
Bogle Sounds a Warning on Index Funds - scdoshi
https://www.wsj.com/articles/bogle-sounds-a-warning-on-index-funds-1543504551
======
btown
[https://outline.com/DGK9Td](https://outline.com/DGK9Td)

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gregorymichael
A bit click-baity, but the warning here from the father-of-index-funds is not
that they've become a bad investment, but that their popularity is leading
toward a handful of financial institutions holding controlling interests in
most of the largest companies. Pretty interesting unitended consequence.

~~~
SilasX
Why would that matter? If they are obligated by their funds' charters not to
intervene, then all the governance decisions happen exactly as if they hadn't
invested, right? 10% vs 90% of share votes being on auto-pilot shouldn't
matter?

Is the argument that the vast majority of them could change their funds'
charter to _allow_ them to be actively involved with governance? If so, that
would be really hard to achieve even if many of them worked at it.

Edit: three people have made the same "it's easier to get a controlling
interest" argument. See my reply in the follow-up before making another
redundant comment.

~~~
timerol
If 90% of shares are non-intervening that means hostile takeovers are now 10x
cheaper to implement. It would be weird to be a company with market cap $100M,
where $10M could buy a controlling interest in voting shares.

~~~
Hermel
Non-intervening usually means the vote according to the recommendations of the
board, and not that they abstain from voting.

~~~
AnthonyMouse
That seems like a different kind of problem though. If funds that _vote
according to the recommendations of the board_ own >50% of the company, the
board becomes unaccountable. (Unless they apply different rules to board
elections, but then we're back to the original problem because the minority
activist can elect their own board.)

~~~
jandrese
This seems to be mostly in keeping with the spirit of index funds. It's a
hands off approach that lets the company run itself.

In theory an index fund should never own that much of a company, because that
means it would own >50% of all publicly traded companies. The whole point is
to spread the risk evenly so you can realize the average returns without
having to put any thought into it. It shouldn't mean it's buying $100k shares
of GE and also $100k shares of Mom&Pop Pickle Fork Inc.

~~~
gbear605
But if all the index funds together own >50%, and they all go with the board,
then it's the same as if it was a single company that went with the board.

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fipple
The summary: if Coke and Pepsi are owned by different guys, Coke will take an
action that makes them an additional $1 million, even if (especially if) it
causes Pepsi to lose $1 billion. Most commonly, cut prices.

If the two companies are owned by the same guy, they have the incentive not to
compete with each other since their owner cares about the sum of their
profits. This is why one wouldn’t be allowed to acquire the other. But the
effect is the same when a single index fund owns a large chunk of both
companies. The companies are encouraged to compete not too fiercely with each
other.

~~~
Glyptodon
Even without index funds the drive towards large portfolios and
diversification would do the same thing. I'd go so far as to say that unified
ownership of competing firms by large investors is just unhealthy in general.
Not really sure what can be done about it though since many companies are
rather multi-industry.

~~~
fipple
Well the idea of an index, whether done through a fund or not, is to buy some
of each company. A value investing approach would be to find the better stock
and invest in it, so Coke stockholders would rarely own Pepsi stock and vice
versa.

~~~
Glyptodon
Still, even without index funds, the first thing most people are told is that
diversification is key and that sector allocation matters more than the
specific companies you hold. Plus people want to mitigate risk, so they buy a
little of each thing that matches whatever profile, and soon a sector
essentially has unified ownership interests rather than competitive (and
antagonistic) ownership interests.

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decimalst-s
Is there anything legally preventing these funds from having some kind of
system where you have fractional voting rights proportional to your number of
shares in the mutual fund vs. the weight of the company in the index it
represent? e.g. You have 100 shares of a mutual fund that has 1% of its
holdings in some company- thus you have 1 vote for that company's shareholder
ballot, or whatever the fractional representation based on market cap would
come out to. I'm not sure if a single holder of funds can cast "partial votes"
in each direction though. Either way, it seems like a problem that could be
fixed through technology.

~~~
lifeformed
The article says that this solution has unintended consequences too, since you
are now transferring voting rights from the share owner, who cares about the
long term performance of the company, to share renters, who generally just
care about the short term, which is counterproductive.

