Should passive investors be indifferent to corporate governance? In a forthcoming essay for the Yale Law Journal, Leo Strine, chief justice of the Delaware Supreme Court, insists not.
‘Index funds should be required to think independently and vote in a way that reflects an informed judgment about what is best for their investors over the long haul – not just what the fund-family proxy unit or, even worse, a proxy advisor, has generically instructed it to do,’ Strine argued.
‘To that end, index funds should be precluded from relying on proxy advisory firms that do not provide guidance tailored to index funds’ unique buy-and-hold perspective.’
In his article, Strine advocates on behalf of those he terms ‘flesh and blood’ investors – not abstract shareholders. These ‘human investors,’ as he also calls them, have stakes beyond equity positions in companies.
For a start, their wealth is determined by their wages far more than by their investments. To this extent, pushing public companies to cut costs – whether by offshoring jobs, slashing research budgets, or anything else – is not truly in these end investors’ interests. The benefit of potentially higher share prices is marginal compared with the wider economic costs.
‘In the corporate governance game, the most vocal and powerful of the electorate will be those with investment horizons the least aligned with human investors,’ Strine observed.
One of Strine’s proposals for righting this imbalance is to regulate more closely the proxy advisors that inform many index funds’ approaches to corporate governance.
‘If proxy advisory firms are going to continue to be an important influence on the behavior of societally important institutions like money managers and public companies, they should be regulated in the public interest,’ Strine contended.
‘Sensible requirements preventing investment funds from relying upon proxy advisory firm recommendations unless those are tailored to the fund’s investment style and horizon would create incentives for proxy advisory firms to do better; and in particular, force them to develop voting recommendations and policies tailored to index investors, who are uniquely long term and committed to sustainable wealth creation.’
What such steps would mean in practice is less clear. How, for example, should index funds vote on the merger of Walgreens and Rite Aid? Will their union make them stronger and so enable the desired sustainable wealth creation, and if so, how is that to be weighed against the impact of any redundancies and the loss of competition? Regardless of whether Snap is permitted into the S&P 500, should passive funds eschew it if they have no voting rights?
Attempts to harness the power of index funds to improve corporate governance are welcome, but are thus unlikely to yield solutions amenable to every interest. Greater transparency, another of Strine’s suggestions, may therefore prove a more satisfactory answer.
‘Increased disclosure demonstrating, as a practical matter, how much a given fund deviated from off-the-shelf voting procedures, would help investors gauge if a fund advertising itself as socially responsible or for the long term actually behaved that way,’ he asserted.
This nevertheless depends on investors paying attention to how their index funds vote and moving their money to those that reflect their values – which in turn relies on brokers and 401(k) plans making a wider range of options available, and fund providers creating those products.
From barbarians to saviors at the gate
On the subject of product creation, Strine has an interesting idea.
‘Human investors should have investment options tailored to their long-term investment horizon,’ he stated. ‘Although many of these other proposals would help sharpen money managers’ focus on the longer term, some investments are structurally better suited to the patient money of a 25-year-old starting to save for retirement. A locked-in 10-year investment in a private-equity fund of funds would arguably be a more appropriate place for retirement investments the saver will not touch for at least three decades, compared with an actively traded mutual fund that frequently turns over its holdings in search of benchmark-beating returns.
‘It is an unwise paternalism to facilitate worker access to churning mutual funds, while denying them the arguably most rational choice after index funds,’ Strine concluded.
Presuming the most rapacious private equity strategies are excluded from these putative funds of funds, and naturally that the fee structure is appropriate and that the industry could accommodate many billions of new investment, such structures would still require decisions to be made about businesses that could never be free of adverse effects.
Yet perhaps an administration committed to economic nationalism will see the merit in appropriating the nation’s savings to invest in domestic enterprises.