Index funds are often described as “passive” investors that hold securities to mirror an underlying index. But their active approach to board monitoring is influencing governance trends worldwide and pressuring boards to lift performance.
Exchange Traded Funds (index funds) have become a global investment phenomenon. ETFs have more than US$5 trillion of assets under management and State Street Global Advisors this year predicted ETF assets will reach US$25 trillion by 2025.
One in three US investors now owns at least one ETF and half of all US investors will have a position in at least one ETF by 2020, according to a BlackRock survey this year.
If these forecasts hold true, BlackRock, State Street, Vanguard and other index managers will own a higher percentage of global equities and have greater governance influence. Index funds currently own about 18% of the global equity market, estimated BlackRock in 2017.
This trend has three main implications for boards. First, index funds will have greater voting power in a company’s stock and boards will need to spend extra time engaging with them, understanding their stewardship approach and responding to index-fund concerns.
Second, because they replicate an index over equities or other asset classes, index funds have broader share ownership and invest in large and small companies. It’s not unusual to see BlackRock, for example, on the share register of an emerging Australian mining company.
This trend is putting smaller listed companies under the gaze of global index funds and their stewardship policies. Smaller Australian companies traditionally had less pressure to lift their governance, because they were mostly owned by retail investors. Now, they could have index funds on their share register that expect higher board standards and performance.
Third, the style of index funds is challenging boards to adapt their investor engagement. Unlike active fund managers that buy and sell shares regularly to outperform a benchmark index, ETF providers have to hold shares to replicate the price and yield performance of an index. They may hold a share for decades and own more of it as their fund size increases.
“In some ways, the long-term focus of index funds makes them ideal advocates of governance change and a strong source of board monitoring and performance.”
ETF critics say an index fund’s passive investment style reduces its influence: it cannot dump a company from its portfolio if it has governance concerns. Or worse, that the index fund’s focus on boards is as much about brand building and marketing as it is about governance and upholding its fiduciary duty to ETF investors through stewardship.
The reality is different. Global ETF providers are using their rising ownership in listed companies to vote against the re-election of directors or adoption of the remuneration report, if warranted. In some ways, the long-term focus of index funds makes them ideal advocates of governance change and a strong source of board monitoring and performance.
BlackRock has led the global push by index funds for higher board standards. The firm’s CEO, Larry Fink, attracted commentary in governance circles last year when his 2018 letter to CEOs proposed a new model of engagement between companies and investors, and greater focus on long-term strategy and value creation, and the organisation’s social purpose.
BlackRock and other index funds are part of the push for boards to have greater involvement in strategy and Environmental, Social and Governance issues. ESG has become a defining governance trend as investors assess boards on financial and non-financial outcomes, including issues such as climate change and human rights.
Index funds have also contributed to the push for better board diversity. BlackRock wants to see at least two female directors on every public-company board and State Street has voted against hundreds of boards that have failed to nominate female directors.
BlackRock is doubling its global stewardship team over the next three years, from 30 members now, to expand its company engagement.
The Governance Leadership Centre asked Iris Davila, Head of Investment Stewardship at BlackRock in Australia, about the growing governance influence of index funds.
Davila joined the team earlier this year. BlackRock’s Pru Bennett, Head of Investment Stewardship in Asia Pacific and a leading governance analyst, is retiring from the firm in early 2019.
Governance Leadership Centre (GLC): Why are index funds paying greater attention to board performance?
Iris Davila (ID): Fund managers, including BlackRock, have a fiduciary duty to their investors. Twenty years ago, asset managers had hardly any queries from their clients about governance. Today, investor interest in board performance has grown exponentially. Investors are much more focused on governance and they expect managers that invest on their behalf to hold boards accountable and drive governance change, where required, through good stewardship.
GLC: Is BlackRock’s focus on ESG principally about risk management and investment stewardship or is it also about enhancing portfolio returns?
ID: The two are interdependent. We want to protect our investors’ capital by ensuring boards oversee appropriate risk-management policies and performance. Good risk management is central to sustainable, long-term financial returns for our clients.
