In recent years, the idea of investing with an environmental or social purpose has gained significant traction, especially among those who wish to invest in accordance with their values.
People who put money in vehicles like ESG index funds expect that their money will be invested in alignment with values such as a commitment to renewable energy or equal pay for women. But new research finds that even though these funds have an explicit ESG mandate, their proxy voting records often contradict their stated objectives.
“As individual investors, we are not aware of how funds are voting,” said an MIT Sloan senior lecturer in finance who conducted the research. “We are putting our money into these ESG funds, but they’re voting against what we believe in.”
The promise and peril of index funds
The way most individual investors own stocks is through funds in their retirement accounts; about 63% of the retirement market is comprised of these equity funds, said Rao, who is associate faculty director for the MIT Sloan Master of Finance program. Since the global financial crisis, many employers have shifted their retirement plans to index funds, given their performance track record.
In fact, investment in these index funds has grown so dramatically that the three largest index fund management firms — BlackRock, Vanguard, and State Street — control 20 – 30% of the U.S. equity market. Consequently, they vote proxies on behalf of millions of individual investors. This is “the bread and butter of corporate governance,” Rao said. “They are voting on behalf of shareholders in corporate decision-making.”
Proxy issues voted on by these large fund management firms can include important resolutions on ESG measures such as the disclosure of hydraulic fracking, human rights and the treatment of workers, or diversity on corporate boards.
Reasonably, people investing in ESG index funds assume that the funds would vote in favor of ESG issues. “If a fund’s prospectus states that it is paying attention to environmental, social, and governance issues, then the fund’s voting should reflect that objective,” Rao said.
Yet little attention has been paid in the past to how these passive funds actually vote their proxies on ESG matters.
Tallying the proxy votes
To better understand how ESG funds vote on proxy resolutions, Rao focused her research on the Vanguard Social Index Fund, the oldest and largest ESG fund, with more than $13 billion in assets under management, and the BlackRock DSI exchange-traded fund, which has assets of about $3 billion. She worked with the New York-based hedge fund Quantbot Technologies to create datasets and manually classify ESG shareholder resolutions appearing on proxies between 2006 and 2019.
Surprisingly, Rao found that the Vanguard Social Index Fund voted against almost all environmental and social resolutions over the time examined. The fund also voted against shareholder resolutions requesting disclosure of board diversity in every single instance since 2006.
In addition, both Vanguard and BlackRock in 2019 voted against proposals requesting disclosure of board diversity and qualifications at Apple, Discovery, Twitter, Facebook, and Salesforce.“What we found was really not good,” Rao said. “I would give Vanguard a D. Their social index fund is one of the largest ESG funds in the market, particularly in the retirement space. It’s the oldest fund, and it votes most of the time against disclosure on environmental and social issues.”
Why ESG funds don’t vote in favor of ESG measures
It’s not uncommon to find multiple funds and voting records for hundreds of companies reported in a single PDF, which can be anywhere from several hundred to 1,000 pages, Rao said. “Proxy voting is an arcane process, which urgently needs to be made more transparent to shareholders,” she said.
The Securities and Exchange Commission appears to have the problem on its radar. Speaking at the 2021 ICI Mutual Funds and Investment Management Conference, SEC Commissioner Allison Herren Lee said, “It’s hard to see how retail investors can formulate an accurate and reliable picture of how a fund votes on ESG issues when they are forced to parse voluminous forms that often use bespoke shorthand for shareholder proposals.”
What’s more, recent research from Morningstar found that when investors were asked to gauge their comfort with proxy voting, they found that only about half actually understood the process.
Rao said that making the data easier to read would help investors to better understand those votes. She also said that the SEC may look further at the marketing practices of ESG funds with the intention of providing even more clarity. “I think this will force funds to tighten up on their disclosure.”
Rao also acknowledged another possibility — historically, no distinction was made in voting shares of ESG index funds versus others in the giant index fund complexes, making the process akin to “robo-voting” the shares.
What can shareholders do?
Those holding shares in an ESG index fund should be able to easily see how funds have voted on ESG resolutions so that they can determine if the fund’s voting aligns with their preferences, Rao said.
Similar to a fund’s fact sheet, which clearly shows fund fees and expenses, there should be a disclosure of the text of ESG resolutions that a specific ESG index fund voted on, and how the fund voted, she suggested.
In general, Rao said that anything individual investors can do to draw attention to the issue is good.
- Post on social media. “Mounting campaigns on social media can be effective in bringing about change in how fund companies vote,” Rao said. Shareholder activism can often result in success. Numerous allegations of poor working conditions against Foxxconn were called out on social media to help spur change, while recent pressure from shareholders at Exxon and Chevron and extensive media coverage helped move the needle on climate change resolutions.
- Contact your mutual fund. Individual investors cannot vote on proxies, but they can communicate with the mutual funds that do. “Engaging with mutual fund companies is a possible lever for change,” Rao said. Whether it’s sending an email or writing a letter, “If you have a lot of shareholders writing to express their opinions, these companies have to respond.”
- Crowdsource. There is strength in numbers — by crowdsourcing the preferences of your fellow employees, you might be able to help spur 401(k) administrators to either choose funds that actually vote their ESG values or hold existing funds accountable. While it isn’t an easy process, doing so can help provide valuable transparency. “It’s a complicated issue and an ongoing dialogue, particularly when it comes to climate change,” Rao said. “Getting companies to report on greenhouse gas emissions is not easy —shareholders need to advocate until they finally get to that point. To change anything, we first need to be able to measure it.”