Index or passive?

19 June 2019

Index funds object to the term 'passive’, claiming their long-term holdings make them active stewards of listed firms. But a new paper from an academic heavyweight disputes this. 

Throwing down the gauntlet

Index managers don’t like the term ‘passive’. It plays into a narrative of absent owners failing to hold companies to account on behalf of investors. In response to accusations that they have underinvested in stewardship, the major index managers have been beefing up their ESG teams and taking prominent public positions on a range of issues: gender diversity; climate change; executive pay; and the role of business in society, no less. 

But a recent paper by Lucian Bebchuk and Scott Hirst asks challenging questions about the stewardship credentials of the major US Index Managers. Bebchuk can’t be brushed off as a patsy for corporate interests. He has a long track record as a staunch defender of shareholder rights and is a high profile advocate for rolling back management protection devices such as staggered boards, poison pills, and dual class shares. Unlike many academics with impeccable finance credentials he has also been excoriating about excessive executive pay. He’s certainly not on Main Street’s payroll. So it is of particular interest that he is weighing in on this debate.

Defenders of index funds say that they are the ultimate long-term holders of shares, which they cannot sell, and so have a strong incentive to engage with companies to bring about positive change. Bebchuk and Hirst demur. Using a mixture of theory and evidence, they argue that incentives for index managers strongly cause them to underinvest in stewardship and to be too deferential to management. Recent research on ‘common ownership’ has accused index funds of encouraging managers in competing firms to collude. But the authors contend that the true concern is the opposite: far from over-influencing managers to undertake anticompetitive practices, index managers don’t influence companies nearly enough and are ill-equipped to push managers to do things that they don’t want to do anyway.

Agency theory in the index fund industry

Bebchuk and Hirst’s theoretical framework is based on the separation of interests of the index fund investor (i.e. the investor in a fund), and the index fund manager. Using the example of a $1bn holding in the fund, they show that the index fund investor should be prepared to incur a cost of up to $1m to undertake stewardship activity that increases the value of the holding by just 0.1%. Yet because index funds receive revenues based on a small percentage of funds under management, let’s say 0.2%, the 0.1% increase in the holding is worth only 0.2% x $1m = $2,000 to the index fund manager. Therefore, the index fund itself is only incentivised to spend a small fraction of the optimal amount on stewardship. Moreover, for an index fund there is no competitive advantage in improving the value of the funds in the index – given that they compete for funds against other index providers, the benefits flow equally to all their competitors. 

A second area where divergence of interests between the fund manager and the fund investor can occur relates to private benefits from relationships with corporate clients. An index provider may, for example, also administer 401(k) plans for corporate clients, which may make them unwilling to act too aggressively towards management. The authors also contend that index funds may rightly be afraid of the power of the corporate lobby in the US. If index funds start acting too aggressively towards management, then Main Street would likely push for regulatory intervention to cut the index funds down to size, an approach that history suggests would likely be successful.

Finally, the authors assert that administrative costs for index investors acting aggressively towards management may be significant. Holders of stakes over 5% who have acquired the stake ‘with the purpose [or] the effect of changing or influencing the control of the [portfolio company]' are subject to onerous Schedule 13D filing requirements which must be updated on every trade. The cost of compliance can be significant, particularly when the index manager only receives 0.2% of any value gain from acting more aggressively towards management. Much easier to steer clear of any controversy and to ensure that filing can be made just annually, under the much less problematic Schedule 13G.

Show me the money

The paper backs up the theoretical predictions with carefully constructed evidence drawn from stewardship reports and records of a range of SEC filings. The authors cite a series of facts that they say show that the major US index managers carry out a suboptimal level of stewardship:

• They estimate that investment in stewardship by the three largest index managers is less than 0.0003% of assets under management, or less than 0.2% of fees and expenses received by the manager as a result of managing the fund.

• Resources in the central stewardship function allow for an average of less than 0.5 days per year per portfolio holding, or less than 2.5 days per year if stewardship were restricted to holdings of over $1bn.

• This equates to investment of less than $3,000 per holding over $1bn, despite the fact that even a 0.1% impact of stewardship activity on such a holding would equate to at least $1m value for the index fund investor.

• Over the decade to 2017: of around 2,400 director nominations at US companies none was made by the largest three index managers; no Schedule 13D was filed (which is a requirement with a holding of 5% or more, if the asset manager’s activities have the purpose or effect of influencing the identity of the individuals serving on the board); no shareholder resolutions were submitted; and no case was identified of one of the three largest index managers acting as lead plaintiff in a significant class action law suit.

