Should Passive Investors have Shareholder Voting rights?

This post is a summary of the arguments contained in this paper. For a detailed discussion of the challenges facing asset managers considering the integration of sustainability concerns, see this paper.

The background on proxy voting:
It feels like a constant to and fro in the debate as to whether or not passive investors should have voting rights. When I started my PhD four years ago, the main criticism was that passive investors were “absentee landlords” that they had no “skin in the game” and would thus either not vote at all or not invest in the required resources to make qualified voting decisions. Fast forward to today, and there are calls to limit the voting rights of passive managers. What has changed? Well the percentage of money flowing out of active and into passive mandates, especially ETFs, has increased further. The winners of this trend have been the “Big Three” (Blackrock, Vanguard and State Street) as passive management is a scale game and about keeping fees low. Another reason for the backlash against passive funds is likely related to failed activist campaigns. In one of the most high profile cases in 2015, Nelson Peltz’s hedge fund Trian lost a proxy fight at the former DuPont after “passive” investors backed the management against Peltz.

Before we go any further, one thing to keep in mind is that most people writing on the topic of passive investing are biased (knowingly or not). Most comments are written by people from either the active or passive industry. For full disclosure, I work in the fund management industry as an equity fund manager for an active house.

Academic articles worth reading:
The argument against: “The Case Against Passive Shareholder Voting” by Dorothy Shapiro Lund of the University of Chicago Law School,
The argument for: “Passive Fund Providers and Investment Stewardship” by Hortense Bioy, Jose Garcia-Zarate, and Alex Bryan of Morningstar (a skeptic might point out that Morningstar’s clients are the big asset managers but that is not to take away from their paper).

Press articles:
“Thanks to ETFs, S&P 500 Companies Have a New Boss — the S&P 500” by Rachel Evans for Bloomberg
The Economist — “Stealth Socialism”
WSJ — “Passive Investors Don’t Vote”
FT — “Index tracking ETFs deny any ‘abdication’ of stewardship role”

Discussion:
The reason to limit passive investors’ voting rights as I see it mainly comes down to the lack of an apparent financial incentive for passive investors to invest in a corporate governance function. This is because any benefit from better governance benefits all investors and passive investors are paid to track an index and cannot generate outperformance through better corporate governance. However, while this may appear true in theory, we have to look at who these passive investors are in practice. On top of their passive equity assets, Blackrock, Vanguard and State Street have $478bn, $431bn and $102bn respectively in active (!) assets. These are not pure passive investors. That’s roughly $1trl in active assets that would require a voting function irrespective of whether passive funds may vote or not, and that’s $1trl of reasons for why these passive managers do have skin in the game (a previous version of this blog had different numbers, these numbers are from the Fichtner et al. 2017). These funds tend to vote all proxies the same irrespective of whether the mandates are active or passive (with the exception of a few special cases). For more on this see the paper “Hidden power of the Big Three? Passive index funds, re-concentration of corporate ownership, and new financial risk” by Jan Fichtner, Eelke M. Heemskerk and Javier Garcia-Bernardo (a copy of which can also be found on SSRN). Since passive investors, unlike active investors, cannot sell out of holdings this means that corporate governance is their only control function. Consequently one could even argue that this actually makes them more incentivised than active managers to ensure good corporate governance.

With regards to financial incentive, the Big Three benefit most from equity inflows that result from a country having a strong equity culture. Any such equity culture requires trust in markets, and corporate scandals undermine this trust. It is thus in their interest to ensure there are no “bombs” in the large indices. Just look at the impact the Facebook “data breach” had on the prices of US indices this week. The less scandals the safer equities appear, the more assets the passive managers can attract, and while The Big Three might have to pay for it, they also receive a large portion of the inflows. For what it’s worth, any positive stock price reaction to better corporate governance also raises the Assets under Management (AuM) of these asset managers and in turn increases the fees they get paid (though this is likely only a minor effect). Finally, shareholder engagement has a certain “halo effect” that supports the image of asset managers and helps them in their asset gathering (think about Fink’s CEO letters that get reported in the press). The Big Three have deep pockets and a large asset base across which to spread the costs of corporate governance enforcement, and can afford to invest in bigger corporate governance teams (Blackrock had Net Income of ~$1bn in just the fourth quarter of 2017).

