Opinion: BlackRock, Vanguard and other index fund giants run politics by proxy. You should focus on profits.

Index fund managers and Congress know the U.S. mutual fund industry is broken: instead of focusing on investment returns, fund managers are using the power of funds to advance policy priorities. Solutions to this broken industry are available, and index fund investors should consider the benefits of the various solutions on offer.

To understand how it got to this point, go back to the 1990s. Investors in index funds, from individuals to government pension funds, made a tacit agreement with fund managers like the Vanguard Group: Providing a diversified portfolio that delivers market returns with low risk and low cost, and choosing our stocks as a prudent investor.

Index fund managers have done just that, buying stocks from thousands of companies without the need for costly analysis to do stock selection rely largely on company boards for recommendations on how to vote the stocks.

In recent years, however, fund managers have strayed from this original bargain. You’re still basically buying all the stock and skipping the research costs. But they increasingly disagree with the board’s recommendations in favor of voting along political lineson sensitive topics Diversity in recruitment to carbon emissions and loaded outputs from abortion to weapons.

Although fund managers present these votes as tied to the bottom line, skeptical customers see narrow-minded preferences at work. Such a blending of finance and politics is one of the reasons retail investors are flocking to alternative investment platforms and why Several states have drained their retirement savings from the most offended index fund managers.

Some index funds get the message. The biggest is BlackRock BLK,
whose CEO, Laurence Fink, has denied his reputation for advocating the use of the fund’s power to support progressive causes. BlackRock recently announced this a plan to give its investors a say if they so choose.

However, BlackRock’s plan only starts with the fund’s largest clients and could take years to reach individual investors. Also, administering such a pass-through reconciliation will increase fund expenses. These costs could be offset by the benefits of a vote that focuses on prudent investment rather than mixing with political causes.

But will index fund investors vote, and will their votes be circumspect? To the extent that index fund managers are now prioritizing politics over economics, pass-through voting would improve the status quo. On the other hand, many investors choose index funds to avoid research. If they don’t want the trouble, they probably won’t be making informed votes.

A better approach appears in a new US Senate bill. Last week, Sen. Dan Sullivan (R. Alaska) introduced himself that Investor Democracy is Expected (INDEX) Act to help restore the original implied bargain. Under the law, index funds with large holdings — mainly the three largest, BlackRock, State Street and Vanguard — could not vote on their preferences on controversial issues, only the preferences of their clients, the investors.

The law offers several advantages. First, fund costs would go down because there’s no need for reconciliation to be done — it’s just an option. Second, index fund managers would not need the staff they currently pay to evaluate shareholder proposals that raise political issues. Third, individual fund investors are not expected to vote, only indexers would not. As a result, most votes would be decided by institutional stock pickers, the “smart money” doing their homework and focusing on financial returns.

Both the INDEX Act and the BlackRock Plan validate other solutions for investors to consider. First, companies can play a role. Most commonly, index fund managers vote on their political views through shareholder motions from social activists. like As You Sow Foundation or The Sisters of St. Francis. These votes are not binding on companies, whose boards must interpret their meaning. Boards could be better informed by holding a separate vote of their non-index fund shareholders. Even if index fund managers voted on their policies, the boards would get a separate vote to rely on.

For an industry-wide solution, mutual funds that continue to be stock pickers can help. If they publish how they intend to vote on shareholder motions, indexers could take that into account in their decision-making, and customers could easily compare how their votes are cast using the “smart money.” A voting visibility database, like the one I developed with a business partner, is an easy way for index funds to track active funds’ voting positions.

The index fund industry enables millions of investors to earn market returns with low risk and low cost. But bargain investors didn’t envision fund managers using their power to express policy preferences. In order to keep the business going, the voting rights of these managers must be eliminated. Fortunately, both the industry and Congress are paving the way for innovative solutions to protect investors and perhaps save the industry from itself.

Lawrence A. Cunningham is a professor at George Washington University, founder of the quality shareholder groupand since 1997 editor of “The Essays of Warren Buffett: Lessons for Corporate America.” For updates on Cunningham’s research into quality shareholders, visit Login here.

Also read: Elon Musk Called ESG a Scam – Did Tesla CEO Do Investors a Favor?

Plus: I urge Peloton to end its two-tier shareholder structure — and other companies should do the same Opinion: BlackRock, Vanguard and other index fund giants run politics by proxy. You should focus on profits.

Brian Lowry

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