Index Funds and he Future of Corporate Governance, Theory, Evidence and Policy

1. Index Funds and the Future of Corporate Governance:
Theory, Evidence, and Policy
Last Revised: November 2019
1
Lucian Bebchuk and Scott Hirst
Forthcoming, Columbia Law Review, December 2019
Presentation Slides

2. Overview
• The slides in this document provide a summary of our
study, Index Funds and the Future of Corporate
Governance: Theory, Evidence, and Policy.
• The slides build on and update our presentations at the
2019 ECGI Annual Meeting in Barcelona in which our
study was awarded the ECGI’s Cleary Gottlieb Steen
Hamilton Law Prize.
2
Overview

3. What We Do
• Develop an agency-cost theory of index fund
stewardship decisions.
• Put together hand-collected and public data to piece
together evidence on the full range of stewardship
activities of the Big Three.
• Find that the evidence is consistent with the agency-
costs view.
• Identify a range of policy implications.
3
Introduction

4. Part of a Larger Project on the Agency Problems of
Institutional Investors
Related work:
• Bebchuk, Cohen & Hirst (2017), The Agency Costs of Institutional
Investors, Journal of Economic Perspectives: Puts forward an analytical
framework for analyzing institutional investor agency problems on
which we build.
• Bebchuk & Hirst (2019), The Specter of the Giant Three, Boston
University Law Review: Provides a supplemental empirical evidence on
the persistent and expected rise of the Big Three,, estimating that the
Big Three could well cast as much as 40% of the votes in S&P 500
companies within two decades.
• Bebchuk & Hirst (2019), The Misguided Attack on Common
Ownership, Presentation at an FTC Hearing: Discusses implications for
the common ownership debate.
4
Introduction

5. The Promise of Index Fund Stewardship
There are three dimensions that have been identified as giving the Big Three
potential advantages as stewards:
1. Large stakes in each portfolio company.
– Enables capturing significant fraction of generated gains.
2. Lack of “exit” option from positions in portfolio companies (while they
remain in the index).
– Protecting/improving value is their only option.
3. Long-term perspective.
We agree that index fund stewardship has promise. But our empirical analysis
indicates that the promise of index funds is yet to be fulfilled, and our policy
analysis seeks ways to better fulfil that promise.
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Theory

6. The Agency-Costs View of
Investment Fund Stewardship
• Stewardship decisions are made not by the fund’s beneficial
investors but by investment fund managers  agency problems.
• The benchmark is the decisions that would be optimal for
beneficial investors.
• We do not argue that index fund stewardship necessarily
produce worse governance outcomes compared to a state of
the world in which the shares were instead held by individual
investors and/or active funds.
• We argue that :
(i) agency problems are a first-order driver of stewardship
decisions index funds, and
(ii) understanding these problems can help identify ways to
limit/reduce their costs.
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Theory

7. Two Types of Incentive Problems.
• Index funds (as well as active funds) have
incentives to under-invest in stewardship
(relative to what would be optimal for beneficial
investors).
• Index fund (as well as active funds) have
incentives to be excessively deferential to
corporate managers
(relative to what would be optimal for beneficial
investors).
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Theory

8. Evidence
• We consider empirical evidence of the stewardship the Big Three
do, and what they do not.
• We first discuss four dimensions of Big Three stewardship:
1. The limited personnel time they devote to stewardship
regarding most of their portfolio companies;
2. The small minority of portfolio companies with which they
have any private communications;
3. Their focus on divergences from governance principles and
their limited attention to other issues that could be
significant for their investors; and
4. Their pro-management voting patterns.
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Evidence

9. Evidence (2)
• We next consider five ways in which the Big Three may fail to
undertake adequate stewardship:
1. Paying limited attention to financial underperformance;
2. Avoiding involvement in the selection of directors, and lack
of attention to important director characteristics;
3. Failing to take actions to bring about governance changes
they consider desirable;
4. Staying on the sidelines regarding corporate governance
reforms; and
5. Avoiding involvement in consequential securities litigation.
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Evidence

10. Investments in Stewardship
• Each of the Big Three has hundreds of $1 billion+ positions in
portfolio companies.
This could justify multiple professionals dedicating substantial
part of their time to monitoring and interacting with such a
portfolio company.
• Whereas supporters of index fund stewardship have focused on
recent increases in stewardship staff, we estimate the personnel
resources (hours and cost) devoted to each portfolio company.
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Evidence: What the Big Three Do

11. Investments in Stewardship Relative to
Equity Investments and Estimated Fees
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Evidence: What the Big Three Do
BlackRock Vanguard SSGA
Stewardship Personnel 45 21 12
Stewardship Investment as % of Estimated Fees
Estimated Stewardship Investment ($m) $13.5 $6.3 $3.6
Estimated Fees & Expenses ($m) $9,107 $3,467 $2,625
Stewardship as % of Fees & Expenses 0.15% 0.18% 0.14%

