Tom Bailey: BlackRock voting rules help ward off index criticism

New rules may allow BlackRock to get ahead of criticism that it is both too powerful, and not doing enough to tackle climate change. 

The rise of index funds and exchange-traded funds (ETFs) has changed the way companies are owned and therefore, according to some, how corporations and the economy functions.

One of the common concerns about the rise of index-style investing is a decline in corporate governance and oversight. The basic idea is that compared to active fund managers or individual shareholders, index fund providers are less engaged. Many people fear that the growth of passive investment raises questions about how effectively corporate managers are being monitored.

For example, a 2015 article from The Economist says: “A rising chunk of the stock market sits in the hands of lazy investors. Index funds and exchange-traded funds mimic the market’s movements, and typically take little interest in how firms are run; conventional mutual funds and pension funds that oversee diversified portfolio dislike being deeply involved in firms’ management.”

With the rise in demand for environmental, social and governance (ESG) investing, such concerns have only grown.

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Three broad reasons are often given for the supposed lack of engagement from passive funds. First, passives lack the incentive to monitor the performance of individual firms and management teams. In trying to deliver benchmark returns, there is not the same incentive to improve individual firms’ performance.

Second, firms may be less able to exert influence over management than active funds or individual shareholders. Whereas active investors can threaten to sell if the sort of policies they favour are not pursued, passive funds are compelled to follow the index. And third, given their diversified holdings (through owning the whole index), passive investors might not have the resources to research and monitor the corporate policies of each firm.

The big asset managers, such as BlackRock, Vanguard, Fidelity and State Street, have emphasised, to varying degrees, how they are actually responsible shareholders and do try to hold companies to account. In 2016, BlackRock, Vanguard and State Street significantly expanded their focus on corporate governance.

Some argue that index fund issuers do engage with companies rather well. Index providers do vote at shareholder meetings. While they cannot use “selling” as a threat against management, they can use the threat of voting at AGMs.

Others have also noted that company management teams have an incentive to maintain good relationship with index funds and ETFs because their votes are particularly important during key moments, such as proxy fights or takeover bids. As a result, index fund providers can also use their ownership weighting as leverage for private meetings with managers. As Larry Fink, the founder of BlackRock, has observed: “As an indexer, our only action is our voice and so we are taking more active dialogue with our companies and are imposing more of what we think is correct.”

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So perhaps index fund and ETF providers are not as bad at corporate governance as it is often assumed. But this brings us to another common fear about index funds; some people worry that the power of big index providers is too great. As more and more money pours into ETFs, the big asset managers, some fear, have too much power over businesses.

BlackRock, Vanguard and State Street are the biggest owners of nearly every large company in the US. The average combined stake in S&P 500 companies held by the ‘Big Three’ has gone from 5.2% in 1998 to 20.5% in 2017. Notably, former SEC general counsel John Coates famously warned in 2018 that in the event of the continued rise of index funds “in the near future, roughly 12 individuals will have practical power over the majority of US public companies”.

So, it is in the context of these two concerns – as contradictory as they are – that we should understand the news about BlackRock’s new shareholder voting rules. From next year, BlackRock will allow its large institutional holders to decide on shareholder voting decisions. Big investors in 40% of BlackRock’s $4.8 trillion (£3.5 trillion) passive equity index funds will be able to vote at shareholder meetings, effective from the start of next year.

On the one hand, this will allow BlackRock to ward off growing criticism about its “inaction” on climate change. The asset manager has become a target of protesters in recent years, who claim that it is not doing enough to force the hand of polluting companies it owns. There is even a campaign group called ‘BlackRock’s Big Problem’. This is a version of the “index funds are not proactive enough” thesis.

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By allowing institutional investors in BlackRock’s funds to decide their own voting policies, BlackRock is potentially able to sidestep this criticism. It will be the responsibility of the institutional investors to vote on the right climate-based policies.

It also allows BlackRock to avoid the tricky problem of voting in favour of environmental policies at companies that might damage shareholder returns in the short term, going against their fiduciary duty – if the investors themselves vote, it is their choice.

But these new voting rules also allow BlackRock to sidestep the “index funds are too powerful” argument. While BlackRock is criticised for not doing enough on climate change, the ability of the giant asset manager to enforce its will on companies is also likely to raise eyebrows. If it does manage to force companies across the world to carry out certain climate-related policies, many may start asking why a private company has such power. Many will ask whether big sweeping change is the responsibility of elected governments, not fund managers.

However, allowing their own institutional investors to vote allows BlackRock to also sidestep this sort of criticism. These two lines of attack on index funds are likely to only grow as index funds continue to increase in popularity – so don’t be surprised if other big index providers follow suit.