1. How to use GuruFocus - Tutorials
  2. What Is in the GuruFocus Premium Membership?
  3. A DIY Guide on How to Invest Using Guru Strategies
Holmes R Osborne
Holmes R Osborne

Index Funds and Proxy Voting

July 02, 2007

Look at any stock and you will find that the largest institutional owners are index funds.  The top three fund companies are Vanguard, State Street, and Dimensional Funds Advisors.  The problem is that these companies do not interact with management.  If the CEO is paying himself $200 million a year and using the corporate jet to take his kids to summer camp, index funds go along and do not make a fuss.

Unfortunately, index funds own a considerable amount of almost every stock.  If one looks at Home Depot, State Street and Vanguard own almost 6% of the outstanding shares.  One can also see that Relational Investors own 1.57%.  Relational is one of the best activist hedge funds in the country and manages money for the California Retirement System.  Ralph Whitworth of Relational led the charge last year to oust CEO Bob Nardelli of Home Depot.  That 6% block owned by index funds is basically going to always back management because they will not get into proxy fights.

Looking at smaller companies, the $136 billion behemoth Dimensional Funds owns almost everything.  If one randomly looks up a smaller company, there is an extremely good chance that Dimensional owns shares and is not taking an active stance when voting proxies.  When these shares are combined with managements’ shares, it makes change even more difficult.  If you have ever called a company’s investor relations department, you will notice that the ones with entrenched management are much slower to return calls and don’t take kindly to constructive criticism. 

Earlier this year, I had a chance to speak to Vanguard founder John Bogle before a luncheon.  I asked him what he thought about index funds not getting active with corporations and CEO pay.  He said that index funds do not have a duty to society to get active with the companies they own.  I would strongly disagree.

Index funds are in the perfect situation to demand change.  They can ask management to take lower pay, borrow less, expect smaller exit packages and retirement plans, and pay larger dividends.  If CEO pay decreases across the board, it would lower expectations for what pay should be.  Since index funds own basically every stock, it could change the entire economy.  All this could be done with a team of proxy voters at the three largest index fund managers.  Some of these managers currently only have a few employees voting and follow a basic criterion that does not look at special situations.  These funds are in a position to demand that management put shareholders first.  This would change the prevailing attitude that management knows best and can do what it pleases. 

Recently, Steel Partners lost a court case in Japan to change Bulldog Sauce.  Bulldog instituted a poison pill that gave extra shares to every shareholder except Steel.  Japan has a confusing system of crossholdings and poison pills.  Crossholdings are when companies own shares in one another.  This system may be good for management but hurts the overall stock market.  Currently, about 28% of all stocks in Japan are owned by foreigners.  If foreigners perceive that they will get treated unfairly, the market will trade at a lower multiple.  Already, many stocks trade below book value because hedge funds know that they cannot force change.  When fund managers believe they will get a fair shake in Japan, they will pay a higher price.  The same goes for America too.


About the author:

Holmes R Osborne
Charlie Tian, Ph.D. - Founder of GuruFocus. You can now order his book Invest Like a Guru on Amazon.

Rating: 2.3/5 (9 votes)


Please leave your comment:

Performances of the stocks mentioned by Holmes R Osborne

User Generated Screeners

althekearoct 17 user defined screen
althekearPE >50th percentile of INDUSTR
althekearLow EV/EBITDA
althekearLynch inspiret Oct 17
althekearsg hk best
althekearDividends Basic
althekearKISS Dividend Strategy
Get WordPress Plugins for easy affiliate links on Stock Tickers and Guru Names | Earn affiliate commissions by embedding GuruFocus Charts
GuruFocus Affiliate Program: Earn up to $400 per referral. ( Learn More)

GF Chat