By Marguerite Rigoglioso
STANFORD GRADUATE SCHOOL OF BUSINESS—How mutual funds operate in electing corporate board directors for firms in which they are invested was a topic once shrouded in confidentiality and mystery. But the 2003 Securities and Exchange Commission mandate that mutual funds disclose their proxy voting opened up a world of information on the ins and outs of voting behavior. Stanford researcher Michael Ostrovsky has combed through several years of data to discover that mutual funds vote in ways that protect them from negative reprisals.
Some mutual funds, he found, tend to be “management friendly” –– consistently approving slates of directors proposed by corporate management. Others, however, are more inclined to register opposition. Even more interesting, when fund managers or proxy oversight committees casting the votes don’t like a particular candidate, they typically won’t say “no” unless they sense that a critical mass of other funds will do the same.
Analyzing more than 3 million votes by 3,600 mutual funds from 2003 to 2005, researchers Michael Ostrovsky, Stanford Business School assistant professor of economics, and Harvard Business School doctoral student Gregor Matvos discerned that certain mutual fund companies exhibited a pattern of withholding votes on board candidates –– essentially voting against the individual –– while others sided with a company’s proposed slate much more often.
For instance, in 2004–2005, Fidelity’s Spartan 500 Index Fund withheld support for directors in only 1.2 percent of cases. In contrast, Vanguard 500 Index Fund, which invests in the same 500 stocks, withheld support in 10.7 percent of cases –– almost 10 times as often. But there was also a clustering effect, whereby when certain funds did withhold votes, they did so in something of a group.
Why is that? “If it were a simple matter of funds voting for those directors they think are good, or withholding votes for those they think are bad, we would see a more even distribution, but the situation is obviously more complex,” Ostrovsky says.
Based on their statistical analyses, the authors offered explanations for why some fund managers or proxy oversight committees generally voted in passive agreement with corporate management’s choices of board candidates and why, when they did not, they tended to do so in a huddle with other nay-saying funds. “Suppose I dislike a director but I know he’ll be voted for by everyone else. I can withhold my vote, but I’ll be sticking my neck out by doing so,” Ostrovsky says. “Essentially, because that information is now public, I’m showing the management of that company that I’m, in some sense, ‘against’ them.”
The ramifications of doing so can be serious for a mutual fund portfolio manager. “In the future, the company’s management may subtly or overtly withhold critical information about their performance that I need for trading,” Ostrovsky says. A firm that is unhappy with a mutual fund and its parent company may also deny them future pension plan management or investment banking business.
That means that when a mutual fund dislikes a board candidate, it may try to figure out in advance how other funds will vote. “In fact, there’s a whole industry of advisors devoted to guiding funds about their voting choices,” Ostrovsky notes. “So word gets around. Plus it’s a small world, and people generally have a sense of what the tendencies are among most funds.”
It is not until a fund manager or committee has determined that a significant percentage of other stakeholders will also oppose a board appointment that it will withhold a vote, says Ostrovsky. That allows the mutual fund not to be singled out for negative treatment –– and it explains the statistical clustering phenomenon in the data. There is also a bandwagon effect –– if a small number of funds decide to oppose management it becomes easier for a few other funds to do the same, which in turn makes it even easier for some other funds, and so on. Thus, small changes in the costs and benefits of opposing the management may get amplified and result in large changes in the number of “withhold” votes.
Documenting these effects required detailed data on the voting patterns of mutual funds. “Thanks to the SEC’s disclosure mandate in 2003, for the first time we have fantastic data on mutual fund voting in companies in which they hold shares,” says Ostrovsky, who, with Matvos, worked for several years to tease out such data and make it useable for research.
In the future, this data can help inform the recent initiatives to replace the current election system, in which a director appearing on a slate may be elected with only one vote. The proposed change would require that the director receive a majority vote for election. “Our data suggest that making the change to a majority voting system might be superfluous and a waste of time, at least without some additional changes,” the Stanford researcher says. “Under the current system, directors who are elected in fact nearly always receive much more than 50 percent of the vote.”
The team is now extracting data from beyond 2005 to explore how mutual fund voting patterns may change over time.
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