Although I'm not sure I get that - I don't quite see how the renter's would be
especially more short sighted - it's not like the fund is obligated to hold
the stocks any longer than anyone else.

~~~
chimeracoder
> you are now transferring voting rights from the share owner, who cares about
> the long term performance of the company, to share renters, who generally
> just care about the short term, which is counterproductive.

This logic is backwards; index fund holders are _more_ likely to hold their
shares for a longer period of time, compared to day traders. The whole point
of index fund investing is to _avoid_ short holds.

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ajmurmann
A while ago some article had a great example of what can happen if the
majority of shares of most companies in the same industry are held by the same
investors: It punishes competition within the same industry. The example was
about the airline industry where investors don't want airlines to go head to
head on pricing. While some companies might benefit from this, it would lead
to lower margins and thus profits for the industry as a whole. So this in
essence might form a cartel.

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neogodless
Maybe I'm misunderstanding something, because I find it odd to hear this from
Bogle himself. Vanguard doesn't own or control the equities in their index
funds. You do. Vanguard is structured so that you can own your piece of the
index fund pie. And while there are large holders of index funds such as
Vanguard's Total Stock Market fund, I don't think there are any majority
holders. For 51% of equities to be channeled through Vanguard but owned by
stockholders does not seem to be a risk.

If I'm wrong, can you explain what I'm wrong about?

~~~
jonbarker
The risk is that Vanguard, State Street, and Blackrock, employ small
'governance teams' whose job is to vote on your behalf. Since they don't have
an explicit fiduciary duty to the shareholders of the index funds, but do have
an implicit one, it can be argued that you don't actually have a vote in how
the component companies are run. More here:
[https://outline.com/njXPEu](https://outline.com/njXPEu)

~~~
jschwartzi
Vanguard explicitly asks you to vote your shares. I've gotten letters in the
past asking me to cast a vote.

~~~
travisp
Vote on mutual fund governance questions. Not on each of the thousands of
companies that the fund is invested in.

------
apo
He also warned in 2017:

 _Bogle noted that trading would dry up if the stock market comprised only
indexers and there were no active investors setting prices on individual
issues. Everyone would just buy or sell the market.

...

Shareholders of index funds could then suffer more than owners of actively
managed funds, and they could take their losses harder due to the perceived
security they feel precisely because they merely own the market and aren’t
trying to beat it. That might make active investors feel a bit of
schadenfreude for indexers who have been free-riding at their expense, but the
feeling probably wouldn’t last. The greater price swings that could ensue in a
heavily indexed, less-active market are likely to exacerbate losses for
everyone._

[https://www.marketwatch.com/story/john-bogle-has-a-
warning-f...](https://www.marketwatch.com/story/john-bogle-has-a-warning-for-
index-fund-investors-2017-06-01)

It seems a good bet that this warning, like most pre-downturn warnings, will
only become obvious during the next major downturn.

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empath75
> "There is no America, there is no democracy, there is only IBM and ITT and
> AT&T and DuPont, Dow, Union Carbide, and Exxon … The world is a college of
> corporations inexorably determined by the immutable bylaws of business. The
> world is a business, Mr. Beale, it has been since man crawled out of the
> slime. And our children will live, Mr. Beale, to see that perfect world in
> which there’s no war or famine, oppression or brutality. One vast and
> ecumenical holding company for whom all men will work to serve the common
> good, in which all men will hold a share of stock, all necessities provided,
> all anxieties tranquilized, all boredom amused."

Network -- 1976

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pdog
Of the proposed solutions, some combination of the following three items would
be a solid first step (incremental without being too drastic):

* Full public disclosure by index funds of their voting policies and public documentation of each engagement with corporate managers.

* Require index funds to retain an independent supervisory board with full responsibility for all decisions regarding corporate governance.

* Make it clear that directors of index funds and other large money managers have a fiduciary duty to vote solely in the interest of the funds’ shareholders.

~~~
xkjkls
> Make it clear that directors of index funds and other large money managers
> have a fiduciary duty to vote solely in the interest of the funds’
> shareholders.

That's easy to say, but deciding what the shareholders interest is can be
incredibly difficult. On any difficult decision, like "should this merger be
approved", index funds taking any position is the same as active management.

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brianliou91
This is fascinating. Selfishly though this seems to signal for investors of
index funds (such as myself) that they will only continue to be good
investments unless major government regulation occurs.

Does anyone know of any investment risk to index funds if everyone is now
doing it?

