By Dr. Massimo Massa, Rothschild Chaired Professor of Banking and Finance, INSEAD, and Dr. Lei Zhang, Associate Professor of Finance, City University of Hong Kong
One of the realities of today’s financial markets is the outsized shareholder voting power wielded by the top mutual funds. As of 2021, the three major asset-management companies (BlackRock, State Street and Vanguard) held approximately 23 percent of S&P 500 (Standard and Poor’s 500) firms. This made them the predominant shareholders in 88 percent of the leading companies in the United States.
Concerningly, it appears that top asset managers prioritise using their shareholder voting power to appease politicians and regulators rather than to hold underperforming companies accountable. They show a willingness to actively shift their voting preferences to align with the prevailing political climate in Washington, D.C.Specifically, top asset managers seem to react to political and social pressures by engaging in a “political game”, adapting to the evolving political dominances of US lawmakers. We contend and substantiate that political and regulatory scrutiny compels large asset-management firms to engage in political conformity, resulting in what we term stewardship theatre, whereby voting behaviours are intentionally tailored to the prevailing political leanings.
We begin with three key observations. First, for fund managers, active stewardship offers minimal financial incentives but carries substantial political implications. Several factors contribute to this situation. While the costs associated with active stewardship are significant, the benefits are relatively modest and must be shared among multiple funds holding the same stocks, which also compete in performance metrics and benchmarks. Additionally, fund managers risk potential losses on their bond investments, which could be adversely affected by the outcomes of their stewardship actions
. Furthermore, in the case of events such as mergers and acquisitions (M&As), fund managers face conflicts of interest because they hold equity in both the acquiring and target companies. Conflicts of interest may also arise when managing 401(k) accounts for large corporations, which can reduce fund managers’ incentives to challenge management decisions.
A second observation is that while centralised voting by asset-management companies appears to be the norm, stewardship teams often operate with surprisingly small sizes, suggesting minimal research and monitoring efforts relative to the significant stakes involved. Centralised voting is likely influenced by “external” stakeholders who exert significant sway over voting decisions. One such influence comes from proxy advisors, such as Institutional Shareholder Services (ISS), which offer recommendations they claim are based on “best governance practices”.
Another influential factor is political and regulatory scrutiny, which may create administrative obstacles, increase regulatory burdens and drive up management costs. We argue that asset-management firms tend to align with the prevailing political preferences of lawmakers and regulators. They may do so by using their stewardship reports. These reports typically emphasise metrics such as the number of engagements, decisions taken, shareholder and management proposals addressed and instances when they voted against management (for example, BlackRock Investment, 2022). This provides a way for the asset-management company to signal their “alignment” with the “political mood”.
The third observation is that major mutual-fund companies engage in lobbying and political activities primarily to avoid regulatory scrutiny from lawmakers. Potential regulations could encompass mutual-fund industry oversight, disclosure requirements, operational constraints, fee structures and antitrust measures aimed at curbing the dominance of large asset-management firms and their creation of “systemic risk” to the whole economy. Top asset managers usually face far greater scrutiny from lawmakers due to their sheer size and influence. After all, BlackRock alone accounts for around US$10 trillion in managed assets; that’s more than is traded on the New York Stock Exchange (NYSE). It is little wonder that US financial regulators such as the United States Securities and Exchange Commission (SEC) and the Federal Trade Commission (FTC) keep a close eye on their activities, including how their fund managers vote. Indeed, mutual funds are already heavily regulated, although in many cases, regulations are tightened or relaxed by regulatory bodies with commissioners appointed by the president on the advice and consent of the United States Senate. Their focuses and attitudes towards regulating the asset-management market are, therefore, influenced by the political party in charge. At the same time, the United States Congress is responsible for introducing numerous bills directly related to the financial sector.
