Since 2008, a massive shift has occurred from active toward passive investment strategies. The passive index fund industry is dominated by BlackRock, Vanguard, and State Street, which we call the “Big Three.” We comprehensively map the ownership of the Big Three in the United States and find that together they constitute the largest shareholder in 88 percent of the S&P 500 firms. In contrast to active funds, the Big Three hold relatively illiquid and permanent ownership positions. This has led to opposing views on incentives and possibilities to actively exert shareholder power. Some argue passive investors have little shareholder power because they cannot “exit,” while others point out this gives them stronger incentives to actively influence corporations. Through an analysis of proxy vote records we find that the Big Three do utilize coordinated voting strategies and hence follow a centralized corporate governance strategy. However, they generally vote with management, except at director (re-)elections. Moreover, the Big Three may exert “hidden power” through two channels: First, via private engagements with management of invested companies; and second, because company executives could be prone to internalizing the objectives of the Big Three. We discuss how this development entails new forms of financial risk.
1 The rise of passive index funds
Since the outbreak of the global financial crisis, private as well as institutional investors have massively shifted capital from expensive, actively managed mutual funds to cheap, index mutual funds and exchange traded funds (ETFs), which we subsume under the term passive index funds. ETFs and index mutual funds are technically different, but they share the fundamental feature that both seek to replicate existing stock indices while minimizing expense ratios. 1 In contrast, active funds employ fund managers who strive to buy stocks that will outperform, which leads to higher expense ratios. Hence, we are dividing asset management into two categories—actively and passively managed funds. 2 Between 2008 and 2015 investors sold holdings of actively managed equity mutual funds worth roughly U.S. $800 billion, while at the same time buying passively managed funds to the tune of approximately U.S. $1 trillion—a historically unprecedented swing in investment behavior. 3 As of year-end 2015, passive index funds managed total assets invested in equities of more than U.S. $4 trillion. Crucially, this large and growing industry is dominated by just three asset management firms: BlackRock, Vanguard, and State Street. In recent years they acquired significant shareholdings in thousands of publicly listed corporations both in the United States and internationally. The rise of passive index funds is leading to a marked concentration of corporate ownership in the hands of the Big Three.
In 2008, Gerald Davis pointed at the historically unique situation in the United States that had emerged when a small number of active mutual funds, such as Fidelity, became large shareholders in a surprisingly high number of firms. This situation was reminiscent of the early twentieth-century system of finance capital when business was under the control of tycoons such as J.P. Morgan and J.D. Rockefeller. But contrary to this earlier phase in the development of capitalism, and despite their great potential power, the large, early twenty-first-century actively managed mutual funds eschewed active participation in corporate governance. The large active funds preferred to “exit” rather than to exert direct influence over corporate governance. 4 Davis coined this system of concentrated ownership without control the “new finance capitalism.”
The rise of the Big Three over the past decade marks a fundamental transformation of the new finance capitalism. Unlike active mutual funds, the majority of passive index funds replicate existing stock indices by buying shares of the member firms of the particular index—or a representative selection of stocks in the case of indices comprising small firms that have less liquid stocks—and then hold them “forever” (unless the composition of the index changes). 5 What the consequences are of the combination of concentrated ownership with passive investment strategies is becoming a central and contested issue. On the one hand, passive investors have little incentives to be concerned with firm-level governance performance, because they simply aim to replicate the performance of a group of firms. On the other hand, the concentration of corporate ownership may entail a re-concentration of corporate control, since passive asset managers have the ability to exercise the voting power of the shares owned by their funds. Indeed, there are indications that the Big Three are beginning to actively exert influence on the corporations in which they hold ownership stakes. In the words of William McNabb, Chairman and CEO of Vanguard: “In the past, some have mistakenly assumed that our predominantly passive management style suggests a passive attitude with respect to corporate governance. Nothing could be further from the truth.” 6 In a similar vein, Larry Fink, founder, CEO and Chairman of BlackRock writes in a letter to all S&P 500 CEOs that he requires them to engage with the long-term providers of capital, i.e., himself. 7
Our aim here is to shed new light on the rise of the Big Three passive asset managers and the potential consequences for corporate governance. We present novel empirical findings, but we also identify possible channels of influence that should be the focus of future research. In other words, the purpose of this paper is both to contribute new empirics on the Big Three as well as to shape the research agenda concerning the momentous rise of passive index funds. The paper continues as follows. The next section expands on theoretical discussions about ownership concentration in the United States and its impact on corporate control in the age of asset management. Furthermore, we discuss the pivotal shift from active to passive asset management and the sources of potential shareholder power for both types of investors. Subsequently, in section three we comprehensively map and visualize the ownership positions of the Big Three in American listed corporations. The analysis of the voting behavior of BlackRock, Vanguard, and State Street is conducted in section four, while section five is devoted to discussing the potential avenues of “structural” or “hidden power” by the Big Three. In section six, we highlight how passive index funds may contribute to the development of new financial risk. Finally, section seven concludes.