~~~
bluGill
The risk is because index funds don't do stock analysis (instead they buy and
hold all stocks) they will invest in bad companies and prop their price up.
Then when the bad company goes bankrupt (as everyone paying attention knows
will happen) the index funds are left holding all the stock suddenly worth
nothing.

Which is to say the traditional more expensive managed funds that actually pay
attention to the fundamentals of the companies they invest in should see a
comeback. While this style of fund is more expensive (because a human can only
examine a few companies in a year in enough detail to decide if they are worth
investing in - as a full time job you can maybe do 50) by investing only in
companies that will do better than average they can beat the market (or
shorting if you want to play companies that will do far worse than average).
So far the low costs of index funds have made them a better investment despite
them not investing in strong companies, but we should see the day where a
managed fund can beat the index funds just because the index funds are leaving
the advantages of analysis on the table.

You can argue [meaning this might or might not be correct] that historically
managed funds have done worse than index funds because there are so many
managers that anytime there is a slight deal someone jumps on it before the
deal is large enough to pay for the costs of finding it. However if you don't
jump on it someone else will and they make something on the deal while you
make nothing. Thus as index funds take over there will be more and more deals
for the managers to find, and managers can wait until they are large enough to
be worth the price.

It will be interesting to see when/where the line is crossed.

~~~
mruts
This is not exactly true. Many (most?) indices are market cap weighted, so if
a company’s stock is tanking (i.e, their market cap proportional to other
tickers in the index is going down), the index will sell the shares.

In my view, index funds aren’t really passive at all, they are crowdsourcing
the best ideas of active management. This is why many indices (like S&P 500)
produce pretty good returns.

If you created an index held every US equity in equal proportions, regardless
of price movement, that would be like what you’re talking.

If you compared the returns of the S&P 500 against this theoretical index
(let’s make it an ETF and call it “DUMB”), you would find that the S&P 500
would have much better returns.

The takeaway from this is that many indices produce stellar returns and aren’t
as “passive” as one might think. Think of factor indices or whatever.

~~~
nostrademons
The point is that the stock won't always tank when they're doing something
that'll negatively affect fundamentals, because too few people are actively
researching & investing in the stock to affect the price. And then when a
tipping point _is_ reached and the stock price starts to go down, index funds
will exacerbate the slide as they rebalance out of the falling stock and sell
off its shares.

Normally markets remain efficient because they provide an incentive for people
to actively research & surface all available information on a company's future
prospects. If most people aren't doing this, then a.) the market price will be
slower to react to bad information about the company and b.) people who _do_
actively react will make larger profits, as they can trade on their
information before the majority of the market takes it into account.

There's an equilibrium level of disequilibrium - as more people pursue passive
investing, returns to active investors rise, until some of those passive
investors realize they can make large profits as active investors, restore
market efficiency, and destroy the profit potential of active investing. I'm
not sure exactly where we are in that cycle, but there's some evidence that
stock prices have become less volatile overall except for major news-related
panics, which would be expected if a large proportion of people are passively
investing.

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brootstrap
Interesting. I've heard these warning signals before about index funds. Lets
just hope index funds stay healthy for another say 60 years so i can fully
utilize all the $$ I am dumping into the market now in my 20s. Please??

~~~
djohnston
i thought an index fund's health depends on the health of the companies inside
it. even if people decided they wanted to replace their index funds with
direct stock purchases they managed themselves, the underlying value of the
fund wouldn't change right?

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darawk
> Limit the voting power of corporate shares held by index managers. But such
> a step would, in substance, transfer voting rights from corporate stock
> owners, who care about the long-term, to corporate stock renters, who do
> not... an absurd outcome.

This sounds like the most viable strategy to me. Just don't let index funds
vote. I don't understand his objection at all. The index fund _managers_ are
not long term investors in these corporations. The people who own the index's
shares are, and they are deferring their votes to the managers right now.

~~~
walshemj
How long has AT&T been in the dow jones index or IBM or Coca Cola ?

~~~
darawk
A long time. What are you getting at?

