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In the latest installment of the Salzburg Questions for Corporate Governance series, FAA Investments senior partner Christopher Lee reflects on the relationship between index funds and corporate boards
This article is part of the Salzburg Questions for Corporate Governance series, facilitated by the Salzburg Global Corporate Governance Forum
This short article will explore the changing roles of index funds, exchange-traded funds (ETFs), and share some important facts and observations with public company board members.
In the last decade, the worldwide index fund industry's size has grown to a staggering USD 10 trillion in assets, per a Financial Times article in Jan 2020, while, in 2018, the traditional activist funds remained at a lean size of only USD 146 billion. Currently, activist hedge funds are comparatively small in the context of the global asset management industry. Fund sizes matter a great deal in both the asset management industry and corporate governance.
In 2010, "Jack" Bogle, Vanguard's founder and father of the index funds industry, famously said index funds would be called to play a larger role in corporate governance as they eventually gather more assets. He termed index funds the "Best Hope for Corporate Governance."
Separately, Larry Fink has also written in multiple letters that BlackRock's iShares ETFs will hold the stocks if they like the companies. Even if iShares ETFs don't like the companies, they will still have the stocks. In other words, ETFs or index funds are permanent shareholders that focus on the long term if the companies are included in the Index.
The Economist magazine, however, once called index funds lazy investors or bystanders, and a 2019 paper by Harvard University, Prof. Lucian Bebchuk argues that index funds still have incentives to under-invest in stewardship and that index funds are "excessively deferential" to corporate management. He adds that index fund managers are unlikely to intervene when a company's financial performance lags based on evidence.
Jack Bogle, the same person who supported index funds in corporate governance, later said in 2018 that the big three's growing dominance could pose huge problems in the coming era and the industry. If historical trends of the growth continue, BlackRock, Vanguard, State Street Global Advisors and other index funds will one day hold voting control of every US corporation.
While the average investor in an activist hedge fund is either a millionaire or billionaire, Main Street investors, or "forced capitalists," as Leo Strine calls them, are the Worker Investors in ETFs. Board members have fiduciary duties to both large and small investors. I suggest the following three areas for board members to consider when facing global index funds: embrace markets innovations, engage calculation agents, and consider international best practices.
Former US Chair of the Federal Reserve and Salzburg Global Fellow Paul Volcker once said the ATM (Automatic Teller Machine) is the banking industry's greatest innovation. In addition, I would argue that ETF is another great innovation in capital markets. As a sub-set of the index fund industry, ETFs now account for nearly USD five trillion globally and increasingly provide more liquid, flexible, and low-cost investment products. Board members need to embrace the latest innovations in capital markets and understand how they relate to governance issues. ETFs are significant shareholders. Salzburg Global Fellow Prof. Edward Rock argues markets should let ETFs exercise their shareholders' rights – let shareholders be shareholders.
The ecosystems of capital markets and ETFs include significant stakeholders like index calculation agents such as Standard & Poor's 500 (S&P 500), Morgan Stanley Capital International (MSCI), and the Financial Times Stock Exchange (FTSE). In addition to engaging the activist hedge funds, boards and management teams should extend investor relations efforts to include this important stakeholder segment by understanding their indexation methodology. Which company is included in the index, and which ones are not? And how much weight in the index per company?
Some of the practices in the UK and Germany are useful for public company board directors to consider. For example, the UK stewardship code updated in 2020 is for both asset owners and asset managers. Boards could use this to ensure fair treatment under stated principles is applied to all stakeholders. In Germany, a few successful ETFs are issued by DWS, an affiliate of Deutsche Bank. One of the successful ETFs is called Xtrackers MSCI USA ESG Leaders Equity Fund, which has USD 2.5 billion invested in top US companies. This ETF’s asset-under-management is larger than many mid-size US activist funds. Indicative of the success, MSCI USA ESG Leaders Equity Fund had almost doubled in size in one year. The ESG Leaders Fund tracks a market-cap-weighted index of US large and midcap stocks, screened for environmental, social, and governance characteristics. Boards could aim to understand the quantitative method and ESG principles employed by Xtrackers.
In summary, while index funds and corporate boards may have been at odds initially, they are now inseparable. Both could employ a longer-term view and international best practices to significantly increase engagement with each other, and further align the long-term interests of company owners, fund managers, and capital markets calculation agents to strive for excellence in corporate governance.
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Christopher Lee is a senior partner at FAA Investments. He also serves on boards of public and private companies and is currently chairing the Investment Committee of Salzburg Global Seminar's Board of Directors. He is also a Salzburg Global Fellow.
The Salzburg Questions for Corporate Governance is an online discussion series introduced and led by Fellows of the Salzburg Global Corporate Governance Forum. The articles and comments represent opinions of the authors and commenters, and do not necessarily represent the views of their corporations or institutions, nor of Salzburg Global Seminar. Readers are welcome to address any questions about this series to Forum Director, Charles E. Ehrlich: cehrlich@salzburgglobal.org To receive a notification of when the next article is published, follow Salzburg Global Seminar on LinkedIn or sign up for email notifications here: www.salzburgglobal.org/go/corpgov/newsletter