Index funds invest trillions, but rarely challenge management

(Reuters) – Index funds now control half the US equity market, giving the largest funds tremendous power to influence decisions and demand better returns from companies where they invest trillions of dollars.

But the leading US index fund companies, BlackRock Inc, Vanguard Group and State Street Corp., rarely use this draft. Instead, they support overwhelming decisions and pay packages with executives at companies in their portfolios, including the worst performers, according to a Reuters analysis of their shareholder voting records.

For example, the three mutual funds supported a doubling of the salary of the CEO of California utility PG&E Corp, after the stock slumped over potential liability as a result of maintenance problems related to California wildfires. The funds supported major pay packages for beauty product executives Coty Inc – including nearly $ 500,000 for children's education – as the company struggled to digest the acquisition of Procter & Gamble's beauty business. And all three cast key votes against the proposed reform of splitting the CEO and board roles of General Electric Co after a decade of poor performance.

Such votes reflect a larger trend of leadership, according to an analysis of proxy voting at 300 of the poorest performing companies in the Russell 3000 index, measured by three-year returns through the end of 2018. The analysis was conducted for Reuters by the computer business Proxy Insight.

The study looked at the 300 worst performers who had proxy votes in 2018. It found that BlackRock voted with management 93% of the time, followed by Vanguard of 91% and State Street of 84% in the proxy year ending June 30. , 2018. The analysis showed that the three index fund companies supported management at the poorest performing Russell 3000 companies only slightly less than they did for all index companies, regardless of performance.

"If we believe that informed and committed shareholders play an important role in disciplining corporate governance, the rise of index investment is a problem," said Dorothy Lund, a law professor at USC's Gould School of Law and author of several published business management studies.

Actively managed funds also support routine management by proxy. But their voting records are not directly comparable to the index funds because active managers routinely signal dissatisfaction with the company's management by simply dumping a stock or never buying it. Index funds, on the other hand, are prevented from actively trading according to their own rules because they aim to match, rather than beat, the market. They are required to own all the companies in the index they track, such as the Russell 3000 or the S&P 500 – both high flyers and dogs.

This leaves the power of attorney as the most important lever for index fund companies to hold companies accountable for practices that undermine shareholders' interests, such as exorbitant leadership. But index providers face powerful incentives when confronting the management of companies in their portfolios, industry experts said.

Without any objective to outperform the market indices, the funds lack a financial incentive to ensure that portfolio companies are well-run, Lund said. Their business models also depend heavily on recruiting everyday investors away from actively managed mutual funds with a promise of lower fees. And big companies – such as those in larger equity indices – are key to attracting new customers to the big fund companies: BlackRock, Vanguard and rival companies expect companies to offer their money to pension plan employees, which often limits the options employees can choose .

These important business relationships mean that index funds treat their portfolio companies more like clients, Lund said in an interview.

"The problem is going to get bigger as these index funds get more money," she said.

The index fund companies say that they take seriously the watchdog role that institutional investors have historically played in the stock market. Proxy voting, they say, is only a small part of their firm involvement with companies, and they prefer to address issues privately.

"Continuing to have a dialogue without sending out all our dirty clothes" helps to maintain long-term relationships, said Glenn Booraem, who oversees Vanguard's proxy and the interaction with portfolio companies.

BlackRock said there was talk or email with managers and directors – sometimes for years – before voting against them. "A vote against the leadership is a sign of a failed commitment," Michelle Edkins, who oversees BlackRock's proxy vote, said in an interview.

"It is wrong to measure the effectiveness of BlackRock's investment management efforts solely by our proxy vote," BlackRock said in a statement. "This fails to recognize our process of direct interaction with companies to increase the long-term value of our clients' assets."

BlackRock, State Street and Vanguard rejected all requests to discuss their votes on specific proxy proposals with poor performance firms, or to provide details of their private interventions with laggard companies. State Street refused to make executives available for comment.

"We use our voice and voice to influence companies on long-term governance and sustainability issues," State Street spokeswoman Olivia Offner said in an email.

The proxy votes on proposals from the company or its shareholders, affecting key issues of executive pay, director appointments and strategic plans, along with a company's actions to address controversial issues such as climate change or gender equality.

BlackRock opposed that manager paid only 3% of the time in 2018 with Russell 3000 companies and Vanguard opposed 5% of the time, according to Proxy Insight. State Street funds did not support wages 9% of the time in that group of companies, according to Proxy Insight. The figure includes a small number of standings on State Street.