2 The age of asset management capitalism
2.1 New finance capitalism
In the early 1930s, Adolf Berle and Gardiner Means famously coined the phrase of the “separation of ownership and control,” meaning that there were not anymore blocks of ownership large enough to wield effective control over U.S. publicly listed corporations.8 The dispersion of corporate ownership that Berle and Means observed empirically represented a markedly changed situation compared to the first decades of the twentieth century, when most large corporations had been owned and controlled by banks and bankers—what Rudolf Hilferding referred to as Finanzkapitalismus (finance capitalism).9 Dispersed ownership however entailed that instead of the owners, it was the managers and directors who wielded control. This, in turn, led to the recognition of the principal-agent problem that underlies modern corporate governance theory: Given their collective action problem, how can the suppliers of capital (principals) ensure that the managers (agents) act in their best interests? In response to this question, corporate governance regulation has progressively shifted towards a more powerful position for shareholders. The extent to which the separation of ownership and control took shape has been a debate ever since. Nonetheless, there is an overwhelming consensus that since the second half of the twentieth century corporate ownership in the United States is by and large fragmented and dispersed.10
Early signs of a fundamental change in the organization of corporate ownership emerged in the late twentieth century. Useem signaled the growing importance of mutual funds in the early 1990s and argued that we have moved from shareholder towards investor capitalism.11 After the turn of the century and more than seven decades after Berle and Means, Davis went a step further and argued that the rapid rise of assets invested by actively managed mutual funds in equity markets and the ensuing re-concentration of corporate ownership led to a “new finance capitalism.”12 Davis found that by 2005 active mutual funds had accumulated 5 percent blockholdings in hundreds of publicly listed U.S. companies. Being the single largest shareholder thus gave the biggest mutual funds—such as his running example Fidelity—potential power over the corporate governance of these listed companies by means of dominating corporate elections.
However, despite this great potential power, actively managed mutual funds at that time did not seek to influence corporate decision-making. Davis mentions three reasons for this. First, he points out that owners holding more than 10 percent of voting rights are considered as “insiders,” which significantly restricts their trading possibilities. Second, actively managed mutual funds are faced with potential conflicts of interest because the firms they are invested in are often also their clients. Particularly eminent is this where mutual funds are large providers of pension fund management for corporations. This curbs the willingness of funds to pursue shareholder activism.13 Third, and more general, shareholder activism is always costly—and the costs are borne only by the activist, while the benefits are enjoyed by all shareholders. Hence, Davis concluded that “networks of concentrated yet liquid ownership without control seem to be the distinctive feature of the new finance capitalism.”14 Davis pointed out that this observed new finance capitalism is historically unique, but also cautiously concluded that its durability remains to be seen. One decade later, we can safely conclude that the re-concentration of corporate ownership was not a temporary market anomaly, but a fundamental reorganization of the system of corporate governance. However, the period 2005–15 is also one of significant transformation of the new finance capitalism.
