Faculty of law blogs / UNIVERSITY OF OXFORD

Looking at the ‘Big Three’ Investment Advisers Through the Lens of Agency


Bernard S Sharfman
Senior Corporate Governance Fellow at RealClearFoundation, and Research Fellow with the Law & Economics Center at George Mason University's Antonin Scalia Law School


Time to read

8 Minutes

The creation of the index fund is one of the greatest innovations in financial history. However, like the relationship between a board of directors and shareholders, there is the potential for agency costs.  This potential is the result of an agency relationship that is formed when the dominant asset managers in the market, BlackRock, Vanguard, and State Street (the Big Three), are entrusted with assets that are beneficially owned by index fund investors. Of particular interest to me are the agency costs that result from the Big Three’s delegated voting authority.  These are the agency costs that I analyze in my new paper, 'Opportunism in the Shareholder Voting and Engagement of the ‘Big Three’ Investment Advisers to Index Funds'.

Moreover, the Big Three are uniquely positioned to act opportunistically because each utilizes an investment stewardship team to coordinate the voting of their fund families and engagement with portfolio companies.  For example, a team can systemically integrate many of its company’s own interests into its voting and engagement activities: the adviser’s need to successfully implement its millennial marketing strategy, the adviser’s strategy to maximize its government support and thereby minimize regulatory risk, the adviser’s strategy to increase the market share of private pension fund assets held under management at their portfolio companies, and the adviser’s strategy to appease its own activist shareholders.  In this way, the Big Three can utilize their delegated voting authority to maximize the profitability of their own investors or the utility of their executive management, but not necessarily the interests of those who invest in the index funds they manage.   

The Interests of Index Fund Investors

Agency costs arise when the interests of the principal and agent diverge. However, trying to identify the interests of index fund investors is no easy task. The Big Three must represent the disparate interests of tens of millions of beneficial investors. If so, then the only reasonable objective for the Big Three to have when using their delegated voting authority is to try and maximize the total value of a fund. Such an approach is called ‘portfolio primacy’ and is to be understood as the ‘lowest common denominator solution’ to the Big Three’s inability to form a coherent picture of the disparate interests of millions of retail investors that would allow the Big Three to ‘coalesce around other objectives’. In sum, if the Big Three are not trying to achieve portfolio primacy (ie maximize investor wealth), then they are acting opportunistically.

Limitations of the Big Three in Voting and Engaging

The potential for opportunism should not be confused with the Big Three’s inability to perform the role of informed voters. The Big Three exist in a super competitive industry with extremely low management fees, providing the Big Three with very little ability to spend resources on becoming informed about portfolio companies.  In sum, the Big Three are not being paid to be informed, only to do as much as they can to serve the interests of beneficial investors when they vote and engage on their behalf. 

Identifying Opportunistic Behavior 

To identify when the Big Three are engaging in opportunistic behavior, it is argued that the absence of a ‘business case’ is the key signal.  That is, those voting and engagement activities where there is a lack of evidence demonstrating that the Big Three are trying to achieve portfolio primacy. For example, a one-size-fits-all voting policy that is not backed by rigorous empirical research demonstrating that the overall value of the index fund should be expected to go up in value. Without such empirical evidence, there is no business case for the voting policy. 

The temptation, of course, is to cherry pick the empirical studies so as to support a particular position that may support opportunistic activities.  That said, if used correctly and judiciously, rigorously executed empirical studies can legitimately support the Big Three’s use of certain one-size-fits-all voting policies. For example, in a recent survey by Alon Brav, Wei Jiang, and Rongchen Li, they identify a large number of rigorously executed empirical studies showing that ‘traditional’ hedge fund activism is wealth enhancing for investors. 

The Default: Deferring to the Board of Directors

In the absence of rigorous empirical studies to support a one-size-fits-all voting policy or from time-to-time making the significant investment required to become informed regarding a particular vote, the only practical way for the Big Three to implement ‘portfolio primacy’ is to implement a general policy of deferring to board voting recommendations and decision-making at the portfolio companies whose stocks make up an index fund. The board, as advised by executive management, is the most informed locus of authority at a public company. For a Big Three member not to defer to board authority without being informed would be evidence of opportunistic behavior. 

It is true that significant bias may exist in some board recommendations. However, the Big Three, being uninformed about portfolio companies, will never know this for sure, requiring them to trust the board to use its position as the most informed locus of authority in the company for purposes of obtaining portfolio primacy.

The Calculus of Opportunism

Since the Big Three are generally uninformed, they cannot enhance the value of the stock market through their uninformed voting and engagement. Instead, they focus on enhancing market share. This is where they get the most ‘bang for the buck’. The successful implementation of a marketing strategy, as reflected in an increased market share of a U.S. stock market currently valued at around $50 trillion, provides an opportunity for the Big Three to potentially acquire trillions of dollars of assets under management (AUM) without having to become informed. This is the business strategy that academic scholars have so far missed in their understanding of Big Three voting and engagement.

