The Financial System and Corporate Governance Impacts of Passive Management
The rapid rise in investors’ use of low cost equity indexing is helping investors implement increasingly cost-effective equity investment programs. However, at the same time, the trillions of dollars that have flowed to passive management are raising questions about potential impacts on the U.S. financial system, the financial services industry and the corporate governance movement.
Passive Management Firms Now Control Large Share of Equity Market
As passive management’s share of the U.S. equity market has grown to around 40% from a negligible amount four decades ago, economists, researchers and investors alike are awakening to potential implications of a market where almost half of the equity capital flows to U.S. companies are determined by characteristics of indexes rather than by traditional, fundamental considerations.
While asset management firms grapple with the consequences of diminished demand for security selection, as well as declining margins, asset owners need to consider the ancillary market impacts driven by the near monopoly of indexers.
To reflect on the magnitude of the growth of passive management, investors may consider the following:
- Between 1995 and 2015, assets held in passive equity mutual funds grew from $55 billion, or 4% of U.S. equity mutual funds, to $4 trillion or 34%[i]
- A Moody’s study predicted that passively managed assets will exceed actively managed assets by 2024[ii]
- A recent industry report projected that index strategies will gain $1.1 trillion in investor assets by 2020 across global markets, while active strategies will lose $1.9 trillion[iii]
The trend raises debate about broad market tradeoffs between active and passive management and spurs concern that the growth in indexing may contribute to a self-perpetuating market bubble and/or heightened market volatility if carried to an extreme.
What Are the Effects of Passive Management on Corporate Governance?
What is also worth considering is the impact of the increased use of passive equity management on corporate governance. Consider the following:
- BlackRock, State Street Global Advisors (SSGA) and Vanguard reportedly manage 90% of indexed assets[iv]
- Vanguard and BlackRock, reportedly rank in the top three owners of 95% of S&P 500 stocks
- Collectively, the “big three” indexers are reportedly the largest owners in 40% of publicly traded U.S. companies
Indexing is a scale business that advantages the operators who can minimize Total Expense Ratios (TER), or the total costs to a fund investor. With this steep barrier to entry, odds are that the trend towards concentration of passive assets among the “big three” indexers and their growing influence on public equities is likely to continue.
Proxy vote results on board diversity in 2017 hint at the influence of index managers on vote outcomes. The year marked an all-time high for the number of proposals filed and for record support. BlackRock and SSGA announced plans to raise diversity as an issue with their portfolio companies and to oppose certain directors if companies are not responsive. In 2017, the average level of support for a proposal on board diversity was approximately 28 percent, up from approximately 22 percent in 2016.
Unsurprisingly, the vote that received the highest tally had BlackRock’s support. A record 85 percent of shares voted in favor of board diversity reporting at Hudson Pacific Properties. Most SSGA funds voted to abstain on the vote. With increasing frequency, the sizable stakes of the “big three” index funds puts them in the position of determining the outcome on votes that raise emerging governance issues.[v]
Historically, the “big three” indexers faced criticism for their approach to corporate governance. It could be argued that low cost passive managers lack the incentive to influence the performance of the companies they own through proxy voting and engagement since they are not actively engaged in price discovery. Moreover, critics of passive managers pointed to a lack of resources allocated to corporate governance, perhaps a result of the indexers low fees and modest profit margins.
BlackRock and SSGA aggressively pushed back on this perspective with recent moves. In March 2017, State Street erected the defiant girl statue squaring off against the Wall Street bull statue to celebrate the launch of its engagement with firms on board diversity. In January 2018, BlackRock Chairman and CEO Larry Fink penned a letter to corporate CEOs, writing, “The time has come for a new model of shareholder engagement – one that strengthens and deepens communication between shareholders and the companies that they own.”
Fink’s letter received wide media attention for its assertion that companies must do a better job on matters in the environmental, social and governance (ESG) space. BlackRock and SSGA announced plans to hire more staff in their corporate governance units.
What Will the Long Run Effects of Passive Management Be for U.S. Corporate Governance?
It is too early to assess whether public pronouncements from the “big three” indexers will result in dramatic advances in board diversity in corporate America, or other sorely needed areas such as executive compensation and board accountability mechanisms. The growing influence of the “big three” indexers – at times at the expense of asset owners whose stakes are lower – also raises questions about their ability to advocate for investor rights at publicly traded companies when their client base includes corporate funds.
Ranges of theories abound about the future of a market where passively managed assets exceed active management. One point is not up for debate – the effects warrant close monitoring and study.
[i] CFA Institute, John C. Bogle, January/February 2016
[ii] Moody’s, February 2, 2017
[iii] Pensions & Investments, June 1, 2017
[iv] Fichtner, Heemskerk and Garcia-Bernardo, Cambridge University Press, April 25, 2017
[v] New York Times, July 20, 2017
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