Are The Big Index Shops Too Kind to U.S. CEOs? by David Winters and Liz Cohernour originally posted Barron’s
The rush of money into index equity funds has officially ballooned into a market mania. Trillions of ordinary investors’ dollars are now committed to a mechanistic strategy that simply buys stocks without a thought for their actual value.
Students of market history know that index mania – like other market fads before it – will end badly. But investors continue to pour dollars into index funds in the gravely mistaken belief they’re enjoying a virtually “free lunch.”
The sad reality is that index funds have turned ordinary investors into the pawns in a game that undermines the integrity of American markets and imposes costs on society that don’t show up in index fund expense ratios. We believe that one consequence of this is that billions of dollars of value created by American companies are being diverted to a select few executives while ordinary investors, distracted by “low fee” hype, are subjected to dangerous risk concentrations in their retirement portfolios.
The massive assets of Big Index — Vanguard, BlackRock and State Street – make them the largest block of shareholders in America’s largest publicly traded companies, holding an average of 16% of the shares outstanding of the top 25 companies in the S&P 500.
When we analyzed the votes by the leading S&P 500 index funds run by Vanguard, BlackRock and State Street over the past five years for the 25 largest companies in the S&P 500, we found that Big Index cast their votes in favor of equity compensation plans 89% of the time, and opposed executives’ pay packages less than 4% of the time. Vanguard voted in favor of directors 99% of the time. State Street had a perfect 100% record on ratifying executive pay. (Figure 1.)
Meanwhile, index hype creates an illusion of safety and diversification that we believe leads ordinary investors to take on a dangerously high concentration of risk in their investment portfolios. By Wintergreen’s estimate, the top 25 securities by market value in the S&P 500 in 2014 contributed over 33% of the index’s total return, while the top 25 securities by performance contributed 55% of the index’s total return. Apple, Microsoft, Facebook and Intel alone accounted for over 20% to the total return of the S&P 500 in 2014.
This momentum-driven style of passive investing has worked wonderfully over the past six years, as the U.S. market has been on a nearly relentless upward trajectory. But what will happen to investors when the music stops? We believe that the same small group of companies that have led the markets rise will likely be among the biggest losers, as passive funds are forced to sell the largest and most liquid names in the index. When the market turns, investors who were seduced by the illusion of safety and “low fee” hype will discover that they took on far more risk than they realized.
Index mania has been a boon for executives of companies in the index, whether or not these executives are delivering real shareholder value. Flows into Big Index’s fund products that tend to vote with management means a significant block of the shareholders in an S&P 500 company can generally be counted on to support executive compensation packages even when shareholders are receiving meager returns. It’s no coincidence to us that the sharp rise in executive pay in recent years parallels the growth in passive investment products. (Figure 2.)
Successful CEOs who are delivering superior returns for shareholders deserve appropriate compensation. But it’s clear that underperforming CEOs can reap undeserved and excessive rewards in a governance environment heavily influenced by index fund managers that are unwilling to address problematic pay plans and entrenched boards.
It does not have to be this way. In early 2014, after reading Coca-Cola’s proxy statement, we sounded the warning that Coca-Cola was set to pull off a “Big Grab” through a wildly excessive equity compensation plan for top Coca-Cola executives. Even though Coca-Cola shareholders ultimately approved the equity compensation plan, our concerns were heard by many Coca-Cola shareholders, including State Street, which voted its clients’ shares against the plan. Coca-Cola voluntarily modified its equity compensation plan to reduce the plan’s dilutive effects on shareholders.
What can ordinary investors do? We believe they should hold the managers of their mutual funds to a high standard. They should ask the management company for its proxy-voting record on key issues like executive compensation, board membership and quality of governance. By making their voices heard, they can play a role in ensuring that our markets create wealth for everyone.
David Winters is CEO and Cohernour is COO of Wintergreen Advisers, a mutual fund company based in Mountain Lakes, N.J. Many of the statements in this article reflect our subjective belief and the information contained herein is not and should not be construed as investment advice.