Compare that to the United States largest public pension fund. The $ 378 billion public employee pension system in California opposed executives paying 53% of the time in the first seven months of 2019 with US companies, according to the latest report.

The $ 210 billion New York State Common Retirement Fund opposed executive pay packages 27% of the time last year with US companies, a spokesman for the fund said. The $ 200 billion pension system run by the Florida State Board of Administration voted against executive compensation 64% of the time among 2,226 U.S. companies over the twelve months ended June 30, said Jacob Williams, the system's head of corporate governance , to Reuters.

Some activist investors cite the low rate of negative votes from top investors as a reason for the persistence of unpopular business practices, such as rich executive compensation and poor disclosure of climate consequences. Median CEO salaries rose 25% to $ 12.1 million in 2018 from $ 9.7 million in 2014 at the top 500 listed US companies by revenue, according to the latest disclosures analyzed by payroll researcher Equilar.

Business executives will usually not even discuss a question unless about one-third of investors cast conflicting votes, said Tim Brennan, who until June supervised proxy votes and decisions as chief financial officer for the Unitarian Universalist Association.

"The voices definitely matter," he said.

CalPERS Investment Director Simiso Nzima said the CEO's salary design would improve if other major investors voted more critically.

"Talking to companies behind the scenes about this particular thing is a bit like trying to boil the ocean," Nzima said.

& # 39; EXCESSIVELY DEFERENTIAL & # 39;

Foresaw an investment revolution when Jack Bogle of Vanguard introduced the first index fund, now called the Vanguard 500 Fund, in 1976. Instead of trying to beat the market, Bogle simply tried to match it – while cutting fees for investors . Bogle, who died in January, often remembered how the early index funds were disparate as mediocre, even called "un-American."

After the 2008 financial crisis hit the balance of retirement, many investors stopped trying to hit the market and embraced lower fees for passive funds. At the end of August, passive US equity funds managed $ 4.27 trillion – up from under $ 1 trillion before the crisis, and slightly more than $ 4.25 trillion in actively managed US mutual funds, according to research firm Morningstar Inc.

Challenging company management in proxy votes create adversary conditions that do not serve the index funds' business interests, wrote Lucian Bebchuk, a Harvard University researcher for corporate governance, in a May research article. The index funds are "excessively deferential" to the managers of the portfolio companies, he wrote, because this approach better serves their business mission to expand the management of assets – and the fees that come with managing those assets. Bebchuk and several other academics say index fund providers do not want to rank top management in listed US companies because they also want to make money selling index funds to their employees through pension plans for the company.

Effective monitoring of the thousands of companies in the stock market indices would also require significant staff and resources with little tangible gain for an index fund. Because the funds all own the same shares – under formulas calibrated to track a broad index – they cannot compete with each other for market performance. Instead, they compete with aggressive discounting of fees.

These low costs are also the biggest selling point of all index funds relative to their actively managed competitors, who have to charge more to pay for teams of managers who constantly research companies and discontinue low performers from their portfolios. Cost pressures do not allow much corporate research, said Ron Gilson, a professor at Columbia University and Stanford University law schools who are following the industry.

"There is not much room for them to invest in stewardship, especially when real stewardship is expensive and you charge some customers near zero management fee," Gilson said in an interview.

For example, BlackRock has 45 people on its team casting proxy votes, according to a company report in August. The votes cover around 16,000 corporate meetings per year. Last year, the Los Angeles County Employee Retirement Association (LACERA) moved about $ 10 billion in stock index assets into accounts that would allow the pension plan to take over a proxy – and remove it from external portfolio managers including BlackRock, according to publicly available meeting minutes.

With expanded voting power, LACERA's support for leadership proposals dropped to 80% in 2018 from 93% the previous year, when BlackRock had more turn, according to LACERA's board presentations. Shareholder support rose to 74% in 2018, up from 56% in 2017. LACERA declined to comment.

BACKING EXECUTIVE PAY

During the 2018 proxy season, top index providers supported business executives through some trying times for company shareholders in the bottom 10% of the Russell 3000 index.

