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What do passive managers do all day?

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Index Funds and he Future of Corporate Governance, Theory, Evidence and Policy

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What do passive managers do all day?

  1. 1. Index Funds and the Future of Corporate Governance: Theory, Evidence, and Policy Last Revised: November 2019 1 Lucian Bebchuk and Scott Hirst Forthcoming, Columbia Law Review, December 2019 Presentation Slides
  2. 2. Overview • The slides in this document provide a summary of our study, Index Funds and the Future of Corporate Governance: Theory, Evidence, and Policy. • The slides build on and update our presentations at the 2019 ECGI Annual Meeting in Barcelona in which our study was awarded the ECGI’s Cleary Gottlieb Steen Hamilton Law Prize. 2 Overview
  3. 3. What We Do • Develop an agency-cost theory of index fund stewardship decisions. • Put together hand-collected and public data to piece together evidence on the full range of stewardship activities of the Big Three. • Find that the evidence is consistent with the agency- costs view. • Identify a range of policy implications. 3 Introduction
  4. 4. Part of a Larger Project on the Agency Problems of Institutional Investors Related work: • Bebchuk, Cohen & Hirst (2017), The Agency Costs of Institutional Investors, Journal of Economic Perspectives: Puts forward an analytical framework for analyzing institutional investor agency problems on which we build. • Bebchuk & Hirst (2019), The Specter of the Giant Three, Boston University Law Review: Provides a supplemental empirical evidence on the persistent and expected rise of the Big Three,, estimating that the Big Three could well cast as much as 40% of the votes in S&P 500 companies within two decades. • Bebchuk & Hirst (2019), The Misguided Attack on Common Ownership, Presentation at an FTC Hearing: Discusses implications for the common ownership debate. 4 Introduction
  5. 5. The Promise of Index Fund Stewardship There are three dimensions that have been identified as giving the Big Three potential advantages as stewards: 1. Large stakes in each portfolio company. – Enables capturing significant fraction of generated gains. 2. Lack of “exit” option from positions in portfolio companies (while they remain in the index). – Protecting/improving value is their only option. 3. Long-term perspective. We agree that index fund stewardship has promise. But our empirical analysis indicates that the promise of index funds is yet to be fulfilled, and our policy analysis seeks ways to better fulfil that promise. 5 Theory
  6. 6. The Agency-Costs View of Investment Fund Stewardship • Stewardship decisions are made not by the fund’s beneficial investors but by investment fund managers  agency problems. • The benchmark is the decisions that would be optimal for beneficial investors. • We do not argue that index fund stewardship necessarily produce worse governance outcomes compared to a state of the world in which the shares were instead held by individual investors and/or active funds. • We argue that : (i) agency problems are a first-order driver of stewardship decisions index funds, and (ii) understanding these problems can help identify ways to limit/reduce their costs. 6 Theory
  7. 7. Two Types of Incentive Problems. • Index funds (as well as active funds) have incentives to under-invest in stewardship (relative to what would be optimal for beneficial investors). • Index fund (as well as active funds) have incentives to be excessively deferential to corporate managers (relative to what would be optimal for beneficial investors). 7 Theory
  8. 8. Evidence • We consider empirical evidence of the stewardship the Big Three do, and what they do not. • We first discuss four dimensions of Big Three stewardship: 1. The limited personnel time they devote to stewardship regarding most of their portfolio companies; 2. The small minority of portfolio companies with which they have any private communications; 3. Their focus on divergences from governance principles and their limited attention to other issues that could be significant for their investors; and 4. Their pro-management voting patterns. 8 Evidence
  9. 9. Evidence (2) • We next consider five ways in which the Big Three may fail to undertake adequate stewardship: 1. Paying limited attention to financial underperformance; 2. Avoiding involvement in the selection of directors, and lack of attention to important director characteristics; 3. Failing to take actions to bring about governance changes they consider desirable; 4. Staying on the sidelines regarding corporate governance reforms; and 5. Avoiding involvement in consequential securities litigation. 9 Evidence
  10. 10. Investments in Stewardship • Each of the Big Three has hundreds of $1 billion+ positions in portfolio companies. This could justify multiple professionals dedicating substantial part of their time to monitoring and interacting with such a portfolio company. • Whereas supporters of index fund stewardship have focused on recent increases in stewardship staff, we estimate the personnel resources (hours and cost) devoted to each portfolio company. 10 Evidence: What the Big Three Do
