Are Mutual Funds Active Voters?

Posted by R. Christopher Small, Co-editor, HLS Forum on Corporate Governance and Financial Regulation, on Friday January 25, 2013 at 9:12 am
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Editor’s Note: The following post comes to us from Peter Iliev and Michelle Lowry, both of the Department of Finance at Penn State University.

In our paper, Are Mutual Funds Active Voters?, which was recently made publicly available on SSRN, we document that mutual funds vary significantly in how they fulfill their fiduciary duty to vote their shares in shareholders’ interests. Approximately 25% of mutual funds vote with ISS on nearly all company agenda items throughout our five-year sample period. However, many other mutual funds disagree frequently with ISS, particularly on contentious votes. We find that certain types of funds are more likely to find it optimal to incur the costs of evaluating the necessary information to independently assess the items up for vote. For example, large funds and funds from top 5 families can spread the costs over a wider asset base, and low turnover funds are more likely to own the stocks long enough to realize the valuation effects of the vote outcome and any consequent changes in company governance. We would thus expect such funds to be more likely to actively vote. A summary measure of fund activism, which is based on six fund characteristics, highlights the extent to which variation in funds’ costs and benefits of actively voting translates into dramatically different voting patterns. Across a sample of contentious compensation and governance votes, we find that passive funds follow ISS in 86% of the compensation and 77% of the governance votes, compared to analogous rates of only 15% and 19% among actively voting funds. Similarly, across a sample of contentious director votes, passive funds are approximately three times more likely than active funds to follow ISS.

Next, we seek to understand the sources of the divergent opinions. Specifically, we consider two sources of disagreement: the overall level of uncertainty surrounding the firms with items up for vote, and the different incentives of ISS versus actively voting mutual funds. We posit that ISS can minimize costs by adopting algorithms and applying them to all companies, while funds have an incentive to take a case based approach. Consistent with this conjecture, we find that ISS nearly always recommends against management on certain issues (what has been referred to as blanket recommendations), and the extent of disagreement between ISS and actively voting mutual funds is greatest among these issues. In contrast, we find no evidence that the extent of disagreement between ISS and actively voting funds is related to the information environment of the firm.

Further results suggest that mutual funds feel strongly regarding the agenda items up for vote. We find that funds who vote in a direction different than that recommended by ISS or whose vote is contrary to the vote outcome are significantly more likely to sell their shares in the subsequent quarter.

A policy of actively assessing the issues up for vote in portfolio companies requires substantial resources. A natural question is whether these resources are well spent. To assess this issue, we compare the performance of funds that vote with ISS most often with those that vote with ISS least often, i.e., passive voters versus active voters. We find no evidence that actively voting funds are wasting resources. Rather, results suggest that the most passive funds earn lower abnormal returns, though the difference in performance between the passive and active funds is not significant at conventional levels.

While our results suggest that individual funds act rationally in their decisions to vote actively versus passively, we note that the high rates of passive voting are worrisome for several reasons. For example, it has been shown that small differences in votes have a substantial effect on firm policies, that the recommendations of proxy advisory firms are unable to predict future firm valuation or operating performance, and that the recommendations of proxy advisory service firms may be affected by conflicts of interest. The voting mechanism can only mitigate agency costs resulting from the separation of ownership and control if shareholders are exercising their voice. The substantial influence of ISS over a wide class of mutual funds gives firms strong reasons to pay close attention to their shareholder base.

The full paper is available for download here.


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