Of course, defenders of the index funds would cite much of this evidence as irrelevant. The objective of these funds is to provide market access as cheaply and effectively as possible for savers, as backed up by the evidence that index managers on average tend to outperform their active counterparts. Moreover, index funds' contribution to stewardship goes beyond their direct efforts. They can also play an important role in helping activist investors run effective campaigns. Ian Appel, Todd Gormley and Donald B Keim have shown that higher levels of index ownership is associated with activists being more likely to seek board representation, engage in proxy fights, and achieve outcomes such as board changes or M&A. They suggest therefore that the growth of passive investment has actually facilitated activists’ ability to engage in costly, value-enhancing forms of monitoring. 

The Purposeful Company, a UK think-tank, built on this idea further and describe an ecosystem of stewardship with different investors playing different roles. Within this ecosystem, index funds are particularly effective at what they call ‘generalised stewardship’: market-wide standards issues like board composition, executive pay, and climate disclosures. These interventions raise standards for the market as a whole. It is then the active and activist managers who undertake ‘specialised stewardship’ through monitoring long-term performance and creating incentives for companies to improve either through the price signals sent by trading or through more direct activism, often with the support of index funds. 

Bebchuk and Hirst’s counterargument is that while this may be true, activists will only ever be involved in a small minority of cases. Investors in index funds would still benefit from more assertive stewardship oversight in the majority of companies that don’t feature on the activist radar, including in areas beyond the normal generalised governance topics. For example, they claim that a review of the Big Three’s stewardship reports identified no case of engagement that related to financial underperformance.

What to do about it?

Bebchuk and Hirst’s identification of the problems is stronger than their proposed solutions, as they admit themselves. The potential policy responses fall under four headings.

1. Encouraging investment in stewardship

One idea they have is allowing index managers to charge stewardship investments against the fund, which could reduce incentives to cut stewardship costs to the bone. But if cost is the main dimension of competition between index funds, it is hard to see how this is a game changer. And in a world of MIFD, where fee transparency rules, it seems odd to base a policy on an approach that only works by virtue of reduced transparency. 

More promising is the idea of sharing outside research services, which could undertake financial analysis for index funds on a pooled basis. However, this is what shareholder advisory services are already meant to do. Yet the remorseless logic of cost minimisation has led this to be a service done on the cheap, and certainly not in a manner that is equivalent to rigorous active financial monitoring of investments.

The third idea is that stewardship expenses could be made mandatory. The problem with this is that it may lead to counterproductive separation of stewardship and portfolio management activity in active managers, otherwise the discrete stewardship expense could be difficult to identify. Alternatively, an industry wide stewardship ‘levy’ could be used to fund independent third-party research on a competitive basis that could be drawn upon by all. This might be used to fund a centralised shareholder advisory service that placed a greater focus on strategic and financial issues rather than just ESG. Such an approach would face the problem of any levy system: how to ensure that internal costs (that would be offset against the levy) are going towards high quality stewardship activity, rather than just being recategorization of existing spend. Finally, without a clear market mechanism, how could the activity of the central research body be directed productively?

2. Business relationships with public companies

To address the potential incentives to be too deferential to management, Bebchuk and Hirst suggest banning providers of index funds from selling other services to public companies – for example administering 401(k) plans. The authors claim (without evidence) that there would be no consumer detriment by disrupting markets in this way, but it seems that such heavy-handed regulation requires a stronger evidence base of the direct harm caused than currently exists. More detailed disclosure of business relationships, also suggested by the authors, is a natural and less onerous first step. This would also enable more detailed empirical research to be carried out on the harm arising from conflicts of interest, and the mere prospect of that research would provide an incentive for firms to manage the conflicts flawlessly. 

3. Bringing transparency to private engagements

The authors suggest that providing more disclosure on the private engagements index funds have with companies could create valuable market information and create accountability for index funds to ensure engagement is effective. They say that providing more transparency in this area is appropriate given that index funds assert that private engagement behind the scenes is a major pillar of their stewardship activity. Perhaps more controversially they also assert that communications made from companies to large index investors should also be made public, on the basis that these may be valuable to the whole market. The case for this is that, unlike active managers, the index funds do not have an outperformance incentive, so this information should not be considered commercially sensitive. 

Creating this level of transparency will, as the authors acknowledge, lead to the charge that it may distort the level and nature of stewardship engagement. However, greater standardised aggregate information on stewardship engagements could be considered as a first step, and indeed formed part of the Purposeful Company’s submission to the FRC on the current Stewardship Code consultation. 

4. Size limits

 By far the most controversial recommendation is that size limits on index funds should be considered. Bebchuk and Hirst propose that by limiting the share of any one manager to 5%, what could in future be a ‘Giant Three’ oligopoly of leading index fund managers might instead better be configured as a ‘Big-ish Nine’. In their view policy makers should consider whether a Big-ish Nine might not be a better configuration for index funds than a Giant Three, given the exposure the latter scenario would create to a single fund management firm’s policy on certain issues. 

