Passive Investors Can Be Active Owners, but Legislators Must Give Them a Hand
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Passive Investors Can Be Active Owners, but Legislators Must Give Them a Hand

IF INDEX FUNDS' AND ETFS' MANAGERS SEEM NOT SO MUCH ENGAGED IN STEWARDSHIP, THE PROBLEM IS NOT SHORTTERMISM BUT ENGAGEMENT COSTS, GIOVANNI STRAMPELLI STATES IN A NEW STUDY THAT ALSO PROPOSES A POSSIBLE REGULATORY FRAMEWORK

As clients take flight from the high costs of traditional, active investment funds, passive index-tracking funds have become a force to be reckoned with. In January 2018 assets held by passive index funds passed the $5tn mark and they held a market share of 43% of equity funds in the US and 16% of total assets under management in Europe. And this could have negative corporate governance implications: passive investors are deemed to be also passive owners, while legislators and regulators across the world want to promote a more active involvement of institutional investors.
 
 A new study by Giovanni Strampelli, an Associate Professor of Business Law at Bocconi University, criticizes the regulators’ (and especially EU regulators’) approach that aims to stimulate institutional investors’ involvement by shifting them from a short-term to a medium- and long-term focus, arguing that passive funds already have a long-term focus and that their problem (if any) is the cost of engagement. Authorities should, then, strive to cut this cost through the promotion of collective engagement, following the blueprint of the UK’s Investor Forum.
 
On the one hand, Prof. Strampelli writes, «as they are unable to sell the shares included in the tracked index, index fund managers are deemed to have even more limited incentives to engage with investee companies than other institutional investors». Furthermore, as competition is all about costs, «there is an acute free riding problem as the costs incurred by an institutional investor in order to engage with the investee company also benefit the other institutional investors in the same company». On the other hand, for the same reason of being unable to sell, index funds have a strong interest in the long-term health of investee companies and they are subject to regulatory and reputational pressures that push them to appear good corporate citizens. In fact, index funds are starting to employ stewardship teams, even if very small, and are regular voters in the shareholder meetings, even if they vote in favor of the management’s proposal most of the times, adopting a low-cost box-ticking approach to voting.
 
The study also discloses some evidence of passive funds privileging private engagement over voting when it comes to fix perceived corporate problems.
 
«Passive index funds», summarizes Prof. Strampelli, «have proved to have a positive impact on corporate governance when low-cost interventions, such as voting, are required, and to act as passive owners when high-cost activities, such as monitoring M&As, would be necessary».
 
The solution, Prof. Strampelli suggests, is then cutting the costs of engagement. Among the measures proposed, the most promising seems to be the promotion of collective engagement: institutional investors would act together, sharing the engagement costs and overcoming the free-riding issue. A working model could be the Investor Forum, established in 2014 in the UK to promote the collective engagement of institutional investors.
 
In the EU, though, there is a legislative hurdle to wipe out: institutional investors could be regarded as parties acting in concert, thus triggering the mandatory bid threshold. The legislator, Prof, Strampelli asserts, should then provide a safe harbor, in the form of guidelines detailing what the actors of collective engagement could and could not do.
 
Giovanni StrampelliAre Passive Index Funds Active Owners? Corporate Governance Consequences of Passive Investing, 55 San Diego Law Rev. 803 (December 2018). Available at: https://digital.sandiego.edu/sdlr/vol55/iss4/3.

by Fabio Todesco
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