~~~
walshemj
So index funds would have to hold AT&T long term.

~~~
darawk
Did you read what I said about that?

> The index fund managers are not long term investors in these corporations.
> The people who own the index's shares are, and they are deferring their
> votes to the managers right now.

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cs702
If the stock market becomes dominated by _copycats copying each other_ , can
it price equity risk accurately?

~~~
nabla9
As long as there are at least some active investors left they can, because
they follow price changes set by active investors passively.

If index funds start to create systematic valuation errors, active strategies
start to perform better and they start to outperform index funds. This is not
the case, because index funds beat active fund management constantly over
longer periods. (The article raises concerns of corporate governance and
accumulation of power that is different issue).

Matt Levine [https://www.bloomberg.com/opinion/articles/2016-08-24/are-
in...](https://www.bloomberg.com/opinion/articles/2016-08-24/are-index-funds-
communist)

>there is an alternative view that the rise of passive investing will improve
capital allocation, because bad active investors will be driven out but good
ones will remain. The passive investors can't influence relative prices, since
they just buy the market portfolio, meaning that the fewer but better active
investors will continue to make the capital allocation decisions. On this
view, lower returns to active management are a sign that prices are more
efficient and capital allocation is getting better

~~~
kolbe
>index funds beat active fund management constantly over longer periods

This was only the case because 'long periods' include the periods in which
free riders (indexes) were small relative to the active and activist
shareholders.

~~~
nabla9
This is still the case and nothing indicates that things have changed.

Index funds have two main benefits:

* Lower cost,

* Never miss a new trend. At any moment only handful of stocks are responsible for disproportionate growth and index funds catch them all.

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zAy0LfpBZLC8mAC
(Index) funds solve a problem that we shouldn't really have anymore.

The problem is that (semi) manually trading securities is inherently
expensive.

Funds solve that problem by massively reducing the number of transactions that
are required: 1000 people investing in a fund investing in 1000 companies
needs 2000 transactions instead of the 1000000 transactions needed when 1000
people invest in 1000 companies directly.

But there really is no fundamental reason anymore why you shouldn't be able to
just buy small numbers of shares from a thousand companies via electronic
systems. A million transactions is not really a problem for modern IT, nor is
managing 1000 positions in your account.

Yes, there are some more practical problems (the valuation of individual
stocks being too high for small investors to buy even a single one, preventing
front running on index changes, tax refunds, ...) - but I would think all of
those should be possible to solve in a way that is both economically feasible
and has the individual investor holding the actual stock to prevent those
accumulations of power. And you still could have the possibility to delegate
your voting rights to some organization you trust--but that could be decoupled
from the investment "product" or account itself, plus you wouldn't be required
to delegate the power for all your investments.

Or we could just make laws that mandate that funds must delegate voting rights
to their investors, i.e., make it as if they were holding the stocks directly
in that regard?

~~~
mcguire
Tracking the index on your own would be more than a full time job. You could
do it automatically, but that just reinvents the fund

The S&P500 had 500 stocks. Do you want to vote ~1.5 times a day?

~~~
zAy0LfpBZLC8mAC
> Tracking the index on your own would be more than a full time job. You could
> do it automatically, but that just reinvents the fund

That reinvents funds ... without the problem of accumulating all the power in
a few hands, which was exactly my point?

> The S&P500 had 500 stocks. Do you want to vote ~1.5 times a day?

No, and why would I have to? For one, many index funds don't vote on many
stocks either. But more importantly, the point is to unbundle voting rights
from the portfolio management aspect. Just as that doesn't mean that you have
to manually track an index, it doesn't mean you have to manually vote either,
does it? You can just delegate it to some group that you think represents your
interests, and you could do so selectively. If some group wants to get some
particular company to change something and you support that, you could just
delegate the voting rights for that one company to that group.

------
njarboe
> Force giant index funds to spin off their assets into a number of separate
> entities, each independently managed. Such a drastic step would—and
> should—face near-insurmountable obstacles, for it would create havoc for
> index investors and managers alike.

Set a cap of $1 trillion or $500 billion that any single firm can have under
management. This probably only breaks up Vanguard and BlackRock. Not sure how
this would cause havoc. Seems like we need to relearn the reason anti-trust
laws we passed in the US and start using them again.