  11. 11. Investments in Stewardship Relative to Equity Investments and Estimated Fees 11 Evidence: What the Big Three Do BlackRock Vanguard SSGA Stewardship Personnel 45 21 12 Stewardship Investment as % of Estimated Fees Estimated Stewardship Investment ($m) $13.5 $6.3 $3.6 Estimated Fees & Expenses ($m) $9,107 $3,467 $2,625 Stewardship as % of Fees & Expenses 0.15% 0.18% 0.14%
  12. 12. Stewardship per Portfolio Company Evidence: What the Big Three Do BlackRock Vanguard SSGA Stewardship Time (Person-Days) Scenario 1: Equal Allocation of Stewardship Time, per Portfolio Company (Worldwide) 1.00 0.40 0.25 Scenario 2: Stewardship Allocated 75% to U.S. Companies, per U.S. Company 2.24 1.07 0.72 Scenario 3: Proportional Stewardship Allocation, per $1bn Position Worldwide 3.71 1.36 1.94 Scenario 4: Proportional Stewardship Allocation, per $1bn Position in U.S. Companies 3.97 1.58 1.79 12
  13. 13. Stewardship Per Portfolio Company (2) BlackRock Vanguard SSGA Stewardship Investment ($) Scenario 1: Equal Allocation of Stewardship Time, per Portfolio Company (Worldwide) $1,200 $476 $295 Scenario 2: Stewardship Allocated 75% to U.S. Companies, per U.S. Company $2,689 $1,287 $866 Scenario 3: Proportional Stewardship Allocation, per $1bn Position Worldwide $4,447 $1,635 $2,332 Scenario 4: Proportional Stewardship Allocation, per $1bn Position in U.S. Companies $4,762 $1,895 $2,147 13 Evidence: What the Big Three Do
  14. 14. Investments in Stewardship (2) • Evaluating the governance and performance of a public company requires evaluating hundreds of pages of documents (or more): – The company’s annual report and proxy statement; – The business performance of the company; – The company’s executive pay arrangements; – Management proposals and shareholder proposals up for a vote; – The views of the company’s directors on these matters; and – Assessments of the directors’ performance. • However, the stewardship staffing of the Big Three enables only limited and cursory review for the vast majority of their portfolio companies. Evidence: What the Big Three Do 14
  15. 15. Investments in Stewardship (3) Conclusions: Consistent with the agency-costs view: – The Big Three devote an economically negligible fraction of their fee income to stewardship. Their stewardship staffing enables only limited and cursory monitoring for the vast majority of their portfolio companies. 15 Evidence: What the Big Three Do
  16. 16. Private Engagement • The Big Three have stressed that private engagement is a central and superior tool that allows them to avoid using other shareholder tools: – Vanguard: Private engagement is the “perhaps more important … component of [Vanguard’s] governance program”; “engagement is where the action is.” – BlackRock: “[M]eetings behind closed doors can go further than votes against management.” 16 Evidence: What the Big Three Do
  17. 17. Private Engagement (2) 17 BlackRock Vanguard SSGA Average Portfolio Companies with No Engagement 88.9% 94.2% 94.5% 92.5% Portfolio Companies with Engagement: Portfolio Companies with a Single Engagement 7.2% 3.5% 5.0% 5.2% Portfolio Companies with Multiple Engagements 3.9% 2.3% 0.6% 2.3% Total Portfolio Companies with Engagement 11.1% 5.8% 5.5% 7.5% Evidence: What the Big Three Do Average Proportion of Companies Engaged, 2017-2019
  18. 18. Private Engagement (3) • Thus, each of Big Three had no engagement with the great majority of companies: For these companies private engagement cannot serve as substitute for the use of other stewardship tools. Evidence: What the Big Three Do 18
  19. 19. Governance-Principles-Based Stewardship • We document that Big Three stewardship focuses on the existence of deviations from their governance principles. • This is consistent with the Big Three’s own descritpions: – SSGA: Seeks to provide “principles-based guidance” – BlackRock: Engages where a company lags behind its peers on environmental, social, or governance matters, or in sectors with thematic governances issues. – Vanguard: Focuses on “board composition issues, governance structures, executive compensation, and risk oversight.” Evidence: What the Big Three Do 19
  20. 20. Governance-Principles-Based Stewardship (2) • Serves the private interests of the Big Three: – Enables economies of scale that reduce required investments in stewardship; and – Makes the potential power of the Big Three less salient. • But does not take advantage of potential benefits from stewardship based on attention to business performance and/or individual director qualifications – (More on this below) 20 Evidence: What the Big Three Do
  21. 21. Big Three Largest 3 Active Largest 10 Active 2012 3.9% 13.7% 10.2% 2013 2.4% 11.5% 11.2% 2014 3.7% 9.2% 8.1% 2015 2.4% 6.3% 7.2% 2016 2.8% 7.8% 8.7% 2017 4.0% 7.7% 8.9% 2018 2.8% 6.9% 9.4% Average 3.1% 9.0% 9.1% Pro-Management Voting Evidence: What the Big Three Do Big Three vs. Active Manager “Against” Votes on Say-on-Pay
  22. 22. • Financial performance is important to investors: Index fund investors would benefit significantly from having index funds: (i) monitoring financial underperformance, and (ii) examining what personnel or other changes could address identified underperformance. Evidence: What the Big Three Fail to Do 22 Limited Attention to Performance (2)
  23. 23. Limited Attention to Performance (2) • Examining the many examples of behind-the-scenes engagements in Big Three Stewardship Reports, we find no cases in which engagement was motivated by financial underperformance. • Examining the proxy voting guidelines of each of the Big Three for deciding whether to withhold support from director/s, we find that all focus on governance aspects and do not include financial underperformance as relevant criterion. Evidence: What the Big Three Fail to Do 23
