Indexed Investments and “The Problem of Twelve”

John Coates has a thoughtful paper on the legal and economic challenges of “the problem of twelve,” the prospect of a majority of shares in public companies being managed by just twelve entities, in effect twelve people.

[T]he rise of indexing presents a sharp, general, political challenge to corporate law. The prospect of twelve people even potentially controlling most of the economy poses a legitimacy and accountability issue of the first order – one might even call it a small “c” constitutional challenge. Large companies have always tried to influence the law to protect or extend the power of those in control of those companies, through litigation and lobbying, among other means. In the late nineteenth century, the polity responded by passing antitrust laws, using those laws to break up large companies, banning corporate participation in elections, creating an administrative state, and legalizing labor unions. Together, those responses can fairly be seen as a small “c” constitutional response to the threat posed by the concentration of economic and political power created by the country’s first merger wave….Indexation, private equity, and globalization threaten to permanently entangle business with the state and create organizations – advisors to index funds and private equity funds – controlled by a small number of individuals with unsurpassed power. That concentration of control underscores the gap between ordinary citizens’ experience of disengagement and distance from their government made visible in 2016, and the increasing wealth gap between the ultra-rich and the bulk of the population. Politics is shaped by perceptions. Law – itself a function (in part) of politics — will almost certainly change in response to thesetrends. The only question is how. [footnotes omitted]

Coates says that passive investors are not passive.

The bottom line of this influence is very different than what the term “passive” investment implies. Rather than blindly choosing stocks in their index and then ignoring them, index fund managers have and are increasingly using multiple channels to influence public companies of all sizes and kinds. Their views on governance issues, their opinions of CEOs, their desires for change at particular companies, their response and evaluations of restructuring or recapitalization proposals from hedge fund activists – all of these matter
intensely to the way the core institutions in the U.S. economy are operating.

In general, we consider this to be a good development, as we believe permanent investors are most constructively engaged in promoting sustainable shareholder value and we are not concerned about inappropriate or detrimental influence because of the very nature of index funds. They are invested in every company in each sector, so will involve themselves only in fundamental governance issues, not ordinary business. However, as VEA Chair Robert Monks has described in detail in his book, Citizens Disunited, and Coates touches on, companies whose stock is held only by indexers underperform, whether as cause or consequence of no active investor being involved.

We would oppose any restriction of engagement with corporate managers by index funds, one of the options Coates suggests, and would urge quite the contrary — a more robust application of the fiduciary obligation of fund managers to promote engagement for, in ERISA terms, the “exclusive benefit” of the ultimate beneficiaries.

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