18 Sep Do passive investors care about corporate governance?
“No passive investor cares much about governance of a particular company.”
Todd Henderson and Dorothy Shapiro Lund, Wall Street Journal, 22nd June 2017
The above quotation comes from an article published in the Wall Street Journal (WSJ), access to which is only available to subscribers, although the academic paper behind it, ‘The case against passive shareholder voting’ published by Ms. Lund is available here.
Ms. Lund makes a number of interesting assertions in the paper:
“… because passive funds seek only to match the performance of an index — not outperform it — they lack a financial incentive to ensure that each of the companies in their very large portfolios are well run.”
“Passive funds lack governance expertise and firm-specific knowledge and so a thoughtful voting strategy would increase costs without meaningfully improving portfolio returns. Thoughtless voting is also likely to harm investors, as well as other shareholders, especially as passive funds grow in size and influence.”
Ms Lund even goes as far as to say:
“… this paper proposes that lawmakers consider restricting passive funds from voting at shareholder meetings. Doing so would reduce the influence of passive funds in governance and also preserve the role of informed investors as a force for managerial discipline.”
The WSJ article was covered in Vanguard’s blog a couple of weeks after publication. It’s interesting to read their side of the story and makes me wonder whether Ms. Lund contacted them when researching her paper.
Back in May, I was fortunate enough to attend Dimensional Fund Advisors’ (DFA’s) Global Conference in Napa, California. Within a tightly packed agenda was this item: ‘Corporate governance at Dimensional’.
The presentation was enlightening and again jars with the evidence presented in Ms. Lund’s paper. DFA made the following points regarding its stance on corporate governance:
- DFA believes that good corporate governance will be reflected in returns. Stock price is a function of discount rate and expected future cash flow. In simple terms, a company which uses profits to fund excessive compensation packages for its executives, meaning there will be less available to reinvest in the business (for example to fund acquisitions), or a board whose interests are misaligned with the interests of their shareholders and where even the merest hint of impropriety can impact how the market views the stock, can lead to lower returns. It’s therefore very much in DFA’s interests, as institutional shareholders on behalf of its investors, to encourage good corporate governance;
- DFA has a Corporate Governance Committee (CGC) which meets quarterly, comprises many members of DFA’s executive (including Nobel laureate Eugene Fama) and which in turn oversees the Corporate Governance Group (CGG) which comprises dedicated associates for corporate governance;
- In 2016, DFA voted in over 269,000 ballots on behalf of 224 portfolios and takes very seriously the cost/benefit trade-offs;
- The CGG has documented key areas of focus – and just like Vanguard it believes in the importance of strong, independent boards.
As Vanguard states in the comments in the blog linked to above:
“… we consider our governance activities to be an essential responsibility and obligation. It’s not our role or intention to micromanage the thousands of companies in which we invest. Rather, we believe that if the proper governance frameworks are in place — beginning with a company’s board of directors — investors will benefit in the long run.”
Ms. Lund also references BlackRock – one of the ‘big three’ passive managers along with Vanguard and State Street but, as their CEO Larry Fink pointed out last year, index funds “can’t sell those stocks even if they are terrible companies. As an indexer, our only action is our voice and so we are taking a more active dialogue with our companies and are imposing more of what we think is correct.”
An academic study published in 2014 “Passive investors, not passive owners” (links to pdf) by Ian R. Appel, Todd A. Gormley, and Donald B. Keim seems to bear this out, although back in 2014 passive investing wasn’t seen as the ‘Marxist threat’ to the world that it is today, so that research drew little comment at the time.
Not only is it inaccurate to say that passive managers don’t care about corporate governance; it’s equally inaccurate to say that passive investors don’t care either. The evidence suggests that demand for environmental, social and governance (ESG) funds and ETFs in the passive space is rapidly growing.
I don’t think that people who choose to invest in passive funds care any less about corporate governance than those who invest in active funds. The reality is that most investors probably never give the topic any thought at all. But are index funds evil? I don’t think so.