2.2 From active to passive asset management and the rise of the Big Three
Passive index funds have enjoyed rapid growth during the last ten years, at the expense of actively managed funds. Passive funds have increased their market share from 4 percent of total equity mutual fund assets in 1995 to 16 percent in 2005. From 2005 to 2015, index funds have doubled their market share to 34 percent.15 The main reason of this rise is the lower cost for investors compared to actively managed funds.16 In the boom times before the global financial crisis, most investors tolerated high fees, hoping that mutual fund and hedge fund managers would deliver superior returns because of their active trading strategy. However, it is has been becoming increasingly clear in recent years that the majority of both actively managed mutual funds as well as hedge funds are not able to consistently generate higher returns than established benchmark indices, such as the S&P 500.17 In fact, only 16 percent of large-capitalization mutual funds are forecasted to beat their particular indices in 2016—the worst performance on record.18
Figure 1 shows the rapid growth of passive index funds that invest in equities. Note that we have excluded assets invested in bonds or commodities because they do not influence corporate governance. Index mutual funds remained the larger category until 2007 when ETFs took the lead. Since 2008, both categories have grown with a roughly similar pace, doubling their assets under management in just three years from 2011 to 2014. In total, passive index funds (equity) had at least U.S. $4 trillion in assets under management at end-2015, thus surpassing the assets under management of the entire hedge fund industry.19
A remarkable feature of the passive index fund industry is its high level of concentration. In the ETF segment, the market shares in December 2016 have been 37 percent for BlackRock, 18.5 percent for Vanguard, and 15.5 percent for State Street, respectively.20 Hence, together these three firms stand for a stunning 71 percent of the entire ETF market; all other ETF providers have market shares below 3.3 percent. Data about market shares in index mutual funds are not publicly available, but it seems clear that Vanguard dominates this segment with probably at least 75 percent market share.21
Existing rankings of asset managers typically include both assets in equites and in bonds, which are not of principal concern in regards to corporate control. Table 1 gives a novel presentation of the top U.S. asset managers in equities and illustrates that BlackRock, Vanguard, and State Street dominate the passive index fund industry. Together they manage over 90 percent of all Assets under Management (AuM) in passive equity funds. The share of AuM in passive funds is well over 80 percent for BlackRock, Vanguard, and State Street, thus making them the only three decidedly passive asset managers in the market. Therefore, we can fittingly refer to them as the Big Three passive asset managers.22
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Table 1: The Top 15 U.S. Asset Managers (Equity), June 2016
Source: In order to compile this table we have collected data on assets under management (AuM) from the websites of the largest asset managers (mostly quarterly reports), while Vanguard has supplied us with the information via email. Some firms, such as Fidelity, have not replied and therefore we have also used the Morningstar fund database to compute the approximate AuM invested in passive index funds. Note: Ranked according to AuM in passive index funds; multi-asset funds have been assumed to invest 60% in equities and 40% in bonds.
Note: Ranked according to AuM in passive index funds; multi-asset funds have been assumed to invest 60% in equites and 40% in bonds.[/dropshadowbox]
Although the Big Three have in common that they are passive asset managers, they are quite different in their own corporate governance structures. BlackRock is the largest of the Big Three—and represents the biggest asset manager in the world. At mid-2016, BlackRock had U.S. $4.5 trillion in assets under management.23 BlackRock is a publicly listed corporation and thus finds itself under pressure to maximize profits for its shareholders. Vanguard—with U.S. $3.6 trillion in assets under management in mid-2016—is currently the fastest growing asset manager of the Big Three. In 2015, the group had inflows of U.S. $236 billion, the largest annual flow of money to an asset managing company of all-time.24 The main reason for the high growth of Vanguard is that it has the lowest fee-structure in the entire asset management industry. Vanguard is mutually owned by its individual funds and thus ultimately by the investors in these funds. Consequently, the group does not strive to maximize profits for external shareholders but instead operates “at-cost,” which allows Vanguard to offer the lowest fees in the industry. Vanguard pioneered passive investing by creating the “First Index Investment Trust” in 1975, however this investment approach was attacked as “un-American” at the time.25 State Street is slightly smaller than BlackRock and Vanguard, but still one of the largest global asset managers. In mid-2016, it had U.S. $2.3 trillion in assets under management.
