The sheer weight of assets held by passive managers is dramatically increasing their power to engage with companies on issues of corporate governance and ESG. Investment Magazine investigates the mixed messages coming out of the three biggest passive managers as they attempt to meet engagement expectations from institutional investors.
Two trends are causing institutional investors to ask more from passive management, fuelling a change in how fund managers operate. The first is the massive growth in assets that are managed passively. Research conducted by Towers Watson in 2013 shows passive managers have tripled in assets under management (AUM) in the past decade, with the combined total for the leading passive managers reaching US$10 trillion. The top three passive managers by AUM – BlackRock, State Street Global Advisors and the Vanguard Group – account for more than half of this.
The compound annual growth rate (CAGR) of passive management from 2003 to 2013 was 12.4 per cent, while the CAGR of the 500 largest asset managers for the same period was 5.8 per cent. As a result, as of December 2014, passive managers held 10.8 per cent of the MSCI All World index.
The power, therefore, of passive managers should not be underestimated, particularly the large index providers, because of the sheer weight of their holdings.
The second trend is the ascent of universal ownership as an investment belief among super funds. Institutional investors are becoming increasingly aware of the positive impact ESG integration and active stewardship practices can have on investment performance.
First State Super’s (FSS) head of research and origination and the author of Crisis and Complexity, Ross Barry, is a proponent of universal ownership and says large super funds are not external to the market, and need to recognise their responsibility and the investment footprint they leave in their wake.
“When you are a large fund you can’t assume you’re exogenous to the market. You are an integral part of the market architecture. The size of those transactions has impacts on the market. It has impact on governance, it has impacts on communities in which those companies operate, impacts on the environment,” says Barry.
Such is the importance of engagement that FSS has dedicated internal resources to enable it to directly take responsibility for long-term issues.
They are not alone.
Louise Davidson, chief executive of the Australian Council of Superannuation Investors (ACSI), says a lot of boards want to concentrate on long-term issues and will increasingly sidestep the funds management industry if they feel better able to achieve this directly.
While complimentary of their fund managers, Talieh Williams, manager of governance and sustainable investments at UniSuper, said as an industry, passive managers needed to be more proactive, particularly regarding proxy voting.
“There has also been an issue here in Australia regarding some AGMs, where we feel sometimes passive managers haven’t taken a strong view on the governance at hand and too readily supported management,” Williams says.
As passive managers are the ultimate long-term holder they are, arguably, best placed to be active owners because they will hold stocks into perpetuity, argues Lucy Thomas, investment consultant at Towers Watson.
Fiona Reynolds, managing director of Principles for Responsible Investment (PRI), develops this reasoning, saying as allocations to passively managed equity strategies continue to increase, it is critical that trustees use passive managers to align long-term interests, protecting against ESG risks and enhance the value through stewardship and active ownership.
The case for active ownership in passive strategies, which takes into account ESG risks, is also supported both by empirical studies and by a broad range of actors in the investment sector, including asset managers, consultants and institutional investors.
However, approximately only 10 per cent of all fund managers have received Mercer’s top rating for best practice in ESG, though the consultant has not released details of specific fund managers’ ratings.
Do passive managers think they should engage with companies?
Symptomatic of an industry in the early stages of transition there is a continuum of perspectives on whether passive managers should engage with companies on ESG issues.
At the crux of the issue is whether active engagement on ESG issues with companies meets fiduciary duty. It is worth noting that the sole purpose test is amoral – a distinct concept separate from immorality – and does not have ethics as a consideration in the decision-making process.
Those who believe engagement increases long-term value are highly in favour of the strategy, while those who feel it is a decision motivated by ethics are less inclined to want it implemented, as they fear falling foul of the law.
Broadly speaking, the chief executives of the three big passive managers are publicly keen to engage with companies, as are certain internal departments, however, others, including some in middle management and external public relations, are more cautious in their response.
Investment Magazine investigated the three largest passive managers – BlackRock, Vanguard and State Street – to find out where they stand on the issue.
The US$4.77 trillion BlackRock, the biggest of the three, has already made public its desire to start down this route of engagement, in the belief that long term financial and societal benefits are best achieved when capital owners are engaged with companies ensuring risks in areas such as governance are mitigated.
In April, Larry Fink, chief executive of BlackRock, sent an open letter to the chief executives of leading US companies encouraging them to do the same.
