The Dilemma of Shareholder Engagement by Large Fund Groups

A small number of large fund groups have become an increasingly influential force by controlling a significant share of publicly-traded companies, a phenomenon often termed ‘common ownership’. They face a dilemma how to use this power, as active exercise of votes leads to anti-competitive concerns, whereas passive approach fuels accusations of poor shareholder monitoring. Funds need to be more transparent in how they exercise their power to brush away these accusations.

A recent study by US academics shows that the ‘Big Three’ fund groups in the United States—BlackRock, Vanguard, and State Street Global Advisors—control collectively an average of about 20.5 per cent of votes at S&P 500 companies. This number is projected to grow to 40 per cent in a few years.

My own study of the role of large institutional investors in British companies uses hand-collected ownership data to show that few big asset managers are the largest shareholders of the FTSE companies, although the ownership is less concentrated than in the US. BlackRock and Vanguard are among the top 10 shareholders in 90 per cent of the FTSE 100 companies; moreover, BlackRock is the largest shareholder in almost half of these companies. Legal & General Investment Management, the largest UK-based asset manager, dominates the list of the largest shareholders of the FTSE 350 companies: the asset manager appears among the top 10 shareholders in almost three-quarters of the companies included in the index. The combined average share of the top 20 asset managers is just below 22 per cent in both the FTSE 100 and the FTSE 350 companies.

Not surprisingly, large fund groups have been in the spotlight of media coverage and debates in global regulatory and academic circles. The growing shareholdings of large fund groups strengthen their influence over corporate boards, but funds are facing a dilemma how to use this power. Exercising voting rights actively risks inducing accusations in hurting competition. That a single asset manager may be among the top shareholders in every listed company in one sector leads to reasonable grounds for potential anti-competitive effects of common ownership.

On the other hand, passive exercise of voting rights raises legitimate concerns that large fund groups, the most influential shareholders, are asleep at the wheel while businesses struggle with managerial misbehaviour, excessive risk-taking, and poor environmental and social record. The concern is particularly strong for passively-managed and exchange traded funds which track an index and have weak incentives for analysing every company individually.

Both problems, due to their enormous stakes for companies, investors, and consumers, have figured prominently in debates.  An often-cited study of airline industry found that common ownership is associated with higher ticket prices. Even if studies of the effects of common ownership for competition are only partially correct, the negative implications for every consumer can be huge. Poor shareholder stewardship, on the other hand, may have disastrous consequences for the long-term growth of companies, their employees, and other stakeholders, as demonstrated by the 2008 financial crisis.

Regulatory bodies have been grappling with these problems with each giving priority to its own domain. A recent EU legislation has introduced minimum shareholder engagement expectations across the Union; the UK, in turn, is revising the Stewardship Code to strengthen engagement by institutional investors. Competition authorities are active as well. The US Federal Trade Commission, the consumer protection agency, held hearings on the common ownership argument in December 2018. Earlier the same year, the European Commission’s competition branch recognized the potential anti-competitive problems with common ownership.

In response to intensifying regulatory interest, large fund groups have come up with hasty defences. First, they brushed away concerns over anti-competitive behaviour by stressing their weak incentives to monitor companies individually. But the weak monitoring defence, effective in addressing anti-competitive concerns though it may be, strengthens concerns over poor shareholder oversight.

The latest response is to downplay the role of the largest institutional investors by arguing that voting outcomes at shareholders’ meetings would have been the same even without the votes of the big asset managers (see, for example, here and here). This strategy too may be short-lived for two reasons. First, the influence of the largest funds continues growing and we are not far away from times when the largest fund groups would control close to half of listed companies. Second, shareholders are not voting in isolation and are often influenced by the voting decisions of their largest and most influential peers. The largest fund groups may unknowingly influence the votes of other shareholders, as well as proxy advisory firms, by acting as the trend makers. We cannot thus simply discount their votes in defining voting outcomes.

Although no action has been taken, discussed regulatory measures include breaking up large fund groups or imposing restrictions on their maximum shareholdings or voting rights. But these proposals will cost dearly for investors, including pension savings invested in stock markets. Index funds have revolutionized the asset management industry by offering diversification at cheap cost. Aggressive regulatory measures will harm first large index fund providers that can use their size to offer the cheapest management fees and their numerous customers.

What we need before considering dramatic regulatory interventions is better understanding how large fund groups act as owners of companies. It is important to understand real (against perceived) motivations of large fund groups as shareholders, when do they engage with companies, and what drives their engagement efforts.

These are questions that fund groups themselves must have an interest in answering. Instead of relying on spontaneous and short-term strategies to downplay their role, the largest funds need to better explain their engagement decisions. Transparency in engagement will shed light on the effects of common ownership and will help brush away the concerns associated with the increasing clout of giant fund families, be it anti-competitive behaviour or weak shareholder engagement.

Suren Gomtsian a is Lecturer in Business Law at the University of Leeds School of Law and Co-Deputy Director at the Centre for Business Law and Practice.