The rise of passive investing – a corporate governance issue

Silvio Gasparet, Director, Capital Advisory, KPMG Mackinson Cowell
Silvio Gasparet, Director, Capital Advisory, KPMG Mackinson Cowell
Curran McCann, Manager, Deal Advisory, KPMG Makinson Cowell
Curran McCann, Manager, Deal Advisory, KPMG Makinson Cowell

The rise of passive investing has been widely chronicled in the global financial media in terms of its appeal to investors and the potential “distortions” to the equity market.  How far this shift will progress is a hotly-debated topic, however the implications on company management are significant.

Background

Proponents of passive investing deride the higher costs and the performance records of most actively managed funds.  Detractors see the recent trend as a fad and one that is not without risks, particularly given the sheer scale of the largest players.  Risks include the potential for flash-crashes and, as passive investing increases even further in scale, the risk that equity prices become divorced from underlying fundamentals.

On the latter, a recent decision by New York-based asset manager VanEck to rewrite the rules governing which companies were eligible for inclusion in its small cap gold miners ETF stirred up quite a controversy.  Van Eck’s announcing an increase in the market capitalisation of permissible investments allowed astute investors to buy the larger companies that were coming into the fund and short the smaller names exiting.  This flurry of trading led to extraordinary price moves that hurt existing shareholders of the smaller cap stocks and cost the Van Eck fund an estimated $300m in front-running.  One analyst called the rebalancing “the single greatest wealth destruction event in index history.” [1]  Whether or not this statement is true, the events highlight a potential pitfall associated with significant scale in passive investing.

Looking briefly at the recent history of passive investing, from 2003, when it represented 8 percent of the global asset management market, money managed in passive strategies has nearly doubled as a proportion of total global assets and accounted for 15 percent as at the end of 2015.[2]

This proportion is higher in certain asset classes and geographies.  Indeed, in the management of equities, particularly in the US, passive investment accounts for a greater share.  Using mutual funds and exchange traded funds (ETFs) as a proxy for the broader equity market, as much as 40 percent of US equities under management as at the end of 2015 followed passive strategies.[3]  In Japan 67 percent of equities under management use passive strategies.[4]

In Australia, around 17 percent of the market as referenced by S&P/ASX 200 Index is “owned” by index or quantitative based funds with the majority being index based funds.[5]

Implications

The rise in passive investing is having the biggest impact on governance.

Unlike traditional active fund managers who would often sell their holdings if they are displeased with the performance of the company, passive investors typically are forced to maintain their holding as long as the stock remains in the index.  As Rakhi Kumar, who heads up stewardship and environmental, social, and governance investing for State Street Global Advisors says “Index investing is like a marriage where divorce is not an option”.[6]

Therefore passive investors are becoming more “active” in their engagement with companies and voting of shares at annual general meetings to effect change in the companies they hold.  Evidence from the United States shows that voting against director recommendations by the largest of these investors is rising.[7]  Index funds have also played major roles in recent high-profile activist campaigns, often siding with the activists that are seeking to shake things up at companies with lagging performance.

In Australia, the influence of passive institutions is magnified given our relatively large retail shareholder base, which typically doesn’t see a high voter turnout at AGM’s.

Considering the gold mining example cited above, although an extreme event, with the change in composition of an ETF, another potential implication is the impact on long term incentive outcomes if stock prices are not driven by underlying fundamentals.  Large swings in prices around the time of a relative total shareholder return calculation could exert significant influence on the outcomes to an executive’s reward.

Engagement

Whether the shift to passive continues unabated or not, we would encourage companies’ board and management to maintain if not increase its engagement with its largest shareholders.

Historically passive investors have typically not had the same attention from boards and management as their active investor cousins.  Although this has been changing, the trend arguably needs to continue further.

Boards and management should also continue to extend their engagement with their broader base of institutional investors.  In addition to regular direct contact with these investors a regular, unbiased qualitative survey of its institutional investors gives the board a clear picture of how their company is viewed by the financial community and how their relationships with shareholders and potential investors could be strengthened.

[1] The Australian, Goldminers in turmoil as huge ETF changes the game, 10 June 2017

[2] Boston Consulting Group Asset Management Report 2016, December 2016.

[3] Morningstar

[4] Barron’s, Man vs. Machine: How Has Indexing Changed the Market?, 8 July, 2017

[5] Orient Capital

[6] Barron’s, Passive Investors Are the New Shareholder Activists, 8 July, 2017

[7] Barron’s, Passive Investors Are the New Shareholder Activists, 8 July, 2017

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