The creation of index funds is arguably the most successful innovation in modern financial history. Index funds hold “rock star” status with investors who love their simplicity, performance, and low costs. Their near-universal popularity, however, has presented investors with a new dilemma. If current trends continue, it’s only a matter of time before index funds own more than half of all U.S. stocks. Why is that a problem?
When investors buy an individual stock, they have a right to attend and vote at the annual shareholder meetings. However, when they buy an index fund, their shareholder rights are given over to the managers of that index fund. That manager is then tasked with voting those shares in the “best interest of the shareholders”.
The Giant Problem
The problem arises because the index fund industry is dominated by 5 companies who collectively own 90% of index fund assets. As the new digital Wall Street takes shape, the macro-shift into index funds appears unstoppable. The trillions of dollars flowing into index funds has concentrated shareholder power into a very small elite group. At some point in the near future, a tipping point could be reached where these giant index fund companies will hold voting control over virtually every large U.S. corporation. This would represent a historic shift in corporate power in America at a time when giant tech companies influence our day to day lives in unprecedented ways.
Jack Bogle Gave The Warning
The founder of index funds, Jack Bogle, was one of the first to sound this alarm. Known as a champion of individual investor rights, Jack Bogle warned that such a high concentration of power would not “serve the national interest”. He went on to say that these giant index institutions hold such an advantage over new entrants, that a change in this concentration was unlikely. (*WSJ 11/29/18 Bogle Sounds Warning on Index Funds)
Two months before the Wall Street Journal published Jack Bogle’s famous “final warning” op ed in 2018, Todd (co-founder) & I spent an hour with Jack in his private office discussing the state of the index funds industry. He was clearly concerned with the direction it had taken. Would the industry he fathered be the cause of individual investor rights disappearing? Jack died a few months later and the industry lost one of its most influential minds. More importantly, the Investor may have lost their greatest champion.
Our Response: Give Investors A Non-Institutional Alternative
INDEX is our answer to Bogle’s last warning. We agree with Jack. Five institutions should not control the future of corporate America. Investors should. That type of power should be in the hands of the people, not institutions. We created INDEX as the “non-institutional” choice for retail investors who love index funds. Using Jack Bogle’s words, we are the unlikely “new entrant”, the maverick in an industry of institutional giants.
We Had To Do More
When INDEX was launched our initial belief was that passive index funds should not influence proxy voting at all. After all, their job was to track an index, not select companies. Index funds don’t have a choice in which stocks to own. However, as more and more long-term investors flocked into index funds, we knew we had to do more. These long-term shareholders needed a voice.
Being small, founder run, and not tied to Wall Street, we knew we could do things for the investor that the big companies just couldn’t, or wouldn’t, do. After reading Jack’s op ed, we went to work and began to study the proxy issue. Soon after, Harvard Law School released a report, then Barron’s, then Bloomberg, then everyone. Jack had unleashed a hail storm and the industry began to see the enormity of the problem.
The popularity of ESG investing also placed the proxy issue squarely into the limelight. How were BlackRock, State Street & Vanguard voting on social issues? In 2019, Barron’s published a report showing that the mutual fund industry voted with management 94% of the time and only favored shareholder proposals 34% of the time. (*Barron’s 6/29/19 “Mutual Funds Almost Always Support Company Management”)
The Voting Record
According to nonprofit group Majority Action, “BlackRock and Vanguard voted for 99% of U.S. energy and utility company-proposed directors” while voting “overwhelmingly against climate-critical resolutions”. (”Climate in the Boardroom” by Majority Action, 2019). Morningstar’s 2019 Proxy Voting Study found that “out of 72 proxy ballot questions addressing social and environmental concerns from companies in S&P 500®, BlackRock supported only five.” In March of this year, Morningstar issued a report which concluded that “BlackRock, Vanguard and State Street voted largely as a block with their firms on environmental and social issues.” (How big fund families voted on climate change”, Morningstar 9/28/2020). Although these patterns begin to tell a story, the real issue for us is still one of control.
Already, 22% of the shares of the typical S&P 500® company sit in the portfolios of the big three (BlackRock, State Street & Vanguard). (*Bloomberg 1/13/2020 Total World Domination). This is a massive voting bloc, especially when you factor in that many shareholders don’t ever take the time to vote. What happens when this voting block reaches 40% or 50%? Effective control of corporate America.
As we studied the proposed solutions, none of them seemed adequate. Does the industry really want the government to step in to regulate these votes? Would independent boards truly be independent? Should these giant institutions be broken up for antitrust reasons? How about stripping away the voting rights for index funds altogether (potentially placing more control in the hands of short-term traders, or “renters” as Jack would call them)? Index fund shareholders traditionally buy markets and hold them for long periods of time, making them a very important part of the industry.
Allow Shareholders To Vote
The more we researched, the more the answer became obvious to us. Why not allow the shareholders of the index fund to vote? America is a democracy after all, why not here? Who better to know the best interest of the shareholder than the shareholder?
The 1940 Securities Act
This seemingly logical and simple solution is complicated by the fact that mutual funds are governed by the 1940 Securities Act which gives the duty of voting to the investment manager of the fund. This law requires that managers vote their proxies in “the best interest of the shareholders.” So, without an amendment to the 1940 Securities Act, the Adviser is still required to cast the final deciding proxy vote. After much legal wrangling, we proposed a compromise. Provide an alternate way for shareholders to voice their vote on the Advisor’s website. The Advisor then tallies the shareholder votes, considers any other factors (such as conflict of interest), and makes a final determination. On September 25th, 2020, our Board approved the new proxy policy for INDEX and history was made. Introducing the first open proxy index fund. Investors in index funds can now have a voice in the process for the first time!
Why It Matters
Why does voting on corporate proxies matter? We don’t expect index fund investor’s to immediately run out and start “voting their shares”. But, we think they will care that they can. Investors know how much influence companies like Facebook and Twitter and YouTube and Google and Amazon and Apple and Instagram have on their day-to-day lives. At some point, they will begin to care, and they will see what a significant opportunity they have to make a difference, to have a real impact.
Vote Your ESG, Not Someone Else’s INDEX doesn’t promote a certain ESG
We champion investor rights to vote their own ESG, not someone else’s. ESG issues are vast and opinions are wide. The most effective way to have your views represented, is to represent them yourself. Instead of allowing someone else to define your ESG, why not define it and vote it yourself?
Make an Impact by Changing Companies, not Boycotting them
We think this is a smarter way to make an impact on the world. Instead of boycotting companies you don’t like, why not own them and change them from the inside out? This also allows you to invest in one of the most successful index strategies of all time.
Internet companies have become some of the wealthiest companies in the history of humanity. More importantly, they have more influence in our lives than many. We believe the decisions they make affect our world on par with, and perhaps more than, political issues.