Investors currently get the same voting advice from the leading proxy advisory firms, whether broadly diversified or highly concentrated. A portfolio-wide focus for voting makes more sense for diversified investors and investors concerned with environmental and social issues.

I filed proposals at Bank of America and Citigroup, asking each to prepare a report on the feasibility of offering customized proxy voting preferences for “clients that seek to maximize portfolio-wide returns by pursuing voting strategies designed to push certain companies to address social and environmental externalities.”

Based on Modern Portfolio Theory, sound investment practice mandates that fiduciaries diversify portfolios to reap increased returns from risky securities while significantly reducing their overall risk. Once a portfolio is diversified, the most critical factor determining return is not how companies in that portfolio perform relative to other companies (“alpha”) but rather how the entire market performs (“beta”). According to accepted research, beta drives 91 percent of average portfolio return. While individual companies can externalize costs to “maximize shareholder value,” diversified shareholders essentially “internalize” such costs through lowered portfolio returns. 

Focusing on individual companies undercuts the 91 percent of potential return attributed to market return (beta) in order to maximize the 9 percent that comes from outperformance (alpha). Externalized social and environmental costs can play an outsized role in the value of that 91 percent.

Yet the two principal proxy advisers provide voting guidance to clients with diversified returns based on maximizing returns at each individual company they cover. Although both services offer overlays addressing values beyond maximizing returns, many fiduciaries need help to justify supporting proposals focused on broad societal interests. The Employee Retirement Income Security Act of 1974 (ERISA) requires fiduciaries to discharge their duties “solely in the interest of the participants and beneficiaries.” Many interpret that to mean maximizing returns regardless of adverse consequences.

Corporate directors focus on maximizing profits at their companies. That’s where their fiduciary duty lies. However, since most portfolios are broadly diversified, their proxy votes should focus on minimizing systemic risk since 91 percent of their potential returns are attributable to market returns.

Unfortunately, many investment managers do not vote to meet their fiduciary duty to fund holders. Instead, they vote as if they are corporate directors at each company in the fund’s portfolio. System stewardship maximizes portfolio-wide returns by pursuing voting strategies designed to minimize the creation of negative social and environmental externalities. That helps both our portfolios and the broader economy.

I also filed proposals at Charles Schwab and other companies asking each to “prepare a report on the reputational and financial risks to the Company of misalignment between proxy votes it casts on behalf of clients and its client’s values and preferences, as well as strategies for addressing such misalignments on important issues.” This option might be more popular with individuals not bound by fiduciary duty and less concerned with maximizing returns than reducing the damage caused by externalizing costs.

James McRitchie
Shareholder Advocate, Corporate Governance