So-called “Passive” investment funds, which follow the markets rather than invest actively in companies, are growing in number. But are they really “passive” owners? Research suggests otherwise. We look at the data and whether, as stewards, they can and do influence corporate governance and performance in their investee companies.
We have remarked in earlier articles about the limitations of the campaign to improve stewardship by investing institutions. The argument is that investors, as owners, should play their part in holding management to account for the success of the business in achieving its goals. The criticism is that fund managers prefer to do what used to be called “the Wall Street Walk” and sell their holdings at the first sign of difficulties, rather than engage with management and try to improve the situation.
Growth of “passive” investment
Of course, so-called “activist investors” such as American businessman Carl Icahn, are not just ready to engage, it is their very raison d’être. They acquire shareholdings for the purpose of bringing pressure on the board to change its policies. Activist investors must be distinguished from “active” investment managers which pursue an investment strategy which involves on-going buying and selling, purchasing investments and continuously monitoring their progress to decide whether to hold or sell in order to maximise profits over quite a short timeframe.
But there is a growing body of investment which is described as “passive”, conducted by fund managers whose purpose is not to buy shares to influence management, like activists, or to buy and sell shares to make short term profits like active investors, but rather to shadow a market index. Their aim is to save the expense of highly paid stock pickers and multiple transaction costs by buying the leading shares in an index and, broadly speaking, holding them for as long as they stay in that index. Recent research has shown that the cost savings in passive management are so big over a long period that these funds can out-perform actively managed funds. In the US, passive management funds have tripled as a share of total investment since 1998 and now represent nearly a third of long-run funds’ assets at $4.5 trillion, according to Morningstar.
Are passive investors “lazy owners”?
So one-third of funds are managed passively compared with two-thirds managed actively. And criticism continues to be levelled at investment managers for ineffective stewardship. So it might be thought the situation is getting worse as an increasing proportion of investors moves into index-tracking. However, some recent research by American academics, Ian R Appel, Todd A Gormley and Donald B Keim, in a paper called “Passive Investors not Passive Owners” published in September 2015, suggests that, counter-intuitively, passive investors appear to have more influence on management than the general body of active investors. The criticism of passive investors as “lazy owners” who piggy back on the efforts of active investors is challenged by these academics who have attempted to compare the impact of passive and active investors in the US between 1998 and 2006. They looked at the record of three of the largest passive fund managers at the time, Vanguard, State Street and Barclays, through the records of the Russell 1000 and Russell 2000, which track the top 1000 and next 2000 companies in the US, measured by market capitalisation, and looked at the lowest 250 in the top 1000 and the top 250 in the next 2000, to eliminate bias (the passive funds apparently invest primarily in the top slice of each of these indices). They looked at the published corporate governance focus of Vanguard, the biggest, and set out to assess what effect the passive funds had caused through their voting record on these policies in terms of changes accepted by boards.
They focused on governance and voting (using ISS data), accounting and compensation (using Compustat/Execucomp from S&P Global Market Intelligence). They also looked at “poison pills” (using Shark Repellent Factset).
What do the passive funds say about governance?
The policy of Vanguard was expressed by F William McNabb III, Chairman and CEO of the Vanguard funds.
“We’re going to hold your stock when you hit your quarterly earnings target. And we’ll hold it when you don’t. We’re going to hold your stock if we like you. And if we don’t. We’re going to hold your stock when everyone else is piling in. And when everyone else is running for the exits. That is precisely why we care so much about good governance.”
More specifically, Bill McNabb spelled out the broad governance issues on which Vanguard focuses:
- Independent oversight, ie board independence
- Annual director elections and minimal anti-takeover devices
- Shareholder voting rights consistent with economic interest ie no dual class share structures that provide disparate voting rights to different groups of shareholders
- Sensible compensation tied to performance.
What does the research show?
The research showed that these four broad governance issues were followed more generally by the largest passive funds during the sample period, resulting in voting to:
- support greater board independence
- oppose takeover defences
- oppose unequal voting rights which occurs when there is a dual class structure
- support compensation plans that align management’s interest with shareholders and avoid excessive awards.