Many of the details behind this approach are omitted. Would the 5% limit apply to any holding (which may be very complicated given that a single company may be a constituent of several index funds) or to holdings in aggregate in some form? What would the remedies be in case of a breach of the limit? There are no easy answers to these and other questions. As the authors themselves admit:

"Clearly precluding or discouraging a Giant Three scenario would represent a major step in the regulatory intervention into the distribution of control in the economy, a step that should not be taken lightly. However, the challenge posed by the Giant Three scenario is unusual in its economic significance and merits the consideration of such measures." 

Nurturing the stewardship ecosystem

Bebchuk and Hirst finish by noting that two common current concerns in the governance world are misguided given their research:

• Concerns about common ownership are almost certainly overblown. Index funds, if anything, affect management too little, not too much. 

• Hedge fund activism becomes more, not less, important to provide specialised stewardship in a world where index funds hold much greater sway.

The paper is something of a polemic against the stewardship credentials of large index funds, and doubtless there will be claims that the analysis is unbalanaced and some of the accusations overblown. Index funds democratise access to equity markets in a way that avoids the risk of unsophisticated consumers getting ripped off by excessive fees. They make an important contribution to raising governance standards across the market. But there is a remorseless logic in the drive to lower and lower fees and this risks consequences for the extent to which company-specific stewardship can be undertaken by these funds. 

So if Bebchuk and Hirst's proposals are considered too extreme, what could nurture a healthy ecosystem for stewardship? Three areas of focus seem most promising. 

1.    Asset owners focussing more on the quality of stewardship activity rather than just minimisation of cost 

The growth of ‘sustainable’ investing strategies of various types shows that for both retail and corporate clients, stewardship is rising up the agenda. This may move the agenda away from one of pure cost to one of how investment is undertaken, and how the purpose of the asset owner is reflected in the purpose of the asset manager. Regulation can nudge here: in the EU major institutional investors are now required to consider and disclose their approach to stewardship under the shareholder rights directive. Legal frameworks can clarify trustee duties to enable investment in line with the ethical choices of beneficiaries. Regulation can ensure that authorised fund managers need to include quality of stewardship in value for money considerations.

Asset owners and managers should be actively seeking out the views of their clients on key stewardship issues. Ultimately, creating strong end-client demand for good stewardship seems the only truly effective away to bring about a step change in stewardship quality in asset managers. It is difficult to regulate commercial companies into providing public goods that their customers do not ask for. The market supplies what the market demands. It is probably the major asset owners – public or collective private pension funds for example – that are most likely to have the expertise and resources to make a difference here, as we have seen, for example, in Canada and Japan. Not too much should be expected of retail investors. But even they, over time, could be provided with mechanisms for making their views known on key stewardship topics.

2.    Development of a better market for collective stewardship. 

The best stewardship outcome may be created by asset managers of different types working together in complementary ways. Index funds acting collectively with active or activist managers who have specialist company and sector expertise can act as a force-multiplier. In the UK the Investor Forum provides a mechanism for collective engagement on strategic issues, albeit at relatively low volumes. The UN PRI Collaboration Platform also provides a mechanism for investors to come together, normally around ESG or other market-wide issues. There is a need to develop regulatory and collaboration frameworks that enable this type of collective engagement to happen on a larger scale, including on company-specific issues, marrying the expertise of specialist active managers with the voting clout of index funds.

3.    Tougher stewardship codes. 

Major market players will always want to have a strong incentive to be signatories to comply or explain stewardship codes in leading markets. These codes should not impose a one-size-fits all model of stewardship on the market. However, as shown by The Purposeful Company in its response to the UK Stewardship Code consultation, there is an opportunity to focus stewardship codes more on expected stewardship activity, rather than just reporting, which can easily become boilerplate. This would enable beneficiaries and asset owners to hold managers accountable for undertaking stewardship activity of a higher quality, reinforcing a healthy market for stewardship.

Index managers take an unfair amount of heat when all they are doing is responding to a strong client demand for simple investment products that aren’t a rip off. It's the failure of the industry as a whole to demonstrate the value of stewardship that has allowed the debate to focus purely on cost minimisation. Asset managers can't be expected to provide services their clients aren't asking for. But perhaps this is now changing. Gillian Tett recently claimed in the Financial Times that ethical investing has reached a tipping point. If investors start to attach value to how investment is undertaken and the related stewardship activities of asset managers, then the market will respond. Recent investments in stewardship by index fund managers demonstrate the point. 

Index management is on the up, and continues to take a growing share of funds under management. With that growth comes responsibility. Bebchuk and Hirst have lain down a strong challenge to the industry. Index funds are increasing the resources they devote to stewardship. But is it enough? They will come under pressure to show that they are backing up the good words with authentic fulfilment of their stewardship obligations.

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