The Big 3 mutual-fund managers (BlackRock, State Street, and Vanguard) have amassed incredibly large public-company holdings through the array of mutual funds they oversee. As a result, they now play a pivotal role in corporate governance in many of the world’s largest and most important companies.
A key concern is whether the Big 3 use their powerful voice in corporate affairs to good effect. Professors Lucien Bebchuk and Scott Hirst argue that they neglect their oversight obligations because of agency costs; Professors Jill Fisch, Asaf Hammadi, and Steven Davidoff Solomon (“FHDS”) counter that the Big 3 have sufficient competitive incentive to effectively engage with their portfolio firms.
In ‘Public’ Mutual Funds, I argue that neither agency costs nor competitive incentives are the primary driver of the Big 3’s stewardship behavior. Rather, the Big 3 act out of fear of public retribution. They recognize that failure to look like good stewards could lead to potentially costly regulations. This “publicness” view stems from work that explains important aspects of securities regulation as a response to the public’s desire to impose on powerful private institutions accountability and transparency mechanisms usually associated with public bodies. This view suggests that the Big 3 act as stewards to avoid the consequences of publicness but does not suggest a need for reform.
The agency costs to which Bebchuk and Hirst refer exist between the Big 3 and the shareholders in the mutual funds they manage. The Big 3 have an obligation to vote their mutual funds’ shares, and exercise the related oversight over portfolio companies, in the best interests of fund shareholders. Bebchuk and Hirst argue that the Big 3 fall short for several reasons, the main one being that the bulk of gains from performance improvements generated from engaged stewardship do not go to them, but rather to their mutual-fund shareholders, which causes the Big 3 to invest less in stewardship than their fund shareholders prefer.
The economics of this argument are sound, but the practical implications are likely insignificant. This is because more active engagement by the Big 3 in governance would ill-serve their mutual-fund shareholders. The Big 3 are responsive rather than proactive. They tend to support shareholder proposals that promote “good governance” principles, and, at times, they back hedge-fund activists. They do not engage in firm-specific research to uncover mismanagement and challenge the offenders.
Bebchuk and Hirst fault the Big 3 for failure to take on this higher level of engagement and blame agency costs for the governance gap. But the primary reason the Big 3 fail to more actively engage is that doing so would be unprofitable for the Big 3’s mutual-fund shareholders. Activist hedge funds hire industry experts, charge high fees, and invest only in the companies they target. This structure makes active intervention profitable. But the Big 3 hire administrators and stock pickers, charge low fees, and invest in diversified portfolios. The model is completely at odds with profitable activism.
It is best for the Big 3 to leave activism to the activists. Even better, if the activists are successful, the Big 3 can share in the gains they create without incurring the significant uncertainty and expense that comes with activist-style engagement. Mutual-fund shareholders would suffer if the Big 3 were more aggressive, which means that agency costs cannot explain their current, more passive, approach to stewardship.
Contrary to Bebchuk and Hirst, FHDS argue that competition for mutual-fund shareholders motivates the Big 3 to effectively engage in corporate governance. The authors argue that the Big 3’s conventional engagement – that is, voting for good-governance shareholder proposals – raises the value of portfolio firms, which increases returns to their funds’ investors, and thereby gives the Big 3 a competitive advantage over competitors.
This logic, while appealing, glosses over the intricacies of competition in the mutual-fund industry. If a fund’s intervention increases the value of a portfolio firm, that increase goes to competitor funds as well. Thus, a rise in firm value only provides a competitive advantage if the engaged fund is overweighted in the target firm compared with its competitors. The Big 3 should, therefore, only intervene when this is the case for the funds they oversee. Instead, however, they apply across-the-board voting principles to all of the companies in their funds’ portfolios. This mismatch means that a search for competitive advantage cannot explain the Big 3’s stewardship practices.
Publicness theory suggests that the Big 3’s simplified voting strategy is a signal to the public and to regulators rather than an attempt to best their competitors. The Big 3 are clearly “public” in terms of their power. Their vast holdings give them a decisive voice in hundreds of leading companies. As a result of their immense power, a chorus of commentators has called for regulation.
One way to defend against these calls, in addition to lobbying and other political strategies, is through actions that convince regulators that there is nothing to worry about. This would explain why the Big 3 engage in stewardship that confers no competitive advantage, why they support good governance (a favorite among regulators), why they talk so much about the high value they place on stewardship, and why they show interest in stewardship now despite their long history of avoiding it. This political- and reputation-based analysis fits the Big 3’s behavior better than the more conventional explanations.
This understanding also carries regulatory implications. I argued above that the Big 3 do not engage in more active stewardship because doing so runs counter to the interests of mutual-fund shareholders. This implies that shareholders are mostly satisfied with the status quo. Also, while the Big 3 might not be acting precisely as regulators prefer (or for the reasons they prefer), they are meeting them halfway. Without readily identifiable wrongdoing, the specter of regulation may be sufficient. Just as the Big 3 intended, their conduct in response to public pressure blunts potential policy concerns.
 Lucian Bebchuk & Scott Hirst, Index Funds and the Future of Corporate Governance: Theory, Evidence, and Policy, 119 Colum. L. Rev. 2029 (2019).
 Jill Fisch et al., The New Titans of Wall Street, A Theoretical Framework for Passive Investors, 168 Penn. L. Rev. 17 (2019).
 Hillary A. Sale, The New “Public” Corporation, 74 Law & Contemp. Probs. 137, 138 (2011).
This post comes to us from Jeff Schwartz, the Hugh B. Brown Presidential Professor of Law at the University of Utah, S.J. Quinney College of Law. It is based on his recent article, “‘Public’ Mutual Funds,” available here.