For example, to support the Big Three’s millennial marketing strategy, the Big Three, individually or as a group, may be tempted to vote in a way that increases market share, ie voting in a way that appeals to millennials, without much regard for how it may impact the value of a portfolio of stocks found in an index fund. This is because an expected small positive movement in market share will, in terms of AUM, overwhelm any expected loss in the value of an index fund or family of funds from their voting and engagement. Therefore, given the potential for such great rewards, it is argued that there is also great potential for opportunistic behavior in order to facilitate the success of this strategy.

Engine No. 1

Perhaps the most blatant example of opportunism associated with the Big Three’s millennial marketing strategy can be found in their support for Engine No. 1’s ‘non-traditional’ hedge fund activism.  Despite having only $40 million worth of ExxonMobil common stock in hand and no specific recommendations to enhance shareholder value or move the company into profitable low carbon emissions, Engine No. 1 was still able to convince enough ExxonMobil shareholders to elect three of its four nominees to ExxonMobil’s board of directors. BlackRock voted for three of these nominees while Vanguard and State Street voted for two of them. 

This was an astonishing accomplishment given that the lack of specific recommendations was a clear signal to ExxonMobil shareholders, including the Big Three, that Engine No. 1 was not informed about the operations and strategies of ExxonMobil and what was necessary to make it a more successful company.

Engine No. 1 succeeded because it focused on gaining the support of the Big Three. The Big Three owned approximately 21% of ExxonMobil’s voting stock, a percentage that probably understated their actual voting power. To garner the Big Three’s support, Engine No. 1 cleverly appealed to their desire to be perceived as investment advisers who are making a difference in helping to mitigate climate change, an important issue for millennials. In order to ‘walk the talk’ it appeared that they ended up supporting Engine No. 1 without a business case. 

A Market Solution

To mitigate the issue of Big Three opportunism it would be desirable for the markets to simply self-correct. But, as Griffith argues, rational apathy does not make this a practical approach for millions of beneficial investors. That is, they will have no interest in having to evaluate and vote on thousands of matters per year. 

Nevertheless, we can envision an alternative market solution. This would require beneficial investors to demand that index funds provide them with the option of conforming their proportional voting interest, as represented by their percentage of ownership in a specific index fund, to a requirement that when voting occurs, the investment adviser is to vote according to general voting guidelines approved by the beneficial investor. For example, this could be a simple check-the-box approach on the part of the investor, whether retail or institutional, directing the fund to: 1) abstain from all voting; 2) vote according to the voting recommendations provided by the portfolio company’s board of directors; or 3) defer to the discretion of the investment adviser.

Fiduciary Duties

Even if a check-the-box approach is available to investors, many investors, including the overwhelming majority of retail investors, will still prefer that the Big Three vote on their behalf. If so, then fiduciary duties are needed because there is no way that beneficial investors, the principals, can adequately monitor the voting and engagement activity of the Big Three, their agents. Such duties will act as a deterrent to Big Three voting that is not in the best interests of these investors. The fiduciary duties of the Big Three can be enforced under two statutes in the US, the Employee Retirement Income Security Act (ERISA) and the Investment Advisers Act of 1940  (Advisers Act).

A.  Fiduciary Duties Under ERISA

In general, the Big Three, as investment advisers to mutual funds and ETFs, do not have fiduciary duties under ERISA unless they directly manage all or part of an ERISA retirement plan. This makes the application of fiduciary duties indirect, working through the EIRSA plan manager.

An ERISA plan manager has a fiduciary duty, the duty of prudence, to investigate an investment adviser’s shareholder voting and engagement with portfolio companies. This duty applies not only to the mutual funds or ETFs that an ERISA plan invests in but also to those fund selections that it makes available to its participants and beneficiaries in self-directed accounts. The fiduciary objective in this investigation is to ensure that an investment adviser, such as a one of the Big Three, is utilizing shareholder voting and engagement consistent with a plan manager’s duty of loyalty under ERISA; that is, ‘solely in the interest of the participants and beneficiaries’ and for the exclusive purpose of providing financial benefits to them. If that is not happening, these funds should be excluded from an ERISA plan.

B. Fiduciary Duties Under the Investment Advises Act of 1940

Under the Securities and Exchange Commission’s ‘Proxy Voting Rule’, the investment adviser has the fiduciary duty to execute its delegated voting authority to be executed ‘in a manner consistent with the best interest of its client and must not subrogate client interests to its own’. Therefore, it would not be unreasonable for the SEC to require investment advisers with delegated voting authority to be ready to demonstrate how their shareholder voting and engagement has met the preferences of fund investors. 

In terms of index funds with many investors, guidance should require how the voting of investment advisers, including the Big Three, meet the requirement of portfolio primacy unless it can be clearly demonstrated that this is not the optimal objective for these investors.  Such guidance should focus both on voting policies and individual votes on such items as proxy contests. 

Bernard S. Sharfman is a Senior Corporate Governance Fellow at RealClearFoundation, and a Research Fellow with the Law & Economics Center at George Mason University’ s Antonin Scalia Law School.

The research associated with Mr. Sharfman's article, 'Opportunism in the Shareholder Voting and Engagement of the ‘Big Three’ Investment Advisers to Index Funds,' was supported by a grant from the Law & Economics Center.


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