The Stewardship Implications of Passive Investing: Mobilizing Large Asset Managers as Stewards of Capital Markets

Jackie Cook is Director of Manager Research and Jasmin Sethi is Associate Director of Policy Research at Morningstar, Inc. This post is based on their Morningstar memorandum. Related research from the Program on Corporate Governance includes The Agency Problems of Institutional Investors by Lucian Bebchuk, Alma Cohen, and Scott Hirst (discussed on the Forum here) and Index Funds and the Future of Corporate Governance: Theory, Evidence, and Policy by Lucian Bebchuk and Scott Hirst (discussed on the forum here).

A defining trend of global financial markets over the past 10 years has been growing investor preference for low-cost investment products with broad market exposure.

The shift in assets from actively managed instruments to passive investing strategies is re-shaping both the asset management industry and the structure of corporate shareholding.

Because of the economies of scale in index investing, the asset management industry is becoming more concentrated and the largest players own and control a greater portion of the global securities market.

Furthermore, index-tracking investing removes much of the flexibility of portfolios to diversify away from risky corners of the market while potentially affording the space for longer-term business strategies and investment horizons.

A growing body of academic literature, including influential research reviewed on this forum, explores the stewardship implications of passive investing, focusing primarily on the “Big Three” asset managers—BlackRock, State Street and Vanguard—the early movers that now own sizeable stakes in most large US public listed companies.

In our recent paper entitled Asset Managers as Stewards of Sustainable Business: Implications of the Rise in Passive Investing we draw on this literature to address the following broad questions: How do passive asset managers, particularly the large ones, exercise their stewardship responsibilities? Are asset managers that offer index-tracking and exchange-traded funds sufficiently incentivized to use their control rights to address urgent ESG risks, such as climate change? What policy strategies would encourage passive investors to play a more active role as stewards of capital markets?

In this post we summarize the main points of the paper.

Markets need active owners

All financial stakeholders benefit when investors are vigilant about corporate governance. How the most powerful financial industry players exercise their control rights as stewards of capital has important implications for the health of capital markets.

Proxy voting and engagement are complementary strategies in the stewardship toolbox of shareholders. Engagement offers management the opportunity to hear from investors who provide valuable perspectives on risks and solutions. Proxy voting gives effect to the engagement process by offering shareholders a strategy for raising issues to be addressed, and a way for markets to signal a degree of concern where governance practices are inadequate. Engagement is underwritten by an investor’s willingness to vote against proposed compensation arrangements and board nominees, or by supporting shareholder resolutions proposing governance arrangements and disclosures that address ESG risks.

Under both US and EU securities law investors play a central role in monitoring and shaping corporate governance practices. Mobilizing investors to be active owners became a particularly important theme for financial market regulators in the wake of the 2008-2009 financial crisis. With the growing financial materiality of environmental and social factors, regulators have a clear interest in encouraging shareholders to invest in monitoring and shaping corporate governance arrangements at investee companies.

This is especially so for the “Big Three” passive asset managers. Together, they control enough of the voting power at most large US corporations to have a strong, if not deciding, impact on important vote outcomes. This gives them significant influence over corporate governance arrangements that underpin sustainable business practices.

Passive managers have three key incentives to be active owners

Larry Fink’s 2018 letter to CEOs notes that “index investors are the ultimate long-term investors—providing patient capital for companies to grow and prosper.”

At least three distinct incentives for active ownership by passive asset managers can be discerned from the academic literature.

Firstly, invested as they are across the length and breadth of markets with limited options for diversifying away from risk, passive asset managers must use “voice” and advocate for long-termism. As self-described “permanent, universal owners”, large passive asset managers have a fiduciary responsibility to address systemic market risks.

Second, the largest asset managers both capture more value from governance improvements and achieve greater economies of scale in monitoring, conducting engagements and actively voting proxies. Where large asset managers centralize their stewardship efforts, they can leverage engagements and proxy research to secure investment risk reductions across the portfolios of their entire suite of fund offerings.

Third, stewardship approach is a branding opportunity for an index fund family. End investors care about fees. However, they increasingly care about what their funds are invested in and how their funds are stewarded. There were 74 ESG ETFs available in the U.S. at the end of 2018. Fund investors naturally expect stewardship to align with funds’ ESG purposes. In distinguishing investment products from those of peers offering near substitutes, and from actively managed investment alternatives, they are incentivized to invest in social and environmental stewardship strategies.

