Economy and Society: Passive fund ownership of US stocks overtakes active—for first time

Economy and Society is Ballotpedia’s weekly review of the developments in corporate activism; corporate political engagement; and the Environmental, Social, and Corporate Governance (ESG) trends and events that characterize the growing intersection between business and politics.

ESG Developments This Week

In Washington, D.C.

Goldman Sachs in the SEC’s crosshairs?

As the Securities and Exchange Commission (SEC) begins to ramp up its ESG-fund enforcement in earnest, it appears to have a major Wall Street player in its sights. According to a Wall Street Journal report published June 10, sources have indicated that the SEC’s year-long plan to enforce ESG claims among ETFs and other mutual funds is entering a new phase with the investigation of Goldman Sachs​​SEC Commissioner Gary Gensler’s one-time employer:

“The Securities and Exchange Commission is investigating Goldman Sachs GS Group Inc.’s asset-management arm over its funds that aim to invest based on environmental, social and governance standards, according to people familiar with the matter.

The SEC’s probe is the latest known instance of regulators’ scrutiny of ESG investing, which has been a boon for asset managers that struggled in recent years to compete with low-fee index funds.

The SEC’s civil investigation is focused on Goldman’s mutual-funds business, the people said, and the firm manages at least four funds that have clean-energy or ESG in their names. The probe could end without formal enforcement action….

The SEC last year warned investors that it found some fund holdings “predominated” by companies with low ESG scores, despite the fund manager’s advertised commitment to picking companies that performed well on ESG screening tests. Data vendors such as S&P Global and London Stock Exchange Group’s Refinitiv score public companies on ESG standards, but the grades can vary widely between ratings firms.

Goldman renamed its Blue Chip Fund as the U.S. Equity ESG Fund in June 2020. The fund’s top three holdings—Microsoft Corp., Apple Inc., and Alphabet Inc.—-have remained the same since then, according to regulatory filings. The U.S. Equity ESG fund’s other top holdings currently include Bristol-Myers Squibb Co., Eli Lilly & Co., and JPMorgan Chase & Co., according to its website. It is a relatively small fund, with $17.8 million in assets under management, according to Morningstar data.

In early 2021, the SEC launched an enforcement task force that sifts through public data and tips for potential enforcement cases related to greenwashing—making deceptive or empty claims about environmental or social values—or similar misleading statements related to ESG practices….

Because the SEC doesn’t yet have rules that dictate what ESG investing means or requires, any enforcement action would need to focus on a fund’s past disclosure, and whether its investing practices materially deviated from what it advertised to shareholders.”

The Index Act and its critics

For at least two years, opponents of ESG have made the case that one of the biggest problems with the investment tactic is that, in their view, it is, almost by definition, undemocratic. Large asset management firms, they argue, create various types of mutual funds into which small investors (individuals and institutions) can buy. But while the investors own shares of the fund, the fund and its manager own the underlying securities (i.e. the stocks). In turn, the argument goes, this gives the managers/shareholders the power to exercise the attendant shareholder rightsincluding the power to vote the shares at annual meetingsimplicit in the securities, at the expense of the fund owners’ presumed rights. That allows large fund managers to accumulate and exercise power using other people’s money.

With the rise of ESG, however, critics have noted what they view as a disparity between the desires and intentions of the managers and those of their customers, leading to the perception that fund managers may not always be acting as fiduciaries and may, in fact, be usurping the customers’ rights for their own personal or political ends.

Recently, this purported discrepancy has become policy fodder, as some in Congress have taken an interest in removing voting rights from fund managers and returning them to fund owners through the introduction of a proposed bill known as the Investor Democracy Is Expected Act, also styled the Index Act. 

But even this may not solve any of the fundamental perceived problems with ESG, at least according to Vivek Ramaswamy, the author of Woke, Inc. and the founder of Strive Asset Management, and Riley Moore, the Treasurer of West Virginia, who, last week, penned an op-ed on the subject for The Wall Street Journal:

“Senate Republicans recently introduced the Investor Democracy Is Expected Act, also styled the Index Act, which would require passive investment-fund managers that own more than 1% of a public company to collect instructions from their clients on how to vote their shares. The senators are right to focus on a major problem: The three largest passive asset managers control more than $20 trillion and vote nearly one-quarter of all shares cast at corporate annual meetings to support social agendas disfavored by many Americans whose money they manage.

But as long as BlackRock, Vanguard and State Street represent the largest shareholders of America’s public companies, they will disproportionately influence the behavior of those companies, regardless of whether their clients regain the power to vote their shares.

As a practical matter, most individual investors in index funds can’t cast informed votes at the shareholder meetings of portfolio companies. An individual investor in Vanguard’s total stock-market index fund would have to cast tens of thousands of votes each spring for the stocks held in that fund alone.

Further, the capital managed by BlackRock, State Street and Vanguard is often allocated to these firms not by individuals but by intermediaries such as state and employee pension funds. These institutions generally take their voting directions from two firms, Institutional Shareholder Services and Glass Lewis, which openly embrace the same political orthodoxies as the big three asset managers.

Certain states have already regained voting power from the big three, yet early evidence suggests they have performed poorly on voting in accord with their citizens’ wishes. According to Insight ESG Energy, a governance watchdog that grades the fiduciary performance and energy literacy of fund managers, BlackRock, State Street and Vanguard earned grades of C-minus, C and C-plus, respectively, for their 2021 voting behavior. Pension funds in Georgia earned an A, but Florida, Texas and Idaho earned grades of D-minus, D and D, respectively.

