Passive investment, active ownership

Financial TimesSometimes it seems as if passive investors have the worst of all possible worlds. Invested across the market, they are exposed to every corporate scandal, disaster or anti-business trend that comes along – and unlike investors pursuing an active strategy, they cannot even sell their shares if companies do something awful.

Investors with shares in companies beset by controversy sometimes say there is nothing they can do to change the company’s behaviour, as they are only invested in them because they belong to a particular index in which the investor owns every share.

 So is it possible for a passive investor to engage effectively with the companies in its portfolio without the ultimate sanction of divestment? John Wilcox, chairman of Sodali, a New York-based investment consultancy, and former head of corporate governance at TIAA-CREF, one of the world’s largest pension funds, says it is.

“Having a passive investment strategy has nothing to do with your behaviour as an owner. It is very clear from stewardship codes around the world that there are ownership responsibilities to owning shares, no matter how you got there,” he says. “At TIAA-CREF a large part of the portfolio was indexed but that had nothing to do with our decisions about whether to examine the companies in our portfolio.”

Being a “permanent” owner is not an excuse not to engage, it is a reason to engage, Mr Wilcox adds. “If you are a permanent owner, you want to make sure those assets perform well.”

Despite being unable to divest, passive investors still have a lot of influence over the companies they invest in, says Jane Welsh, head of indexation research at Towers Watson, the consultancy.

“They are generally such large investors and have such large positions that their vote is worth a lot. The last thing companies want is to have big investors vote against them,” she adds. “It is embarrassing and, on top of that, the company has to go back to the drawing board and start again.”

In addition, Mr Wilcox says, proxy advisory firms and organisations such as the UN’s Principles for Responsible Investment and the Carbon Disclosure Project do half the job for passive investors by highlighting the issues that need attention.

Rakhi Kumar, head of corporate governance at State Street Global Advisors, says there is a big difference between passive investment and passive ownership.

“As an asset manager with one of the world’s largest passive offerings and a near-perpetual holder of index constituents, active ownership represents the tangible way in which SSgA can positively impact the value of our underlying holdings,” he says.

“Our size, experience and long-term outlook provide us with corporate access and allow us to establish and maintain an open and constructive dialogue with company management and boards. The option of exercising our substantial voting rights in opposition to management provides us with sufficient leverage and ensures our views and client interests are given due consideration.”

Some active managers will sell out if they are concerned with the risks a company is running, Ms Welsh says, but not all of them will. Some active managers, particularly those with a long-term approach, act more like passive investors by identifying the risks and working with the company to address them over the long term.

“I have some sympathy with the typical pension fund; they are exposed to everything because they are invested in the entire index,” says Aled Jones, head of responsible investment for Europe, the Middle East and Africa at Mercer, the consultancy. “But it does not mean they should not be asking questions about specific issues.”

If anything, when it comes to engaging with a company’s management, being a passive investor is an advantage, he suggests. “Active investors often have a high turnover of shares in their portfolios so they do not hold the shares long enough to have an influence. For really meaty issues in areas such as environmental, social and governance issues, it can take a year or two of engagement to make progress.”

Because they are invested across the entire market (they are also known as universal investors), passive investors have an interest in raising standards everywhere, not just in individual companies, Mr Jones points out. As a result, they can engage at the market level by talking to regulators and stock exchanges or by focusing on sector leaders in the hope that the rest of the market will follow.

“We do not consider the objectives of raising governance standards at individual companies and the market as a whole to be mutually exclusive, and both serve to enhance the value of our portfolios,” says Mr Kumar.

“SSgA adopts a two-pronged approach, whereby issuer-specific engagement is complemented by ongoing dialogue with market regulators.”

Passive investors are not completely powerless when it comes to exiting poorly managed companies. Funds can alter their mandates to exclude certain investments. The Norwegian Government Pension Fund is currently waiting to hear whether the government will order it to divest from fossil-fuel companies. The fund has also sold out of palm oil companies because of fears over deforestation and dropped individual companies such as Walmart and Vedanta for failing to meet its investment guidelines.

There are a number of indices that focus on the best performers in areas such as environmental performance, such as the FTSE4Good, the Dow Jones Sustainability index and MSCI’s global sustainability indices.

In addition, argues Lorne Baring, founder of wealth manager B Capital, “passive investors do exit poor companies. Badly managed companies lose value and soon drop out of the index that the passive fund tracks. As an example, a FTSE 100 company that is underperforming the market will probably be ejected from the FTSE 100 and replaced by a stock that is performing well. The investor is passive, the fund is passive, however the mechanics of the tracker deselect companies that are underperforming.”