The “Big Three” have historically been passive voters

The “Big Three” have historically been passive voters: they are more likely than their peers to vote in line with management recommendations. They often fail to support shareholder resolutions supported by a majority of shareholders, including other large asset managers, sending mixed signals to corporate management on important ESG issues, such as the need for disclosure of GHG emission reduction targets and governance arrangements that build climate resilience.

One explanation is that passive fund providers are under much stronger pressure than active managers to keep fund fees low. Voting against management requires a clear rationale and, therefore, research. With tens of thousands of ballot items to vote on each year, passive asset managers defer to management to reduce stewardship costs.

Another explanation is that the opacity surrounding engagement may be an attractive feature for asset managers. As Bebchuk and Hirst point out, the largest asset managers may be vulnerable to political and regulatory backlash where votes conflict with vested and powerful interests. We reference the criticism of BlackRock and Vanguard’s votes in support of the 2017 Exxon Mobil climate scenario resolution by a National Association of Manufacturers-backed lobby group called the “Main Street Investors Coalition” as a case in point.

Asset managers themselves say that they prefer engagement, and reserve voting against management as a last resort. They argue that the success of engagements depends on a long-term relationship; adversarial voting could undermine gains made through cooperative dialogue. Furthermore, dialogue allows asset managers to work with management to achieve nuanced solutions to complicated problems.

Engagement is a powerful tool with market-wide benefits. While there is evidence that the largest asset managers have intensified their engagement efforts, dialogue with corporate management is expensive, slow, and not easily observable. It follows that asset managers are incentivized to under-invest.

There also is a strong argument for expecting that the largest asset managers would use proxy voting in tandem with engagement to achieve an optimal impact for a given stewardship investment.

Sustainability is central to the global stewardship movement

We trace the global proliferation and growing influence of stewardship codes and the emergence of collaborative approaches to engagement on ESG issues to emphasize that investment fiduciaries are under growing pressure to demonstrate their stewardship efficacy on ESG issues.

The stewardship movement has been fueled in no small part by growing investor anxiety that financial markets are not responding quickly enough to the investment risks of climate change. The imperative of rapidly decarbonizing the global economy was laid out in the IPCC’s Special Report on Global Warming of 1.5 ºC one year ago. This means that, over the coming decades, the savings that investors entrust to asset managers will be heavily impacted by how decidedly asset managers use their influence as the most powerful players in private sector finance steward this transition.

The December 2015 Paris Climate Agreement recognized the central role of the global financial industry in steering capital towards decarbonization. The TCFD recommendations for decision-useful corporate climate-risk disclosure are now a reference point in the proxy voting guidelines and stewardship reports of many large investors. These underpin shareholder resolutions requesting quantitative GHG reduction goal disclosures, reporting on the resilience of business plans and portfolios under a 2-degree policy scenario and specific oversight measures aimed at strengthening the “climate competence” of corporate boards.

Recent revisions to the European Fund and Asset Management Association (EFAMA) stewardship code and the UK stewardship code, both spurred by the Revised Shareholder Rights Directive (SRD II) which came into effect across EU states in June, endorse a collaborative approach to tackling systemic investment risk.

This approach to investor engagement is exemplified by The Climate Action 100 (CA100+) initiative, launched in December 2017 at the inaugural One Planet Summit by overlapping groupings of investors.

The CA100+ is global coalition of investors accounting for $34 trillion in AUM, including some of the largest asset managers—like LGIM, Allianz, PIMCO and DWS. It is now two years into a 5-year agenda to collectively engage the most systemically significant GHG emitters globally as well as companies well positioned to drive the low carbon transition. The broad objectives are to improve climate governance, reduce emissions and advance climate risk disclosures at targeted companies in line with TCFD recommendations.

Policy can promote more-active ownership by passive asset managers

Where asset managers rely on engagement as an active ownership strategy, end investors need to be able to gauge the impact of private dialogues and understand how proxy voting is used where engagement fails to achieve objectives within acceptable timeframes. The added visibility as well as the credible commitment to escalation that participation in collaborative investor initiatives affords addresses the well-documented free-rider problem inherent in any socially beneficial, costly and unobservable undertaking.

Consistent with positions articulated by Bebchuk and Hirst and Strampelli [1], we argue that a policy approach aimed at achieving greater transparency around engagement activities as well as enabling collaborative investor engagement would have the combined impact of reducing the cost of active ownership and addressing the collective action impediment to greater investment by asset managers in investment stewardship.


1Strampelli, G. 2018. “Are Passive Index Funds Active Owners? Corporate Governance Consequences of Passive Investing.” San Diego Law Review, 2018; Bocconi Legal Studies Research Paper No. 3187159. back)

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