Most observers predict that passively managed funds will continue to grow (and at the expense of actively managed funds, inevitably). As global economic growth rates are not picking up—a situation which has been characterized as “secular stagnation” or the “new mediocre”—average returns for most international equity and debt markets are expected to be comparatively low in the near to medium future.26 McKinsey Global Institute has even forecasted that over the next twenty years average returns for U.S. and European equities could be as low as 4 percent per year, while U.S. and European government bonds could even have return rates of zero.27 This further bolsters the competitive advantage of low-cost passive investors vis-à-vis actively managed funds. Ernst & Young has forecasted annual growth rates for the ETF industry of between 15 and 30 percent in the next few years.28 According to PwC, assets invested in ETFs are predicted to double until 2020.29 These forecasts make it imperative that we study the different sources of potential shareholder power of these large and growing passive asset management corporations, and the Big Three in particular.
2.3 The power of passive asset managers
When we talk about the power of large asset managers, we are concerned with their influence over corporate control and as such their capacity to influence the outcomes of corporate decision-making.30 Shareholders can exert power through three mechanisms. First, they can participate directly in the decision making process through the (proxy) votes attached to their investments. In a situation of dispersed and fragmented ownership, the voting power of each individual shareholder is rather limited. But blockholders with at least five percent of the shares are generally considered highly influential, and shareholders that hold more than 10 percent are already considered “insiders” to the firm under U.S. law. The growing equity positions that passive asset managers hold thus increase this potential power.
However, this potential to influence corporate decision-making does not imply that shareholders will actually exercise their power. According to Davis, the large active asset managers in the early twenty-first century, such as Fidelity, preferred to sell their shares when they were dissatisfied with the performance of a particular firm, because the “Wall Street Walk” is easier than activism.31 This exit option is a second, indirect way of exerting shareholder power. If a considerable amount of shares are sold this negatively impacts the share price and puts pressure on the management team. In order to contain competition in the market for corporate control, management teams thus have an incentive to make sure their decisions are appreciated by their shareholders.
Third, shareholders can influence corporate decisions by direct engagements and “voice” their concerns directly to management.32 A recent survey found that 63 percent of very large institutional investors have engaged in direct discussions with management over the past five years, and 45 percent had had private discussions with a company’s board outside of management presence.33 The dominant view in the literature is that the mechanisms of exit and voice are complementary devices, with intervention typically occurring prior to a potential exit.34 The threat of exit is the base that allows the exercise of power through voice. Passive asset managers however do not “exit.”35 This may have important implications for the power of passive investors because they cannot credibly claim to exit a firm based on performance assessments.
More fundamentally, a passive investment strategy leads to the question of why passive investors would be interested at all to concern themselves with corporate governance at the level of individual firms. If a fund holds—for instance—500 stocks the risk of any individual stock will be irrelevant. Indeed the incentive structure of passive index fund managers is such that they are rewarded more for keeping the costs low than for improving firm governance.36 Since passive managers are willing to take whatever return-risk relationship the market offers, why vote at all?
In addition, the decentralized attribution of ownership in separate funds and ETFs may hamper a centralized voting strategy in at least two ways. BlackRock for instance has more than 200 mutual funds and equity ETFs as well as several closed end equity funds and hedge funds—all of which could have positions in a particular firm. These portfolios may have different interests when it comes to shareholder vote. Even more differences occur because BlackRock holds some shares in short positions. Any vote that helps the long positions in BlackRock will hurt the short positions. So which way will BlackRock vote? These decentralized ownership structures may also hamper the ability to systematically use the voting power at all as it demands a serious coordination effort on behalf of the asset managers. Still in 2015, BlackRock faced a record U.S. $3.25 million fine by the German financial watchdog BaFin for misrepresenting their stakes in German firms. BlackRock admitted that they had to reorganize their internal procedures in order to be able to report on their aggregated ownership. If BlackRock already struggles with reporting on their ownership stakes, it may be even more difficult for them to consistently use their proxy votes, even if they wanted to do so.
