Free Markets and Democracy Put To the Test

I am a big, big fan of free markets and democracy.  However, as an economics major in college, I learned that, in reality, markets are rarely totally free — from monopolies, externalization of costs, etc.  And our democracy is full of imperfections keeping even views held by a majority from being expressed as government policy.

In the world of investing, these two concepts collide in the form of shareholder voting.  When you own stock in a company, you have partial ownership giving you a say in how the company is run.  This voice comes in the form of shareholder voting — either in person or via a proxy vote.  Usually, shareholders get some boring announcement about the upcoming annual shareholder meeting soliciting your vote for the board of directors of the company.  Once in a while a bigger issue comes up for a vote, like deciding on a merger or a stock split, and you get to make a decision.  Of course, the bigger the ownership stake you have, the more votes you get.   That’s the democracy part of investing.  Sadly, like in our democracy, most eligible voters don’t even cast their votes.

What happens if you, like most investors, especially 401(k) account holders, own mutual funds rather than individual shares of stock?  The mutual fund company management is actually supposed to vote your shares on your behalf.  This is another point where the democratic process breaks down.  How is a mutual fund company supposed to know what we individually want, other than to get the best return on our investment?  Some actively managed mutual funds take an active role in introducing issues for a shareholder vote.  They may see a troubling executive compensation package or lax corporate governance or a very risky business practice and exert their power as significant shareholders on their investors’ behalf.  This is what I would hope for in my mutual fund company’s approach and in how they represent me.

What if you own shares in a passive index mutual fund or exchange traded fund?  This is where a not-so-free market shows up.  Passive index funds are gaining a larger and larger share of the investment market every year — from an 18% share of the whole market to 36% just from 2008 to 2018.  Yet, they do not act as a free market investor.  They simply buy and hold whatever is in the market index.  They do not sell shares when a company exhibits terrible corporate governance or becomes the defendant in a massive civil suit.  Index funds now are the largest institutional shareholders in almost all large public U.S. corporations.  But, those owners rarely introduce shareholder resolutions to get companies to change behavior.  Even if they did, the companies would not have to worry about those index fund managers selling their stakes in protest. You can look up how Vanguard has voted its proxies; those votes have almost always been in agreement with whatever the company management proposes.

As the indexing trend has grown, interested investors are asking questions about whether this disconnect between the values of individual investors and votes on corporate business is healthy for the stock market or for the companies themselves.  My hope is that index fund investors soon get a say in how their votes are cast. That’s the way democracy and free markets work best.

 

Any opinions are those of Dave Werle and not necessarily those of Raymond James. Expressions of opinion are as of this date and are subject to change without notice. There is no guarantee that these statements, opinions or forecasts provided herein will provide to be correct. Investing involves risk and you may incur a profit or loss regardless of strategy selected. Keep in mind that individuals cannot invest directly in any index, and index performance does not include transaction costs or other fees, which will affect actual investment performance. Individual investor’s results will vary. Past performance does not guarantee future results. Future investment performance cannot be guaranteed, investment yields will fluctuate with market conditions.

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