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Jeffrey Manns

Abstract

America’s mutual fund governance has long consisted of a system of money manager dominance and shareholder impotence. While mutual funds pool together unprecedented sums of capital, investors historically have had no meaningful role in governance and have faced a choice of “love it or leave it” when it comes to their investments in mutual funds.

The controversy over mutual fund managers’ advocacy of Environmental, Social, and Governance (ESG) principles in portfolio companies has reinvigorated interest in repairing the dysfunctional principal-agent relationship between investors and money managers. The management of BlackRock, the world’s largest money manager, ignited an ESG voting controversy by championing unfettered managerial discretion to vote portfolio company shares. Leaders at the two other largest asset managers, the Vanguard Group and State Street, followed in BlackRock’s footsteps in embracing broad managerial discretion related to ESG issues.

But in the face of a shareholder backlash, each of the “Big Three” mutual funds has backed down from unilateral voting decisions. They have introduced variants of “Bounded Choice” approaches that allow mutual fund shareholders to choose how their individual shares will be voted from preset categories of managerial voting guidelines. While well intended, these “Bounded Choice” approaches to portfolio voting fracture the voting power of mutual funds and strip the funds of their potential impact on the corporate governance of portfolio companies.

I argue that BlackRock’s initial logic was right that mutual funds should speak with one voice when it comes to their portfolio companies because they have out-sized stakes and risks. But I argue that mutual funds should recognize their principal-agent relationship with shareholders in a more democratic way. The voice of the funds in portfolio company voting should be that of the majority of shareholders rather than of either fractionalized shareholders or largely autonomous managers.

I make the case for an annual, majority-wins Say-on-Voting approach, which would give investors the ability to approve or reject the managers’ voting guide-lines for the funds’ shares in portfolio companies. The logic of giving investors veto power over managers’ voting guidelines is to vest oversight and accountability back in the hands of the investor principals, rather than their agents. If managers cannot gain majority support for their voting guidelines, the default would be for portfolio shares not to be voted (except for quorum purposes), an outcome that would be consistent with the passive nature of most index and exchange-traded funds.

The need to gain majority investor support for voting guidelines would incentivize mutual fund managers to make the case for voting guidelines more clearly to their investors. The point of mutual funds is that investors want to rely on the expertise of money managers in overseeing their money. But investors should not be stripped of their status as principals in the process and be reduced to completely passive partners. The hope is that addressing these governance and agency issues may actually reduce the politicization of ESG and other substantive issues by incentivizing investors to be better informed and more engaged in mutual fund democracy.

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