12. Stewardship per Portfolio Company
Evidence: What the Big Three Do
BlackRock Vanguard SSGA
Stewardship Time (Person-Days)
Scenario 1: Equal Allocation of Stewardship Time,
per Portfolio Company (Worldwide)
1.00 0.40 0.25
Scenario 2: Stewardship Allocated 75% to U.S.
Companies, per U.S. Company
2.24 1.07 0.72
Scenario 3: Proportional Stewardship Allocation,
per $1bn Position Worldwide
3.71 1.36 1.94
Scenario 4: Proportional Stewardship Allocation,
per $1bn Position in U.S. Companies
3.97 1.58 1.79
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13. Stewardship Per Portfolio Company (2)
BlackRock Vanguard SSGA
Stewardship Investment ($)
Scenario 1: Equal Allocation of Stewardship Time,
per Portfolio Company (Worldwide)
$1,200 $476 $295
Scenario 2: Stewardship Allocated 75% to U.S.
Companies, per U.S. Company
$2,689 $1,287 $866
Scenario 3: Proportional Stewardship Allocation,
per $1bn Position Worldwide
$4,447 $1,635 $2,332
Scenario 4: Proportional Stewardship Allocation,
per $1bn Position in U.S. Companies
$4,762 $1,895 $2,147
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Evidence: What the Big Three Do

14. Investments in Stewardship (2)
• Evaluating the governance and performance of a public company
requires evaluating hundreds of pages of documents (or more):
– The company’s annual report and proxy statement;
– The business performance of the company;
– The company’s executive pay arrangements;
– Management proposals and shareholder proposals up for a vote;
– The views of the company’s directors on these matters; and
– Assessments of the directors’ performance.
• However, the stewardship staffing of the Big Three enables only limited
and cursory review for the vast majority of their portfolio companies.
Evidence: What the Big Three Do
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15. Investments in Stewardship (3)
Conclusions: Consistent with the agency-costs view:
– The Big Three devote an economically negligible fraction of
their fee income to stewardship.
Their stewardship staffing enables only limited and cursory
monitoring for the vast majority of their portfolio companies.
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Evidence: What the Big Three Do

16. Private Engagement
• The Big Three have stressed that private engagement is a central
and superior tool that allows them to avoid using other
shareholder tools:
– Vanguard: Private engagement is the “perhaps more
important … component of [Vanguard’s] governance
program”; “engagement is where the action is.”
– BlackRock: “[M]eetings behind closed doors can go further
than votes against management.”
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Evidence: What the Big Three Do

17. Private Engagement (2)
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BlackRock Vanguard SSGA Average
Portfolio Companies with No Engagement 88.9% 94.2% 94.5% 92.5%
Portfolio Companies with Engagement:
Portfolio Companies with a Single Engagement 7.2% 3.5% 5.0% 5.2%
Portfolio Companies with Multiple Engagements 3.9% 2.3% 0.6% 2.3%
Total Portfolio Companies with Engagement 11.1% 5.8% 5.5% 7.5%
Evidence: What the Big Three Do
Average Proportion of Companies Engaged, 2017-2019

18. Private Engagement (3)
• Thus, each of Big Three had no engagement with the great
majority of companies:
For these companies private engagement cannot serve as
substitute for the use of other stewardship tools.
Evidence: What the Big Three Do
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19. Governance-Principles-Based Stewardship
• We document that Big Three stewardship focuses on the
existence of deviations from their governance principles.
• This is consistent with the Big Three’s own descritpions:
– SSGA: Seeks to provide “principles-based guidance”
– BlackRock: Engages where a company lags behind its peers on
environmental, social, or governance matters, or in sectors
with thematic governances issues.
– Vanguard: Focuses on “board composition issues, governance
structures, executive compensation, and risk oversight.”
Evidence: What the Big Three Do
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20. Governance-Principles-Based Stewardship (2)
• Serves the private interests of the Big Three:
– Enables economies of scale that reduce required
investments in stewardship; and
– Makes the potential power of the Big Three less
salient.
• But does not take advantage of potential benefits
from stewardship based on attention to business
performance and/or individual director qualifications
– (More on this below)
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Evidence: What the Big Three Do

21. Big Three
Largest 3
Active
Largest 10
Active
2012 3.9% 13.7% 10.2%
2013 2.4% 11.5% 11.2%
2014 3.7% 9.2% 8.1%
2015 2.4% 6.3% 7.2%
2016 2.8% 7.8% 8.7%
2017 4.0% 7.7% 8.9%
2018 2.8% 6.9% 9.4%
Average 3.1% 9.0% 9.1%
Pro-Management Voting
Evidence: What the Big Three Do
Big Three vs. Active Manager “Against” Votes on Say-on-Pay

