Passive investment vehicles have experienced tremendous growth in recent years. Today, reports suggest the combination of the top three firms in the space, BlackRock, Vanguard and State Street, constitute the single largest shareholder in over 40% of listed companies in the U.S.[1] Recent reports are predicting continued exponential growth in index investing, with research from Ernst & Young forecasting that over the next three years exchange traded funds (ETFs) will grow by a compound average growth rate of approximately 18%.[2] In the first six months of 2017, net flows out of actively managed funds and into passively managed funds accounted for US$500 billion.[3] Much of these gains have been on the back of a growing body of research showing that the vast majority of active managers fail to beat their stated benchmark.[4] This research, in combination with low fees, enhanced transparency and increased diversification offered by passive vehicles have contributed to their rise in popularity.
As passive investments and index strategies continue to gain popularity, new questions are being raised on the overall impact and influence on market systems and efficiencies. Corporate governance is one such area where pundits for and against, are weighing in on unintended consequences and the opportunities brought about by increased dollars in such strategies. This blog explores this debate, starting first with framing both sides, then outlining the unique governance position of leading indexers, and concluding with a look into the how influence is being exercised by these investors. For our purposes we will mainly focus on actions and data involving the three largest passive investment firms, BlackRock, Vanguard and State Street – whom we collectively refer to as the “big three.” [1]
Before exploring the debate surrounding passive investment vehicles and any governance implications, let’s briefly review how such strategies work. Most passive vehicles are designed to replicate the performance of a specific index or benchmark. As they are passively managed, the expense ratio is generally low. Importantly, passive managers, unlike active managers, are not stock pickers. While there is a vast array of strategies implemented by passive investors, the general premise is based on a buy-and-hold strategy, where investors are not trying to beat the market by profiting from short-term swings, but rather to create maximum value over a long-term investment horizon. This means that passive investors are in the unique position of being essentially “long only” in the basket of stocks they are invested in – an important point which we will revisit later.
THE DEBATE
The foundation of healthy corporate governance is based on shareholder rights and voice in the decision-making of management. Systems of corporate governance, such as annual general meetings and proxy voting, function as a check and balance on managers, dissuading self-serving decision making that is not in the best interest of shareholders. In terms of index investing, concerns have been raised that these investors will leave companies unchecked and therefore corporate governance standards and, ultimately, company performance will weaken. This assertion is based on managers of indexing strategies being unable to vote with their feet and sell underperforming stocks; as well as concerns that due to the sheer number of stocks held in any one index the proper care and due diligence cannot possibly be taken to effectively flag issues and vote on proxy matters.
Additional concerns have been raised with what is essentially an index oligopoly, as BlackRock, Vanguard and State Street dominate the industry. This concern is tied to a worry that as the big three control a growing ownership block in stock markets that competitive forces will erode and oligopolistic practices will emerge. Bill Ackman, hedge fund manager and shareholder activist, has compared the growing dominance of index funds with the Japanese keiretsu systems of cross-corporate ownership, which has been widely blamed for corporate underperformance in the country.[5] The keiretsu system is a loose network of businesses, often across industries, who may have stakes in each other’s business or operate in a manner that is beneficial to the others in the group. The system is criticized for creating inefficient market practices.
Passive Investors have argued that, as inherently long-term investors, they place greater weight on sound governance strategies than their active counterparts. Bill McNabb, Chairman and CEO of Vanguard, explains their unique governance position in a 2015 speech at the Harvard Law School:
“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.”[6]
In effect, because of the inability to ‘vote with their feet,’ the big three have had to find other ways to influence corporate action. This influence is being exercised in three ways: corporate engagement; public influence or voice; and proxy voting.
EXERCISING INFLUENCE
Corporate Engagement
Dialogue between investors and companies is seen by the big three as an important component of their fiduciary responsibility to shareholders, as well as a method to help management better understand the needs of their investors and make more informed decisions. According to a company report, during the 2017 proxy season Vanguard held 954 company engagements and voted on over 171,000 proxy proposals.[7] State Street reported a similar large volume of activity, conducting 611 corporate engagement meetings in 2016.[8] Such engagements give investors the opportunity to flag issues and to discuss priorities with company leadership. To manage their expanding number of engagements, BlackRock and Vanguard have both reported that they are bolstering their corporate governance teams. Critics have argued that the increase in manpower is not enough to effectively cover the big three’s large universe of diverse holdings. Chances are most firms won’t hear from the likes of the big three unless they have serious governance concerns. For many C-suite and investor relations professionals it is an uncomfortable reality that you can’t put a face to some of your largest investors, and opportunities for outreach are limited or non-existent.
Environmental, social and governance (ESG) issues have been a major focus of corporate engagement among the big three, dominating their stewardship agendas. In 2015, BlackRock teamed up with Ceres, an investor advocacy group with a sustainability focus, to produce a guide providing strategies for investors to incorporate ESG considerations into corporate interactions.[9] The 68-page document reads as a “how to guide,” covering multiple facets of engagement from writing shareholder proposals, to divestment, to influencing public policy. Additionally, BlackRock, Vanguard and State Street all publish annual stewardship priorities on their websites. While the communications of these priorities serve to focus the agenda of corporate engagement, they are also creating influence beyond the hundreds of physical engagement meetings that the big three hold each year.
