Parsing Active And Passive Investing

November 27, 2013

Not all index-tracking funds are silent when it comes to questions of governance.

[This article previously appeared on our sister site, IndexUniverse.eu.]

 

"Active" and "passive" seem like contradictary terms.

After all, index funds tracking capitalisation-weighted benchmarks don’t choose their investments. Instead, they rely on the collective will of the active investors who buy and sell individual stocks. Index funds then select their holdings from a ranking of companies by their market size.

Tracker funds also depend upon the assumption that other market participants price stocks efficiently. In the language of economists, index funds are “free riders”; they benefit from the contribution of others to setting stocks’ valuations, without paying for the associated costs.

Clearly, index fund operators don’t have to pay for much of the infrastructure maintained by their active competitors—notably highly paid portfolio managers and research analysts. Index funds usually charge substantially less as a result.

But the dividing line between active and passive is less clear than it might seem in one area of rising importance—governance.

There are widespread calls for asset managers to take a more assertive stewardship role.

According to the UK government, “shareholders and the public have lost confidence in the way companies are run. Making companies more accountable in how they work will increase investor and public confidence.”

Institutional investors are also under scrutiny themselves.

In his 2012 review of UK equity markets and long-term decision making, economist John Kay questioned whether asset managers—the intermediaries between savers and the companies they invest in—are contributing to the economy or taking too big a cut of savers’ hard-earned cash.

And as things stand, Kay pointed out, some fund managers play next to no role in guiding executives’ behaviour at the companies whose shares they control.

“The structure of the industry favours exit over voice, and gives minimal incentives to analysis and engagement,” Kay wrote. “This lack of incentive for engagement is an inescapable feature of an investment landscape characterised by a competitive fund management industry and the fragmented holding of shares.”

Not all fund managers take a back seat when it comes to engagement. A specialist subcategory of activist shareholders has emerged, particularly in the US market.

These managers, usually remunerated by potentially highly lucrative, option-like pay structures, aim to make money by taking a minority equity stake at companies they perceive as underperforming. The activists then use aggressive media campaigns as part of their attempts to force changes in the make-up of company boards and in management policy.

For example, US fund manager Third Point recently called for the departure of Sotheby’s CEO William Ruprecht. Third Point’s founder, Dan Loeb, argued in his open letter that the auction house was “like an old master painting in desperate need of restoration.” Third Point owns 9.3 percent of Sotheby’s shares, making it the largest individual shareholder.

 

 

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