Passive Funds Still Have Active Responsibility

CHICAGO – A key attraction of exchange-traded funds is the passive, set-it-and-forget-it aspect but that should not necessarily apply to company governance oversight, according to Morningstar analysts.

ETFs might seem like a blunt investing instrument, but they can wield considerable clout with their voting power, said Hortense Bioy, director of Passive Strategies and Sustainability Research, Europe at Morningstar.

It is a key subject planned for the “Are Index Funds Eating The World?” panel discussion that Bioy is scheduled to moderate this morning at the Morningstar Investment Conference.
Although asset managers have been growing enormous passive funds, their obligation is still active, Bioy said.

“For each share is attached voting rights,” Bioy said. “They have a fiduciary duty to vote because they want to protect their investors’ value.”

That means looking over the company’s operations leading up to each annual meeting. That comes down to executive compensation and other governance issues. It is one of the key ways to keep companies accountable as oversight can vary from regulator to regulator.

“Ten years ago, company governance was the most boring thing, there was nobody who talked about company governance,” Bioy said. “But we talk about company governance more today because we realized that companies have to be better run. There was a financial crisis so that obviously shows a lot of investors that there were issues that companies were not really managing well, right?”

But it does not stop there.

As a fund covering a sector, there are the sector’s issues to consider as well. It is not enough to leave those issues with socially conscious funds, Bioy said, pointing out the environmental impact of the oil sector as an example.

On big issues, passive fund managers can make a large impact – and some are starting to recognize not only that clout, but also their responsibility.
After a student fatally shot 17 people in Parkland, Fla., last year, BlackRock made the surprise announcement that it would not sit on the sidelines as the world’s largest money manager – and reportedly the largest share owner of two public gun companies.

The company’s CEO publicly warned companies that their share value can suffer if they do not pay attention to social impact. But the company also talked privately about the issue with gun manufacturers.

“BlackRock was more vocal about it than Vanguard, so it’s getting really interesting,” Bioy said.
Fund managers are in a tight spot because they need to own the companies within the index, even the ones managers might find objectionable. So, investor pressure is the only lever available to them.

Pulling that lever can be problematic for some managers because of other relationships they have with companies, Bioy said.

“Take the example of BlackRock,” she said. “They run the pension funds of a lot of companies out there. Some people are saying, ‘Well, they are your clients, so of course, you may not want to upset them too much.’ So, it’s tricky. It’s a business world, right?”

But BlackRock is stepping up and more companies are also applying pressure, but unlike BlackRock, they are not disclosing many details.

“They said they’re doing more,” Bioy said. “They’re publishing engagement reports, but they’re not naming the companies with which they engaged.”

The companies are also not clearly stating their aims and actions. “Like how hard are they on companies?” Bioy asked. “How ambitious are they with their objective?”

So, isn’t the point for many companies to keep cost and fees to a minimum? Yes, Bioy said, but that does not exempt managers from their fiduciary duty by ignoring company behavior. Although it is an expense, in the scheme of things, the investment is not large.

“Seriously when you have 40 people in a team,” Bioy said, referring to stewardship teams, “if you add even 50 more people or hundred people, Vanguard has 17,000 employees. They’ve got $4 trillion in assets – so for those guys, it is not an issue.”

Besides fiduciary risk, Vanguard and other large managers faced a different risk if they are not aggressive about oversight.

“Reputational risk,” Bioy said. “Well, like for example, let’s say Vanguard owns between 6% or 7% of Apple, and there’s a big scandal. There’s a reputation risk – like was Vanguard asleep at the wheel?”

Bioy recognized that the cost is more of an issue for smaller managers but she said they would have to be “targeted” in their approach.

“You can’t change the world and you can’t change things overnight,” Bioy said. “It is changing especially at the broad level. It is changing with like gender diversity. They’re trying to shake things to avoid having the same people on board that have been there for like 20, 30 years because it’s quite common in U.S.”

Best Practices

Bioy said Morningstar is refining best practices for asset managers as they discover them. A 2017 report, “Passive Fund Providers Take an Active Approach to Investment Stewardship,” which Bioy co-wrote, provided a best practices list derived from what they knew then.
An asset manager should:

• Have a comprehensive responsible investment policy and make it publicly available on the firm's website.
• Cast votes on the shares held by all funds, including passive funds.
• Make the voting policy and voting records of all funds—including passive funds—publicly available on the firm’s website. This is an area where regulators could help by making public disclosure of voting records a requirement where it is not yet mandatory.
• Publicly disclose rationales for key votes (that is, votes against management, abstentions, and contentious votes). Providing reasons behind a vote allows stakeholders to assess whether the asset manager has voted in line with its policy and in the best interest of shareholders.
• Consider recalling lent stocks or restricting lending for important votes and when it is believed the benefit of voting shares outweighs the forgone lending income.
• For those relying on third-party governance providers for voting and/or engagement activities, monitor and audit recommendations and services closely to ensure they comply with the asset managers’ policies.
• Be an active owner and engage with investee companies either directly or collaboratively, or ideally both. Emphasis should be put on the quality of engagements, not the quantity.
  Disclose the number, topic, and outcome of direct engagements with companies, as well as the full list or a sample of companies engaged with over the year. Providing names of companies engaged will allow index managers to improve public awareness and understanding of their engagement activities.
• Do not limit company dialogues to governance matters alone, and address environmental and social issues because they are a source of reputational and regulatory risk that can affect a company’s bottom line.
• Engage with regulators, policymakers, index providers, and other stakeholders to help improve markets, and disclose the parties to and topics of some or all of these conversations.
• Use the firm’s scale by consolidating active and passive equity portfolios for voting and all asset classes, including fixed income, for engagement.
• Communicate with clients and stakeholders through regular investment stewardship reports.

Steven A. Morelli is editor-in-chief for AdvisorNews. He has more than 25 years of experience as a reporter and editor for newspapers and magazines. He was also vice president of communications for an insurance agents’ association. Steve can be reached at smorelli@advisornews.com.

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