GLC: Is there a correlation between strong ESG and higher investment returns?
ID: The data on that from various studies is mixed. Lots of factors, including ESG, drive investment returns over time. What we do know is strong ESG starts with the G – that is, governance. Competent, independent and diverse boards drive better Environmental, Social and Governance outcomes, and better govern risk on behalf of shareholders.
GLC: Is it possible for investors to measure board performance?
ID: There’s no definitive measure for board performance because most of what goes on is behind closed doors. So, we use proxies for board performance.
Among many factors, we consider the board’s experience, independence, diversity and skills; its understanding of strategy; the organisation’s disclosure standards and transparency; the board’s willingness and ability to engage with investors and handle difficult questions; the choice and monitoring of the CEO and whether executive rewards are appropriate and aligned with shareholder interests; and the firm’s environmental and social impact.
At an individual level, we consider how many other boards a director serves on and the risk of “overboarding”. We use our discretion; some directors are more capable than others, and some board roles have higher workloads. We are concerned when a director appears to have limited capacity to deal with an organisation crisis because he or she is on too many boards. We also consider the director’s skills and experience and how they align with the firm’s strategy.
GLC: APRA’s report on CBA this year implied that boards need to dig deeper in their organisation. What does BlackRock expect of individual directors in terms of organisation detail and involvement?
ID: We don’t expect directors to have a quasi-management role or micro-manage the executive team. We do, however, expect directors to have a strong understanding of their organisation’s business model and long-term strategy, and to be aware of its culture and values. We also expect directors to have a relationship with more than the CEO and his or her direct reports; they need to listen to and understand the views of multiple stakeholders in the firm.
GLC: What are early warning signs of underperforming boards that you look for?
ID: Low willingness to engage with investors is a trait of a potentially dysfunctional board. We don’t expect boards to orchestrate massive engagement programs, but we do expect those of large and small listed companies to meet with key investors each year and preferably outside of the key proxy season (when many annual general meetings are held).
We get concerned when a board shirks difficult conversations with investors or will not respond to tough questions. It suggests the board is dismissive of shareholders or not sufficiently across the strategy. We are also concerned when boards struggle with conversations on non-financial issues. We favour integrated financial reporting because it forces boards to think about where the value of the company lies which is beyond financial factors and includes human, environmental, social and intellectual capital.
GLC: Should Australian boards have more industry specialists as directors?
ID: We expect boards to have at least one director with strong executive experience in the firm’s industry. But we’re more interested in diversity generally.
For example, it’s important that boards think about their organisation’s climate-change risks, but we wouldn’t advocate for boards in industries with exposure to climate change risk to include a climate-change expert. A good climate change expert does not necessarily make a good independent director of a listed company. Boards need directors who have enquiring minds and know when to seek outside expertise to assist in their oversight role of management.
Directors will never have the same information or day-to-day insights as management, but an independent, skilled board that works as one can still add great value to large, complex organisations and their shareholders by providing appropriate oversight and counsel to management.
GLC: Why are index funds positioned to drive governance change?
ID: From BlackRock’s perspective, our index strategies mean that we are long-term investors focused on long-term strategy and results, and organisational sustainability. We are less focused on short-term results or the company’s quarterly earnings and share price.
We may own a company’s shares today, in five years, 10 years or longer if they are still around. That gives us an important role in monitoring board performance and driving governance change, where needed, through stewardship.
Given that we cannot sell shares if there are significant ESG issues at an investee company, we have two tools: engagement and voting, which we use to drive positive change. We have been, and continue to be, a voice for the greater good in governance.
GLC: BlackRock assesses boards worldwide. How do Australian boards compare?
Generally, Australian governance standards stack up well against other developed nations. There are always exceptions and room for improvement, but Australian governance is up there with the world’s best.
I am reluctant to say our boards have “best practice” governance because we should always be trying to do things better than before. But we do see a lot of Australian boards making an effort to enhance board performance and engage more with investors.