I just read the following Twitter thread, which got me thinking:
Marc Andreessen: Ah, but the shareholders themselves are mainly not applying the pressure, rather their managerial agents–professional investment managers–are. See for example Larry Fink, who owns ~0.0000001% of the capital he speaks for.
Elon Musk: Exactly, decisions are being made on behalf of actual shareholders that are contrary to their interests! Major problem with index/passive funds.
PEG: Deeper problem: according to Modern Portfolio Theory, the most rational investment strategy is to buy the market. But the reason why the market reflects the fundamentals of companies is because arbitrageurs (active investors) make it so. So what happens when everyone is passive?
Elon Musk: Exactly. Right before he died, Jack Bogle (of Vanguard fame) said index/passive funds were too great a percentage of the market and he really knew what he was talking about! There should be a shift back towards active investment. Passive has gone too far.
Most observers expect that the share of corporate ownership by index funds will continue to grow over the next decade. It seems only a matter of time until index mutual funds cross the 50% mark. If that were to happen, the “Big Three” might own 30% or more of the U.S. stock market—effective control. I do not believe that such concentration would serve the national interest.
My concerns are shared by many academic observers. In a draft paper released in September, Prof. John C. Coates of Harvard Law School wrote that indexing is reshaping corporate governance, and warned that we are tipping toward a point where the voting power will be “controlled by a small number of individuals” who can exercise “practical power over the majority of U.S. public companies.”
You may also recall these recent articles which were showing the top shareholders of Twitter, after Musk bought a stake. It was Musk 9%, Vanguard 8%, Blackrock 8%.
So I was wondering: isn’t the huge flaw of index funds that you cede voting power to the fund provider, like Vanguard and Blackrock, and these people can then push their own agenda at these companies? They don’t even have the incentive to act in your best interest as the shareholder, as they’re playing with your money, not their own.
What do you think? Could index funds cause huge inefficiencies not only in price-setting but also in how companies are run?
The TER is growing ever smaller. If you get 0.05% for managing assets in a passive ETF, do you really care to deliver the best results? Or do you rather rely on a growing “user” base?
With such a small TER the temptation is high to push your own agenda at the cost of performance. You may become a target of corruption.
My point is: I think no ETF holder is gonna blame Vanguard for poor performance of their passive ETF. But have you ever asked yourself, what are they doing with your voting power? Which board members are they choosing and based on what principles?
I’m not yet sold on the idea that Index funds create inefficiencies in the market, though it does require regulatory oversight to make sure that they don’t use their voting rights for their own personal benefits rather than the one of their clients. Algorithmic trading would cause far greater inefficiencies in my opinion.
I do agree that investors caring only about the returns they get without caring about the voting rights they are too keen to give away to fund managers is a problem and we might end up with only a few non-elected powerful managers/billionaires concentrating most of the decision power of most of the biggest world companies. I don’t see an answer to that other than investors caring more to exercise their vote, no matter how small their power is. This affects both passive and active management, the use of mutual funds/ETFs is the vector by which it happens, not specifically the passive approach.
Institutional options toward more democracy in the exercise of shareholders rights could include :
Direct indexing (the client owns his shares in the companies but automatic rebalancing is implemented at the firm level). For this to become mainstream, it would require changes in taxation in countries that tax capital gains on sale, because sales would occur all the time.
Funds (passive and active) giving their clients the option to express their opinion (vote) on the topics regarding shareholders in the companies they’re invested in and then voting accordingly. I’m not naive enough to think most people would actually exert it, but that would be a start. This should be particularly enforced on pension funds that derive their power by law (one must invest in them, which gives them corporate power by the sheer amount of assets they hold).
Another way of implementing the former would be to have more activist funds that vote accordingly to the goals they want to pursue. One would expect less returns from them but they’d allow investors to delegate their voting power to achieve certain goals, much like one would do by supporting an NGO.
Or another option: create a new share class specifically dedicated to institutional investors, which would be cheaper but hold no voting rights. The voting rights would then be concentrated in the hands of the people investing their own money, while the people only in for the returns would benefit from cheaper prices (and thus cheaper costs).
If I get it right, you would like for passive shareholders to give up their voting power? That is, to never vote and thus increasing the voting power of existing active shareholders? I think this still leaves room for inefficiency, as the active investors can control the capital of the passive ones.
I wonder: what if we could buy shares in a fund provider, that would passively invest in the total market, and we could then vote to choose the board of the fund provider itself? This way we could at least exert pressure over the fund to choose our representatives.
Sorry but I find such ignorant approach short-sighted.
