Passive attack: are index trackers the new shareholder activists?

The rise of large passive investors promoting governance change

Large passive investors play as crucial a role as active managers in promoting effective corporate governance in companies they invest in as the global debate on stewardship and rising CEO pay take centre stage, leading fund managers said.
Some of the world’s biggest passive fund managers including BlackRock, Vanguard and State Street Global Advisors are now the biggest shareholders in US and UK companies. And increasingly, the role of many of these funds are coming under scrutiny in companies like Sports Direct, which saw an unprecedented 53 percent of shareholders vote against the re-election of the chairman earlier this month.

“We had to go public on Sports Direct” – John Kay

“Unlike active managers, who can sell stock if they don’t like the approach management is taking at a company, in our index portfolios we cannot,” said Michelle Edkins, Global Head of Investment Stewardship at BlackRock.

“So it’s a different way of thinking – it’s about using your voice – on behalf of your clients- and demonstrating that you are in it for the long term, and willing to be a constructive partner for companies on governance matters, particularly where change may be necessary to ensure sustainable financial performance over time.”

In the case of SportsDirect, some of its largest investors came out in public to attack the retailer’s corporate governance practices. For the first time since its launch two years ago, the Investor Forum whose 40 members represent 27 percent of independent shareholders, publicly called on the company to undertake an independent review.

Professor John Kay, a member of the Investor Forum board and author of the Kay Review whose report was instrumental in the formation of the forum, said: “We had to make our concerns about Sports Direct public, because our talks in private with Mike Ashley weren’t having the desired effect.”

Bowing to investor pressure, Sports Direct said this week it would carry out an independent review of its practices. Just today its CEO Dave Forsey resigned and was replaced by founder and majority owner Ashley.

The Investor Forum, which brings together active, passive and activist managers managing some 1.5 trillion in assets, was formed in October 2014 to bring together institutional investors to collectively engage on stewardship.

Kay said: “I don’t think passive management and activism are at all inconsistent. Some of our biggest managers like Legal & General and BlackRock as index tracking managers cannot sell shares and are not conventionally active, but have been playing a very prominent role on the corporate governance side.”

In a recent research paper, Wharton finance professor Todd Gormley found that that the rise in passive ownership in the US was actually facilitating activism.“We see more proxy fights when there is more passive ownership,” Gormley said. “Hostile takeover attempts also increase alongside passive ownership and with more passive ownership, those attempts tend to be more successful.”

In a letter to CEOs earlier this year, BlackRock CEO Larry Fink said activists who focus on long-term value creation sometimes offer better strategies than management and in those cases, BlackRock’s corporate governance team will support activist plans.

During the 2015 proxy season, in the 18 largest US proxy contests, BlackRock voted with activists 39% of the time.

Gormley said it would be difficult to create a bespoke index, weeding out unwanted stock as that would be moving into active management territory, making the funds more expensive to run.

“Passive investors, which are primarily interested in minimizing tracking errors, cannot easily exit positions and this is one potential reason why they are supportive of activists that seek to improve long-term value in stocks that they are unable to exit,” he added. Tracking error is the difference between a portfolio’s returns and its benchmark.

Sacha Sadan, director of corporate governance at LGIM, said the fund manager voted against at least one resolution at 18% of UK companies in 2015, highlighting how index investors are not necessarily passive owners. The fund manager also held 545 company meetings in 2015.

“LGIM takes seriously our stewardship obligations in helping to bring positive change to the companies in which our clients invest. We use our position as a large shareholder to influence and promote best practice,” he added.

Vanguard, another large passive fund manager with $3 trillion in assets under management, said the investment firm used its “vote and voice” to effect change in companies it invests in.

“We have a very significant voice in the market, given that our ownership in companies is growing and in the case of index funds, we are essentially permanent shareholders,” said Robert Main, head of corporate governance at the firm.

“We are taken very seriously by the companies we invest in, and usually companies are responsive to our concerns.”

Kate Brett, a principal at Mercer, said the consulting firm was increasingly seeing greater investment in corporate governance teams at investment managers and a greater level of transparency from investment firms.

“Asset owners are increasingly keen to appoint passive managers who they feel are more engaged. There is now a greater understanding that passive investment doesn’t mean you cannot be an active owner,” she added.

Edkins added: “One way to judge the change in approach is to look at fund firms building up their teams on engagement and we have been seeing more of that over the last few years.” BlackRock now has a team of 22-member team based in five regions globally.