  24. 24. Limited Attention to Performance (3) • Could it be argued that this is because the Big Three “lack the expertise and access to information to identify operational improvements … to improve the performance of companies in their portfolio?” (Fisch, Hamdani & Davidoff Solomon, 2018) • But lack of in-house expertise should not be taken as given – it is an endogenous choice made by index fund managers: – Index fund managers have the resources and could improve their ability to identify and remedy financial underperformance if they had incentives to do so. Evidence: What the Big Three Fail to Do 24
  25. 25. Limited Attention to Performance (4) • Could it be argued that index fund managers rationally avoid monitoring and addressing underperformance because activist hedge fund are already doing it? (Gilson and Gordon (2013) make a version of this argument) • Not a valid justification because: – Activist hedge funds will only engage where underperformance is very large and can be fixed quickly; and – Activist hedge funds may take some time to arrive. Evidence: What the Big Three Fail to Do 25
  26. 26. • How well a given director suits a board may depend not just on governance dimensions (are they independent? chosen through an appropriate governance process?) • But also on various individual & company specific characteristics (e.g., how much and what kind of experience a director has in the company’s industry? what talents, tools, and education they have?). • Assessment of these characteristics could lead to conclusion that the beneficial investors of a Big Three fund would benefit from removing/adding a given director. Evidence: What the Big Three Fail to Do 26 Little Attention to Many Important Director Characteristics (2)
  27. 27. Little Attention to Many Important Director Characteristics (2) • However, we provide evidence that, outside the small number of activist proxy fights, the Big Three pay little attention to director characteristics and do not try to remove or add particular individuals to the board. • We examine the proxy voting guidelines of each of the Big Three regarding whether to withhold support from directors. • We find that such guidelines focus on general governance principles do not call for taking relevant qualifications/characteristics into account. 27 Evidence: What the Big Three Fail to Do
  28. 28. Little Attention to Many Important Director Characteristics (3) • Could it be that the Big Three use such characteristics in their behind- the-scenes communications with companies? • We provide evidence that this is not the case. • We gather data on over 4,000 5% positions held by the Big Three during 2008-2017. – Blackrock had 2,367 positions, Vanguard 2,051, SSGA 183. • Communications regarding individual director selection by a 5% holder would require a Schedule 13D filing. • However, only 9 Schedule 13Ds were filed by BlackRock during 2008- 2017, and none by Vanguard or SSGA We can infer that they avoided such communications. Evidence: What the Big Three Fail to Do 28
  29. 29. Little Attention to Many Important Director Characteristics (4) Can the Big Three simply free-ride on activist hedge funds? No: • The Big Three’s preferred directors may differ from those that activist hedge funds nominate. (e.g., SSGA criticizing agreements with activist hedge funds) • The Big Three could communicate about director selection with the numerous portfolio companies where hedge funds are not active. • However, avoiding involvement in the selection of particular directors is consistent with the agency-cost view. Doing so: Would require significant stewardship investment. Would involve non-deference to corporate managers. Evidence: What the Big Three Fail to Do 29
  30. 30. • Proposals submitted by shareholders that receive majority support (including consistent support from the Big Three) have led to considerable improvements in numerous companies (e.g., with respect to annual elections, majority voting, elimination of supermajority provisions). • However, we document that, among the almost 1,500 corporate governance proposals submitted during 2014-2018, including among the large subset of proposals supported by the Big Three, none was submitted by the Big Three. Evidence: What the Big Three Fail to Do 30 No Submission of Shareholder Proposals for Changes Desired by the Index Funds (2)
  31. 31. No Submission of Shareholder Proposals for Changes Desired by the Index Funds (2) • Can avoidance of shareholder proposal submission be explained on grounds that the Big Three don’t need to submit proposals for governance changes they desire because other (smaller) investors are doing so? • No. – Because of the limited resources of smaller investors, proposals for many changes that the Big Three would favor are not submitted at all, or are submitted only after many years of delay. – As a result, we document that a large proportion of the Big Three’s portfolio companies lack governance arrangements they themselves favor.  Submission of shareholder proposals on those issues by one of the Big Three would likely have significant positive effects for their beneficial investors. Evidence: What the Big Three Fail to Do 31
