How to solve the paradox of active ownership

Successful equity managers tend to be poor active owners, while active owners tend not to win equity mandates. Could unbundling the activities be the solution?

Pension funds are increasingly accepting the need for active ownership on environmental, social and governance issues, but few seem to have developed an effective approach to implementation. It is becoming clear that a number of environmental, social and governance (ESG) issues are both ethically and financially significant for pension funds. For example, it is in neither in the interests of society or in the financial interests of pension scheme beneficiaries that climate change is left to go unchecked, and yet pension fund capital is today being used to build a new generation of coal fired power stations around the world, accelerating carbon emissions. Perhaps the clearest sign of pension fund acceptance of this agenda is the fact that many of the world’s biggest pension funds have in the last year or so signed up to the UN Principles of Responsible Investment.
But how should pension funds go about implementing active ownership? The most popular approach, at least for UK schemes, is to delegate implementation to theasset managers employed by the scheme to manage equities. For most pension funds, this strategy does not seem to be working very well – at least according to a survey I recently conducted for Hymans Robertson of the 50 largest pension fund asset managers operating in the UK market. See Downloads
The survey finds that only a handful of asset mangers that have substantial programmes to implement active ownership. The best devote substantial resources to this area. Some employ as many as 15-20 specialist staff, contact hundreds of companies a year and are able to point to significant results in terms of changes to corporate behaviour.
On the other hand, the survey shows that the vast majority of equity managers take a much more limited approach to active ownership. For most that responded, active ownership work on ESG issues involves little more than employing a voting agency to ensure the shares get voted consistently with client policies. While this is certainly a start, it falls well short of the kind of carefully
planned programmes of dialogue and relationship that are implied by the concept of active ownership. Voting in a vacuum is unlikely to deliver results. One test of whether asset managers are effective at implementing active ownership is whether they are willing to meet companies to express their concerns about ESG issues and request specific changes to corporate practice. The asset managers with the greatest commitment to active ownership hold over 100 meetings each year with company directors and other senior managers specifically to discuss ESG concerns (see chart in downloads). At these meetings, and by other means, these managers make hundreds of specific requests for modifications to governance arrangements, environmental disclosures and other aspects of company ESG management. Furthermore, many companies appear to be quite willing to accede to at least some of these requests from their shareholders.
However, the survey found that as many as half the managers who responded do not have any dedicated meetings with companies to discuss ESG issues.
This is not quite the same as saying that these non-activist managers never talk to companies about ESG issues. Some of these managers report that ESG issues may come up from time to time in routine investment meetings. However, their intent on these occasions is merely to gather information for investment decision-making purposes, not to attempt to influence company behaviour on these issues. One large asset manager gave the example of BP’s poor health and safety record in the US. The manager said that even before BP’s Texas City refinery disaster it had been concerned about the potential financial impact of BP’s poor track record onthis topic, and had asked the company questions. However, the manager said that this information was solely used to inform investment decision-making. At no point did it seek to use its influence as a large shareholder to encourage BP to improve its management of health and safety risks. When I asked why not, the asset manager said that it didn’t see changing corporate behaviour as part of its role. Indeed several large and successful asset management companies covered by the survey were quite explicit in opting not to engage in this kind of activity. As another one put it in their survey response, “we are not engaged in influencing corporate decisions”.

“as many as half the managers who responded do not have any dedicated meetings with companies to discuss ESG issues.”

Unfortunately many of the asset managers that have been most successful at winning equity mandates from pension funds in recent years happen to fall into the non-activist category. This means that pension funds who hope to deliver on their UN PRI active ownership commitments by delegating to their existing equity managers are likely to be disappointed.
It also begs a question about the extent to which these non-activist asset managers are currently meeting the requirements specified by their mandates from pension funds. Several pension funds have told me that they are not very happy with the level of active ownership displayed by their asset managers. However, they have
indicated that this is not a sackable offence. While an asset manager is delivering satisfactory investment performance, it is hard for fiduciary investors to sack them for non-performance on this topic. Conversely, it is difficult for a fiduciary investor to appoint an equity manager simply because of excellent active ownership capability, unless this is accompanied by top decile investment capability. This combination has not frequently arisen in recent years.
This creates a problem: the most commercially successful pension fund equity managers tend not to implement active ownership effectively while the most effective active ownership managers tend not to win equity mandates. One solution is to unbundle the two activities. Hermes, F&C, Governance for Owners and one or two others managers offer an active ownership service that can be purchased independently of asset management.Through this service these managers already fulfil an active ownership role on behalf of nearly 20 external pension fund clients (including a few very large schemes). This approach is not ideal, particularly
because it does not provide the desirable link between active ownership and investment decision-making. But, in practice, it seems better than the alternative which is, as we have seen, an extremely limited form active ownership. So, at least for now, unbundling active ownership seems to be the way forward. It enables pension funds to deliver a high quality active ownership implementation, even when their equity managers do not want to play this role.

Craig Mackenzie is a senior lecturer at Edinburgh University Business School and serves as an advisor to Hymans Robertson LLP. He was previously head of ESG engagement activity for Insight Investment and Friends Ivory & Sime.