Mutual funds are a systemic risk by being dumb money. Normally this is talked about in the context of index investing. The more money blindly tracks an index, the more that index becomes detached from reality. This causes measurable inefficiencies in the market [0]. In practice, this isn’t that big of a deal, since “follow the index” essentially means “do what the smart money does”, so the distortion is not that great.

In the context of voting, the analogous action would be abstaining (or voting with the majority of voting active shareholders). I suspect the reason this is not done is a combination of there not being enough active voting shareholders (as you say, that is why boards are a thing), and the risk of activist investors.

On a much smaller scale, we have something similar happening in my local HOA. The county owns about a dozen units as part of it’s public housing program. Combined with the low turnout at HOA meetings, and the 1 property = 1 vote, this means that they could vote for essentially anything they want.

In practice, their policy is to show up to all meetings but abstain from votes unless they are needed to make a quarum. If they are needed, they vote for whatever the consensus was among every else there.

[0] See the index effect. Being added to an index increases a stock’s value, despite there being no change to the underlying fundamentals.

I’m not sure why you’re specifically focusing on mutual funds. Holding of public shares is supposed to be a passive income whether it’s individual investors (who are hopefully diversifying their investments), mutual funds, ETFs, etc. The board works for the shareholders by collecting data, assessing that data, and then making recommendations so that investors don’t have to do that research. Sure, it’s possible that the shareholders vote against the advice of the board, but it’s pretty rare.

I’m focusing on mutual funds because, when you own shares of a fund instead of shares in the business directly, you don’t get to vote (usually) even if you want to.

And now I’m going to focus even more specifically:

This is a virtuous cycle (or vicious cycle for other stocks) where Costco is seen as a fairly ethical company, so investors who are looking for stocks that meet their values choose companies like Costco (whether they are individual investors or investment vehicles marketed as fitting certain values).

Most stocks these days are held not only in mutual funds, but in index mutual funds, where they literally don’t make the decision you just cited as the thing that keeps the corporate boards aligned with the shareholder values. They just buy every company weighted by market cap instead, and in so doing, jettison all of that kind of influence they would have otherwise had.

In summary, mom & pop investors (i.e. folks who invest entirely or almost entirely via the index funds offered by their 401(k)) are not only disenfranchised in terms of share voting, but also don’t actually choose what companies to invest in – the fund managers and 401(k) plan administrators have taken all of that power from them.

Do you see the problem yet?