I do think Vanguard has been a great boon for American investors and would not
like them punished for their success. Not sure how to square that fact with
the need to break them up.

------
kjw
Related to this, supervoting shares are popular with tech startups that are
going public, but the street generally frowns upon these structures from a
corporate governance perspective.

Founders pitch supervoting control as a way to make sure the company can
realize its long term potential by protecting themselves from activist
investors with a short term view.

So far, ownership of new IPOs hasn't been affected much due to their small
market caps and subsequent miniscule weighting in indices. It will be
interesting to see if increasing concentrated ownership by index funds may
eventually play a factor and perhaps increase acceptance of supervoting.

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pedrocr
This seems quite easy to fix. Just give me the option of voting my shares in
the underlying companies of the index funds I own. I just want to own the
market average but I'm happy to be an activist investor in the decisions I
happen to care about.

Index funds may even want to differentiate themselves by having good research
teams to advise me on what to decide and having convenience options where I
get to set specific generic voting policies that they will then implement
automatically for me.

~~~
walamaking
Have you ever voted before? Assume 10 questions per company. Exposure to S&P
500 would mean 5,000 questions to answer. I don't know what the general stats
are, but some proxies I've seen have 20+ questions.

Now, you will most likely be uninformed about most of the decisions that need
to be made, which lead to your 2nd point about default options suggested by
the index fund manager. But that just circles back to Bogle's points in the
article. Also, with index fund costs at rock bottoms, good luck getting
quality research into your voting options.

~~~
pedrocr
_> But that just circles back to Bogle's points in the article. Also, with
index fund costs at rock bottoms, good luck getting quality research into your
voting options._

The alternative is active funds where you're already paying for exactly the
same thing plus a bunch of compensation for underperformance to people who
pretend to know what they're doing. Paying a research team is cheap in
comparison and once funds are at <0.10% expense ratios making them cheaper
isn't that big of a market advantage anyway. A good research team and
interface would definitely make me pick a 0.10% fund over a 0.05% one for a
life-long investment career. If I'm reading the numbers in the article
correctly at the scale of Vanguard that's a cool billion dollars a year to
provide research and systems.

------
randyrand
If I own a 1000 shares of an index fund, (which maybe includes 3 shares of
AAPL or something) shouldn't the 3 shares of voting power go to me? Why not?

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peter303
He didnt mention Federal Thrift program which is like five giant index funds
of five asset classes. I dont think they have any activism. But some top
federal official could polticize them like you-know-who who often disparages
individual companies and perhaps ask for the sale of a large amount of stock.

------
chanakya
I don't understand why this is a problem. The actions of index fund managers
are constrained enough to be almost automatic (hence the rock bottom fees).
They just balance the portfolio to track an index. With this constraint, how
does it give them power over corporations?

------
hartator
Author complains about high barrier of entry to create a new index fund, but
all solutions he list are just even more barriers of entry.