“The effects of the short-termist phenomenon are troubling both to those seeking to save for long-term goals such as retirement and for our broader economy,” Fink wrote.
Pru Bennet, director of BlackRock’s corporate governance and responsible investment team for the Asia Pacific region, says the fiduciary duty to their clients, coupled with the fact they can’t sell passive investments (the selling of stock being a strategy active mangers use to send a message to companies to change), means engagement is essential to solve for both corporate governance and ESG risks and concerns.
However, though Kevin Hardy, head of beta strategies Asia Pacific and country head for Singapore at BlackRock, was supportive of corporate governance he did not believe managers should have to adopt more of an ESG stance to their holdings, as “this could be interpreted as taking actions that are misaligned with their core purpose of tracking an index”.
Vanguard takes a similar stance saying it is required to manage funds and ETFs in the best interests of investors, and obliged to maximise returns in order to help investors meet their financial goals.
“It would be exceedingly difficult, if not impossible, to fulfil these obligations while managing portfolios that reflect the social concerns of all of our investors,” it said in a statement to Investment Magazine.
Nevertheless, as of November 6, 2014, Vanguard became a signatory to the Principles for Responsible Investment, administered by the PRI Association (PRI). While the principles relate primarily to Vanguard’s active investments (in the US) the PRI encourages asset managers and others to integrate ESG issues into corporate engagement and investment practices to support long-term value creation and contribute to a more sustainable global financial system.
It was pointed out by Thomas of Towers Watson that Vanguard has also become more vocal of late; writing to companies, suggesting the fund manager wants to strengthen its relationships.
For example, chief executive and chair of Vanguard, Bill McNabb, recently wrote in an open letter to company directors: “In the past, some have mistakenly assumed that our predominantly passive management style suggests a passive attitude with respect to corporate governance. Nothing could be further from the truth. We want to see our clients’ investments grow over the long term, and good governance is a key to helping companies maximise their returns to shareholders. We have no interest in telling companies how to run their businesses, but we have valuable governance insights to share.”
This, the fund manager believes, strikes the appropriate balance between corporate responsibility and fiduciary obligations.
Of the big three fund managers State Street (US$2.4 trillion as of March 31, 2015) was the most consistent in its view and the most committed to the principal that active ownership and incorporating ESG into the decision making process can help increase returns of indexed funds.
“Incorporating and engaging with companies on ESG and performance issues can help mitigate risk and optimise returns for indexed investors,” says Rakhi Kumar, head of corporate governance at State Street Global Advisors (SSGA).
She went on to say that, as a result, SSGA has for years invested in a team of ESG experts based in Boston and London to provide active stewardship of its global assets, and in the near future will be establishing a team in Sydney.
Several specialists within SSGA support the governance team in executing its stewardship responsibilities. These include members of SSGA’s proxy operations team who are responsible for managing fund setups, vote executions, vote reconciliations, share recalls and class action lawsuits, and members of SSGA’s client reporting and compliance teams.
Kumar adds SSGA has a “robust in-house global proxy voting principles” and six market-specific voting guidelines to ensure they hold all index companies to a minimum ESG standard expected from companies operating in a market.
Commendably, in their annual stewardship report, SSGA say their “stewardship role in global capital markets extends beyond proxy voting and engagement with issuer companies”.
“It also includes promoting investor protection for minority shareholders in global markets through partnerships with local investors and regulators, and working with investee companies to encourage adoption and disclosure of ESG practices.”
How do fund managers engage?
According to its annual report during 2014, SSGA engaged with 610 companies on various ESG issues, up from 375 engagements in 2013. About 40 per cent of the engagements were reactive, conducted during proxy season from March-June to discuss proxy voting related issues.
Overall SSGA voted at 14,284 AGMs in 68 countries in 2014 compared to 14,022 in 68 countries in 2013, an increase of 262.
For comparison, Amanda White writing in Investment Magazine’s sister publication top1000funds.com reports Norges Bank Investment Management which manages the assets of the 6.9 trillion Kroner (US$894 billion) Norwegian Government Pension Fund Global, held 2,641 meetings with companies in 2014, and raised environmental, social and governance issues at 623 of those.
