How passive investors could solve the problem of executive pay

We're huge fans of tracker funds and exchange-traded funds (so-called "passive" investments) at MoneyWeek.

They're cheap. They're introducing some much needed creative destruction and competition into the fund management business, as the more mediocre active managers face a genuine threat to their livelihoods.

And now there's another reason to love tracker funds they may be the key to finally tackling the thorny issue of egregious executive pay packets...

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The argument for curbing executive pay

We're not secret Jeremy Corbyn fans here. We're not suggesting there should be a maximum wage cap or that the government should get into the business of imposing wage controls.

However, we do have a problem with executive pay packets that reward chief executives who are salaried managers, ultimately with the sort of generationally life-changing wealth that should really only be accruable by those who take huge risks to achieve it entrepreneurs and owners.

"But they're only paying the market rate", goes the outcry from columnists in the business pages who haven't looked into the issue very hard. This is not true.

The fundamental problem with executive pay as with all of these things boils down to incentives. The big problem is that no one involved in setting executive pay has any incentive to do anything but drive the price of executives higher.

The people who are supposed to hold management to account the owners, the shareholders have been curiously reticent to do so. You'd think that they'd care (after all, money spent on excessively high wages is money that doesn't go to shareholders).

So why the apparent indifference? Because most of the ultimate shareholders the likes of you and I funnel their money through intermediaries such as fund managers.And one of the big problems that most fund managers have with holding company managements to account over pay is that they are the very definition of people in glass houses.

Every time they go to lob a stone, they get worried that someone might start paying attention to the size of their own pay packets.They might start asking: "Eh, hold on a moment. You're criticising us for ripping off shareholders. But who's paying for your monumental pay packet, if not the investors in your fund?"Thus, with some honourable exceptions, the approach to executive pay has been rather muffled.

That's why BlackRock's latest foray into the subject is encouraging.

Why passive investors are smarter than lots of active investors

BlackRock wants companies to stop giving executives bigger pay rises than ordinary staff, and also for their retirement contributions to be similar to the rest of the workforce.

Given its size, BlackRock is a major shareholder in many of these companies. So its voice matters. And the letter is pretty clear on its views.

"We consider misalignment of pay with performance as an indication of insufficient board oversight, which calls into question the quality of the board. We believe that shareholders should hold directors to a high standard in this regard," is one choice quote.

Now, your average BlackRock employee is not short of a bob or two. And Larry Fink, the chief executive, chairman, and co-founder of BlackRock, makes a lot more than most CEOs or fund managers, for that matter.

But that's not relevant to this particular discussion.

The key difference between BlackRock and other fund managers is that it's primarily a passive investor. It has to own these companies whether it wants to or not. You might think that's a disadvantage (as they can't withdraw their investment). I'm not sure that it is.

Passive funds can't differentiate themselves from one another on the basis of havingcelebrityfund managers, or arcane investment strategies. If an investor decides to use a BlackRock fund rather than a fund from one of its rivals, such as Vanguard it's most likely because it was the cheapest option they could find.

Passive investors contrary to what the word passive' might suggest are probably smarter and better informed than many investors who use active funds.(That won't always be the case, but for now, they are still the "early adopters").

Investors who use passive funds have made an effort to wrap their heads around the concept of investment costs. They also understand how difficult it is for most active managers to keep outperforming. They also grasp their own limitations as far as attempting to time or beat the market go.As a result, they've opted for the cheapest investment option available.

In short, passive investors (or their financial advisers) are well informed and demanding.That means that the passive investment world is brutally competitive.

So from a business point of view, it makes sense for BlackRock to stand up for the interests of these people as aggressively as possible. It becomes a selling point:"Everyone knows passive funds are cheap. But did you know that we also look out for your interests by challenging ridiculous incentive schemes and outsized pay packets?"

Will it make a difference? BlackRock doesn't have a strong record of aggressively challenging executive pay packets, and nor does its arch rival Vanguard. Indeed, a study discussed in Harvard Business Review in October last year argued that companies where index funds were large shareholders tended to have even more excessive executive pay packets.

Yet if the major selling point of passive funds is that they deliver better value for the end-user, then the next logical area for these giant asset managers to start competing on is: who can do the best job of representing the interests of shareholders against overly comfortable managements?

We'll see if they can deliver. Meanwhile, we wrote in more detail about the problems of executive pay and how to profit by investing in companies where the interests of managers and shareholders are properly aligned in MoneyWeek just before Christmas. Check it out here.