The next battle ground for passives – holding companies to account

by , 5th February 2018

The current row over a gobsmacking £100m-plus bonus for the chief executive of house builder Persimmon is just one very clear example of the fact that shareholder empowerment has a long way to go in this country. Questions over how the board managed to sign off on such an egregious pay packet have already claimed the scalps of the chairman and the head of the remuneration committee, and the CEO – Jeff Fairburn – is under increasing pressure to give up the rest of the bonus (he’s already taken £45m) or leave his job.

But Fairburn’s elevation to near-oligarch status as a result of being lucky enough to run a house builder, at a time when the UK government is throwing money at the sector in the form of “help-to-buy” subsidies, is just the glaring tip of a very large iceberg.

Corporate pay and conduct has become an increasingly sensitive issue in the wake of the 2008 financial crisis. Banking executives appear to have been rewarded for their incompetence both in the run up to, and in the wake of, the crisis. And meanwhile, the average person has grown increasingly aware of massive wealth inequality (driven largely by the zero-interest-rate policies required to bail out the banking sector). That’s understandably led to anger and a loss of faith in the system. What might have looked like a free market in talent, designed to get the best people leading the best companies, now looks remarkably like crony capitalism and cushy well-paid jobs for the boys.

So it’s little wonder that people are angry. And some are now using dissatisfaction with corporate behaviour as another stick to beat passive funds with.

The objection goes roughly like this: passive funds are forced to own whatever’s in the index. So if they don’t like what a company’s management team is doing, then they lack the ultimate sanction of being able to sell out. They have to hang on whether they like it or not. This is why investors should be entrusting their money to active managers, who can threaten to walk out of the door if their demands aren’t met.

This argument would be more convincing if it wasn’t for the fact that it’s the active fund managers who have mostly been in charge of looking after our capital over the past few decades, a period in which executive rewards have soared far in advance of both shareholder returns and shop floor wages.

The good news is that all this attention means that the big passive providers are starting to realise that this is a key area where they can differentiate themselves from each other. Competing on price is one thing. But to establish a brand as the shareholders’ champion – that’s something that might get potential investors to focus less on ever-decreasing fees, and more on your success at keeping overpaid managements in line.

This year, in his annual letter to the boards of every company that passive giant BlackRock has a stake in, Larry Fink warned that “every company must not only deliver financial performance, but also show how it makes a positive contribution to society. Companies must benefit all of their stakeholders, including shareholders, employees, customers and the communities in which they operate.” He announced a significant expansion of the company’s investment stewardship team. “Our responsibility to engage and vote is more important than ever.” And he emphasised that US companies needed to make clear how they were planning to create long-term value from any increased cash flows that might come from Donald Trump’s tax cuts.

Fink’s not the only one. His main rivals – State Street and Vanguard – are also upping the ante on engagement. And fund data provider Morningstar notes that it’s not all just talk – all of the big index managers “are increasingly taking an active role in the oversight of investee companies.” Last year State Street voted against nearly 600 out of 5,200 pay proposals, according to the FT.

This shift makes sense. Yes, passive investors can’t sell out of a company. But on the other hand, that means there’s even more reason for them to engage aggressively with the managers. Indeed, in many ways – as Fink himself argues – passive funds are the “long-term” shareholders providing the “patient capital” that we keep saying that a reinvigorated capitalism is crying out for.

The times they are a-changing. Active managers and corporate managements need to catch up before the index funds leave them lagging behind yet again.

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