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The global boom in shareholder activism is being fuelled by an unlikely source: index managed funds. These so-called “passive” funds – described as the new “kingmakers” in financial markets – are taking a more active approach to governance and could reshape aspects of it.

Larry Fink, CEO of BlackRock, an index-fund pioneer, attracted international headlines in January 2020 with his annual letter to CEOs. BlackRock is the world’s largest asset manager and a vocal proponent of corporate and governance change.

Fink’s latest letter focused on climate change. He argued that climate risk is an investment risk and that there will be significant reallocation of capital – sooner than is widely realised – away from industries and organisations that have higher sustainability risk.

BlackRock intends to make sustainability integral to its portfolio construction and risk management; begin exiting investments that have higher sustainability-related risk, such as thermal-coal producers; launch new investment products that screen fossil fuels; and strengthen its commitment to sustainability and transparency in its investment-stewardship approach.

Fink’s letter effectively put boards on notice that large investors are poised to reallocate capital based on sustainability risks around climate change and other Environmental, Social and Governance (ESG) issues. The implication is clear: organisations that lag on sustainability could lose some investor support or face a higher cost of capital over time.

Fink’s letter is closely followed in the global investment and governance communities for three reasons. First, the BlackRock founder has a reputation as a visionary thinker in investing and the interaction between financial markets and governance. His previous letters on the purpose of the corporation, the need for long-term thinking, and reducing gender inequality in organisations (and on boards) attracted much attention. But none eclipsed the media sensation his latest letter caused.

Second, with almost US$7 trillion in assts under management (at September 30, 2019), BlackRock has the financial clout to influence governance change. The US-based global investment manager owns thousands of listed companies worldwide through its funds.

Third, BlackRock’s governance approach has been a forerunner to a greater stewardship focus from other index funds, namely Vanguard and State Street Global Advisors. Both asset managers release annual stewardship reports and have become more active in governance debates.

BlackRock’s stewardship approach, although influential, has its critics. Some view the annual letter as more of a marketing exercise for the firm than a bellwether for investment markets and the governance community. Others, such as Sierra Club executive director Michael Brune, argue extra scrutiny of BlackRock is needed to ensure it matches its words with its actions.

As Brune notes, BlackRock last year voted against every resolution backed by the Climate Action 100+ investor coalition, the same group BlackRock has committed to join.

There are also doubts about the real influence of index funds, such as Exchange Traded Funds (ETFs), given they have to hold stocks to replicate an underlying index. For the most part, ETFs cannot buy or sell stocks based on their sustainability performance. BlackRock, for example, holds numerous fossil-fuel stocks because they are part of sharemarket indices it replicates.

The opposing view says index managers, as long-term investors in companies, are ideally positioned to influence governance change. Unlike active managers, index funds might hold a stock for decades, regardless of its price, if it remains in a particular index.

Boards, index funds and shareholder activism

Debate aside, there is no doubt that index funds, including in Australia, are taking a more active approach to governance through their engagement and voting on resolutions at Annual General Meetings. And that their ownership of Australian listed companies is rising.

The combined share ownership of BlackRock, Vanguard and State Street in ASX 200 companies has increased from 2.9 per cent to 5.4 per cent over five years, according to research by Orient Capital, a leading provider of share analytics and market intelligence. Orient provided this research to AICD’s Company Director magazine last year.

These ownership levels will rise as the index funds grow. The global ETF market is projected to reach $US7.6 trillion by the end of 2020 and exceed the actively managed funds market by 2027, according to EY’s Global ETF Research survey. Lower fees and a recognition that index funds (after fees) on average outperform active funds are driving this growth.

Australia’s ETF industry is small by comparison: the value of ASX-quoted ETFs was about $61 billion at end-December 2019, ASX data shows.

But like other developed markets, the big index providers in Australia are proving to be anything but passive in terms of engagement with listed-company boards on ESG issues, their voting and in building up their ESG analysis capabilities.

Boards appear to have underestimated the growing governance influence of index funds. Australasian Investor Relations Association (AIRA) CEO Ian Matheson told Company Director magazine last year that growth in passive investment on share registers had crept up on boards.

He said: “ASX-listed companies, large and small, are seeing passive investors emerge on their share register or increase their shareholding. From an engagement perspective, boards have lagged on this issue and collectively underestimated the influence of index funds.”

From an investor-engagement perspective, boards of large and small ASX-listed companies have less experience communicating with index funds, or do not know them in the same way they know active fund managers or stockbroking analysts. That will have to change as BlackRock and other index funds have greater say in how companies respond to ESG issues.

“The implication is clear: organisations that lag on sustainability could lose some investor support or face a higher cost of capital over time."

Index funds redefining the definition of activism

Shareholder activism is often misunderstood in Australia. In the ‘80s and ‘90s, shareholder activists were often described as “corporate raiders” – opportunistic investment firms that preyed on weak companies, bought and restructured them, and sold for a profit.

That form of activism remains, but is small in Australia. Most activism these days is from industry super or active funds, and considered to be active investing rather than traditional “activism” designed to drive aggressive strategic change in companies.

Institutional investors are taking a more active approach to organisation performance through their scrutiny of ESG data and voting at AGMs. Or by relying on advice, fully or partly, from proxy advisory firms that assess listed companies in this area.

True shareholder activism in Australian – funds that specialise in developing proactive strategies to unlock value in companies – is limited. Expectations that US hedge funds specialising in shareholder activism would set up in Australia have not been met. Depending on one’s definition of activism, there are few specialist investors in Australia in this field.

Much media attention on activism has focused on short-sellers – firms that identify strategic, reporting and/or disclosure problems in listed companies – and seek to profit from that information and a falling share price.

Aggressive short-selling practices – and tactics of some firms in this area – have raised concerns from exchanges, regulators and companies. But like other forms of activism, short-selling-related activism is reasonably limited in Australia.

Although some boards might view the rise of index funds as ‘activists’ as a threat, having long-term, patient capital influencing governance change is arguably an opportunity. Boards in Australia and overseas have long argued that investment markets need more of a long- rather than short-term approach to corporate strategy and performance.

The message for boards is clear: as index funds continue to own more of listed companies in Australian and worldwide in 2020, they will become a bigger force in shareholder activism and a greater influence for governance change. Fink’s letter implies that change – in areas such as climate change – could happen faster than many organisations and their boards expect.

 

Tony Featherstone is consulting editor of the Governance Leadership Centre and a former managing editor of BRW and Shares magazines.