22. • Financial performance is important to investors:
Index fund investors would benefit significantly from having
index funds:
(i) monitoring financial underperformance, and
(ii) examining what personnel or other changes could address
identified underperformance.
Evidence: What the Big Three Fail to Do
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Limited Attention to Performance (2)

23. Limited Attention to Performance (2)
• Examining the many examples of behind-the-scenes
engagements in Big Three Stewardship Reports, we find no cases
in which engagement was motivated by financial
underperformance.
• Examining the proxy voting guidelines of each of the Big Three
for deciding whether to withhold support from director/s, we find
that all focus on governance aspects and do not include financial
underperformance as relevant criterion.
Evidence: What the Big Three Fail to Do
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24. Limited Attention to Performance (3)
• Could it be argued that this is because the Big Three “lack the
expertise and access to information to identify operational
improvements … to improve the performance of companies in
their portfolio?” (Fisch, Hamdani & Davidoff Solomon, 2018)
• But lack of in-house expertise should not be taken as given – it is
an endogenous choice made by index fund managers:
– Index fund managers have the resources and could improve
their ability to identify and remedy financial
underperformance if they had incentives to do so.
Evidence: What the Big Three Fail to Do
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25. Limited Attention to Performance (4)
• Could it be argued that index fund managers rationally avoid
monitoring and addressing underperformance because activist
hedge fund are already doing it? (Gilson and Gordon (2013)
make a version of this argument)
• Not a valid justification because:
– Activist hedge funds will only engage where
underperformance is very large and can be fixed quickly; and
– Activist hedge funds may take some time to arrive.
Evidence: What the Big Three Fail to Do
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26. • How well a given director suits a board may depend not just on
governance dimensions (are they independent? chosen through
an appropriate governance process?)
• But also on various individual & company specific characteristics
(e.g., how much and what kind of experience a director has in the
company’s industry? what talents, tools, and education they
have?).
• Assessment of these characteristics could lead to conclusion that
the beneficial investors of a Big Three fund would benefit from
removing/adding a given director.
Evidence: What the Big Three Fail to Do
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Little Attention to Many
Important Director Characteristics (2)

27. Little Attention to Many
Important Director Characteristics (2)
• However, we provide evidence that, outside the small number of
activist proxy fights, the Big Three pay little attention to director
characteristics and do not try to remove or add particular
individuals to the board.
• We examine the proxy voting guidelines of each of the Big Three
regarding whether to withhold support from directors.
• We find that such guidelines focus on general governance
principles do not call for taking relevant
qualifications/characteristics into account.
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Evidence: What the Big Three Fail to Do

28. Little Attention to Many
Important Director Characteristics (3)
• Could it be that the Big Three use such characteristics in their behind-
the-scenes communications with companies?
• We provide evidence that this is not the case.
• We gather data on over 4,000 5% positions held by the Big Three
during 2008-2017.
– Blackrock had 2,367 positions, Vanguard 2,051, SSGA 183.
• Communications regarding individual director selection by a 5% holder
would require a Schedule 13D filing.
• However, only 9 Schedule 13Ds were filed by BlackRock during 2008-
2017, and none by Vanguard or SSGA
We can infer that they avoided such communications.
Evidence: What the Big Three Fail to Do
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29. Little Attention to Many
Important Director Characteristics (4)
Can the Big Three simply free-ride on activist hedge funds? No:
• The Big Three’s preferred directors may differ from those that activist
hedge funds nominate.
(e.g., SSGA criticizing agreements with activist hedge funds)
• The Big Three could communicate about director selection with the
numerous portfolio companies where hedge funds are not active.
• However, avoiding involvement in the selection of particular directors is
consistent with the agency-cost view. Doing so:
Would require significant stewardship investment.
Would involve non-deference to corporate managers.
Evidence: What the Big Three Fail to Do
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30. • Proposals submitted by shareholders that receive majority
support (including consistent support from the Big Three) have
led to considerable improvements in numerous companies
(e.g., with respect to annual elections, majority voting,
elimination of supermajority provisions).
• However, we document that, among the almost 1,500 corporate
governance proposals submitted during 2014-2018, including
among the large subset of proposals supported by the Big Three,
none was submitted by the Big Three.
Evidence: What the Big Three Fail to Do
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No Submission of Shareholder Proposals
for Changes Desired by the Index Funds (2)