The common sense of not putting new laws until clear evil has been observed
should be applied here.

~~~
yborg
>the common sense of waiting for a massive crisis before doing something by
which time it is too late for millions of investors who lose everything

That _is_ the conventional approach, I think Mr. Bogle is suggesting that we
act to prevent such issues ahead of time for a change.

And the main barrier to entry he refers to is essentially the size of the
established players. They have economies of scale that a new entrant would be
hard-pressed to match. And the author is the man who essentially invented the
index fund, and whose company, Vanguard, currently is the market leader in
these products and has the most to gain from maintaining the status quo.

------
viburnum
Now that everything is getting rolled up into index funds, might as well just
turn over the means of production to the workers.

------
thoughtstheseus
Well, significant amounts of assets will be essentially controlled (votes) by
people who do not own it...

------
turc1656
I work in this industry. I'm on the indexing side of it, not the ETF/fund
side. We obviously have relationships with all the major fund providers,
especially the three big names mentioned in the article. And I happen to work
for the big dog - S&P.

 _" Why? Partly because of two high barriers to entry: the huge scale enjoyed
by the big indexers would be difficult to replicate by new entrants; and index
fund prices (their expense ratios, or fees) have been driven to commodity-like
levels, even to zero."_

I can attest that is absolutely 100% true. This business structure is perfect
when economies of scale come into play. And S&P is a master of this. It's
extremely difficult for others to compete with us because, like everything
else, there is a range of services/quality. S&P is at the top end - the
Mercedes of index providers. People pay more, but they get the best
service/products. The margins are extremely high for any business. But for an
service that is considered to have been "commoditized" (and it has to a large
extent), our margins are insane. All our competitors want to attack those
margins but they have trouble because they aren't able to provide the quality,
variety, or depth of service that we do. Which leaves them only able to charge
much less and be on the lower end of pricing. Time and time again I've seen
some clients leave to go with someone cheaper and become displeased and end up
coming back. That's because they simply don't have the internal systems, data
contracts, or expertise from having been doing this for as long as we have.

Another thing is that the business model in general is damn near unbeatable.
The 500 and DJIA combined require very little work overall as they are just
two out of thousands of products we have. But they account for hundreds of
millions of dollars in revenue. That's sort of like having a hit movie or
book. But the difference with this business model as opposed to most other
areas of capitalism is that the revenue is _recurring_. No where else have I
seen unpatented, non-copyrighted intellectual property retain its value like
this. Usually there is a surge at the start and then it tapers off fast after
release/purchase. That creates a cash cow which they use to build stronger
infrastructure and stay at the top.

That being said, let me address the main concern of the article - the issue of
ownership for the index funds (not the index providers). I might very well be
missing something here, but the answer seems obvious to me. They should just
update the law so that the shares owned by the fund providers aren't
considered theirs but rather the end holders of the ETFs/funds that they are
packaged into. In fact this is so obvious to me I don't understand how it's
not already the law since that's the case for a lot of other things like this.
If you have a Charles Schwab account and issue an order for a buy, they buy it
for you by placing the order under their trading ID on the market. You are
later updated to be a holder of record during the trade settlement process.
Schwab is a service/pass-through agent. It's very similar for the fund
providers. They just buy the shares to package/securitize in advance and then
sell to someone. This is the creation/redemption aspect of ETF management.
When the creation/redemption process goes on or ETF shares change hands, a
process similar to becoming a holder of record through trade settlement should
occur. Yes, that would result in you technically being listed as owner of a
fractional amount of shares, but that's a hell of a lot better (and easier to
deal with) than saying that the fund provider owns all the shares and you just
trust them to vote properly for you.

~~~
bulletsvshumans
I don't want to vote for each of the thousands of stocks I own indirectly
through my index fund. I want Vanguard to vote on my behalf such that it
proportionately replicates the votes of the non-index shareholders. This
strategy is just an extension of the idea behind index funds in the first
place: mirror the existing market.

~~~
zAy0LfpBZLC8mAC
In other words: You want them to not vote at all.

Which is a dumb idea, of course, as that just leaves the control over your
capital to your adversaries. Passive investing works because goals are
aligned: The only way to influence an index fund on the investing side of
things into doing something stupid is by doing something stupid yourself. If
you want to make an S&P500 index fund buy some penny stock, you have to buy it
yourself first in massive quantities paying massive prices for it to drive up
the market cap. Voting does not work that way.

~~~
bulletsvshumans
The other stockholders are almost never your adversaries. Their interests are
in alignment with yours: to vote in such a way that it maximizes the value of
the stock.

The only exception would be some kind of action that is specifically
discriminatory towards your shares over theirs, which is typically not legal.
If it were to occur, that is the only situation where I would want Vanguard to
be voting on my behalf.

You're right though that not voting is equivalent and much easier than trying
to replicate votes.

~~~
zAy0LfpBZLC8mAC
> The other stockholders are almost never your adversaries. Their interests
> are in alignment with yours: to vote in such a way that it maximizes the
> value of the stock.

Nope. Their interest is to vote in such a way that it maximizes the value of
their portfolio. If that doesn't match your portfolio, then your interests are
not aligned.

> The only exception would be some kind of action that is specifically
> discriminatory towards your shares over theirs, which is typically not
> legal.

There is nothing discriminatory about voting for selling a division of company
A to company B, say, and it is certainly not illegal. But it might well still
be in the interest of the owners of company B who also happen to hold the only
voting 10% of company A, and to the detriment of the owners of the other 90%
of company A.

