A Republic, Not a Direct Democracy

Why mutual-fund investors don’t need a suffrage movement.

Illustration by Mark Alan Stamaty

This week, the Securities and Exchange Commission is expected to vote on a proposal requiring mutual funds to disclose publicly how they vote on proxies—the annual plebiscites through which shareholders elect directors and ratify or reject proposals on executive pay and other issues. Introduced last September as one of several Hail Marys SEC Chairman Harvey Pitt hurled in a futile effort to preserve his job, the proposal aims to prevent future Enrons. The theory: If mutual funds, which collectively own about 19 percent of U.S. stocks, were forced to disclose their votes, they would be shamed into pressuring companies to improve governance practices. Powered by the sunlight that shines on their voting records, the funds would cease rubber-stamping executive option plans and transform the proxy voting process from a moribund stage show into a boisterous democracy.

The discussion surrounding the proposal touches upon topics that seem more at home in the Federalist than the Federal Register. Are mutual funds republics, in which shareholders explicitly delegate the decision-making powers to managers? Or are they vehicles for direct democracy that should enable their investors to participate in the one-share, one-vote governance of public companies? And precisely how much democracy do shareholders want? The answers: Yes, no, and not much.

In a rare joint public appearance earlier this week, Ned Johnson, the near-reclusive CEO of Fidelity, and John Brennan, the CEO of Vanguard, wrote an op-ed article in the Wall Street Journal opposing the disclosure requirement. The two organizations are stylistic opposites. Nonprofit Vanguard primarily indexes and frequently casts nay votes on stock-option plans. For-profit Fidelity is an active stock-picker and prefers “constructive engagement”—consulting with management behind the scenes—on proxy-relatedissues.But Brennan and Johnson agree that when individuals invest in mutual funds, they essentially grant to fund managers the exclusive responsibility of evaluating proxies—along with all other factors that go into a decision to buy or sell a stock.

The act of purchasing mutual fund shares, in other words, is an act of consent. Shareholders pay fund managers to comb through proxy funds at the dozens or hundreds of companies they own. Just as shareholders don’t expect fund managers to disclose why they bought AOL at 55 and sold it at 14, they don’t need, or even want, to know whether fund managers approved Boeing’s latest stock-option plan.

Investors in Fidelity’s Magellan Fund don’t actually own shares in the companies that Magellan buys. Instead, mutual fund investors own shares in a corporate entity—an investment company, as defined by the 1940 Investment Company Act—whose business is buying and selling securities. Owning shares in Fidelity Magellan grants you a say in how that fund is governed. Like companies, mutual funds have their own proxy processes. So, if Magellan shareholders decide they really want details of how they vote on proxies, they could introduce a shareholder resolution and then rally fellow shareholders to support it.

But shareholders don’t have that much appetite for participatory democracy. Take, for example, TIAA-CREF, which invests on behalf of the nation’s college professors, among others. Its large stock fund, the College Retirement Equities Fund, is a sort of Berkeley among institutional investors—its shareholders include many academics for whom protest is an avocation. A core group of CREF gadflies continually agitates for shareholders to pass resolutions that, say, purge tobacco and defense stocks from its portfolio. But very few of the political scientists or other academics whose retirement savings reside in CREF really care. Last November, a shareholder resolution that would have forced greater disclosure of proxy votes failed.

In markets, people vote with their money. When a stock or a mutual fund disappoints, people sell. Withdrawing money from a fund, or selling shares in a company, is a far more effective means of protest than voting 100 shares against a compensation policy. It hits managers where it hurts.

Investors’ confidence in mutual funds has plainly been shattered. In 2002, U.S. equity funds had a $10 billion outflow, the first year in which such funds suffered a net withdrawal since 1988. That voting pattern will do more to encourage mutual funds to reform than any SEC regulation ever could.