If Not the Index Funds, Then Who?

In recent years, large asset managers have reached incredible sizes, managing trillions of dollars of assets on behalf of tens of millions of clients. The largest three – BlackRock, Vanguard, and State Street – taken together (the “Big Three”), vote about 20 percent of shares in most large companies, with the majority of these shares held in passive index funds. This concentration of financial power has ignited debates over the role of large asset managers and the effects of index fund portfolios in corporate governance. The size and composition of the portfolios of the large asset managers have significant implications, both normative and positive, for the economy and society more broadly.

Asset managers’ clients increasingly invest in low-cost index funds that passively track the entire market, meaning that an individual client may hold stakes in thousands of publicly traded firms. These clients are affected in many ways beyond the financial returns of the individual companies in their portfolios. No shareholder is just a shareholder. Shareholders might also be customers, employees, or creditors, and they are invariably taxpayers and members of the general public. There are often conflicts between what is best for corporations’ profits or share prices and what is best for the broad constituencies affected by corporations’ actions. And because shareholders and other corporate constituencies overlap, maximizing profits may not maximize shareholders’ overall welfare.

In my article If Not the Index Funds, Then Who?, forthcoming in the Berkeley Business Law Journal, I discuss how solving the problems that have dominated corporate governance research – getting managers to maximize profits or increase the share price – may in fact be bad for shareholders if they are harmed by firms’ actions.

There is no shortage of examples of corporations that have increased their share price while harming society. Companies may profit as they release harmful toxins; expose employees to dangerous working conditions; lie to consumers about hazardous products; imperil the financial system; and regularly break the law. In principle, governments could take steps to minimize the harms corporations impose. But officials are often unable or unwilling to intervene. Revolving doors, corporate lobbying, and political economy issues limit the government’s oversight, giving corporations extensive latitude to profit at the expense of others. Under the standard manager-shareholder agency problem that defines the corporate governance literature, managers of companies that increase profits by harming society are performing splendidly. But despite higher-value portfolios, many investors are made worse off by profit-maximizing actions taken by corporations.

My article considers the role of the large asset managers in acting in their clients’ best interests rather than focusing on just the value of clients’ portfolios. I argue that instead of looking to asset managers to increase profits at corporations, asset managers should instead focus on improving the alignment between corporations and society more broadly. Through their broad clientele and enormous index fund portfolios, asset managers can, in principle, represent the public interest better than most other actors. This argument is not based on charity or altruism, but instead is founded on what clients would actually prefer as individuals. In my article I explore this issue by discussing two overarching questions.

First, what should the objective function of a large asset manager be? Scholars and commentators have emphasized important characteristics of the holdings of asset managers: their size, the inability to exit because of index positions, common ownership of competing firms, and their long-term focus. However, this focus overlooks the sheer number and diversity of clients, which implies that many or most actions that affect a firm’s financial value will also affect clients in at least one of their roles as consumers, employees, creditors, taxpayers, neighbors, or just members of the general public. For example, a corporation that cuts costs by releasing a harmful toxin will benefit clients’ financial portfolios, but some of its clients will likely be among those harmed by the toxin. Doing what is best for clients entails considering both the profits and the harms related to the toxin. My article shows that, in many cases, managers who narrowly maximize the profits of individual portfolio companies do not act in their clients’ best interests. Instead, an asset manager who is taking clients’ interests into account should consider both profits and the social welfare implications of firms’ actions.

With the asset manager’s objective function in place, my paper considers a second question: What can, and should, asset managers do to further their clients’ interests? Most fundamentally, asset managers can improve clients’ welfare by inducing corporate managers to take the effects of their actions beyond profit into account. I show that there are many actions that asset managers could take that would both improve clients’ welfare and the value of their portfolios.

The ability of asset managers to influence portfolio companies is predicated on both their size and their index fund portfolios. I discuss how asset managers can use their public voice coupled with private engagements and proxy voting to effect change at portfolio companies. This discussion considers agency costs and the requirements that they face in managing index funds to make recommendations that asset managers could in fact implement. There are three broad classes of actions that asset managers can take, and I make specific recommendations in each area. First, asset managers can take actions that improve the values of individual firms. While this area has received much attention in the corporate governance literature, I suggest underexplored ways that asset managers can improve the value of individual firms. Second, asset managers can take actions that increase the financial value of clients’ portfolios, potentially at the expense of the profitability of some firms. And finally, asset managers can move past financial metrics alone to consider the types of actions that improve clients’ overall welfare. There are close, and often unexplored, links between firm value, portfolio value, and client welfare. Asset managers will best serve clients when they take these relationships into account.

This post comes to us from Nathan Atkinson. a postdoctoral researcher at ETH Zurich Center for Law & Economics. It is based on his recent article, “If Not the Index Funds, Then Who?” available here