Passive Investing: Navigating the New Composition of Ownership
7 November 2019
By Marla Hurov
The rise in passive investing has been nothing short of transformative. In 2017, the number of index funds actually surpassed the number of listed companies in the capital markets. In fact, over the past ten years, we’ve seen incredible fund flow into the passive world. In 2007, active managers made up 53% of the market. Today they only comprise 33%. Conversely, passive managers only accounted for 12%, and now are 20% of the market. The growth of passive funds has been exponential, from $700 billion a decade ago, to almost $4 trillion in our present day. Top holder concentration for passive investors has also soared to 33%.
So, how is this trend in passive investing changing the face of owner composition and impacting the day-to-day (and future) of IROs everywhere? At our recent IR conference, a panel of experts examined the evolving landscape of IR and how the rise of passive investing is affecting the IR community. Karen Greene, IR Partner at Q4, Victoria Sivrais, Founding Partner at Clermont Partners, and Mike Coffey, VP Head Solutions of Engineering at Q4, explored how passive investors make their investment decisions, the most effective ways to engage with this growing group, and most importantly, what IROs need to consider in this new context.
Challenges facing IROs today
According to Karen, the most pronounced change in the rise of passive investing is that “a large portion of top holders own voting shares, who an IRO simply can’t influence.” That’s because “they’re held by a passive investor, who doesn’t want to take meetings with your management team. They’re just not subject to the same influence you have over active investors.”
She relayed an anecdote from her former IRO life, when she had several strategic referendums that required a shareholder vote. “Passing our Say on pay was particularly challenging, because three of [our] top five holders were passive investors.” Reaching those investors required a very different approach communicating with the Street.
Strategic communication with passive and active investors
When it comes to engaging the passive side, at a minimum, Victoria recommended having an annual roadshow to passive investors and their compliance officers (outside of proxy season). She underscored that the most impactful way to influence the passive side is “talking about and understanding potential pitfalls around compensation and governance issues around the ‘E’ and the ‘S’ of ESG.”
Karen added that it’s essential to “develop policies around ESG, showcase these policies, and understand where your investors stand on these issues – before you meet with them.” She advised IROs to meet with passive investor Compliance Officers, several months ahead of proxy season. “My general counsel and I would walk them through a summary of changes they could expect in that coming year’s proxy,” giving them “a heads’ up on the issues to be presented and how we viewed our strategy holistically.” These meetings also “helped us understand what was important to these investors.”
She recalled spending close to 60 days just looking for the right person to speak with at a large, well known index fund. Despite becoming a “project onto itself,” it ended up being “one of the most valuable uses of [their] time.” Karen brought her CEO, general counsel, and Head of their Compensation Committee, to walk them through the Company’s compensation structure and the Company’s direction. In the years that followed, “developing that relationship was critical.”
The other key piece is “understanding what indices you fall in and which ones you should fall in,” because that impacts whether you get added or removed from indices over the long term. Pointing to the Black Rocks, Vanguards, and State Streets of the world, Victoria said that you need to “understand your shareholder base at a fund level, for long term valuation — where you can drive and push.”
According to her, the rise of passive investing and the movement of fund flows to the passive side has also made it increasingly critical “to have a strong IR program, which communicates effectively to a smaller number of active investors.” When it comes to your active set, “if you’re relying primarily on the firm level investment style of that firm, you’re likely missing another important set of very passive investors. Those benchmarking against an index – while hiding in an active fund.” It’s critical to think about how your whole base looks and who you can and cannot influence.
Victoria’s advice to IROs: “take out the passive guys and think about them from a governance compliance standpoint.” And then, “determine the active influenceable shareholders in your base. They’re the ones who you can actually influence, so make sure you’re nurturing them.”
Understanding index behavior in the markets
As a seasoned analyst, Mike highlighted the importance of anticipating and understanding rebalances, in particular the Russell Rebalance. “It occurs every year and can have a big impact on your stock price.” He explained: “If you go from the Russell 2000 to 1000, you’re now one of the largest companies in the US by market cap, but the reality is that there’s a lot less assets in large cap funds than in small cap.” Being tuned into index selling on that day is critical.
Victoria added, “what’s interesting about the Russell is that you see the pressure leading up or down to the reconstitution…it invites shorts and hedge funds to play around in your stock, so you see heightened volatility either way.”
Karen also cautioned IROs to be aware of the drivers behind index behavior. When she was in the asset management space, she had sector peers who were K-1 filers. According to Karen, “that precluded their inclusion in a lot of the indexes.” When these competitors changed their structure to C Corp as well, they became included in several of the indices. “We saw money flowing out of us and into them, while nothing had changed to our structure or indices.”
