Friday, November 6, 2020
This week I want to call everyone’s attention to a fascinating new paper by Edwin Hu, Joshua Mitts, and Haley Sylvester, Index Fund Governance: An Empirical Study of the Lending-Voting Tradeoff.
As the authors explain, for a long time, the SEC prohibited mutual funds from lending their shares to short-sellers if doing so would interfere with the funds’ stewardship obligations. As a result, funds typically would recall any loaned shares in time to vote them at the annual shareholder meeting. However, in 2019, the SEC changed its rules to allow funds to loan their shares even if doing so would sacrifice their ability to vote, so long as it would be in the funds’ best interest. Hu, Mitts, and Sylvester study the effects of the rule change and find that the number of shares available to borrow around the time of shareholder meetings jumped by 58% in companies with a high level of index fund ownership, and there are increases even when important matters, like proxy fights, are on the ballot. The extra shares don’t result in greater short interest, but they do apparently take them out of the voting pool – or potentially make them available for activists to vote.
The really interesting question this raises is whether these managers really are acting in the funds’ best interest – trading the value of the vote against the value of the lending fees – or whether instead, perhaps due to a fee split between the fund and the adviser, the managers are sacrificing the interests of the fund in order to benefit the adviser. It’s complicated; not every share that becomes available to borrow actually does get lent out, which, as I understand it, means no fees are earned but the vote is still lost. On the other hand, for some votes, the fund may reasonably calculate that there is unlikely to be an impact on value, or that the fund’s votes are unlikely to be pivotal (on this, I direct interested readers to Fatima Zahra Filali Adib’s paper, previously highlighted in this space, observing that funds can determine when their votes are likely to matter to outcomes, and they allocate attention accordingly). That said, the authors also tell the tale of a company called GameStop, where activists won a proxy contest, arguably because index fund holders – who would otherwise have voted with management – loaned their shares instead of voting them.
Relatedly, Joshua Mitts has just posted another paper on share lending, where he argues that passive funds that are part of large mutual fund complexes can use negative information about a stock gleaned from the active side of the business to raise the prices they charge to short sellers who borrow their shares. Doing so allows passive funds to, in a way, earn profits from “active” participation in the market. Mitts also claims that this activity helps make prices more efficient, which is ultimately to the long term benefit of passive investors.