Industry funds, with their ideology and history of affecting change due to profit-for-member motives, have been instrumental in driving transformation over the past decade, pressuring passive fund managers to vote their stock in companies. Investment Magazine examines how this is changing the skill set of passive managers and if this will impact on costs.
Increasing pressure from regulators, institutional investors and groups, such as the Principles for Responsible Investment (PRI) and the Australian Council of Superannuation Investors (ACSI), is causing the skill set offered by passive management to change as they begin to engage with companies on issues of corporate governance and ESG.
Pru Bennet, director of BlackRock’s corporate governance and responsible investment team for the Asia Pacific region, says the change in demand has come about in the past 10 years.
“The level [of asset owners using proxy voting] is now up around 60 per cent – it has doubled since 1997,” Bennet says. “The pressure from managers to vote, from where I sit, has come from industry funds.”
However, fund managers’ relatively recent, and still small, attempts at engagement means that super funds are taking matters into their own hands.
Ross Barry, head of research and origination at First State Super (FSS) and the author of Crisis and Complexity, says the fund doesn’t require anything from its passive managers – not because of a lack of worry, rather the issue is of such importance the fund has taken direct responsibility, dedicating internal resources.
He adds that while managers can be closer to a lot of the companies and understanding the issues, FSS ultimately makes its own decisions. “If we disagree with the mangers we direct them how to vote on our behalf,” Barry says.
UniSuper’s manager of governance and sustainable investments, Talieh Williams, says passive managers can have limited influence because the companies know they are going to be stuck on the register.
But she adds: “Companies will be influenced when they see passive managers exercising those really large holdings in relation to resolutions that are put to AGMs. That is a key area where they can be proactive and have influence through their voting activities, and that might lead to greater engagement.”
For Louise Davidson, chief executive of ACSI, there is a strong argument for passive managers to be using their ownership rights, engaging with companies and voting their shares because, one, the size of their holdings make them powerful and, two, companies with improved ESG benefit stakeholders in the long term.
Fiona Reynolds, managing director at PRI, takes a similar stance: “At the end of the day, if you own the market, then you have to care about how the market functions, you need to care about systemic risks and how the financial system and companies function as a whole.”
Currently asset owners, investment managers and service providers representing US$59 trillion assets under management have signed up to incorporate the PRI’s six principles of responsible investing, recognising that the generation of long-term sustainable returns is dependent on stable, well-functioning and well-governed social, environmental and economic systems.
Reynolds adds with such a diverse signatory base, which are at different levels of maturity when it comes to ESG and responsible investment, she appreciates that PRI needs to be a broad church.
However, she also recognises the importance of not letting continually underperforming signatories use PRI as a box ticking exercise.
“This is why we have put forward proposals to our board to put in place some kind of action with regard to underperforming signatories. All PRI signatories have to publicly report and disclose their responsible investment activities on an annual basis, including their active ownership and engagement practices and activities,” Reynolds says.
This demand from asset owners and representive groups is forcing passive managers to engage with companies, an area historically tackled by active managers.
Passive managers vs active managers
An advantage the big three passive mangers – BlackRock, State Street Global Advisors and Vanguard – have is they also undertake active strategies allowing them to draw on this experience as passive managers begin to engage.
BlackRock’s Bennet says the manager draws on the experience of both active and passive managers in its engagements. Certain transactions are escalated to active managers for input, while the passive managers provide their voting recommendations.
“Sometimes they [the active manager] will come back and want to vote differently,” Bennet says. “If that’s the case we will talk through that with them and understand their rationale. From an Australian perspective, we have never voted differently to the will of the active manager; we’ve always come to an agreement on what the right decision is.
“It’s very important to get the input of active mangers because they know the company really well. We [the passive managers] know governance, which should be a fairly consistent model across all companies, but we are not a transport specialist, or telecommunication specialist, or oil and gas specialist – we can call on the specialists of those companies to help us make a better decision.”
However, Helga Birgden, global business leader of responsible investment at Mercer, says active and passive managers have different ways of engaging and because of this are rated slightly differently by the consultant.
For active managers Mercer looks at the extent ESG criteria is part of a manager’s investment decision-making – the ideas, the research, portfolio construction and the engagement at the strategy level.