Reaching active investors in this new world
Given that active managers now only make up 33% of the market, “there are less active managers to introduce your story to, so the competition for their capital is intense,” Victoria commented. With that in mind, she recommended three effective ways to reach active investors:
1. Make the onboarding process easy. Simplify your story and make your materials “shareholder friendly,” focused on the areas that these investors care about the most.
2. Understand the pitfalls for new investment. Leverage conversations with your current investors and sell side analysts, to understand and address impediments for getting into the stock. Karen added that it’s helpful to get in front of the macro sticking points arising in discussions. “Head-off what might be negative perception and try to right that ship.”
3. Clearly define what differentiates you from other stocks —why you’ll be the investment that drives superior returns, in both good and bad markets.
It’s also increasingly paramount to find new ways of reaching active managers. Victoria pointed to the example of showcasing your team and brand on digital channels. “Use videos of your CEO and business leaders, and make your website phenomenal. It’s the first place new investors go.”
ESG: The most critical way to influence the passive side
Looking at the fund flows going into ESG, the stats are absolutely astounding. Assets under management impacted by SRI funds and methodologies were $12 trillion in 2018 — $22 billion in ESG related ETFs. And Black Rock projects that number will go up to $400 billion by 2028. When it comes to proxy statements and shareholder proposals, Victoria passionately believes that “passive investors are on the forefront of what’s changing from an ESG proxy standpoint.” For her, “the ‘E’, ‘S’, and ‘G’ is the best way you can actually influence passive investors.”
Clearly, ESG is not the exclusionary investment that it’s been in the past. SRI funds are now integrated into investment philosophies. “Even the active guys, who say they don’t do anything around ESG, will ask you about your corporate culture and supply chain policies,” Victoria said. Mike added, “going back ten years ago, the Calvert funds were probably the only socially conscious ones. Fast forward to today and it’s not just the index funds — every company has a mandate.” As an IRO, you need an ESG strategy, because “it’s risen to the top of the selection process.”
When it comes to ESG policies, Karen pointed to the importance of “understanding that these investors demand certain criteria.” She explained, “they’re not going to invest in a company with poor ESG ratings.” The reality is that ESG “governs their ability to invest in you as a public company.” This means that “the clearer, more up front and visible you can be about your policies, the more you can lead these conversations and avoid complications down the road.”
“Make ESG prominent on your website and talk about it at your annual roadshows with passive investors and the compliance side,” Victoria advised. “You also need to know where their focuses lie, particularly in regards to the big guys (Vanguard, Black Rock, State Street), and be prepared to answer their questions.” Begin with baby steps like “getting ESG on your site, putting a slide in your deck, getting rid of the zero marks on your reports. It doesn’t have to be a heavy lift, to start seeing differences in your practices.”
It’s important to analyze your ratings from sources including Sustainalytics, ISS ESG, and RobecoSAM. “You need to look at these reports and understand your vulnerabilities.” She explained: “You can be negatively impacted from having a zero score.” In fact, many companies have a zero score for something as basic not putting ESG on their website. The issue at hand is that “if you want to play in the world of ESG ETFs, you will get excluded if you’re in the bottom quartile of your peers,” Victoria stressed. One of Karen’s former companies learned that lesson the hard way. “Not paying attention to these surveys was a big misstep.” She recalled, “we had been rated on parameters we weren’t even aware of at the time.” It resulted in an entire year of trying to “dig out” of that rating.
Victoria also drew attention to what she considers to be one of the IRO’s biggest impediments: “the person leading the ESG charge.” She explained: “It might be 15 different people from your organization. Unless you have a mandate from the C-Suite, it’s hard to bring that information together and to the forefront.” Karen agreed, rallying IROs to be proactive “disruptors in their organizations” with the C-Suite and board.
“Progressive IROs need to focus on ESG,” Victoria concluded. “It’s beyond the management team. It’s a board level conversation.” If you’re a smart C-Suite board, you’ll see the fund flows going towards ESG and “realize that you can’t overlook it.” The reality is that they will be “a large contingent of your shareholder base, in the not so distant future.”
That means “if you want to continue to see your valuation go up and to the right,” you need to make it a priority. She wrapped up the session with some overarching words of wisdom: “Target passive investors from an ESG perspective. And understand the closeted passive contingent in your active base.”
Q4’s Power Up conference was a huge success. Thanks to all of our attendees and speakers for helping us get closer to solving IR’s biggest challenges. We hope to see you next year! Pre-registration is already open, so sign up for Fall 2020 today.