Global assets flowing out of “actively managed” investments and into index funds have totaled more than $1 trillion over the past three years, according to Morningstar.
Therefore, significant voting power over the decisions of U.S. public companies is now concentrated among just a handful of key institutional investors. Most notable among them are the three dominant index fund managers: BlackRock, State Street Global Advisors, and Vanguard, which collectively manage some $13 trillion in total assets.
There are significant resulting implications for corporate finance executives, as well as boards of directors.
Index funds are awakening to their influence and the responsibilities associated with their place at the top of the shareholder register. They are increasingly driving the results of binding votes on M&A transactions and proxy fights, as well as nonbinding advisory votes on compensation and other corporate proposals. In either case, investors may hold boards accountable for any perceived lack of responsiveness.
At the same time, hedge fund activists are adjusting their tactics and trying to build relationships with index funds. While index funds have historically tended to be more patient than their actively managed counterparts in supporting companies, a continuation of that trend can’t be taken for granted.
These shifts are rapidly changing the investor relations function. Major strategic outcomes — those involving a shareholder vote — will increasingly be decided by a few investors who might have little prior exposure to any given board and management team.
The rise of passive investing has thus elevated index fund-focused investor relations — “Index IR” — to a C-suite and board imperative. Advance preparation and a refreshed approach to investor relations (with active participation by independent directors) are essential to achieving successful outcomes.
Historically the realm of the back office, the “investment stewardship” functions within these funds are now the primary interface with U.S. public companies. The index funds are substantially growing their staffs to increase their levels of engagement.
Many companies have found some index investors to be unresponsive to requests for meetings. That dynamic will likely change as these stewardship groups grow. Top management at these index funds are citing commercial demand and fiduciary obligations as a rationale dedicating more resources to corporate governance.
Perhaps as a result of this increased focus, index funds have become more outspoken on their priorities, which often differ from traditional investment considerations.
Index funds want to discuss corporate purpose, long-term strategy, and corporate governance matters, all in the name of long-term value creation. They are prioritizing issues such as ESG, climate risk, and human capital management.
They want to know, for example, how a company’s board operates, its composition and tenure, board and management succession planning processes, and how the board achieves diversity.
In line with these priorities, index funds now expect to engage with engagement with independent board members. Although management is still the primary point of contact for investors, more companies report making an independent director available for engagement with shareholders, especially index funds. These discussions are no longer narrowly focused on specific voting items such as Say-on-Pay.
Proxy voting records show that in a contested election, actively managed funds are much more likely than index funds to support an activist’s proposal.
Index funds don’t have the same performance pressures as active managers, and they may be more skeptical of an activist’s proposal because they don’t have the option to sell if the activist’s plan does not work out.
However, index funds will occasionally support activist campaigns. The funds’ governance personnel typically work closely with internal active portfolio management colleagues on voting issues requiring valuation analysis, like proxy fights and M&A. That means performance pressures may indirectly filter into the voting decisions of index funds.
Further, activists are increasingly gaining seats at the table of mainstream investor initiatives in a bid for exposure and legitimacy.
For example, the Investor Stewardship Group (ISG), representing moe than $20 trillion in assets under management, launched in early 2017 to create basic standards of investment stewardship and corporate governance for U.S. investors and boards.
BlackRock, State Street Global Advisors and Vanguard were among the founding signatories of the ISG, which also includes activist hedge funds.
Moreover, representatives from four prominent activist hedge funds now sit with the three primary index fund managers and other funds on the important Council of Institutional Investors’ (CII) Corporate Governance Advisory Council.
These new “partnerships” create multiple opportunities throughout the year for activists to have numerous interactions with the index funds, strengthen their relationships, and possibly gain support for their campaigns. That’s notable, because companies generally do not have similar frequent opportunities to interact with index funds.
We are also seeing some combinations of traditional activists with ESG activists. For example, JANA Partners LLC and California State Teachers’ Retirement System recently sent a joint letter to Apple urging the company to develop new software tools to help parents limit their children’s phone use, citing the potential for consumer backlash.
A skeptic might conclude that this newfound interest of activists in ESG issues is motivated by the activists’ desire to garner favor with index funds, which have highlighted ESG issues as important to their constituencies. Such activism also potentially introduces a new suite of wedge issues that might help activists in their traditional campaigns.
The increasing importance of index funds for corporate finance executives and boards of directors has heightened the need for innovative, highly targeted investor relations strategies and tactics. Index IR is likely to grow as more public companies recognize the influence of index funds.
Zach Oleksiuk is a managing director in Evercore’s strategic shareholder advisory business. He was previously head of Americas for BlackRock Investment Stewardship and worked at Institutional Shareholder Services (ISS) in various roles.
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