The bigger picture?
Some companies worry that passive managers could be instrumentalised by activist investors or even by NGOs. But the whole discussion on the power of passive money is likely about two overarching questions:

Firstly it is about the role of shareholders: This goes into the shareholder versus stakeholder debate, the debate about whether shareholders are actually owners (legal scholars will tell you “No”), what issues shareholders should have a say on, what responsibility shareholders have towards other stakeholders, what we think of financialisation in general, and what role governments foresee for fund managers (think “Stewardship Agreements”).

The second, somewhat related debate is about time horizons and the breadth of their portfolios. While the Big Three are primarily asset managers and not asset owners as is the case with Sovereign Wealth Funds, they are nevertheless “universal owners”. As universal owners they own a little stake in pretty much every company. This should mean that they care about negative externalities produced by portfolio companies (say one portfolio company saves money by dumping sewage into a river, this may raise the costs of another portfolio company downstream that relies on clean water). This may also mean that they increasingly take a longer-term view on, for example, environmental issues, while other investors (especially activists) will favor a shorter investment horizon. This point of differing obectives of the Big Three is itself related to the other topical debate of “common ownership” and the means by which investors might influence the corporate objective function (here is a link to a good post by Martin Schmalz).

Conclusion
There is a difference between the big passive houses and the smaller ones. In general it is true that the business model of passive investing is built on low fees and that this does not afford the smaller providers the ability to set up sufficient corporate governance departments. I remember talking to one company that told me one of their largest investors was a sector ETF and that they had been unable to talk to them about a forthcoming corporate action despite making multiple attempts to engage. For the big houses though, a corporate governance function is a small price to pay to reduce the risk of corporate scandals and to reap the effects of any halo effect.

In the past the shareholder base globally (but especially in the US) was much more dispersed and shareholders often faced collective action problems. As a result we had managers that were free from shareholder control and in some cases set upon empire building. The ownership concentration today, while worrying on the face of it, has had the result that corporate managers face much greater scrutiny then in the past. Whether or not we want the Big Three to be the referees of shareholder proxy contests also depends on the alternative of taking their voting rights away and giving activists more say. And we have to remember that the ultimate owners of many of the passive houses’ assets are retail investors and pension funds that have outsourced the management to them. Especially the pension funds will have much longer investment horizons and are thus likely to support the current approach of the big passive managers. If they did not they would take their money away and there would be a passive manager with a different business model with regards to corporate governance.

A recent example, again involving Nelson Peltz, perhaps gives hope that the current system isn’t broken: In 2017 Nelson Peltz took on the management of Procter & Gamble and tried to gain a seat on the board. According to CNBC Peltz lost the vote by 0,2%. Peltz had won the support of all three proxy solicitors, Egan-Jones, Glass Lewis and ISS but lost nevertheless (this is interesting as the power of proxy advisors is also a huge debate). Again, according to CNBC “of P&G’s top three shareholders, State Street Global Advisors and BlackRock sided with Peltz, while Vanguard backed P&G”. This is noteworthy for two reasons: the proxy advisors weren’t on the winning side, and the three big “passive” houses voted differently showing that they did their own research and did not blindly follow proxy advisors as is sometimes suggested.

To finish on a balanced note, the case of P&G is of course a high profile US proxy battle and likely one that received greater attention from corporate governance experts than other proxy battles at smaller US or foreign investee companies would have. The proxy system certainly has further room for improvement but limiting the votes of passive funds is not what is needed.

Thanks for reading.