That’s in part because Florida and two large Texas pension funds last year joined the big three to elect three dissident directors to Exxon Mobil’s board to implement a more aggressive climate-change strategy, after which Exxon Mobil reduced its oil-production targets through 2025 from its earlier forecasts. One of the Texas pension funds also voted for shareholder resolutions requiring banks to restrict financing to new fossil-fuel projects. As Texas’ democratically elected Lt. Gov. Dan Patrick has observed, it strains credulity to believe that the votes accurately represent the intentions of Texans and Floridians whose money is invested in these pension funds.

Most importantly, shareholder voting itself represents only the tip of the iceberg in shareholder-led social advocacy, because very few corporate decisions require a shareholder vote. BlackRock boasts that in the first quarter of 2022 alone, it “engaged” 719 public companies on topics including “climate risk management, environmental impact management, human capital management, and social risks and opportunities.” BlackRock CEO Larry Fink writes an annual letter to America’s CEOs. In this year’s letter, he demanded that they set “short-, medium-, and long-term targets for greenhouse gas reductions” and “issue reports consistent with the Task Force on Climate-related Financial Disclosures.” In his 2020 letter, he told portfolio companies to publish disclosures in accordance with the Sustainability Accounting Standards Board.

These informal yet heavy-handed forms of advocacy are often more influential than shareholder votes. 

The aggregation of capital in the hands of three firms—and the associated power to shape corporate America’s social agendas—is an anticompetitive problem that demands a competitive market solution. One of us (Mr. Moore) is a state treasurer who has taken steps to cut ties with large asset managers that fail to advance the interests of his state’s citizens. This is a type of market response: State treasurers aren’t market regulators, but they are market participants who allocate capital on behalf of their constituents. Moving money has a greater impact than reclaiming voting power.

A key limitation remains: the absence of large asset managers that take different approaches to shareholder advocacy. Invesco, the fourth-largest U.S. provider of exchange-traded funds, now makes declarations resembling those of BlackRock: “Asset managers have a crucial role to play in supporting investment aligned with global efforts to reduce the impact of climate change on our planet”; ESG—an acronym for environmental, social and governance—“is something that’s fundamental to investing”; “we’re well down the path of embedding ESG in everything we do.” The big three may soon become the big four.

That’s why one of us (Mr. Ramaswamy) recently created an asset manager that guides companies to focus exclusively on product excellence, not politics. More competitors are needed.”

On Wall Street and in the private sector

Financial Times: “Passive fund ownership of US stocks overtakes active for first time”

As noted above, most ESG investment is handled through various mutual funds, including index trackers and Exchange Traded Funds (ETFs), which are both passive investment vehicles. The major passive investment playersBlackRock, State Street, and Vanguardare the three firms most often cited by opponents of ESG for what they deem their undue influence on the investment process and the centralization of capital in too few hands. Vivek Ramaswamy and Riley Moore, for example, critique these three specific firms for their stranglehold on the market.

Despite the rise of what some label as the massive passives over the last decade, most investment in U.S. capital markets has remained in the hands of active investorsuntil now.  The Financial Times reports:

“Passively managed index funds have overtaken actively managed funds’ ownership of the US stock market for the first time, data show.

Passive funds accounted for 16 per cent of US stock market capitalisation at the end of 2021, surpassing the 14 per cent held by active funds, according to the Investment Company Institute, an industry body.

The pattern represents a sharp reversal of the picture 10 years ago, when active funds held 20 per cent of Wall Street stocks and passive ones just 8 per cent.

Since then, the US has seen a cumulative net flow of more than $2tn from actively managed domestic equity funds to passive ones, primarily ETFs….

The seemingly unstoppable rise of index-tracking funds has in turn helped fuel an unprecedented concentration of ownership — and thus voting power.

The five largest mutual fund and exchange traded fund sponsors — out of 825 in all — accounted for 54 per cent of the industry’s total assets last year, the ICI found, a record high and up from just 35 per cent in 2005.

The 10 largest control 66 per cent of assets (against 46 per cent in 2005) and the top 25 as much as 83 per cent, up from 67 per cent. The proportion of assets held by the many hundreds of managers outside the elite 25 has thus halved over the period.”

In the spotlight

MSN: “Edelman CEO advice to other top execs: Beware of the ‘pushback against wokeness’”

Richard Edelman, CEO of Edelman (a public relations company), recently issued a warning to companies and their executives about taking too prominent a role in politics, suggesting that getting too involved often leads to negative impacts for the company.

“With an ongoing war in Europe, an ongoing public health crisis, and various social issues gripping America, corporate executives increasingly find themselves facing questions from employees about whether or not they plan to take a stand. 

But if CEOs were to take a stand against this backdrop, according to Edelman CEO Richard Edelman, it shouldn’t be representing the company.

“They should speak out as citizens, but they shouldn’t speak out as CEOs,” Edelman recently told Yahoo Finance at the World Economic Forum in Davos, Switzerland (video above). “And the CEO position, again, this remit of issues can expand beyond the long length of my arm. And we better be careful here because there’s starting to be a pushback against wokeness.”…

“You have to put priority on those [issues] that are directly affecting your business,” Edelman said. “Again, supply chain or health of your employee base. But on ones where it’s a matter of personal choice, leave that for your personal politics and donations to senators. But your mandate as the CEO is to stand up and speak up only on those issues where you actually can add value.””