She adds: “The giant Dutch pension fund manager PGGM engaged in dialogue with 510 companies last year, and says it got results from those with 21 related to the environment, 32 related to social factors, and 80 related to corporate governance.”
SSGA’s report continues showing a comparative breakdown of company engagements by region in 2013 and 2014 that much of SSGA’s engagement efforts were focused on companies domiciled in the United States, the United Kingdom, Europe (ex UK) and Australia. During the year, SSGA engaged on compensation or remuneration related issues in approximately 36 per cent of the cases (42 per cent in 2013), on general governance issues in approximately 43 per cent of the cases (39 per cent in 2013) and on ESG issues in approximately 14 per cent of the cases (same as in 2013).
Examples of the SSGA engagement process having a positive impact on corporate governance and ESG practices include:
- At Emerson Electric Inc., after multi-year engagement with the company, an increase in the transparency of the company’s reporting of their political contributions.
- NIKE, Inc., enhanced disclosure on its political contributions after a multi-year engagement effort, enhanced the quality of reporting around its hydraulic fracturing.
- Ameren Corporation, enhanced its disclosure around water and waste management practices.
Vanguard gave its aggregate proxy voting record for the period January 1, 2014 to December 31, 2014, (1710 resolutions in Australian equities in the listed period) but did not give details of any specific examples of success they has with engagement at the time this article went to press.
Stopping investment in human trafficking
As of December 2013, BlackRock has US$252 billion in AUM with specific ESG mandates and in the past year voted at 5,341 meetings for the APAC region. “When you look at the top 50 companies, BlackRock is holding about 5 per cent in most of them. Given the size of our holdings we have regular annual engagements with a lot of the chairman of those companies,” says Bennet of BlackRock.
During proxy voting season, instead of just voting against proposals because of a lack of information or receiving advice from proxy advisors to vote against, BlackRock says it tries as much as possible to contact the company.
For example if it receives a remuneration report which on prima facie hasn’t disclosed enough around the long-term and short-term incentive, then it will engage with the company and try to seek a better understanding of their executive remuneration structure.
“If we have a constructive conversation with that company we will then go ahead and support the remuneration report, possibly meet again with the company after the proxy season when we have more time, and then talk through the changes they are prepared to make. That’s a much more effective way to seek change in a company rather than just voting against,” she says.
A series of articles by The Guardian last year exposed that human trafficking likely existed in the supply chain of a Thai company in which BlackRock was invested.
This comes at a time when Thailand has been downgraded to a tier-3 country by the US government in the 2013 Trafficking in Persons Report, meaning Thailand could potentially face sanctions by the US Government if the situation in human trafficking does not improve.
Once made aware of the situation BlackRock’s corporate governance and responsible investment team (CGRI), alongside the fundamental equity team, engaged with the company’s investor relations officer.
In their quarterly report (September 2014) on elevating global governance BlackRock say it encouraged the company to formalise its stance on human trafficking and modern slavery into its Code of Conduct and also to step up efforts in urging the Thai government to also deal with the issue.
In addition to the company bringing in NGOs to audit its suppliers, the company has been paying a premium to suppliers that have the Thai government’s Non-IUU (Illegal, Unregulated and Uncertified) certificate.
So far 40 out of the company’s 55 fishmeal suppliers are non-IUU certified. The company’s target is to have all of its suppliers certified by 2015.
In a statement BlackRock says: “We intend to monitor the situation closely and follow up with the company on a regular basis to make sure that effort and progress is sustained. We will also try to attain access to senior management and the board to ensure that senior executives are indeed taking charge of the issue.”
There is a strong argument for passive managers to use their ownership rights to engage with companies on ESG issues by voting their shares. This is being driven by the massive growth in assets that are managed passively and the ascending investment belief of universal ownership.
Mangers are starting to grasp this idea, with the three biggest embracing the principal of active engagement on governance at a minimum, and some going the next step and taking on issues of ESG that often threaten long-term returns.
As ACSI’s Davidson says: “It really makes more sense for passive managers than anyone else because they hold certain shares just by virtue of being in the index. Improving the ESG performance of companies is to their benefit.”
However, with only 10 per cent of all fund managers achieving Mercer’s top rating for best practice in ESG, there is a long way for managers to go, and the time to change may be shorter than they like with intuitional investors looking to bypass or leave mangers if they fail to deliver the required engagement.