The Party Structure of Mutual Funds

Ryan Bubb and Emiliano Catan are Professors of Law at New York University School of Law. This post is based on their recent paper. Related research from the Program on Corporate Governance includes The Agency Problems of Institutional Investors by Lucian Bebchuk, Alma Cohen, and Scott Hirst (discussed on the Forum here); Index Funds and the Future of Corporate Governance: Theory, Evidence, and Policy by Lucian Bebchuk and Scott Hirst (discussed on the forum here); and The Specter of the Giant Three by Lucian Bebchuk and Scott Hirst (discussed on the Forum here).

To understand corporate governance in the United States, one must understand the voting behavior of mutual funds. In our paper The Party Structure of Mutual Funds, we develop the first systematic account of the structure of mutual fund preferences over corporate governance. We focus on two basic questions. First, what are the main ways in which mutual funds differ in their corporate governance preferences, as reflected in how they vote? Second, given that variation in voting behavior, what are the characteristic “types” of mutual funds in terms of their corporate governance philosophies?

To answer these questions, we use a comprehensive sample of mutual funds’ votes on 181,951 proposals from 5,774 portfolio companies by 4,656 mutual funds, covering the years 2010-2015. We apply a set of unsupervised machine learning techniques to the data to distill the key patterns in how mutual funds vote.  First, we apply a type of principal components analysis to summarize each mutual funds’ voting behavior in terms of their location in a two-dimensional “preference space.” Figure 1 below plots funds’ locations. Each dot represents a mutual fund, and we also mark with triangles the average location of the funds advised by each of a set of prominent advisors.

Figure 1

The distribution of fund scores in this two-dimensional preference space takes a triangular shape, with a group of funds clustered around each of the three vertices of the triangle. Management is located near the lower-left vertex, and several of the very largest fund advisors are located in the same cluster of funds. The leading proxy advisor, ISS, is located near the lower-right vertex of the triangle, and the second leading proxy advisor, Glass Lewis, is likewise located near the upper-left vertex.

The first dimension of our estimated preference space primarily captures the tendency of funds to oppose (support) management when the leading proxy advisor, ISS, recommends against (in favor of) management but its main competitor, Glass Lewis, does not. It thus captures fund voting behavior for proposals on which the two proxy advisors disagree. In contrast, dimension 2 primarily captures funds’ tendency to vote in line with Glass Lewis’s recommendations, irrespective of ISS’s recommendations. These findings show that the corporate governance philosophies tracked by the recommendations of the two leading proxy advisors underlie the main ways mutual funds differ in their voting behavior.

Second, we apply cluster analysis to identify three main groups of mutual funds, shown in Figure 2, in terms of how they vote. We conceptualize these groups as mutual fund “parties” and show that they are a fundamental feature of mutual fund voting. For example, for most proposals with at least a minimal amount of disagreement among mutual funds, the majority of one party was opposed to the majority of the other two parties. Driving these disagreements between the parties are distinctive patterns in their voting behavior, on the basis of which we label them the Traditional Governance Party, the Shareholder Reform Party, and the Shareholder Protest Party.

Funds in the Traditional Governance Party—which is by far the largest party in terms of assets under management and includes the “Big Three” passive managers, i.e., BlackRock, Vanguard, and State Street—are distinctly deferential to management on issues that are traditionally understood as matters for the board, and not shareholders, to decide. But members of the Traditional Governance Party are most likely to break with management over proposals that implicate fundamental shareholder rights and proxy contests, reflecting assertions of shareholder power in their traditional domain.

The Shareholder Reform Party, in contrast, opposes management at much higher rates than the other two parties over a range of proposal categories involving targeted requests for reforms to corporate governance. These include proposals on fundamental shareholder rights related to voting, CSR proposals, shareholder proposals on compensation, and proxy contests. The Shareholder Reform Party also casts withhold votes on uncontested director elections in a targeted manner in order to advance concrete governance reforms.

Finally, the Shareholder Protest Party opposes management at much greater rates than the other two parties on uncontested director elections and on say-on-pay votes. These votes amount to symbolic “protest” votes—they are effectively nonbinding—that voice general displeasure with management rather than request specific reforms, hence our label for this party.

Figure 2

We then investigate the factors that shape mutual funds’ party membership. We find that funds under investment advisors that have stronger incentives to do their own research for voting are more likely to be members of the Traditional Governance Party and less likely to be members of the Shareholder Reform Party. A proxy for whether the investment advisor takes a “compliance approach” to voting, based on the titles of the executives in charge of voting at the advisor, strongly predicts party membership, particularly for passive advisors. Most strikingly, among funds in our three parties, almost all of the funds advised by passive advisors that our proxy indicates follow a compliance approach are members of either the Shareholder Reform Party or the Shareholder Protest Party. In contrast, almost all funds advised by passive advisors that do not use compliance language in their proxy executives’ titles are members of the Traditional Governance Party. This suggests that party membership among passive advisors in large part reflects advisors’ decisions whether to outsource to proxy advisors in order to economize on the costs of voting.

Our characterization of the party structure of mutual funds provides a new perspective on institutional investors’ voting behavior that sheds light on important corporate governance issues. Consider, for example, the rise of passive management. The ongoing shift away from active management and toward passive management has led to concerns that passive managers are likely to do a poor job monitoring corporate management (Bebchuk and Hirst, 2019). Concerns about the incentives of passive managers has led to calls by some scholars to strip passive managers of their right to vote corporate shares (Lund, 2018).

Our framework provides a richer and more nuanced account of this phenomenon: large passive advisors are more likely to be members of the Traditional Governance Party. While it is true that the Traditional Governance Party supports management at greater rates than the other two mutual fund parties, we characterize more specifically the corporate governance philosophy and voting behavior of the party. We show that the Traditional Governance Party is distinctly deferential to management on operational matters that are traditionally understood as within the province of the board, rather than shareholders. In contrast, the Traditional Governance Party commonly breaks with management on proposals related to fundamental shareholder rights—entailing efforts to change the company’s basic corporate governance rules (e.g., proposals to declassify the board or to adopt dual-class structures)—and proxy contests. This suggests that the shift toward passive management does not portend a new era of managerial entrenchment through shifts in fundamental governance rules or unreflective opposition to shareholder dissidents’ efforts to challenge corporate management.

The full paper is available for download here.

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