“Then you look at what that means in terms of the portfolio decision. Whereas with passive, the focus is on voting and engagement and what the organisation as a whole is doing, rather than a particular strategy level,” Birgden said.
Colin Melvin, chief executive of Hermes Equity Ownership Ltd, which represents 41 institutional investors around the world on issues pertaining to active engagement and responsible investing – including HESTA in Australia – cautioned that there are different forms of engagement, and many fund managers are not actually bringing about change.
The current business model, according to Melvin, disincentives active managers from engaging for change. Most active managers that are engaging, do so to obtain information on which to base investment decisions, rather than engaging to see change in the company on issues of corporate governance and ESG.
Similar to the view of First Sate Super’s chief investment officer, Richard Brandweiner, Melvin believes the current setup benefits the short-term objectives of intermediaries, rather than the long-term goals of super funds.
Melvin proposes super funds lengthen mandates, as this will introduce more alignment between the active asset owners and the outsourced fund manager.
“There needs to be a shift from short-term transactions to long-term relationships,” Melvin says. “Sustainable stewardship isn’t only possible, it’s necessary.”
The different nature of engagement by active fund managers means that passive managers, or other entities such as Hermes Equity Ownership, are better placed to represent the long-term interests of institutional investors, according to Melvin.
Changing skills, and cost impacts
According to State Street Global Advisors the skill sets needed for analysts are changing particularly in the area of ESG.
In a statement to Investment Magazine it says: “We are increasingly looking for analysts who understand business and strategy as we evaluate governance and sustainability issues in the context of the overall strategy and long-term performance of the company. Therefore, [we desire] an equity analyst who understands governance or a governance analyst who can analyse equities.”
Lucy Thomas, investment consultant at Towers Watson is clear that as engagement becomes the norm the skill sets required in passive management will definitely evolve, becoming more aligned with some of the active managers.
“It’s not just a technical look at risk limits, it’s also understanding where change can happen. Where to prioritise voting and engagement, where the value is, what level of influence can be exerted “and if that’s worthwhile. In terms of what is needed that is quite a different skill set,” Thomas says.
She adds the business model of passive managers is to increase assets and they do this by differentiating themselves.
“What’s the next step in differentiating themselves? I think this is becoming the next place. They are going to have to find a way to incorporate the costs and still deliver on the margins that they have been doing. There will be cost to the managers in doing this, but they are big enough to warrant it. I think the big guys are definitely best placed to do this.”
Reynolds of PRI takes the view that the alternative – not factoring in systemic risks – could be a lot worse for investors. “What’s the cost of not working towards effective markets? Look at the cost of the global financial crisis to investors,” Reynolds says.
Because of the systemic risk in not dealing with these issues, she is convinced of the need for engagement. Hearteningly, for those concerned about the possible costs, she does not believe this will make passive management expensive.
“Also, many institutions already have these competencies in-house. I believe owners that understand the value of active ownership are happy to have an informed conversation about the costs.”
According to Birgden of Mercer, it is extremely important for passive managers to be “crawling all over” the companies they hold to understand them, adding this should be part and parcel of what they do so there shouldn’t be additional resource costs.
“It’s really about more contemporary intelligence,” she says. “We are seeing best practices in fixed income, in some hedge funds, so we shouldn’t think that passive strategies are immune from the lifting of all boats on ESG, but neither should it require it to come at a terrible cost,” Birgden says.
Bennet of BlackRock agrees there is a cost, but argues this is justifiable because there is also a fiduciary duty for managers to undertake this type of work.
“There’s all sorts of costs in managing funds and this is one of the ones which is really not avoidable,” Bennet says.
Vanguard has nearly US$1.7 trillion in index equities and believes its investment in engagement is very small relative to its impact, adding positive change in companies can have a very significant impact on asset growth.
Currently, it employs a team of 10 governance analysts that are responsible for evaluating proxy proposals and advocating for change through engagement. In a statement to Investment Magazine the fund manager says the skill sets required are unique, requiring both a high level of expertise and an ability to provide constructive input to executives and directors.
State Street Global Adviser says since its stewardship activities are integral to its investment philosophy and strategy, the costs are apportioned over all assets.
Conclusion
The nature of passive managers is changing, with their skill sets becoming more akin to that of some active managers. This will have a cost implication, which look likely to be borne by the managers themselves, but the cost of not having this could be even greater because of the systemic risks present in poorly governed companies.
