Don’t Ignore Your Passive Shareholders
They may help you swim more confidently with the activist sharks
The Changing Face of Institutional Shareholders
In recent years two broad-based trends have influenced the composition of institutional shareholder classes among a growing number of publicly traded companies. First, shareholder activism has returned with a vengeance to Corporate America. The specter of veteran raider Carl Icahn, Pershing Square’s Bill Ackman and other activist sharks strikes fear into executive C-suites worried that their next quarterly earnings call will precipitate the arrival of the dreaded 13D filing (acquisition of a stake of 5 percent or more by a single investor). Few executives would wish to experience the travails the teams at Valeant Pharmaceutical, Yahoo! and others have faced recently in the crosshairs of activists.
The second broad trend is the rapid rise of index funds as a percentage of the total volume of assets held in mutual funds and their more recent cousins, exchange traded funds (ETFs). Index funds seek to replicate a benchmark index, as opposed to the traditional goal of mutual fund managers in actively buying and selling stocks to outperform a benchmark. The rise of index funds has given increased prominence to so-called “passive” institutional shareholders and sparked a debate as to what role, if any, this new class of shareholder plays in influencing corporate governance.
Executive management teams need to not only be aware of these trends but to understand how they can employ a governance strategy aligned with the needs of their own shareholder base. In particular, there is some recent evidence to suggest that longstanding assumptions about passive shareholders are misguided. Contrary to popular belief, passive investors are not necessarily passive owners. Executive teams may find investing in a productive working relationship with passive shareholders to be time well spent. A resulting improved fitness in governance practices can even be good preparation against a shark attack, and more cost-effective than endless panicky fire drills before a threat has even materialized.
The Rise of Indexing
Index investing got its start in the 1970s when John Bogle of the Vanguard fund family put together a mutual fund that sought to replicate the performance of the S&P 500, then and still the most widely followed benchmark investors use as shorthand for “the market.” Until then, the mutual fund industry had been dominated by so-called active managers, who put together (and frequently turned over) portfolios of stocks they believed would have the ability to outperform the market over time. From that humble beginning of just one fund, passive index strategies have grown at a blistering pace and now account for around 40 percent of all equity mutual fund assets. In recent years the pace of growth has accelerated. For example in 2015, while active mutual funds saw a net outflow of $207 billion in investor capital, passive funds enjoyed a net inflow of $414 billion.
Who are these passive institutions? Vanguard, the first mover in the field, is still very much a major player. So are financial behemoths BlackRock and State Street Global Advisors, whose iShares and SPDRs brands, respectively, have powered the rapid rise of exchange traded funds (ETFs) since their debut in 1993. ETFs, almost all of which are passive (index-linked) instruments, now amount to over $2 trillion of outstanding investment assets under management.
There has been a longstanding tendency in the investment community to dismiss the role of passive investors in corporate governance. Much of this attitude has to do with the simple fact of passive investing. An index fund’s main goal is to replicate the index, and that constrains the fund’s ability to sell out of a position in response to poor performance. That fact, many argue, deprives the index fund of its single biggest leverage point against poor management. Why should a corporate executive team pay any attention to the index fund as a shareholder, this thinking goes, if the shareholder lacks the credibility to threaten voting with its feet? Active fund managers, by contrast, can and will sell out of a position if they think poor corporate management will lead to poor share price performance.
Passive index funds do not invest in a company with the explicit goal of influencing shareholder decisions. But specifically because their own investment mandate dictates that they will not be trigger-happy sellers, these funds truly are long-term shareholders. It is their fiduciary responsibility, on behalf of their own investors, to use whatever means they can to see the companies in their portfolios well-run. Absent the threat of selling, passive shareholders can only exert their influence on management teams through active pressure as owners.
This gives rise to a countervailing argument against the “lazy passive investor” theory. Passive investors can indeed be active owners – they are just active in a different way from traditional mutual funds with a stock-picking strategy. Stock-pickers are less likely to push for governance reforms than they are to simply sell out of a stock they don’t like, while index funds will pursue their governance interests through the influence they have as shareholders to promote good governance.
A recently published study by three academic researchers from Wharton and Boston College found a statistically meaningful correlation between good governance practices and companies with a proportionately high cohort of passive institutional shareholders. The study analyzed companies on the Russell 3000 index, a popular stock benchmark ranked by market capitalization (share price times number of shares outstanding). The Russell 3000 is divided into a large cap stock index (the Russell 1000) and a small cap index (the Russell 2000). Companies at the bottom of the Russell 1000, by virtue of their smaller contribution to the index, tend to have a smaller cohort of passive shareholders than the top tier of Russell 2000 companies with their commensurately larger weights as index constituents.
Good Governance Leads to Good Performance
The study found that companies at the top of the Russell 2000 index – i.e. stocks that would tend to be highly weighted holdings in small cap equity index funds – were much more likely to have in place shareholder-friendly governance measures than were the bottom-tier companies in the Russell 1000 index. Prominent among these measures were: significant numbers of independent board members, single share classes with voting parity (i.e. as opposed to multiple share classes with restricted voting rights for non-inside investors) and an absence of anti-takeover measures such as poison pills. The study went on to find evidence that the increased presence of passive institutional shareholders was associated over time with the improvement in corporate performance, in particular, return on assets.
Corporate governance is not a free lunch; influencing and implementing good practices costs time and money for both shareholders and management teams. With this in mind, it is important for executive teams to realize that passive institutional shareholders have limited resources with which to deal with what is usually a very large number of companies in their portfolio holdings. The three practices mentioned above as being characteristic of funds with large passive shareholdings – maintaining independent boards, not engaging in anti-takeover provisions and maintaining a single share class with full voting parity – can all be implemented through relatively routine governance proposals at shareholder meetings. They are less likely to require protracted negotiations to implement, and that potentially makes them reasonably easy and cost-effective fixes for corporate management as well.
Think about those low-impact best practices in contrast to what shareholder activists tend to seek out when they invest in companies: large share buybacks, mergers or spin-offs of noncore businesses being prominent among the sharks’ wish lists. Those are high-intensity undertakings that will occupy considerable management resources, regardless of whether the executive team elects to fight the activists or cave to their demands.
Working with passive shareholders to implement cost-effective best practices is not guaranteed to keep the activist sharks away. But it can potentially put the odds in your favor. Activists also have real constraints they have to deal with, mostly time constraints to deliver the returns their own investors expect. Activist funds have grown to represent more than $120 billion in total assets under management, which is a not insignificant percentage of total hedge fund assets. They invariably go after the low-hanging fruit first – companies performing poorly with a spotty track record of corporate governance.
By contrast, shareholder-friendly companies with demonstrated best governance practices in key areas and a productive working relationship with passive shareholders – their partners for the long term – can be an unappetizing prospect for the sharks. For executive teams, a bit of time and money spent nurturing these relationships can prove immensely valuable in the long run.