Mutual funds have a fiduciary duty to exercise voting rights in the best interests of their shareholders. Yet, the authors posit, more than 25% of funds passively vote according to recommendations by Institutional Shareholder Services (ISS). They suggest that mutual funds with stronger incentives do not passively follow ISS recommendations and as a result generate higher alphas.
Most mutual funds rely on Institutional Shareholder Services (ISS) for some information and recommendations, and the extent of reliance determines whether a fund is a passive voter or an active voter fund. The authors’ objective is to investigate the extent of active voting among mutual funds and to ascertain the benefits of active voting for both shareholders and underlying firms.
Evidence suggests that more than 25% of mutual funds vote with ISS for their complete portfolio, whereas 8% of funds indiscriminately vote with the management of the underlying firm. Active voter funds are less likely to always follow ISS; only 12% of them passively follow ISS’s recommendation 99% of the time. In comparison, 99% of the time, passive voter funds will vote with the management when the ISS recommendation is in favor of the management. The authors’ findings also suggest that as a result of lesser influence of ISS, active voter funds earn abnormal returns of 0.85% a year higher than passive voter funds.
How Is This Article Useful to Practitioners?
It is imperative for both individual investors and underlying firms to know whether the mutual funds they are associated with are passive voters or active voters. From the perspective of the underlying firm, funds that are active voters are larger in size, belong to larger fund families with a lower turnover ratio, and are more likely to devote more resources to in-depth analysis. They are also likely to have frequent disagreements with the ISS recommendation.
Active mutual funds are more positively related to change in shareholders’ value by active engagement and are less likely to follow the ISS approach of providing blanket recommendations on all agenda items across a wide array of companies. Thus, the presence of an active voter fund as an investor is beneficial for an underlying firm because it mitigates the influence of ISS and helps sway shareholders’ votes toward value-maximizing outcomes. But the authors’ results also indicate that mutual funds that disagree with ISS on the governance issues are more likely to sell more shares.
From the perspective of an investor, there is a significant positive relationship between active voting and fund alphas. These active funds conduct more in-depth analysis of the governance issues, are more likely to engage directly with management, and thus are more likely to be positively related to value creation. Although active voter funds hold 9.31% of the average firm’s equity, they follow ISS’s recommendation of voting against the management-recommended director about 46% of the time for a firm in which they have a small position compared with 26% for a large position.
With regard to voting on proposals, such as compensation- and governance-related proposals, active voter funds are more likely to vote against ISS recommendations irrespective of whether the recommendation is against or in favor of the management.
How Did the Authors Conduct This Research?
Although mutual funds have been filing their voting records with the SEC since 2003, the authors restrict the sample to 2006–2010. They use the voting analytics database, which contains the votes of the top 250 mutual fund families. They also access data from the CRSP mutual fund database to obtain the highest-quality match possible between both databases. Generally, mutual funds have multiple options of voting choices, but the authors group together the “against,” “abstain,” and “withhold” choices. They also take into account only actively managed funds and exclude index funds because index fund managers do not have the same incentives to actively vote in the absence of any discretion on the stocks they can hold.
Information about the underlying firm is obtained from multiple databases, such as CRSP, Compustat, Execucomp, IRRC, and Thomson Reuters 13F filings. The final data sample consists of 2,051 mutual fund schemes across 234 mutual funds. The authors consider four groups of votes: management-proposed directors, proposals on compensation-related issues, proposals on governance-related issues, and other shareholder proposals. The final sample includes 2,131,300 director votes; 248,393 votes on compensation; 136,814 votes on governance-related issues; and 74,699 votes on other shareholder proposals.
The article encompasses various aspects associated with engaged voting among mutual funds and the influence of ISS on mutual fund voting strategies. This article is an excellent read for all market participants—in the capacity of an investor, a mutual fund manager, or the management of an underlying firm.