You only “get more money if a company is making money” if you’re a shareholder. What if you’re not a shareholder, but you still have 20% voting power? How are you gonna make money? Don’t you see that your interests are then not aligned with the interests of the shareholders?
Twitter board of directors each had like 0.00001% stake in the company. How can you expect them to care about financial results, if they’re just getting paid a fixed salary?
Also, I think enabling passive investors to vote would solve one problem and create another. You solve the issue of ceding power and its concentration in the hands of the fund manager. You then replace this power with scattered opinions of passive investors.
You invest in passive funds because you don’t want / know how to run a business. How should you know what’s best for the company? So yeah, it would probably be the best if passive investors didn’t vote at all and let the active ones handle the important decisions.
But then compare a situation pre- and post- passive investment. If you have 100% active investors and then passive investors join in and gradually buy out 50% shares, but they never vote. How does it affect the active investors? Is everything the same? Or are things like share price, access to capital, responsibility for your decisions, affected?
No, not true. Why do you say this? Who pays the money? Where does the money come from? I pay money to Vanguard, Vanguard buys the stock of Company X, Company X pays dividend, I get the dividend. Vanguard has no stake. It is holding the stock on my behalf and voting on my behalf.
Debatable. If this is true, then you could say dictatorships are also better than democracy, because with a lot of concentrated power, you have better oversight etc etc.
It’s hard to draw parallels, because we’re not shareholders in our countries. And they don’t pay us dividend, we pay them a tax. So we are clients of the state, not shareholders.
For clarification, when I talk of “passive investing”, I am thinking of investing following an index as opposed to stock picking/market timing. I think it doesn’t encompass the whole problematic which should include funds managed actively. While one could consider that an investor putting their money in an actively managed fund and then not caring about it anymore invests “passively”, this isn’t what I mean when I write that passive investing isn’t the problem.
My understanding is that we agree on that and that the exercise of voting rights/electing board members by representatives of the funds which are employees hired by the board of the management company or board members put in place by their peers at other companies (because of the concentration of voting power in the hands of big fund management companies) is the real issue.
In my understanding, direct indexing would be more about bypassing the fund structure for decision making regarding the companies an investor would be invested in. In a garden variety fund structure, the investor buys shares in the fund, but only the fund itself owns the shares of the companies it invests in. That means the voting powers are concentrated at the fund level and the people investing in the fund get none of them (and Vanguard “ownership by the fund clients” model doesn’t change a thing in that, they still lock the electing process of board members and the owners of the fund have no real say on management).
Direct indexing would mean that the shares of the companies are actually held direcly by the investor, the management company only manages the assets of their clients, by applying an automatic rebalancing model to their assets following an index, robo-advisor style.
That being said, I think the model you propose whould have better results: let the fund participants elect the board of the fund, then the board of the fund do its job and vote for the benefit of the investors at the many companies where they are represented. It still adds accountability while keeping things organized (most participants in my model wouldn’t vote, so that wouldn’t really change things from where they are now on a back to earth level).
No it’s not just semantics. You’re missing the point. What I’m saying is that funds act as shareholders, but the capital doesn’t come from them (so they don’t have skin in the game) and they don’t get any of the profits (no incentive to vote for profit).
Which is precisely the problem. You invest, and Blackrock can do want they want, you don’t even know what’s going on behind the scenes. And you don’t care.
And I’m not saying that ignorant passive investors should decide how to run companies.
I’m saying that if you concentrate their voting power in one hand, and this person/entity is not under any scrutiny, it’s not good. You should rather let the company be run by the people who actively invested and have skin in the game.
If Blackrock has 10% stake in both Coca Cola & Pepsi, do they not have an internal conflict of interest? Does this not incentivize oligopolies?
For the past few decades, having individuals cede their voting power to big funds was appealing. During that time, most shareholder votes were about business basics including director elections, corporate strategy and mergers. Asset managers such as BlackRock and Vanguard voted based on what seemed best for clients financially.
But two forces have changed this in recent years. First, the corporate ballot has become a battleground for politics and social policy. The most debated topics at shareholder meetings now are not business strategy or director savvy but environmental justice and civil rights.
Second, while asset managers remain duty-bound to vote as investment fiduciaries, the social and political activists have reshaped their thinking. Activists, managers and political appointees now often say it’s in every shareholder’s financial interest at every company to prioritize their favored political and social goals — such as net-zero emissions or civil rights audits.
The partial interest misalignment is certainly there. It’s an agency problem like any other.