  32. 32. • Because the Big Three hold positions in many companies, wide- scale governance reforms (even with a small effect per company) could significantly benefit their portfolios. • But the evidence we hand-collect shows a pattern of limited involvement. Evidence: What the Big Three Fail to Do 32 Staying on the Sidelines of Corporate Governance Reforms (2)
  33. 33. • We examine all comment letters submitted on 80 SEC proposed rule changes regarding corporate governance during 1995-2018: • With each holding about 5% or more of corporate equities, the Big Three could be expected to express a view whether the proposed rule is (i) desirable, (ii) undesirable, or (iii) not practically important and worthy of SEC attention. • However, each of the Big Three submitted comments regarding 10% (or less) of (i) the set of all proposed rules, as well as (ii) the set of proposals getting most attention. Evidence: What the Big Three Fail to Do 33 Staying on the Sidelines of Corporate Governance Reforms (2)
  34. 34. • We also examined 10 important cases of precedential securities litigation during 2007-2018. – These attracted significant amicus curiae briefs (more than 100 in total). – They were also often cited by the subsequent judicial decisions. • The two largest public pension funds filed or joined amicus briefs in 4 of 10 cases, alone or jointly with another party, despite being many times smaller than the Big Three. • However, the Big Three remained fully on the sidelines—none of them filed a single amicus curiae brief in any of these ten precedential litigations. Evidence: What the Big Three Fail to Do 34 Staying on the Sidelines of Corporate Governance Reforms (3)
  35. 35. • The limited involvement of the Big Three in both SEC comments and amicus briefs is consistent with the agency-costs view: – Explicitly supporting pro-shareholders reforms would not be deferential to company managers. – Explicitly opposing reforms reduces the salience of their deference. The private interests of index fund managers, but not the interests of their beneficial investors, are likely to be served by staying on the sidelines. Evidence: What the Big Three Fail to Do 35 Staying on the Sidelines of Corporate Governance Reforms (4)
  36. 36. Policy • We put forward a set of reforms that policymakers should consider to address the incentives of index fund managers • We discuss the implications of our analysis for two important debates • We explain how the recognition of the incentive problems we analyze can contribute to improving index fund stewardship 36 Policy
  37. 37. Implications for Policymakers • Policymakers should recognize the incentives of index fund managers to under-invest in stewardship and to be excessively deferential to corporate managers. • Our paper put forward proposals several policy measures that should be considered for improving stewardship: – Encouraging investments in stewardship; – Limiting or disclosing relationships with portfolio companies; – Making private engagements more transparent; – Rethinking Section 13(d) rules; and – Size limits for investment fund managers. 37 Policy
  38. 38. Implications for Hedge Fund Activism • Opponents of hedge fund activism view “long-termist” index fund stewardship as a preferable substitute for “short-termist” activist hedge funds. • Our analysis shows that index fund stewardship cannot serve as an effective substitute. • Because of the incentive problems of index fund managers, hedge fund activism has a critical role in stewardship. Policy 38
  39. 39. Implications for Hedge Fund Activism (2) • But hedge fund activism is not a substitute for index fund stewardship. • We argue that the hedge funds-index funds combination cannot generally address effectively corporate governance failures. – Contrast the views of Gilson and Gordon (2003). • First, hedge fund activism requires the support of index fund managers: – Insufficient support by index fund managers may impede or discourage hedge fund activist engagement (Brav, Jiang & Li, 2018). – Support for activism is against index fund managers’ deference incentives. • Second, activist hedge funds will only engage if they expect to make substantial returns.  They will ignore many opportunities for smaller gains even though they would be valuable for index fund investors. Policy 39
  40. 40. Implications for the Common Ownership Debate • We argue that criticism of common ownership is counterproductive. • The first-order concern is that the Big Three do too little and have too little influence, not that the Big Three do too much and have too much influence. The push for greater scrutiny of index fund stewardship would therefore likely produce counterproductive effects. • For further details see The Misguided Attack on Common Ownership (2018), our presentation at an FTC hearing on common ownership. 40 Policy
  41. 41. Recognition and Reality Index fund managers have significant incentives to be perceived as responsible stewards. Greater recognition by beneficial investors and the public of the incentive problems we identify can lead to improved stewardship. We hope that our work will contribute to bringing about such changes. 41 Policy
  42. 42. Conclusions • The evidence we have collected is consistent with the agency- costs view of index fund stewardship that we put forward. • The agency problems that we have identified deserve the close attention of policymakers, market participants, and corporate governance scholars. Conclusions 42

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