Engagement, divestment and the effect of ETF flows

If we really believe ETF flows have no effect on underlying securities, the engagement-divestment debate is scuppered

Mark Northway

Mark Northway Sparrows Capital

Investors are at the centre of a lively debate about how to influence the firms they invest in to become more ethical and sustainable. The issue is further complicated when investment is through collective funds or ETFs.

The tussle between divestment, where investors chastise wayward firms by selling their shares, and engagement, where stakeholders remain at the table and try to encourage improved behaviour through stewardship and engagement, remains fraught.

If the touchpaper was not already burning bright, Stuart Kirk, former global head of sustainable investments at HSBC Asset Management, told ETF Stream’s ESG ETFs Investor Workshop that “no amount of inflows and outflows from ETFs affect the price of underlying securities”.

Is this a stake through the heart of divestment as a strategy for wrapping a firm’s knuckles?

While there are certainly questions to be raised about the merits of divestment versus engagement, including attempts to make the latter efficient and accessible to fundholders, many would disagree with Kirk’s state view that a sustained and broad selling of a firm’s shares would have no impact on its share price and cost of capital.

The power of divestment?

Kirk’s assertion is that secondary market share price is a function of risk and is impervious to capital flows. He contends that where there is a seller, there is always a buyer. While this latter statement is certainly a truism, it is patently absurd to suggest that divestment by a cohort of investors has no impact on the share price.

The market is an ecosystem of investors with different motivations, some long-term, some shorter, and some driven by seeking trading profit in the most limited timeframe possible.

Buyers on the other side of a forced sale will collectively push for a bargain, and if forced sales multiply, then there will be downward pressure on the stock price of the affected firm.

A company that is being punished by large numbers of sellers is likely to see its share price fall. In the short term that has no direct impact on the company or its directors – except to the extent that their remuneration is linked to share price or to total shareholder return. But if the stock becomes a pariah, the cost of capital for future share issuance will increase; the company will have to issue new shares at a lower price/higher yield to attract capital.

The academic perspective

Research by Jonathan Berk at Stanford University and Jules van Binsbergen at Wharton University, acknowledges that while there is a measurable impact from divestment, it is “too small to meaningfully affect real investment decisions”.

But the authors note that if divestment worked well, it would create something of a paradox: Driving down the stock prices of dirty companies could mean those who choose to invest in so-called sin stocks would be able to buy them more cheaply and therefore enjoy higher returns than their green-investing counterparts.

“Not only do you as a green investor get lower returns, but on top of that you are rewarding investors that do not care about being green with higher returns,” the study stated.

Regardless of how much divestment moves the dial, though, we would agree that it is the blunter of the two instruments that investors have in their armoury in the drive to improve corporate behaviour.

A seat at the table

A problem for fund and ETF investors is that even if they believe fervently in engagement, it has traditionally been very difficult to ensure that the levers of good stewardship are employed consistently and appropriately.

Investors in collective funds, by their very nature, are one step removed from influencing the underlying firms that the product gives them access to. This remoteness is even more pronounced in the case of retail investors.

As the passive industry has matured, a growing body of academic research has pointed to the notion that index-based investing tends to produce better returns for investors than the average active fund.

But a number of studies, including one by Oxford University, have pointed out that the “implications for corporate governance are ominous” due to the passive investing industry.

This view emerged because of the notion that the auto-pilot approach to managing money in the passive world led to dampened, or even extinguished, shareholder engagement.

But the tide is shifting when it comes to stewardship and indexing. Product providers have upped their stewardship game in recent years to ensure that voting power and the influence that comes with large shareholdings has been used actively and responsibly.

There had been growing criticism that a handful of the largest asset managers – which also includes Vanguard and State Street Global Advisors – held outsized influence on the outcome of key votes at corporate AGMs, given the significant presence they have on most of the largest company share registers.

This year, Blackrock, the world’s largest fund manager, went a step further by launching its Voting Choice service which allows institutional holders of its index funds the opportunity to direct the votes that relate to their holdings at the annual general meetings of underlying firms. Blackrock has announced the intention to expand this facility to individual investors in due course.

While the end goal of schemes such as Voting Choice – to give the vast majority, or even every, investor a say in how an underlying company is run – is laudible, there are potential concerns about the viability of such a development.

Consistent delegation

Just one global fund or ETF can have thousands, of underlying holdings. The iShares Core MSCI World UCITS ETF (IWRD), for instance, invests in 1,507 companies.

Investors in collective vehicles choose to outsource their stock selection decisions to a manager in most bases because they lack the resources and skill to manage a pool of diversified holdings.

It is therefore illogical to assume that they will want to – or have the resources to take ownership of voting on the detailed strategic and governance decisions of all of those underlying businesses.

It is reasonable to assume that some investors will want to direct stewardship activity over some of their investee companies for some of the time. But the converse is also true that most investors will not wish to do so at any one point in time. So, we are not going to get away from a default delegated stewardship process.

Fund providers, therefore, need to have a stated strategy that outlines their views and intentions in relation to broad stewardship, ESG and climate change – or they need to sub-contract this role to a proxy firm. Such a strategy should be expressed at the fund level, rather than at the provider level, to ensure consistency between each capital allocation mandate and its associated stewardship process. This means that providers and managers may be voting portions of their overall shareholding in different ways.

Twin track approach

An alternative approach to allocation and stewardship, as highlighted by a 2019 Cambridge University study titled To divest or engage, is to run a twin-track strategy – employing exclusion only where engagement is unsuccessful.

This approach was recommended by Dimson et al in 2014 to the Norwegian sovereign wealth fund, and has been adopted by the FTSE Russell Climate Balanced Factor index that was used for managing Legal & General Investment Management’s Future World fund.

No escape for product providers

The bottom line is that giving voting powers to individual underlying investors is in most cases a red herring: it enables large providers to proclaim themselves leaders in stewardship and engagement, while in reality, it is a cop-out.

It absolves these hugely powerful institutions from needing to develop views and strategies of their own, something that the world desperately needs if it is to hit its climate and societal goals.

Mark Northway is investment director at Sparrows Capital

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