I actually think that the main problem lies elsewhere:
The big indices like S&P 500, MSCI World etc dominate the stock market and hence the fund management industry. Once you’ve made it into one of those indices as a company, there is little room and maybe incentive to grow further. It’s basically a tourist trap situation: Why bother with quality if you get the money anyway?
Your point that passive investors is relevant insofar as it might worsen the problem.
At heart, this is an empirical question.
Is there any evidence that companies included in big indices are underperforming?
Firstly, there is some evidence: it may just be that if you invest only in the biggest companies - as you must in a cap-weighted index - most of the potential growth has already happened.
Secondly, indexing has been around for a while.
If there is growing inefficiency in firms listed in big indices, people would figure it out and start either petitioning for firms to leave the index or take them private and spruce them up. In fact, that may already be happening. Private Equity is where a lot of money is going anyway. The stock market is not an attractive place to be for many companies anymore.
The true question for investors is if the stock market is actually still the best place to invest your money. Or is it just for the suckers who can’t get in on the real money which is done in private deals?
Maybe, if you want to be active, don’t invest in the stock market but directly invest in business that you can control. For the rest of us, stay in the stock market and enjoy your 5-7 %.
So I think the discussion about Vanguard, Black Rock et al is a moot one.
@Bojack I totally agree with your thoughts, especially on the potential misalignment of interests. It feels strange to me not actually owning the stocks included in my ETF. This has troubled me most with owning ETFs (apart from index providers possibly being in cahoots with ETF providers - I believe the SEC is looking into something in this regard). Basically, I’m owning a mere shell.
Apart from shareholder rights, which I deem very important, what about all the profits from security lending, natural dividends (chocolate from sprüngli, pajamas from calida), and fancy shareholder parties at omaha or maybe lvmh in paris ?
But: I don’t even dare thinking of building my own global portfolio of stocks and rebalancing all the time - what a huge pain!
I was actually looking into this a bit and I found a page where you can see how Vanguard has voted on our behalf in the boards of all the companies they hold shares of:
On the topic of how ETF owners may influence outcomes of shareholders votes.
One aspect of this is that we, as retail buyers, may want to consider proxy voting guidelines as we select our ETF providers. Vanguard and Blackrock do publish theirs. They are subtly different. For example compare Blackrock’s:
we ask companies to articulate how their business model is aligned to a scenario in which global warming is limited to well below 2°C, moving towards global net zero emissions by 2050
With Vanguard’s:
A fund is likely to support proposals that […] Are not overly prescriptive about time frame, cost, or other matters.
We see a growing interest among investors — including
BlackRock’s clients — in the corporate governance of public
companies. […] To that end, in October 2021, BlackRock
announced the first in a series of steps to expand the
opportunity for clients to participate in proxy voting decisions
where legally and operationally viable. […] These
Voting Choice options are currently available to institutional
clients invested in many equity index strategies […] We are
working to expand that universe.
To come back to the original quote from Musk, it made me think of the Jun 16 “Money Stuff newsletter” from Matt Levine, the chapter titled “Fracking”. Levine makes the case that what he calls a “giant universal investor”, owning 10% of everything, has a natural incentive to care about externalities.
I am tempted to agree with Levine and to think that “Shareholder interest” in this contest is a fallacy. There is sometimes a tension between the interests of people who’s high net worth is concentrated in a few companies (eg: Musk), and those who are more vested in society at large (retail investors, some institutions). The pooling of our votes through ETF may help this tension resolve in our favour more often.
Why not create a new ETF, where you create a system online, where every owner of ETF can vote on any of the 5000++ companies, then the Fund owner weight the votes and use them. No need to create a new share type and it seems fair.
Of course the biggest issue is that there are 5000 companies to check and vote for, and you need to have some kind of default vote or some activist might vote on some obscure company and in fact have too much power, even if through the etf proxy.
Don‘t forget that the companies themselves are not „getting big money“ unless they’re issuing large numbers of shares and increasing capital. The biggest part of the stock market is participants trading existing (and often non-existing ) shares between each other.
On the other hand, the companies making it into the indices are already winners - and there’s prominent investors having had huge success on such winners (Buffett, Smith).
So I searched the internet and it seems they do have online sharholder meetings:
Whatever certain fund matters are.
Also Vanguard claims they are owned by their funds. But I didn’t find any information on which funds, which ownership allocation, and who gets to represent the fund.
For all I know the fund manager represents the fund. Maybe those managers are chosen by vanguard, maybe some European ETFs hold the majority of vanguard shares. In the end management controls themselves and don’t answer to anyone. That would be worse than Blackrock which is at least a publicly traded company.
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) shares between each other.