In his book “The Battle for the Soul of Capitalism”, John Bogle criticized the abuses of the top management of public companies: “Our imperial chief executives, with all their fame, their jet planes, their perquisites, their pension plans, their club dues, their Park Avenue apartments, appear to have forgotten that they are employees of the corporation’s owners.”
Shareholders will suffer as they have to cover these costs. They should have a leading role in corporate governance policy to curb these abuses. The index funds, encouraged in this site because of their advantages for investors (cheapest solution for a diversified portfolio) do not seem yet to play their role of control of executive managers.
The increasing concentration in the fund industry – active and passive – means that investment companies are increasingly in the hands of the same owners, Blackrock and Vanguard in particular. Passive investment funds such as ETFs are effectively managing a growing share of the corporate world. This is because the shares purchased by the ETF providers lead a change and a concentration in ownership.
Passive funds, by definition, have no close relationship with their individual investments – because an index dictates what to buy. Active funds, especially “activist” investors and hedge funds, have a greater incentive to monitor company management. Major shareholders influence the strategic alignment of companies, which passive funds cannot do, especially for cost reasons. Active investors are also addressing the question of compensation since directors and managers could take advantage of the lack of countervailing power and pay themselves inflated amounts.
Passive funds actually derive little immediate benefit from their involvement in the affairs of a company: On the one hand, unlike active funds, they cannot sell holdings in bad companies since they have to follow an index. On the other hand, they have no competitive advantage, since other product providers follow the same indexes and would benefit from their efforts.
Passive investing does not mean that one remains inactive or cannot actively use one’s stake in a company. In fact, entire teams of people deal with this issue in the main fund houses. BlackRock, with its iShares brand, is the world’s largest ETF provider. Its CEO, Larry Fink, writes yearly an open letter to all CEOs of public companies and puts two tools forward: shareholder dialogue and shareholders’ vote. The climate is an example of issue, but BlackRock does not consider itself an activist investor and always seeks dialogue. In extreme cases, the company can vote against the nomination of board members, which seems to be extremely rare. Under the term investment stewardship, Vanguard employs a team of 35 governance professionals and focuses on the following four themes: Management composition, strategy and risk oversight, compensation and shareholder rights. The tools are similar to BlackRock’s with the promotion of best practices, interactions with companies and shareholder voting.
The benefits to the index fund investor remain, but the main service providers should address this governance anomaly with greater determination. Ideally, Vanguard and BlackRock should further develop their charter of good corporate governance practices, particularly with respect to directors’ incentives and compensation. The threat of voting against resolutions should push companies to avoid abuses, without index fund managers having to interfere in the affairs of companies and move to costly micro-management.
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