Passive managers take to shareholder activism

More than $413 billion flowed into U.S.-based passive funds in 2015, according to Morningstar Inc., raising questions as to whether those passive investors can have sufficient influence on the companies receiving their capital based simply on their inclusion in an index.

Three academics — one from Boston College and two from the Wharton School, University of Pennsylvania in their 2014 research paper “Passive Investors, Not Passive Owners”— show how investors' interests are unquestionably being represented aggressively by passive fund managers.

I agree, and say the influence gap can be bridged as long as passive managers get active on behalf of their investors and in the interests of long-term value creation.

Unlike active managers who can sell companies when they disagree with management, passive managers represent near permanent capital that cannot vote with its feet — as long as a company is included in the index it remains in the portfolio. But that long-term ownership requirement actually enhances influence and perspective.

As passive flows grow, managers have a distinct responsibility to become long-term asset stewards and actively engage with companies in the index across a range of important governance and sustainability issues that are key to generating value over the long run.

But how can passive managers make a difference when they are required to own every stock in the index? The most effective way to create meaningful change is to build a thoughtful engagement program with a focus on sector, thematic or market-specific issues that can scale across multiple companies. Managers can identify companies for active engagement based upon criteria such as the size of holdings; poor long-term financial performance within a sector; lagging market and industry standards; or priority themes and sectors according to emerging environmental, social or governance risks. However, they must also be prepared to use their voting power to reinforce value priorities with clearly articulated rationales if engagement falls short.

There are several areas where passive managers can get active with their asset stewardship to influence corporate governance and sustainability issues. Ensuring strong independent board leadership is increasingly important for providing a counterweight to management and achieving an appropriate balance between a company's short- and long-term objectives, as concerns grow over corporate short-termism. It provides an effective mechanism for assessing the performance and compensation incentives for management in the context of a company's long-term strategy.

Engagement on sustainability issues can take a variety of forms across environmental and social issues.

One recent sector project focused on oil and gas companies across our global holdings and led to discussions around how companies are navigating the challenges of falling crude oil prices, geopolitical risks emerging from Russia, Africa and the Middle East, as well as the ongoing debate around climate change, stranded assets and emission reductions. Talks with a Taiwanese packaged food company centered on monitoring food safety within its supply chain. Meetings with a garment sector company brought up how supply chain labor and fire safety standards can be improved. And after a multiyear engagement effort with various companies on environmental standards, we saw significant improvements in the quality and transparency of reporting around hydraulic fracturing processes as well as water and waste management practices. In addition to company-specific dialogue, we also engage with local regulators and government agencies to address systemic, marketwide concerns.

By consolidating voting decisions and engagement, managers can harness the full power of their company holdings and exert greater influence with management and boards. Proxy advisers are a useful source for data and analytics, but we believe managers should not outsource their votes to them. Unfortunately, far too many managers continue to do so. In a 2014 study, “Are Mutual Funds Active Voters?,” two academics from Pennsylvania State University found that more than 25% of mutual funds indiscriminately voted with the recommendations of a proxy adviser across all companies in their portfolios over a five-year sample period. We also believe stewardship should extend beyond proxy voting and engagement to include promoting investor protection for minority shareholders in global markets through partnerships with local investors and regulators.

Rising passive flows are raising the ownership stakes and influence of passive managers in companies around the world. With great influence, however, comes great responsibility. In a global economy struggling with structural and technological disruptions, passive managers need to get active. Long-term active stewardship can make a lasting and positive difference across the corporate universe.

Ronald P. O'Hanley is president and CEO of State Street Global Advisors, Boston.