Regulatory initiatives can either benefit or hinder top asset managers, depending on their capacity to influence and adapt to regulatory changes. Small institutions may even resist such regulations more vigorously, viewing them as barriers to entry, while larger institutions with greater resources to comply and influence policy may be less impacted and see them as useful deterrents to potential competitors. However, antitrust measures aimed at curbing the dominance of large asset-management firms and their creation of “systemic risk” to the whole financial market are expected to disproportionately impact the largest asset-management groups, which are under closer public scrutiny and likelier targets of legislative attention. Therefore, given that the fear mostly surrounds curbing the dominance (and the systemic-risk implications) of large asset-management firms, the incentive to engage in stewardship theatre—where voting behaviours reflect political motivations—is strongest for top asset-management companies closely connected to political power centres. It clearly does these funds little harm to be seen as actively supporting the political ideologies of the lawmakers in power. Doing the opposite may run the risk of prompting greater scrutiny and stricter regulations.
We focused on the voting behaviours of US mutual funds over the 17-year period between 2004 and 2021. In particular, we looked at how fund managers voted on sensitive (and potentially political) shareholder proposals relating to environmental and social issues and how this behaviour altered depending on which political party was in control of the U.S. Congress.
Overall, support for environmental and social proposals was low, with less than 30 percent of leading funds voting in their favour during this period. However, what our study found was that how fund managers voted shifted at specific times to reflect the shifting balance of political power. Political conformity in voting behaviour has been mostly concentrated among the top 10 biggest mutual-fund groups. In fact, they were much more likely to vote in line with the political majority than smaller funds. This suggests their size and clout made them more subject to political pressures and gave them greater incentives to lobby politicians, further increasing their ability to align with the current political mood. For example, during periods when the Democrats were in power, asset managers from the leading mutual funds were 30.33 percent more likely to vote in favour of stronger environmental and social proposals. Yet this figure slipped to just 22.97 percent when there was a split majority in Congress and plummeted to just 17.25 percent when the Republicans were in power.
Even in today’s online world, physical proximity clearly offers the chance for greater access and potential influence. And, indeed, location was also a factor in how fund managers voted. Those firms based closest to the corridors of power in Washington were even more likely to vote in line with the party in charge. The access offered by the physical closeness to the political movers and shakers allowed these funds to be more attuned to the prevailing political preferences at any given time.
Demonstrating that these actions were politically motivated is the fact that this behaviour was not observed when we analysed voting patterns for non-political shareholder proposals—in other words, those unrelated to environmental and social issues. Importantly, this was regardless of proxy advisors’ voting recommendations, which typically suggest voting in a certain way based on the best financial outcome for shareholders. It was also regardless of the individual fund manager’s personal political beliefs. Instead, they voted to gain the fund family the most political capital. Further, a desire to conform to the political power most likely to craft regulation was underlined by the general disregard for state politics. The party affiliations of the state governors of the underlying portfolio firms’ headquarters did not impact asset managers’ voting behaviours. Political conformityhas been undertaken to curry favour with Washington lawmakers.
The challenge is how to deal with the stewardship theatre voting behaviours of top asset managers. Given the increase in political polarisation in the US, our findings have important policy implications for future regulations. Unlike the more transparent political influencing that comes from giving direct financial donations to individual parties, this behaviour is more subtle. Fundamentally, it’s a question of how to regulate the lobbying or political activities of asset-management companies. Clearer disclosures of such behaviour would be one solution, but it’s perhaps naïve to believe that’s something mutual funds would undertake willingly.
The upcoming US election offers the real possibility of a change in the prevailing political party in Washington. It seems likely that it may also lead to very different voting behaviours among the top US mutual funds as they shift their allegiances and maintain their political influences.
Dr. Lei Zhang is an Associate Professor of Finance at the City University of Hong Kong (CityU). He received his Bachelor’s and Master’s degrees from Fudan University and his Ph.D. degree from INSEAD. His research interests include credit markets, banking, institutional investors, risk management and international finance. He has published papers in leading finance, management, accounting and economics journals.