Why the rise and rise of passive funds should strengthen corporate governance

John Redwood
Passive funds have more reason to be active with company management than active funds (Source: Getty)

A growing proportion of world financial assets are held in passive funds of one kind or another.

In the US, more than one third of all mutual funds are passive. In the UK, one quarter of all money under management is managed under a passive strategy. The arguments in favour of passive include lower costs and the difficulty of beating an index.

In practice, no investing scheme can remove all judgement. Someone has to make the original decision to put money into a passive strategy, and then has to choose which passive vehicles to use. Some people as a result go for active decisions on asset allocation, but buy passive vehicles in each asset and geographical area they want in order to keep the costs down.

Some active managers do outperform their chosen index more often than not, and can add value over the longer term. But passive funds are growing so quickly because of the difficulty and cost of active management.

Read more: Active v passive: Where is the debate now?

An investment manager may decide he or she has expertise with UK shares, but not with Chinese or Japanese ones. That is an argument for having a portfolio of individually chosen UK shares, with passive index matching funds for Asia.

Given the difficulty of beating an index, an investor may wish to hedge the position by putting some money with a manager who thinks they can beat the index, but keeping some other money in a passive vehicle in case he doesn’t. Using passive funds can also be a quick and relatively cheap way of making shifts in a portfolio when a manager suddenly wants to put money to work in a market or part of the world they do not have in their portfolio.

Some worry about the rising popularity of passive investing, fearing the impact it could have on corporate governance. Investors have to remember they are co-owners of important companies. It is shareholders’ duty to monitor the management and vote on the strategy they propose. Some argue that too many passive funds would mean no engagement on behalf of all those shares held in these portfolios.

Read more: Corporate governance is more important now than ever

The good news is that several of the passive manager groups are keen to influence managements and vote their holdings. Passive funds need not be passive owners.

In a way passive funds also have more reason to be active with management than active funds. An active fund can simply sell shares when management misbehaves or makes a foolish decision. A passive fund has to hold, and has every reason to want to help the company improve. Some active managers go short of shares, where they actually want the company to do badly. The passive manager wants all the shares in the index he seeks to replicate to do well.

A group of US academics has examined the impact of passive investors on US shares. In a couple of studies, Gormley, Keim and Appel have found that companies with a higher proportion of passive shareholders tend to have more independent directors and to be under more pressure to have shareholder friendly governance. They also found that a 10 per cent increase in passive ownership can lead to a better return on assets, from their study of the Russell 2000 companies.

Apparently passive houses are more likely to vote against management proposals as well as voting for activist demands for better governance. In short, there is growing interest by institutional shareholders across the board in voting on big corporate decisions like mergers or disposals, and to take a view on the level of management pay and its relationship to company performance.

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