These “big three” collectively vote 25% of the shares of the SP500

In the debate about what we get for the money we pay to fund managers , we tend to think of passive managers, not as managers – but as funds.

We can of course get access to indices by buying ETFs which reduce the cost of getting a market return to the package of derivatives within the ETF. But most of us buy passive funds , run by passive fund managers who charge us many times the cost of the derivative for something that ostensibly does the same thing. I’ve long wondered “what do passive managers actually do?”. I work accross the road from Legal and General, Britain’s largest fund manager and often nip in to their reception to read their papers.

When I chat with my friends there , they get very earnest about stewardship and explain to me that what a passive fund manager actually does is act as our steward – ensuring that the companies whose debt and equity we invest in , do what they say they do “on the packet”.

I have listened to these arguments respectfully , I was once lectured by Alastair Ross-Goobey for questioning whether this stewardship actually happened or whether his company (Hermes) just enjoyed a lot of good lunches with corporate managers. The lecture was very old school, it really wasn’t my place to question what he was doing.

My deference to passive managers appears to have been misplaced. I spent time yesterday (when I could have been watching the rugby) reading a very long paper

As the article is 118 pages long , I can’t publish it all on here, but you can download it from this link

The article supports a view expressed in the Financial Times earlier this month that the Big Three passive managers are routinely ignoring the voting instructions of their proxies and missing out on chances to govern well. That article comes out or research by Share Action for charities voting their funds.

Here is the “abstract” that gives you a flavour of what goes on in the next 100 pages

Index funds own an increasingly large proportion of American public companies. The stewardship decisions of index fund managers— how they monitor, vote, and engage with their portfolio companies— can be expected to have a profound impact on the governance and performance of public companies and the economy.

Understanding index fund stewardship, and how policymaking can improve it, is thus
critical for corporate law scholarship. In this Article we contribute to such understanding by providing a comprehensive theoretical, empirical, and policy analysis of index fund stewardship.

We begin by putting forward an agency-costs theory of index fund incentives. Stewardship decisions by index funds depend not just on the interests of index fund investors but also on the incentives of index fund managers. Our agency-costs analysis shows that index fund managers have strong incentives to

(i) underinvest in stewardship and
(ii) defer excessively to the preferences and positions of corporate managers.

We then provide an empirical analysis of the full range of stewardship activities that index funds do and do not undertake, focusing on the three largest index fund managers, which we collectively refer to as the “Big Three.”

We analyze four dimensions of the Big Three’s stewardship activities:

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
4. and their limited attention to other issues that could be significant for their investors; and their pro-management voting patterns.

We also empirically investigate five ways in which the Big Three could fail to undertake adequate stewardship: the limited attention they pay to financial underperformance; their lack of involvement in the selection of directors and lack of attention to important director characteristics; their failure to take actions that would bring about governance changes that are desirable according to their own governance principles; their decision to stay on the sidelines regarding corporate governance reforms; and their avoidance of involvement in consequential securities litigation.

We show that this body of evidence is, on the whole, consistent with the incentive problems that our agency costs framework identifies.
Finally, we put forward a set of reforms that policymakers should consider in order to address the incentives of index fund managers to underinvest in stewardship, their incentives to be excessively deferential to corporate managers, and the continuing rise of index investing.

We also discuss how our analysis should reorient important ongoing debates regarding common ownership and hedge fund activism.
The policy measures we put forward, and the beneficial role of hedge fund activism, can partly but not fully address the incentive problems that we analyze and document. These problems are expected to remain a significant aspect of the corporate governance landscape and should be the subject of close attention by policymakers, market
participants, and scholars.

So what  do we get from studying the “Big Three” American passive managers?

Well – they don’t seem to be investing much in stewardship at all

In the most extreme case of SSGA (State Street Global Investors) require each stewardship person to steward over 1000 companies,

Allocating $300,000 to pay each of these stewards, the total cost of running stewardship is a tiny fraction of revenues generated

and relative to the $bn invested in companies you can see huge variances between the best (BlackRock) and Vanguard and SSGA who vie with each other for the wooden spoon.

Whether you are looking at these big three beasts through the lens of human resource, financial resource of investment as a percentage of funds under stewardship, we do not appear to get a lot of value for our money.

These numbers may explain why the stewardship of the big three appears to be failing in its objectives (and why I was right to ask the question of Alastair Ross-Goobey).

So what about the UK?

In the UK , the big three American managers are supplemented by Legal and General and a few smaller players (much of the passive fund management for NEST is done by UBS).

The passive funds themselves now have governance boards and those who invest in the passive funds, amongst them the workplace pensions, have their governance boards and the FCA and tP{R are charged with governing the governors.

So why has there never been anything in any of the governance papers I have read, that has asked whether we are getting value for the money we pay for passive FUND MANAGEMENT?

I use the capitals, because I want to know the answer to the question I put to Alastair Ross-Goobey 25 years ago

“What do passive fund managers do all day?”

I am not a trustee, and so long as I keep on asking questions like that, I am unlikely to be one ever.

It seems to me that passive managers in the big three US firms don’t do much stewardship. Which is odd and disappointing. To quote Bebchuk and Hirst

In a recent empirical study, The Specter of the Giant Three, we document that the Big Three collectively vote about 25% of the shares in all S&P 500 companies that each holds a position of 5% or more in a large number of companies;

 and that the proportion of equities held by index funds has risen dramatically over the past two decades and can be expected to continue growing strongly.

 Furthermore, extrapolating from past trends, we estimate in that article that the average proportion of shares in S&P 500 companies voted by the Big Three could reach as much as 40% within two decades and that the Big Three could thus evolve into what we term the “Giant Three.”

Over to our fiduciaries.

The work done by Bebchuk and Hurst was originally published in November 2018, since when much has happened in corporate governance, most importantly the explosion of interest amongst the public in ESG.

By way of example, Pension Bee, one of Britain’s progressive pension providers has decided to conduct a major governance review on their managers _ L&G, SSgA and BlackRock, to ensure that they are getting value for their policyholders.

I hope that the article by Bebchuk and Hurst will be informing them as they try to get better value for their policyholder’s money. I hope that People’s Pension will be asking SSgA about the amount of money spent on their 4.5m members’ savings, to get better value from their savers. I hope that NEST and NOW and Smart are doing the same.

I hope that the IGCs, busy preparing their April reports , will be considering this year, what stewardship is actually going on in the funds they offer to those in workplace pensions and – this year – to those spending the money from their workplace pension pots.

And I hope that the FCA, DWP and tPR teams who are working on VFM regulation (especially as it touches ESG) will be asking the passive managers just what is going on at the passive managers. I’d like to think that Chris Woollard , as he moves from running the competitions and markets division of the FCA, to running the FCA itself, will be ensuring that it is not just the active managers who are kept under beady scrutiny.

Thanks to Emmy Labovitch

I was cursing Emmy yesterday, for destroying my enjoyment of the rugby and the boxing in the evening. She’d sent me the document and I couldn’t help read it. It is written in horrible American legalese, the sentences are long and complex and the arguments tortuous, but if you get a chance to read it for yourself- do.

Emmy keeps me honest, as good fiduciaries should, the PPF and many other British institutions are better off for her. This blog’s for you Emmy!

You can download the article – from this link

Or you can look at an abbreviated version of the paper via this slideshow