Voice
Passive investors have been actively shaping the conversation around ESG issues through channels such as annual letters, website content, media interviews and conferences. A recent example is BlackRock’s 2018 Letter to CEOs, from its CEO, Larry Fink. The letter asserts that a new model of governance is required stating[10]:
"Society is demanding that companies, both public and private, serve a social purpose. To prosper over time, every company must not only deliver financial performance, but also show how it makes a positive contribution to society."
Similarly, Vanguard’s McNabb is a supporter of The CEO Force for Good (CECP), which brings together over 150 CEO’s with the goal of empowering corporations to be a force for good in society. In February of this year, McNabb co-authored an open letter from CECP, which re-states the need for long-term strategy and suggests questions for corporates to consider when presenting publicly-disclosed, investor-facing long-term plans. Both examples demonstrate a clear push that is seen by all the big three towards long-term strategic frameworks and the affirmation of board oversight on these plans. This is a departure for the investment industry which many have argued, including Fink and McNabb, has become dangerously focused on the short-term and the quarterly cycle.
The focus on long-termism can be understood as one of the foundational, perennial governance issues which the big three have pressed with companies. Others include: board compensation and effectiveness; alignment of executive compensation with the long-term strategy and shareholder interests; and promotion of governance structures that encourage increased accountability. BlackRock explicitly asks companies to provide information on how board effectiveness and performance is assessed. Vanguard and State Street have vocalized similar requests. The combination of these focus areas indicates a move from the big three towards governance models that go beyond oversight and compliance and to one focused on enhancing long-term sustainable performance.
The big three have also taken leadership in the development of ESG integration and reporting. The world of ESG reporting has struggled over the past decade to find a common reporting framework and language, such as those that exist in financial reporting with GAAP or IFRS. Against this backdrop, the high-profile publications and campaigns of the big three, together with collaborations such as BlackRock and Ceres, have served to provide direction for corporates and standard agencies, alike, and to give us all priorities we can begin to wrap our arms around. Further, BlackRock has publicly supported the Financial Stability Boards’ Task Force on Climate-related Financial Disclosure (TCFD) reporting standards, while Vanguard has aligned with the Sustainability Accounting Standards Board (SASB). These steps help provide companies with more insight into what types of information and in what format investors are looking for, and ultimately to help teams better communicate both performance and strategy.
Proxy Voting
Of course, all investors (passive or not) have proxy voting as a direct tool of influence, and the big three have certainly not shied away from exercising this power. While the big three are unlikely to initiate a proxy battle, their shares can become an important vote that can swing results. This was reportedly the case in the 2017 proxy fight at Procter & Gamble, where BlackRock and State Street supported activist Nelson Peltz in his bid for a board seat, and Vanguard voted with management. The voting was so close that a recount of the preliminary tally was required, and Peltz was eventually appointed to the board. [11]Another well-cited example is the 2016 ExxonMobil proxy battle. In this case, BlackRock and Vanguard jointly led a shareholder resolution to force the company to publish an annual assessment of the business impact of climate change policies, such as the 2-degree Celsius scenario ratified by the Paris Agreement.[12]
UNDERSTANDING INFLUENCE
The big three’s public campaigns have grabbed headlines and spurred discussion, however, is there evidence of meaningful influence on corporate governance practices? Analysis of voting results provides one tangible view on influence. As documented in recent research from the University of Amsterdam, the big three are seen to exercise consolidated voting practices across all funds held within a firm’s universe – supporting the view of structural power through ownership and voting influence.[1] Analyzing behavioural voting practices, the researchers found that the big three voted with management 90% of the time – suggesting a hesitancy to exercise power. However, proposals where the big three voted against management typically related to ESG issues, which given their nature are mainly proposed by activist shareholders.
These findings are further supported by a 2016 study which found that an increase in passive investment is associated with greater support for shareholder-initiated governance proposals.[13] The same study identified three corporate governance changes that are thought to be influenced by increased passive ownership. These are: increased board independence; removal of takeover defenses; and lower likelihood of unequal voting rights. The findings of the report suggest passive investors are conscience owners, and that managers today, face a more contentious and active shareholder base, despite an increase in passive investment and decrease in activism. While results provide compelling evidence for real influence exercised by the big three, additional research is required to understand if the influence of voice, and public campaigns by leaders such as McNabb and Fink are being internalized by management teams who are not in direct contact with governance teams or facing the big three in proxy battles.
One thing is clear, the big three are taking actions to engage with companies and vocalize their expectations in the realm of corporate governance in an effort to increase the long-term value of their holdings. In this way, good corporate governance is seen not as a matter of compliance, but rather as an indicator a quality of leadership and ultimately an enabler of better performance.
