Are Mutual Funds Active Voters? via SSRN
Pennsylvania State University – Department of Finance
April 15, 2014
Review of Financial Studies, 2015
Mutual funds vary greatly in their reliance on proxy advisory recommendations. Over 25% of funds rely almost entirely on ISS recommendations, while other funds place little weight on them. Funds with higher benefits and lower costs of researching items up for vote are less likely to rely on ISS. These actively voting funds are less likely vote in a ‘one size fits all’ manner and they earn higher alphas, consistent with benefits from this allocation of resources. For the underlying firms, the presence of actively voting funds mitigates the influence of ISS and helps sway shareholder votes toward value-maximizing outcomes.
Are Mutual Funds Active Voters? – Introduction
“I … have grave concerns as to whether investment advisers are indeed truly fulfilling their fiduciary duties when they rely on and follow recommendations from proxy advisory firms.” – Daniel M. Gallagher, SEC Commissioner, July 11, 2013.
Mutual funds are required to vote their shares of portfolio companies in the best interests of the funds’ shareholders. For each individual fund, the costs of researching each agenda item up for vote in each portfolio company would be substantial. It is thus not surprising that an industry has grown to service this regulatory requirement. Proxy advisory service companies aggregate information across thousands of companies, and they provide background information relevant to the votes and recommendations on the direction in which to vote. While nearly every mutual fund relies on these proxy advisory service companies for some information, the extent of reliance varies greatly. As highlighted by Commissioner Gallagher’s quote above, there is a growing concern that many mutual funds may be relying indiscriminately on the recommendations of proxy advisory service companies, and in so doing may not be fulfilling their fiduciary duty to their clients. The objective of our study is to investigate the extent of engaged voting among mutual funds, and to examine the ways in which this process affects both fund shareholders and the underlying firms. We proceed in three steps.
The first step of our analysis is to empirically estimate funds’ voting strategies. We posit that funds will base their voting strategies on the costs and benefits of ‘active voting’, where active voting is defined as funds independently assessing and evaluating the issues up for vote. As shown by a simple model, funds with higher net benefits of voting will be more likely to actively vote, whereas funds with negative net benefits of voting would find it optimal to follow the recommendation of a proxy advisory service company, for example Institutional Shareholder Services (ISS). We test the model using six proxies for funds’ net benefits of voting, which arguably capture funds’ costs of information collection and benefits of active engagement: fund family size, fund size, location in an area with high fund concentration, fund turnover, percent of fund net assets invested in a firm, and percent of firm equity owned by the fund. Using these proxies, we find strong support for the model’s predictions: among contentious compensation and governance votes the ISS recommendation has little predictive power for funds with high net benefits of voting, but substantial explanatory power among funds with low net benefits of voting. Our analysis highlights the extreme variation in funds’ reliance on proxy advisory service companies.
Our research design enables us to compare the economic importance of funds’ net benefits of active voting with other factors that have been shown to influence fund votes. Consistent with prior literature, we find that the characteristics of the firm and agenda item up for vote are statistically significant predictors of fund votes.1 However, the economic effects of these previously identified factors are swamped by funds’ costs and benefits of active voting. The identity of the voters has substantially more explanatory power than the item on which shareholders are voting.
To better understand the sources of this divergence of opinions between ISS and actively voting funds, we focus on the extent to which the incentives of ISS differ from those of mutual funds. The largest difference in incentives arguably relates to the fact that the mutual funds are owners of the firms in which they are voting, whereas ISS is not. Consistent with this difference, ISS has been accused of trying to minimize costs by issuing ‘blanket recommendations’ where they uniformly recommend For or Against certain governance or compensation policies across all companies. Consistent with these allegations, we find that on many important proposals (e.g., right to call special meeting, require majority vote for directors) ISS nearly always recommends voting against management, whereas actively voting mutual funds are significantly more likely to vote in a firm specific manner. Active fund behavior is consistent with the idea that a ‘one size fits all’ approach to corporate governance is frequently not optimal (see, e.g., Coles, Daniel, and Naveen (2008)).
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