by Cydney Posner
You might be interested in this article in the WSJ discussing the ascension to power-broker status of passive investors, such as index funds. The article contends that “leverage over America’s corporate boards… increasingly belongs to investors such as [the] pioneers of passive investment funds that track indexes instead of trying to beat the market like Wall Street’s classic stock pickers.” The trend represents a reversal of past perceptions of passive investment funds: “Passive funds used to be unequipped and unwilling to weigh in on most corporate events. With their new power, they are waking up to how much sway they can exercise over takeovers, the fates of chief executives and other crucial decisions.”
Why has this happened? The article contends that it’s largely because more and more investor capital is flowing into passive funds. The WSJ has reported that, according to Morningstar, over the three years ended August 31, “investors added nearly $1.3 trillion to passive mutual funds and their brethren — passive exchange-traded funds — while draining more than a quarter trillion from active funds.” And when invested, those additional funds have amounted to significant stakes in a growing number of large companies. According to an analysis performed by the WSJ, as of June 30, “U.S.-based mutual funds and exchange-traded funds that track indexes owned 11.6% of the S&P 500, up from 4.6% a decade ago….” As an example, the WSJ reported that, in 2005, the U.S.-based passive funds of one index fund manager owned 5% or more of only three S&P 500 companies, but by June 30, 2016, they owned 5% or more of 468 companies, representing 94% of the S&P 500. And increasingly, the stake of passive investors is larger than that of activist funds. According to the WSJ, in 2005, US-based passive mutual funds and ETFs collectively owned stakes that were larger than active investors in only 12 S&P 500 companies; by June 30, 2016, that number had risen to 112 companies.
Although their ownership stakes allow passive investors to be influential, the article reports that they “say they don’t use their new power like activists investors, who accumulate shares and make demands. They typically view themselves as long-term holders that shouldn’t meddle in day-to-day management.” However, while decades ago, reluctance to meddle meant consistent deference to management, today, passive investors are more willing to use their clout. According to the founder of a notable index fund quoted in the article, the fund has “‘moved from a position of reluctance to make our weight felt to absolute interest in making our weight felt.’” Where previously, he had been advised to “leave the performance of companies in their portfolios to ‘the invisible hand of the marketplace,’….These days, [he indicated] ‘we are the invisible hand of the marketplace.’”
But that clout is often not wielded in support of activist positions: the article indicates that activists are concerned about significant holders that, in the view of activists, are too deferential to management, and thus may use their large holdings — which are often determinative in votes — to oppose activist initiatives. According to the article, “executives [of passive funds] say they have different investment time horizons and fee structures than activists, which affects their decisions about portfolio companies.” An academic study cited in the article showed that, when big stakes are held by passive investors, companies tend “to shed tactics seen as defensive against shareholders, such as staggered-elected boards, and to increase the independence of board members. It found little impact on executive compensation or capital allocation, the kinds of operational changes activists often seek.” One representative of a large passive fund manager expressed her view they “can have influence” in about 1,200 of their domestic portfolio companies. But she believes that often “meetings behind closed doors can go further than votes against management….”
SideBar: That’s not to say, however, that powerful institutional investors, including some passive investors, have always remained reliable allies of management and never align themselves with activist investors. In 2015, Reuters cited Proxy Insight data showing that, with regard to three large well-known institutional investors, the percentage of dissident proxy cards that they “have voted to support – meaning they supported at least one dissident board candidate — has increased every year since 2011.” (See this PubCo post and this News Brief.)
In light of this change in attitude by passive investors, together with the growing impetus toward shareholder engagement (see this PubCo post), portfolio companies are increasingly seeking to meet with their key investors to discuss issues. And index funds report that “they routinely talk to companies and use data and research to make sure their approach to governance questions is best for their investments and all shareholders over the long haul.” However, relative to the volume of their investments, most index funds and other passive investors are not staffed at levels to address governance issues with each portfolio company individually as often as they might otherwise prefer. The article reports that, in an interview, a principal at one well-known index fund involved in its governance efforts, acknowledged “that his team can’t effectively meet with all the [portfolio] companies…in one year. He said he tries to take a longer view, communicating regularly with portfolio companies in person, over the phone or via email.” At another fund, the head of corporate governance instructs “her team not to agree to every meeting companies ask for because of time constraints. ‘If I don’t have something to say to you, it’s meaningless,’ she said.” Companies that want to engage with their key passive investors will need to be selective and plan ahead. (See this PubCo post for a discussion of a recommendation that companies proactively engage with their key shareholders in advance of activist approaches.)