The three funds' support for a large fundraising for PG&E chief Geisha Williams – to $ 8.6 million in 2018 from $ 4.2 million the year before – came after the company suspended the dividend. The executive pay package received overwhelming support from other investors, although a stable dividend is a key reason for owning utility shares. The PG&E share lost a quarter of its value in 2017. The tool sought Chapter 11 for bankruptcy protection earlier this year after serious fires in 2017 and 2018 resulted in more than $ 30 billion in liabilities amid investigations into whether the equipment's equipment had caused the fires.

When the index fund companies helped defeat the proposal to split the leadership and CEO roles at GE in 2018, their huge efforts in the company allowed them to cast 1.3 billion votes against the measure of a total of 2.8 billion votes in opposition . Investors supporting the initiative cast nearly 2 billion votes in hopes of dampening the strength of GE's CEO in the boardroom.

In November 2017, the three index fund companies unanimously supported the pay packages of beauty products company Coty Inc, one of the worst performers in the Russell 3000 index, after losing 72% of its value in the three years ended in 2018. Nearly $ 500 $ 000 in tuition for leading children – an unusual extra benefit – came as part of pay packages ranging from $ 3 million to $ 12 million. The Florida State Board of Administration was one of the few dissents who voted against Coty's pay schemes.

The major index funds also supported the re-election of Coty chairman Lambertus Becht, who received a $ 3.6 million special payout for his work on the company's $ 12.5 billion procurement of Procter & Gamble's beauty business in 2016. adviser Institutional Equity Services said Becht's total compensation of $ 4.6 million "significantly exceeds the market standards for non-executive director salary." Other major investors voted for Becht's reelection, but some dumped Coty's share as it struggled to digest the acquisition.

PG&E, General Electric and Coty spokesmen declined to comment on this story.

It is rare for a proxy to vote for a majority of investors in a company to oppose pay packages for executives. Even in such cases, BlackRock usually supports management. In 2018, among the 57 Russell 3000 companies that failed to win a majority of investor support for their pay plans, BlackRock with management was around 60% of the time, according to consulting firm Semler Brossy and the company's voting records.

BlackRock supported rich pay packages for directors at Clovis Oncology, each earning around $ 500,000 a year despite the company's modest $ 1.4 billion market value. That's twice the typical salary for directors of the top 500 US companies by revenue, according to Equilar. Vanguard and State Street sided with BlackRock. In total, 58% of the votes cast were against a proposal to ratify the director's salary. Clovis, who declined to comment, responded by cutting the CEO's salary by a quarter after taking into account the low support and investor feedback, the company said in its 2019 authorization.

CEO of Switch Inc, Rob Roy, received almost $ 100 million in compensation in 2017 when he took the Las Vegas-based data center operator public. The following year, BlackRock supported the election of three directors in the Switch Compensation Committee who had awarded Roy his large pay package. State Street supported two of them. Vanguard voted against all three in the compensation committee.

"The awards are unusual, and the complete lack of performance-enhancing criteria raises concern," wrote ISS proxy advisory in a May 2018 research report. Each of the three Switch directors received 97% of the votes cast.

Switch shares lost about two-thirds of the value over the 15 months following the initial IPO in October 2017. Switch and CEO Roy declined to comment.

EVERYTHING ABOUT $ 84 MILLION PAYMENT

In one case, BlackRock noted concern about a large payout to an executive, but voted for it nonetheless.

In February 2017, legendary railroad manager Hunter Harrison demanded $ 84 million upfront to join CSX Corp as CEO. BlackRock went against the size of the payment, citing investor concerns about Harrison's health, according to a June 2017 BlackRock report on proxy voting. Before investors voted on his pay package, a Wall Street Journal story detailed how an undisclosed medical condition forced Harrison to work from home, breathing with the help of an oxygen machine.

BlackRock, which owned a 6% stake in the railroad company, laid aside its concerns and supported the pay package, which received 93% support from all investors. Vanguard, with a 7% stake, and State Street, with around 4%, also voted in favor. Several months later, in December 2017, Harrison died.

CSX passed a rule requiring its next CEO to submit to a physical examination. The resolution that led to the change at CSX was filed by Virginia's attorney, Fish Fish Jr., and it was approved by the company before any vote. He said he was surprised that none of the big fund managers came up with his own proposal. CSX declined to comment on Harrison's salary.

"These funds speak a big game, use a lot of flourishing language," Fishwick told Reuters in a telephone interview. "I haven't seen them do much."

(GRAPHICS: Index Fund now controls half the equity fund market – here)