Passive investors, active owners?
At the same time, the Big Three explicitly state that they want to be active shareholders. State Street for instance highlights that they follow “a centralized governance and stewardship process covering all discretionary holdings across our global investment centers. This allows us to ensure we speak and act with a single voice and maximize our influence with companies by leveraging the weight of our assets.”37 BlackRock established a central team to report on and direct its proxy voting and corporate governance recommendations in 2009 and states that it “will cast votes on behalf of each of the funds on specific proxy issues.”38 In 2016, BlackRock, Vanguard, and State Street significantly expanded their corporate governance teams. What, then, are the opportunities and the incentives the Big Three have for an active corporate governance strategy?
Arguably, the reasons Davis used to explain the inactivity of active investors in terms of corporate governance may not apply to passive investors—or are at least diminished significantly. First, unlike active funds, passive funds rarely hold ownership stakes in listed corporations larger than 10 percent, which would make them “insiders” under U.S. law.39 This means that they are less restrained to use their shareholder power. Second, Davis argued that actively managed funds may revert from voting on their shares because the firms they are invested in are often also their clients, particularly in pension fund management. While pension business still amounts to hundreds of billions for the Big Three, the proportion of this line of business seems to be smaller than for Fidelity. And third, now that the Big Three have reached such a large scale, shareholder activism has become much “cheaper” for them in relative terms. This all increases the opportunities for the Big Three to use their shareholder power. And while it is true that they cannot credibly threaten management with permanent exit (only with temporary exit via share lending to short-sellers), they can threaten to vote against management at the annual general meeting (AGM). This is generally considered as a clear signal of discontent towards management, which gives management teams an incentive to keep large shareholders from voting against their proposals. Management teams may also want to keep a good relationship with their passive blockholders because their votes are particularly important during key moments such as proxy fights or takeover bids. Because they are blockholders, the voting power attached to their equity investments therefore serves as leverage for private engagements as well.
This leaves the question of what incentives passive investors have to pursue centralized corporate governance strategies. After all, as pointed out above, the risks of individual stocks are largely irrelevant to their business model. There are, however, at least two types of incentives to pursue an active corporate governance strategy. The first relates to their role and responsibility as a shareholder. Whereas in previous times the concentration of corporate control and the concomitant influence of large blockholders was seen as problematic, today the opposite is true: Large blockholders are expected to vote because otherwise managers would be too powerful. Legally, the fiduciary responsibility of institutional investors towards their clients includes that they are expected to fulfill their role as a shareholder, including voting at the AGM. Different funds within the same group may seek to minimize the costs associated with monitoring a company and centralize this monitoring role internally. This leads at least to a form of reticent behavior: “a generally reactive, low cost activism.”40
Second, while active investors can and will sell shares when they observe or anticipate diminishing (future) returns, passive investors are generally “stuck.” This means that their main interest is not short or medium term value creation, as is the case for most investors. Instead, their main interest is in long-term value creation. As Vanguard explains: “Because the funds’ holdings tend to be long term in nature (in the case of index funds, we’re essentially permanent shareholders), it’s crucial that we demand the highest standards of stewardship from the companies in which our funds invest.”41 Although the Big Three are not fully similar, they have shared incentives as passive long-term investors. And together, they are a force to be reckoned with. For example, in 2015 activist investor Nelson Peltz rallied against DuPont’s CEO Ellen Kullman over whose slate of directors should be elected to DuPont’s board. The outcome of this high profile proxy contest was determined when the Big Three disclosed that they were voting all their shares in favor of Kullman. The Big Three did not follow Institutional Shareholder Services (ISS) recommendations and as such voted against most of the regular short and medium term oriented shareholders. This illustrates that the Big Three at times may have a conflict of interest with short-term oriented investors. For this reason, they have an incentive to influence management to act in their interests. Indeed, McCahery et al find that large institutional investors with a longer time horizon and less concern about stock liquidity intervene more intensively with management teams through private engagements.42
2.4 Research approach and data
In order to shed light on the opposing views on the power position of the Big Three, the first step must be to develop a better understanding of their ownership positions in contemporary equity markets. Information on the ownership profiles of the Big Three is anecdotal, incomplete, or difficult to compare. We therefore engage in a comprehensive mapping of the ownership positions of the Big Three. In addition, we examine how concentrated corporate ownership is when we combine the positions of the Big Three. The second step is to investigate the extent to which the Big Three are able and willing to use their proxy votes and follow a centralized proxy voting strategy. If the Big Three follow a strategy where they pursue influence through their proxy votes, we expect a high level of similarity of the voting behavior of their funds. Therefore, we investigate the voting records of the separate funds of U.S. asset managers at AGMs. This allows us to compare the voting behavior of the Big Three to other asset managers. Third, once we have established the level of internal consistency of proxy voting, we conduct an explorative analysis of the type of proposals where the Big Three oppose management. We use this analysis to see how active the Big Three actually are and if they indeed can be seen as reticent investors.
