promoting the success of their engagements on subjects like board diversity make clear that they are aware of the significant influence they are able to exert over the directors and executives of corporations. Our analysis of the perceptions of market participants thus reinforces our earlier conclusion that the Big Three exercise significant influence.

The Distorted Incentives of the Big Three

We next consider the two incentive problems of index fund managers, which—as we explain—have not been adequately addressed by those defending index fund managers. The first incentive problem is that index fund managers have incentives to underinvest in stewardship activities. Index fund managers bear the costs of stewardship, but their own investors enjoy the gains that result from those activities. Index fund managers themselves only capture a very small part of those gains, in the form of the small proportion of their investors’ assets that they charge as fees. As a result, index fund managers have an incentive to invest considerably less in stewardship than their own investors would prefer. We show that arguments raised by critics that investment managers benefit from stewardship by attracting additional assets, or because of the size or breadth of their holdings, are unlikely to provide the Big Three with sufficient incentives to undertake substantial stewardship.

The second incentive problem is that index fund managers also have incentives to be excessively deferential to corporate managers compared to what would be optimal for their own investors. This is because index funds are likely to bear several different types of costs from non-deferential actions, including lost business from corporate managers, compliance costs that would be borne by investment managers if they influence the control of portfolio companies, and the possibility of a corporate-led backlash to their considerable power. As we explain, the Big Three have expressed doubt regarding these claims, but neither they nor academic commentators have raised any arguments why this is unlikely to be the case.

The Stakes

Finally, we discuss the significant stakes involved in this issue. The Big Three’s growing power creates the promise that they could overcome the problems with dispersed ownership of corporations and the limited ability of small shareholders to influence corporate managers. The Big Three’s incentive problems are important because they leave this promise unfulfilled. This is especially important because of the lack of any corrective mechanisms that would reward the Big Three for good stewardship decisions and thereby lead them to improve their stewardship performance. If they do not do so, corporate managers are likely to continue to be insulated from challenges by investors, even when such insulation is not warranted. This will be the case if attempts by the Big Three to downplay their power are taken at face value. Instead, the power and potential of the Big Three should be fully recognized, and the Big Three should be encouraged to fulfill that potential.

Our article is available for download here.