The popularity of index investing has raised questions about corporate governance and how far index managers will go to ensure the companies they hold are acting in investors’ best interests.
To better understand how major passive fund providers are becoming more ‘active’ in their stewardship efforts, Morningstar surveyed the 12 largest providers of index funds and exchange-traded funds (ETFs) across the US, Europe and Asia, including BlackRock, Vanguard, State Street, Fidelity and Amundi.
Morningstar’s passive strategy research team published its findings in a research paper, ‘Passive fund providers take an active approach to investment stewardship’, which finds that while most index managers are stepping up engagement efforts through proxy voting and engagement disclosure, investor scrutiny of stewardship practices is intensifying and the industry has room to improve.
On the flip side, index managers in the US and Japan are increasingly willing to voice concerns – and in some cases directly challenge corporate management – catching up to the efforts of European managers from the past several years.
Hortense Bioy, director of passive strategies research for Europe at Morningstar, says in a statement accompanying the study: ‘As the flows continue into passively managed strategies, we can only expect the scrutiny of index managers’ corporate governance activities to intensify. Assets under management in traditional index funds and ETFs have grown to $8.1 tn globally, with index managers often ranking among the largest investors in public companies.
‘Despite this, there is little research available that sheds light on how index managers carry out their stewardship responsibilities. Our research shows the largest index managers have stepped up their efforts in the areas of voting and engagement, as they seek to influence investee companies and help improve ESG standards across the board.
‘But practices vary significantly among index managers and firms need to be doing more to enhance disclosure and communication to improve public awareness and understanding of their activities.’
Seven key takeaways on stewardship activities among index managers
1. Voting activities: Nearly all the firms Morningstar surveyed apply the same stewardship principles to all their holdings irrespective of whether they are in active or passive portfolios. Consolidating all holdings for voting and engagement allows managers to leverage their full scale.
2. Scope of voting activities: The largest asset managers tend to vote for all portfolio holdings where possible and as long as the potential benefit of voting outweighs the cost of exercising the right. For example, BlackRock and Vanguard exercise voting rights for close to 100 percent of their equity portfolio assets. Other firms focus on their home country or region, or on their largest holdings.
3. Forfeiting voting rights – synthetic ETFs and securities lending: Voting rights cannot be exercised for equity funds employing synthetic replication. This is not the only case where an asset manager may forfeit its right to vote. Many physically replicated index funds and ETFs engage in securities lending. When a stock is on loan, the right to vote is temporarily transferred to the borrower. Borrowers, which tend to be short sellers, generally commit not to vote these shares.
The research reveals a contrasting picture between Europe and the US. European managers are less inclined to forego voting rights, especially for shares in domestic markets, and will more systematically recall stocks or restrict securities lending. By contrast, US managers tend to recall shares only in rare cases where the impact of the vote can be material and the benefit of voting shares outweighs the foregone lending income.
4. Voting behavior: The starting position for all surveyed asset managers is to be supportive of company management and boards, as most votes are linked to routine administrative matters. But some firms tend to back management more often than others: BlackRock, Vanguard and Fidelity’s index subadviser Geode Capital reported the highest percentages of ‘for’ votes in the past three years. The data also suggests that asset managers in Europe tend to report higher – and, in some cases, increasing – percentages of ‘against’ votes than their US counterparts
5. Increased commitment to engagement: The research shows that index managers have no intention to free-ride with respect to engagement. Many are intensifying their efforts in that area. Of the 12 surveyed firms, nine report that they are currently undertaking direct engagement activities with investee companies and express a willingness to reach more companies in years to come. They also, and perhaps more importantly, intend to improve the quality of their interactions.
6. Resources: Perhaps the best evidence of the increased importance of stewardship responsibilities for index managers is the recent growth of their corporate governance teams. For example, BlackRock expanded its team from 20 members in 2014 to 33 today, Vanguard’s team went from 10 in 2015 to 21 this year, and UBS will employ 11 dedicated professionals by the end of 2017, up from four in 2015.
7. The issue of cost: As asset managers’ stewardship-dedicated teams continue to expand, the related expenditure will continue to rise. This raises the question of whether these firms will be able to absorb the extra cost without increasing their fees. While large asset managers with economies of scale should be able to absorb the additional costs, it might be more of a challenge for the smaller firms.