In order to analyze the voting behavior of asset managers, we used data from the ISS website. ISS is a major proxy voting advisory firm that records the voting behavior of investors. Proxy votes are collated by ISS for their clients and are publicly available. We collected a set of 8.6 million votes on 2.7 million unique proposals at AGMs worldwide. These votes are cast through 3,545 funds that are part of a set of 131 Asset Managers. From this we created a cleaned set of 117 asset managers and 1.45 million proposals voted on by their funds at AGMs. These disclosures are legally mandated in the United States, which means the data on the voting of U.S. asset managers voting in U.S. companies is of very high quality.43
For the analysis of ownership concentration, we use data from the Orbis database by Bureau van Dijk. Orbis provides information on over 200 million firms worldwide, with over 59 million in the Americas, giving expansive coverage of the ownership holdings of all major asset managers. Over 140 providers collect data from commercial registers, Annual Reports and SEC Filings to create the database, enabling unprecedented insight into the scale and scope of asset managers. Compared to Thomson One, another database often used for studies on corporate governance, Orbis is as accurate but more complete (Orbis also reports on families as owners which is crucial in determining where the Big Three are the largest owner). For the analysis of the United States we downloaded all 3,882 publicly listed companies, corresponding to the exchanges: “NYSE MKT,” “NYSE ARCA,” “NASDAQ/NMS,” “NASDAQ National Market,” and “New York Stock Exchange (NYSE).” We excluded the following two company categories: “Mutual and pension fund/Nominee/Trust/Trustee” (932 companies) and “Private equity firm” (thirty-eight companies), because we focus on the ownership of U.S. publicly listed corporations and entities belonging to these two categories are not owned and controlled by public shareholders. We excluded among shareholders “State Street Bank and Trust Co.” because this subsidiary of State Street acts as a custodian, holding the shares for the respective ultimate owners. Public ownership (many small ownership stakes combined) was also excluded.
3 The power position of the Big Three in the network of corporate ownership
3.1 Breadth and depth of the Big Three’s blockholdings
In this section, we conduct a comprehensive analysis of the significant ownership positions of the Big Three. We focus on two central dimensions of ownership by institutional investors—breadth and depth. An investor has broad ownership when being invested in a large number of corporations. In addition to this “breadth” dimension, it is also important to take into account the “depth” scale of ownership—the size of the individual holdings. Thus, breadth and depth together provide a comprehensive picture of the ownership profile of an investor. Table 2 presents the fifteen largest global holders of 3 percent blocks in publicly listed corporations—the higher the number of holdings the broader the ownership profile of the asset manager. Furthermore, we show three different levels of ownership depth: >3 percent, >5 percent, and >10 percent blockholdings.
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Table 2: The Top 15 Global Blockholders of Corporate Ownership, March 2016
Source: Authors, based on Orbis.
Note: Ranked according to 3% blockholdings; Big Three in italics. The >10%holdings are also included in the >5% and so on.
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