Over the past few decades, the ownership of public corporations has been turned on its head. While private individuals owned approximately two-thirds of U.S. equities in 1970, today it is institutional investors like Blackrock, Vanguard, and State Street that control two-thirds of such shares. This increase in institutional assets, often referred to as fiduciary capitalism or mutual fund capitalism, came with the rise of pension funds and mutual funds. More recently, the popularity of Exchange Traded Funds (ETFs) has shifted assets from active to passive investment strategies. In a recent paper, available here, I explain how these changes in ownership prompted the recent increase in the engagement by institutional investors with corporate boards and executives.
Investors generally have two choices when they are unhappy with a company’s performance: engage with the company’s management or sell their stock. Individual investors face a collective action problem when seeking to engage with companies, as the costs of doing so are generally too high for any individual while all individuals would benefit. As a result, managers have often been free from shareholder interference.
By concentrating voting rights in a small number of institutional investors, fiduciary capitalism has provided a remedy to the collective action problem. However, the concentration of assets has also had a negative effect, because asset managers that sell large stakes risk incurring high transaction costs. They may, for example, own any one stock in an amount equal to several days’ trading volume in that stock. A decision to sell could significantly lower its price. What’s more, fund managers of ETFs and other passive assets do not have the option of selling their entire stake in a company’s stock, as the investment strategy requires them to track the performance of an index. As long as a company’s stock is in the benchmark index, they cannot sell it.
The concentration of ownership and the growth of passive assets are now so great that corporate engagement is far more practical than divestment for the largest institutional investors. Liquidity constraints have increased the cost of exit while the relative cost of engagement has fallen, as it can now be spread across a larger asset base. While providing a remedy for the collective action problem that individual investors face, fiduciary capitalism has made institutional investors more powerful while compelling them to be more involved in corporate affairs.
Large-scale corporate engagement is still a relatively new phenomenon for many institutional investors. A study by Ernst & Young found that as recently as 2010 just 6 percent of S&P 500 companies reported investor engagement. As of June 2016 the figure had increased to 66 percent. Governments and the public appear supportive of a more active role for institutional investors. What consequence these changes will have on companies depends to a large extent on how the large asset managers perceive their role within the financial system. Despite criticism of an excessive focus on short-term shareholder returns, increased ownership concentration among the largest global institutional investors can benefit companies.
Those investors own shares in almost all companies, and are, therefore, concerned with negative externalities such as pollution. If, for example, one of their portfolio companies saved money by polluting the local water supply, another portfolio company might have to spend money to clean the water. Further, passive managers arguably have a longer investment horizon, because they are constrained from selling a stock that remains in a benchmark index.
There is also a regulatory reason for engagement. Even absent a change in the law, the definition of “best practice” in corporate governance is continually evolving, as is the understanding of fiduciary duty. While a 2005 report by law firm Freshfields stated that “integrating ESG considerations into an investment analysis (…) is clearly permissible and is arguably required in all jurisdictions”, the 2015 United Nations report, “Fiduciary duty in the 21st century,” went further, explaining that “Failing to consider long-term investment value drivers, which include environmental, social and governance issues, in investment practice is a failure of fiduciary duty.”
With a limited ability to sell shares of underperforming companies, institutional investors must become active stewards of the companies they invest in to fulfil their fiduciary duties to their clients. Companies should, in turn, expect engagement by a greater number of investors and on a wider range of issues. For any companies that have taken shareholder consent for granted, the recent defeat of ExxonMobil’s management on the topic of climate change should act as a wakeup call.
Although the investment horizons of passive investors are in theory infinite, the investment behavior of their investors is not. As long as retail investors’ investment horizons remain short and the performance of active managers is benchmarked daily, it is unlikely that institutional investors can become truly patient providers of capital. What should give hope to advocates of responsible investment, though, is that in practice proxy voting decisions are mostly separate from the investment function of portfolio managers (with a few exceptions, such as votes on capital increases or takeovers and other major corporate actions). This means that even where fund managers have short investment horizons, the fund’s corporate governance department may take a longer view in making decisions on proxy votes.
This post comes to us from Patrick Jahnke, a PhD candidate at the University of Edinburgh. It is based on his recent article, “Voice versus Exit: The Causes and Consequence of Increasing Shareholder Concentration,” available here.