Dan Jones, Shareholder Analytics and IR

The popularity of passive investment amongst institutional and retail shareholders continues to grow and for good reason. Passive funds have outperformed active in each year since the GFC. The term ‘passive’, however, may well be misleading.

While it does describe a manager’s approach to automated stock selection and investment, it fails to capture the growing role these managers are playing in influencing voting outcomes at companies in the name of long-term value creation. Before getting into that, what does the current passive investment landscape look like?

The changing investment landscape

There has been a boom in passive investment as traditional active managers, who deliberate trade stocks with the aim of outperforming the market or their selected benchmark, called generating ‘Alpha’ are having difficulty competing with low cost passive managers who prefer to track an index, such as the S&P 500 or the S&P/ASX200, to consistently produce market average returns or generate ‘Beta’.

According to Morningstar, the organic growth rate, a measure of the ‘new’ dollars being invested in ETF’s, averaged 16% over the 10 years to 2017, compared to just 2% for active Mutual Funds. According to Citi Group, in the 12 months to March 2017 there was a net outflow of $534bn from actively managed funds globally, while passive funds attracted net inflows of $442bn. It should be noted at year end there were US$11.4 trillion in actively managed funds compared to $6.7 trillion for passive.

Passive investment now accounts for almost 40% of US equity assets under management (AUM), compared to 20% in 2008. This change is being driven by the world’s largest fund managers. BlackRock, which has more than US$3.4 trillion in equity AUM, reported almost $150bn flowed into its passive funds in 2017, while active funds experienced a net outflow.

Convergence of passive and active investment strategies

There has also been an emergence of investment approaches that combine traditional passive strategies, such as index tracking, with stock picking, an active strategy. This combined approach is called ‘smart Beta’. An example of this is a manager who actively weights a traditional index with the aim of better risk management or diversification, such as adjusting for the S&P/ASX200’s relative over exposure to the big banks.  Alternatively, managers may create their own proprietary index which may be weighted using various valuation metrics and performance measures, rather than purely on market capitalisation.

Although the personalised index-selection criteria and potential ongoing adjustments in a smart beta strategy could be considered an active approach, smart beta strategies should ultimately be thought of as passive investment because managers are not making deliberate buy/sell decisions in relation to individual stocks.

According to Morningstar, smart beta grew from US$108bn AUM in 2008 to US$616bn by the end of 2015. Invesco Powershares, a US-based ETF provider, estimated smart beta strategies took 21% of all equity ETF inflows between 2010 and 2015, representing 12% of total ETF industry assets.

An evolution in traditional ‘passive’ ownership

Another point of inflexion between active and passive exists where traditional passive investors, while maintaining their core passive strategies, are taking a substantially more active role relating to the promotion of corporate responsibility. This is being led by the world’s three largest fund managers – BlackRock, Vanguard and State Street, which collectively manage almost A$20 trillion in assets.

Passive investors are the ultimate long-term holders of stock because their mandates do not allow them to sell an asset simply because it is underperforming and, therefore, they are more focussed on the drivers of shareholder value over the long term. They pay greater heed to a company’s Environmental, Social and Governance (ESG) performance when making investment decisions, which is understandable given the growing body of research showing companies with strong ESG practices tend to outperform. Risk management company Axioma recently found that portfolios which were overweight in companies with strong ESG scores outperformed their benchmark by 243 basis points over the four years to March 2018.

The restrictions on a passive shareholder’s discretion to sell poor performing stocks has resulted in them flexing their significant and increasing voting power in pursuit of better ESG outcomes. It is becoming more common to see passive funds vote against resolutions because a company is not adequately addressing shareholder concerns relating to ESG.

What this means for corporates

There are a several important takeaways for corporates resulting from the changing investor landscape. Corporates should;

• Know who your passive shareholders are. Regularly monitor your beneficial shareholder base to ensure clarity on core investors at all times. Understand which passive investors hold mandates for large Superannuation Funds, who are often very ESG-orientated and own on average 10% of every ASX200 company and which party retain ultimate voting rights.
• Ensure your passive shareholders are part of your engagement strategy. Voting guidelines of many passive managers are readily available, which allows companies to identify and discuss any issues they may have with the guidelines or work through scenarios where the company feels the guidelines may not strictly apply.
• Tailor communication to your audience. Passive shareholders have little concern for financial data, as they have not made a deliberate decision to buy a stock. A company should make ESG metrics a primary focus when engaging with index investors and, if needed, adjust their communication collateral to reflect that.
• Monitor how investors vote at their AGM. Beneficial ownership analysis providers, such as FIRST Advisers, are able to ‘get behind’ the nominee accounts and identify how individual funds and fund managers have voted. Use this intelligence to understand passive investor sentiment, prioritise investor engagement, both before and after the proxy deadline, and address the passive shareholders concerns to improve voting outcomes.
• Publically disclose ESG performance in line with accepted reporting standards. As discussed in First Advisers ESG IS MAINSTREAM ON MAIN STREET blog, the market is demanding disclosure around ESG factors, and companies are being measured against this.

As AGM season approaches, it is a good time for an IR teams to review the effectiveness of their investor engagement plans. FIRST Advisers’ integrated offer encompasses deep experience and expertise in beneficial ownership analysis, vote tracking and Investor Relations advisory. We are ideally positioned to help companies understand who their shareholders are, how they are voting and the best way to ensure they are properly informed.