How passive funds could save shareholder capitalism

Passive fund management continues to grow rapidly, gobbling up market share from the active fund management industry.

As a result, passive funds are subject to lots of objections some more reasonable than others from active fund managers, who are still trying to defend their corner.

One of the newer lines of attack in these socially enlightened times is to argue that passive funds are bad at corporate engagement. Any objections the managers of index-tracking funds might have to things like ethics and executive pay lack bite, because they have to own the stocks in the index whether they like what they're doing or not.

It's a critique I might have more time for were it not for the notable lack of effective engagement by the active industry over the last few decades.

Active managers haven't exactly been raging successes as stewards

As a passive index fund, you have to own what's in the index. If you track the FTSE index, you have to own the stocks in the FTSE. As a result, you lack the ultimate sanction you cannot sell out of a company, even if you disapprove of its corporate decisions.

An active fund manager who gets to pick and choose the stocks to put in their portfolio can, if fed up with a company's policies, eventually decide to sell out in disgust.

This is one of the latest popular angles of attack on passive asset managers. And at first glance, it has a lot of validity.

But only at first glance.

The fundamental problem with the argument, is that active managers had the playing field to themselves for decades. And during that period, executive pay rocketed far in advance of either a) average pay or b) total shareholder returns. In other words, rewards have accrued disproportionately to managers, rather than either workers, or owners.

Why is that the case?

Firstly, there have always been serious questions about corporate incentive schemes. Certain academics, economists and smart investors have been looking at the problem of executive pay and its increasingly tight links to short-term share price performance for years, particularly since the days of the dotcom bubble. In effect, bosses have every incentive to game the system to maximise their bonus, rather than making choices that ensure the company's health over the long run.

Secondly, no one who actually understands how corporate pay is set could ever believe that it's a reward for talent, or that the price is set in some sort of global market for chief executives.

Instead, put simply, wages for executive boards are set by a clique of other exuberantly-paid people who have absolutely no incentive to keep pay under control. Indeed, if anything, they are incentivised to push it higher, as it distracts attention from their own chunky pay packets.

In theory, the people who own the company the shareholders should be keeping that under control. Ultimately, they get whatever's left after the company has paid all its overheads. So their goal should be to pay management no more than is necessary to get the job done well.

The problem is that the majority of shareholders these days are represented by fund managers. The fund managers have no interest in engaging with the problem of executive pay because the average fund manager's pay packet looks a lot more like that of a top executive than it does that of the average unit holder in their fund.

So why rock the boat?

The real reason for the growing pressure on corporate boards

So given the lack of sound stewardship shown by active managers, it's a bit rich for the industry to try to criticise passive owners on that front now.

It's fair to say that boards are coming under growing pressure today. But that pressure has only mounted in the last few years. And it's been nothing to do with fund managers. It's had a lot more to do with the post-2008 environment.

Firstly, individual investors have become more aware of the high charges they've been paying the industry. They've become more aware that they've paid those high charges and, in most cases, received nothing back for them. They could have got a better performance at a lower cost by investing passively.

Secondly, individuals generally have started to wake up to the scandal of executive pay. In the pre-2008 days, the population as a whole felt that the system was working for them. If they owned houses or shares, they were going up in price. They weren't too worried about poking too closely into the workings of the system, or the pay packets of those at the top. There was a general assumption that things were functioning as they should.

But after 2008, and the unedifying sight of masses of banking executives fleeing from metaphorical burning buildings with sacks of taxpayer-funded loot slung over their shoulders, people started asking questions. And more to the point, they started voting for politicians who promised to sort out the "fat cats" (not that they have).

How passive funds could lead the way on better corporate governance

So there's an increasing appetite for more effective corporate governance. And, in turn, I suspect that passive funds will end up leading the way on this too.

Think about it: passive funds operate in a highly competitive market, where there are few obvious ways to differentiate your product from that of the competition.

So if you want to build a brand which will enable you to justify charging a few more basis points for your FTSE tracker than the next guy, then what do you do?

It strikes me that selling yourself as a highly-engaged steward of your clients' capital one who won't put up with self-serving nonsense or unethical practices from corporate managements is the ideal way to do it.

Indeed, that's exactly what Larry Fink, the chairman and chief executive of BlackRock, one of the world's biggest passive investors, is doing right now. In his annual letter to the boards of companies that BlackRock has a stake in (which is most of them), he argued that "every company must not only deliver financial performance, but also show how it makes a positive contribution to society".

That's a bit vague and in many other contexts could be dismissed as wishy-washy corporatese. But coming from Fink, it has more of an edge to it. Make no mistake this is brand-building.

As well as saving investors money, you can sell yourself as the defender of honest capitalism. It's not a bad way to differentiate yourself from your big-name rivals.

And if you're forced to own shares in a company, then you have no choice but to engage and to consider the long term.

So I reckon that there's even more incentive for passive funds to try to score a few high-profile victories and keep the pressure up on managements, than there is on active funds to do the same.

In short these objections to passive funds are not unreasonable. They should make more effort to engage.

But the difference is, they have a genuine motivation to do so. Active funds, on the other hand, have had plenty of opportunity over the last few decades to make a difference and it's pretty clear that they've failed on that front.