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Lawrence A. Cunningham’s Quality Investing: BlackRock, Vanguard and other index-fund giants are playing politics with proxy votes. They should focus on profits.

Index-fund managers and Congress know the U.S. mutual-fund industry is broken: rather than focusing on investment returns, fund managers are using fund power to promote political priorities. Fixes for this broken industry are at hand, and index fund investors should consider the benefits of the different solutions on offer.

To understand how things got to this point, go back to the 1990s. Investors in index funds, from individuals to state pension plans, made an implicit bargain with fund managers such as Vanguard Group: provide a diversified portfolio delivering market returns, with low risk and little cost, and vote our shares as a prudent investor.

Index fund managers did just that, buying shares in thousands of companies without the need for costly analysis that stock pickers do and largely relying on company boards for recommendations on how to vote the shares.

In recent years, however, fund managers have strayed from this original bargain. They still buy basically all shares and skip research costs. But they increasingly disagree with board recommendations in favor of voting along political lines, on thorny topics from diversity in corporate hiring to carbon emissions and charged issues from abortion to guns.

Although fund managers portray these votes as tied to the bottom line, skeptical clients see parochial preferences at work. Such mingling of finance and politics is one reason individual investors flock to alternative investment platforms and why several states have pulled their pension savings from the worst-offending index fund managers.

Some index funds are getting the message. The largest is BlackRock
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whose CEO, Laurence Fink, has denied his reputation as a proponent of using the fund’s power to support progressive causesBlackRock recently announced a plan to let its investors have a say if they so choose.

Yet BlackRock’s plan starts with only the fund’s largest clients and could take years to reach individual investors. Also, administering such pass-through voting will increase fund costs. Those costs could be offset by the benefits of voting focused on prudent investment, rather than mingled with political causes.

But will index fund investors vote, and will their votes be prudent? To the extent that index fund managers now put 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 hassle, they are unlikely to cast informed votes.

A better approach appears in a new U.S. Senate bill. Last week, Sen. Dan Sullivan (R. Alaska) introduced the Investor Democracy is Expected (INDEX) Act to help restore the original implicit bargain. Under the Act, index funds with large stakes — mainly the biggest three, BlackRock, State Street and Vanguard — could not vote their preferences on contested topics but instead could only vote the preferences of their clients, the investors.

The Act offers several advantages. First, fund costs would fall because there is no requirement that votes be passed through — it is simply an option. Second, the index fund managers would not need the staff they currently pay to evaluate shareholder proposals raising political issues. Third, it is not expected that individual fund investors would vote, only that indexers would not. As a result, most votes would be decided by institutional stock pickers, the “smart money” who do their homework and focus on financial returns.

The INDEX Act and the BlackRock plan both validate other solutions investors should consider. For one, companies can play a role. The most common way index fund managers vote their political views is on shareholder proposals made by social activists, such as As You Sow Foundation or The Sisters of St. Francis.  These votes are nonbinding on companies, whose boards must interpret their meaning. Boards could become better informed by holding a separate vote of their non-index fund shareholders. Even if index fund managers vote their politics, boards would get a separate vote to rely upon.

For an industry-wide solution, investment funds that continue to be stock pickers can help.  If they publicize how they intend to vote on shareholder proposals, indexers could consider that in their decision making and clients could easily compare how their votes are being cast versus the “smart money.”  A voting visibility database, such as the one I developed with a business partner, is a simple way for index funds to track the voting positions of active funds.

The index fund industry enables millions of investors to get market returns with low risk at little cost. But the bargain investors signed onto did not envision fund managers using their power to express political preferences. To preserve the bargain, the voting power of those managers must be eliminated. Thankfully, the industry as well as 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 Shareholders Group, and publisher, since 1997, of “The Essays of Warren Buffett: Lessons for Corporate America.”  For updates on Cunningham’s research about quality shareholders, sign up here

Also read: Elon Musk called ESG a scam — did the Tesla chief do investors a favor?

Plus: I’m pushing Peloton to end its dual-class shareholder structure — and other companies should do the same

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