31. No Submission of Shareholder Proposals
for Changes Desired by the Index Funds (2)
• Can avoidance of shareholder proposal submission be explained on
grounds that the Big Three don’t need to submit proposals for
governance changes they desire because other (smaller) investors are
doing so?
• No.
– Because of the limited resources of smaller investors, proposals for
many changes that the Big Three would favor are not submitted at
all, or are submitted only after many years of delay.
– As a result, we document that a large proportion of the Big Three’s
portfolio companies lack governance arrangements they themselves
favor.
 Submission of shareholder proposals on those issues by one of the
Big Three would likely have significant positive effects for their
beneficial investors.
Evidence: What the Big Three Fail to Do
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32. • Because the Big Three hold positions in many companies, wide-
scale governance reforms (even with a small effect per company)
could significantly benefit their portfolios.
• But the evidence we hand-collect shows a pattern of limited
involvement.
Evidence: What the Big Three Fail to Do
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Staying on the Sidelines of
Corporate Governance Reforms (2)

33. • We examine all comment letters submitted on 80 SEC proposed
rule changes regarding corporate governance during 1995-2018:
• With each holding about 5% or more of corporate equities, the
Big Three could be expected to express a view whether the
proposed rule is (i) desirable, (ii) undesirable, or (iii) not
practically important and worthy of SEC attention.
• However, each of the Big Three submitted comments regarding
10% (or less) of (i) the set of all proposed rules, as well as (ii) the
set of proposals getting most attention.
Evidence: What the Big Three Fail to Do
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Staying on the Sidelines of
Corporate Governance Reforms (2)

34. • We also examined 10 important cases of precedential securities
litigation during 2007-2018.
– These attracted significant amicus curiae briefs (more than 100 in
total).
– They were also often cited by the subsequent judicial decisions.
• The two largest public pension funds filed or joined amicus briefs in 4
of 10 cases, alone or jointly with another party, despite being many
times smaller than the Big Three.
• However, the Big Three remained fully on the sidelines—none of them
filed a single amicus curiae brief in any of these ten precedential
litigations.
Evidence: What the Big Three Fail to Do
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Staying on the Sidelines of
Corporate Governance Reforms (3)

35. • The limited involvement of the Big Three in both SEC comments
and amicus briefs is consistent with the agency-costs view:
– Explicitly supporting pro-shareholders reforms would not be
deferential to company managers.
– Explicitly opposing reforms reduces the salience of their
deference.
The private interests of index fund managers, but not the
interests of their beneficial investors, are likely to be served by
staying on the sidelines.
Evidence: What the Big Three Fail to Do
35
Staying on the Sidelines of
Corporate Governance Reforms (4)

36. Policy
• We put forward a set of reforms that policymakers should
consider to address the incentives of index fund managers
• We discuss the implications of our analysis for two important
debates
• We explain how the recognition of the incentive problems we
analyze can contribute to improving index fund stewardship
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Policy

37. Implications for Policymakers
• Policymakers should recognize the incentives of index fund
managers to under-invest in stewardship and to be excessively
deferential to corporate managers.
• Our paper put forward proposals several policy measures that
should be considered for improving stewardship:
– Encouraging investments in stewardship;
– Limiting or disclosing relationships with portfolio companies;
– Making private engagements more transparent;
– Rethinking Section 13(d) rules; and
– Size limits for investment fund managers.
37
Policy

38. Implications for Hedge Fund Activism
• Opponents of hedge fund activism view “long-termist” index
fund stewardship as a preferable substitute for “short-termist”
activist hedge funds.
• Our analysis shows that index fund stewardship cannot serve as
an effective substitute.
• Because of the incentive problems of index fund managers, hedge
fund activism has a critical role in stewardship.
Policy
38

39. Implications for Hedge Fund Activism (2)
• But hedge fund activism is not a substitute for index fund stewardship.
• We argue that the hedge funds-index funds combination cannot generally
address effectively corporate governance failures.
– Contrast the views of Gilson and Gordon (2003).
• First, hedge fund activism requires the support of index fund managers:
– Insufficient support by index fund managers may impede or discourage
hedge fund activist engagement (Brav, Jiang & Li, 2018).
– Support for activism is against index fund managers’ deference incentives.
• Second, activist hedge funds will only engage if they expect to make
substantial returns.
 They will ignore many opportunities for smaller gains even though they
would be valuable for index fund investors.
Policy
39

40. Implications for the Common Ownership Debate
• We argue that criticism of common ownership is counterproductive.
• The first-order concern is that the Big Three do too little and have too
little influence, not that the Big Three do too much and have too much
influence.
The push for greater scrutiny of index fund stewardship would
therefore likely produce counterproductive effects.
• For further details see The Misguided Attack on Common Ownership
(2018), our presentation at an FTC hearing on common ownership.
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Policy

41. Recognition and Reality
Index fund managers have significant incentives to be perceived as
responsible stewards.
Greater recognition by beneficial investors and the public of
the incentive problems we identify can lead to improved
stewardship.
We hope that our work will contribute to bringing about such
changes.
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Policy

42. Conclusions
• The evidence we have collected is consistent with the agency-
costs view of index fund stewardship that we put forward.
• The agency problems that we have identified deserve the close
attention of policymakers, market participants, and corporate
governance scholars.
Conclusions
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