The ‘Big Three’ of BlackRock, Vanguard and State Street Global Advisors (SSGA) have just as much incentive as active managers to regularly engage companies, according to a recent paper by the National Bureau of Economic Research (NBER).
The research, titled Corporate Governance Implications of the Growth of Indexing, found the common argument that low-cost index funds have the tendency to be free riders when it comes to engagement is not entirely accurate.
In fact, large passive fund issuers “have among the strongest direct financial incentives” to engage because of their large shareholding in most companies.
Referring to past research, NBER said a 1% increase in the value of typical ‘Big Three’ positions in a company increases their annual management fees by $133,000, which means their incentives to increase value are “comparable in magnitude to those of activists”.
NBER argued: “The substantial direct incentives of large index funds estimated in the data are due to the tension between fees and scale: although they charge substantially smaller management fees than actively managed funds, their large assets under management (AUM) and ownership stakes often offset the weaker incentives due to smaller fees.
“This suggests that empirical research should not treat all index funds in the same way. For small index funds, the benefits from engagement are likely to be very low (and lower than those for active funds) given the combination of their very low fees and low ownership stakes. In contrast, this may not be true for the Big Three, whose ownership stakes are substantial and exceed those of active funds.”
These dynamics are reflected in asset managers’ spending on engagement, NBER said, with the ‘Big Three’ performing “substantially” more governance research and more often voting against proxy advisors compared to smaller passive providers.
However, there are some nuances to consider. For instance, the research found passive funds were 9.5% more likely than active funds to vote with company management on issues such as director elections.
Also, while the initial shift to index funds may have been net positive for engagement – as money moved from single stock ownership by private investors in the US to pooled funds – over time passive products began taking company ownership share from active managers.
While the quality of engagement performed by index funds may or may not be lower, one argument is the shift to passive has put downward pressure on fees for all funds, meaning while the costs of engagement remain roughly the same while the amount of management fee allocated to these activities naturally falls over time.
However, NBER argued this relationship between reduced fees “is not necessarily accompanied by lower engagement by fund managers”. Instead, fee reductions in passive funds tend to coincide with AUM growth, meaning revenue continues to increase, while the quality of engagement and corporate governance by passive funds can also improve.
Also worth noting is the type of information being collected and acted on by passive and active funds, respectively. Pointing to previous research, NBER said hedge funds and active mutual funds tend to have an edge in firm-specific financial issues as these tend to be the focus of their investment strategies.
Passive funds, meanwhile, are better positioned to be informed on market-wide issues such as corporate governance standards. Because of their ‘own the market’ approach, they gain the benefits of scale in collecting data from all companies and can in turn compare the performance of – and affect outcomes – across entire markets.
This means while active managers can steer change via more intimate and granular engagement to generate positive investor outcomes, the ‘Big Three’ can monitor the performance of entire portfolios on financial, corporate governance or even broader ESG metrics and apply pressure to those falling behind the pack.
Such behaviour was evidenced in another recent NBER paper, titled The Big Three and Board Gender Diversity: The Effectiveness of Shareholder Voice, which found the passive giants were responsible for between a third and two-thirds of the 50% spike in women on US company boards between 2016 and 2019.
The efficacy of such campaigns by index fund behemoths will be increasingly in focus as their ownership of entire markets grows further – the ‘Big Three’ already controlled a quarter of S&P 500 company votes by 2019.
Whether these asset managers should exert influence to generate positive investor outcomes or broader societal change, and which stances they should take on certain issues, will be a subject of regulatory interest going forward.
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