Independent directors were supported as it was assumed they would be more effective, and interestingly passive ownership was associated with smaller boards.
Opposition to takeover defences was a common feature of passive funds’ voting, and associated with the removal of poison pills and restrictions on shareholders’ ability to call special meetings.
Dual class structures and unequal voting rights were universally opposed by passive investors.
How can passive funds influence governance?
How might passive investors influence governance when they haven’t the resource to engage with lots of individual companies, or, indeed, the wish to do so? The answer is described as the power of passive investors’ “voice”. This seems to be the consequence of the very fact that these funds cannot sell, so they make themselves more awkward in terms of their voting record in regard to governance matters. Indeed, it appears that this “activism” by passive fund managers bizarrely results in active fund managers becoming less active and letting the passive managers lead in confronting managements. It seems that the very threat of adverse voting by passive funds is effective in influencing boards to take action to avoid such adverse votes. Here, in an extract from the research report, are a couple of quotes from one fund manager:
Glenn Booraem, controller of Vanguard funds, notes that engagement with directors and management of companies is a key component of Vanguard’s governance program, and that Vanguard has “found through hundreds of discussions every year” that it is “frequently able to accomplish as much—or more—through dialogue” as through voting……… And in a speech from October 2014, the CEO and Chairman of the Vanguard group, F.William McNabb, noted that Vanguard sent out 923 letters to firms in 2013, 358 of which requested specific changes in governance, and that 80 of these companies had adopted substantive changes without having to go through a shareholder proposal.
Can passives improve company performance?
Activist investors will take their stakes in the expectation of improving performance. So a natural question is whether passive investors are likely to affect performance, or indeed even influence the contentious issue of executives’ pay or other important corporate policies. The conclusions of the research were that there appeared to be a measurable improvement in performance as a result of the interventions by passive investors. This was judged in to relation to Return on Assets (ROA) and in relation to Tobin’s Q (the ratio between the value of companies according to the stock market and their net worth measured at replacement cost). However, there was little evidence in the period studied that passive investors had any effect on managerial pay. This, of course, was prior to the Dodd-Frank Act in 2010, which potentially gave passive investors additional means of influencing pay. There was similarly little evidence that passive investors were able to influence policies in relation to dividends or capital restructuring.
So are “passives” actually “active” owners?
Overall, the conclusions of the research were that while passive institutional investors were not active owners in the traditional sense of accumulating or selling shares in a target company, or activists with the express purpose of influencing management, they were not passive owners either. As the researchers say:
“The observed differences in actual governance structures suggest that passive institutions are attentive to firms’ corporate governance, and that they use their large voting blocs to exercise voice and exert influence. For example, we find that higher passive fund ownership is associated with less support for management proposals and greater support for shareholder-initiated governance proposals.”
However, as they also say:
“The findings also do not address whether passive investors attempt to determine the individual governance needs of each company in their large portfolios or instead follow a ‘check the box’ approach to governance”.
What is our own assessment?
So how do we at Applied Corporate Governance view this research?
In relation to our holistic view of corporate governance, clearly the definition used by the American academics is much more limited. It basically takes the shareholders’ position as paramount and defines the fund manager’s fiduciary duty as being to look after the value of the shareholders’ investment. Hence, in a sense, it is looking at stewardship of the funds invested, exercised through the fund’s stewardship of the companies making up the ultimate investments. It also restricts its understanding of what we call stewardship to the limited number of actions, by the fund mangers, which it can measure through the data captured by organisations like ISS. So we have to view their research as representing a study of whether the owners are exercising their stewardship role properly and effectively in the limited way they define.
Within that more limited perspective, we would have to say that the study would appear to show that passive investors, perhaps surprisingly, appear to contribute positively to improving the stewardship of the largest companies in the USA.
Our own broader perspective would, of course, lead us to recommend that the huge passive investment funds adopt our Five Golden Rules approach to corporate governance. They would then go beyond the limited ISS definition to assess performance holistically through ethics, common goal, strategic management, appropriate organisation and accountability. This is what we will be working on with our supporters in the years ahead.
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