THERE S NOTHING QUIET ABOUT BEING PASSIVE: How Index and ESG Are Changing the Institutional Investment Landscape

Transcription

1 THERE S NOTHING QUIET ABOUT BEING PASSIVE: How Index and ESG Are Changing the Institutional Investment Landscape January 2018

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3 The Ripple Effects of Index Ownership Index Investing = Catalyst of Changed Behavior Index ownership has created a dramatic shift in the behavioral paradigms that govern today s capital markets Four Primary Impacts of Index Growth ( 4 R s ): Redefining Buy & Hold Revolutionizing SRI & ESG Revising the Activist Mindset Reforming Legislation (Both Explicit & Implicit): 3

4 Expanding the 4 R s Redefining buy and hold. Index investors, by definition, lack the ability to divest a stock if it meets the index s criteria. This can lead to a considerably longer investment time horizon, where capital gains may not be realized for years or even decades. As a result, the index investor s perspective focuses on those catalysts that will generate the best returns over the long term. While the lack of divestment discretion limits the index investor s options to actively influence returns, their sizeable holdings can be wielded in creative ways to replace divestment with engagement. Revolutionizing SRI and ESG. With empirical evidence indicating a strong correlation between weak corporate governance and poor profitability, a focus on SRI (Sustainable and Responsible Investment) and ESG (Environmental, Social and Corporate Governance) aligns with the index investor s longer-term investment interests and tendency towards loss aversion. As a result, governance is increasingly being viewed as a proxy for long-term cost of capital. The importance of ESG is further underscored by the formation of the Investor Stewardship Group (ISG) in January. Revising the activist mindset. Without divestment discretion, index funds are turning to ESG as a means to exert control. Increasingly, index investors are partnering with active managers to engage on governance matters and facilitate long-term changes at their portfolio companies. As a result, activist vulnerability is no longer isolated to the known activist names in a company s ownership profile, as index holdings are now acting as a tailwind to activist demands. Reforming legislation. Combining the impacts of MiFID II, the Brokaw Law, Corporate Governance Reform and Transparency Act and other reforms with the ever-shrinking set of buy-side and sell-side analysts, investors are increasingly adopting a generalist mindset. Unfortunately, this is happening just as information flow is constricting, thus raising the risk of undue reliance on misinformation or bias. Investors will increasingly rely on governance, which unites the generalist s primary concerns: a healthy balance sheet, sound capital allocation, etc. 4

5 The Landscape Continues to Evolve We have observed a distinct shift in the behavioral paradigm that governs institutional investing: Traditional Models: How investors should make investment decisions Will soon become somewhat obsolete based in old interaction data Never had to account for MiFID II, ESG or Index investing Less people covering more stock resulting in great weight place on individual perception and emotions Behavioral Models: Explains and interprets observed decision making and tendencies How will the investment community adjust? The Importance of Behavioral Finance What is more important facts or biases? Investors are loss averse & display Bounded Rationality Investors exhibit consistent biases in expectations and methodologies 5

6 Redefining Buy & Hold Understanding the adjustment by active management is an exercise of behavioral finance Key Investor Biases: Loss Aversion = the fear of loss is a far greater influence than joy of winning Conservatism = place more emphasis on info utilized for the original recommendation Confirmation = seeking info and utilizing new info that justifies original opinion Overcoming Bias = Objectively listen to what the empirical data says! Continued Contraction of the Sell / Buy Side Enhancing bias among both the active AND passive world Fewer people covering more stocks Illusion of Control Bias (Active) I buy what I understand or what I can control Anchoring Bias (Passive) Governance data is already available (ISS/ Glass Lewis Dilemma) Feedback Dynamic: Active - Used to be a Recommendation Now it is a more of a calculated demand Passive Engagement is the only option 6

7 The Agent Principal Dilemma Directional trend of investor tendencies management clamoring for greater control The continued contraction of both the sell- and buy-side has narrowed active management tolerance bands. The growth in index money has resulted in extremely concentrated positions and undesired exposures to poor equities The Agent Principal Dilemma Applies to Passive Money Too The perceived misalignment between the incentives of management and the best interests of shareholders Index money does not possess the luxury of timed discretion and has VERY long time horizons Index cannot practice divestment / Only active managers have luxury of discretion Focus is less on management and more on control Key question = What avenues of control are available for a passive or active manager? 7

8 How To Interpret ESG/SRI Although broad, the ESG Framework is a set of parameters that ultimately allows the relative comparison of respective discount/hurdle rates and risk premiums/discounts ESG/SRI primary focus = the relative strength of corporate governance Do the values preached and strategies presented by management align with the best longterm interests of the shareholders? Index money = 401(k) money, Pensions, Insurance and Endowments Empirical Evidence ESG directly affects Cost of Capital Empirically proven that stricter governance results in: Less latitude afforded to management (think free cash dilemma ) Smaller risk per unit of cash flow Strong correlation between weaker corporate governance and poor profitability 8

9 ESG What To Really Focus On ESG Little E, Little S, BIG G 100% of index funds are ESG focused (explicitly or implicitly) Engagement is their only option to enact change ESG is more of a cost of capital issue than it is ideological Governance is a proxy for risk that gauges the long term focus on management Emotions and biases continually weighted heavier than facts! Mechanics of Index & Influence over sub-advisors forcing the Actives to hop on the ESG bandwagon Buy High / Sell Low major issue during market corrections Vanguard Windsor Fund example How ISS and Glass-Lewis can potentially skew investor perspective 9

10 The Vanguard Precedent A variety of global institutions are now beginning to require greater ESG transparency: State Street = Governance Focus Vanguard = Climate Change SEB Blacklist Norges omission of Oil & Gas This move has less to do with the ideological and focuses almost entirely on the long term cost of capital Determining whether or not management has accounted and planned for any adverse catalyst that can potentially eat away at future returns 10

11 Understanding the ISG The Investor Stewardship Group (ISG) is a group of leading institutional investors and mega-mutual fund advisors who have established the Framework for US Stewardship and Governance. The Framework provides a set of basic principles of investment stewardship for institutional investors and corporate governance for public companies based in the United States. 11

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13 Connecting the Dots: Long-term Wealth Maximization and ESG Objective: Institutional investors are accountable to those whose money they invest As stewards, the objective of investment management centers on wealth maximization over the very long-term: What other objective could be practically and logically applied to a U.S. public pension fund serving tens or hundreds of thousands of beneficiaries or a mega-mutual fund advisor contractually managing the savings of millions of people at one time? The only reasonable path is for an investor steward to assume that the overwhelming majority of a very large number simply want the best LONG TERM return possible for the risk taken, resulting in the maximization of their wealth. Thus, every decision by these institutions, whether it involves how to investment the funds under the steward s control, shareholder voting, or corporate governance advocacy, is to be guided by this objective. Key Consideration: What are the long term risk catalysts that should substantially eat away at long term returns? 13

14 Revised Mindset of the Activist The inability of passive institutions to sell poorly performing stocks in their portfolios (due to their mandate to closely track underlying indexes) might make them willing and influential partners in an activist campaign we show that the level of passive ownership is significantly related to the goals of activist campaigns activists are more successful in obtaining outcomes related to corporate governance or control, which are topics that receive considerable attention in the proxy voting guidelines of passive institutions Standing on the Shoulders of Giants The Effect of Passive Investors on Activism Because passive investors are unwilling to divest their positions in poorly performing stocks, which would lead to fund performance deviating from the benchmark, they may place an even greater weight than active fund managers on ensuring effective governance in the firms they own Corporate managers knowledge that these passive investors are not likely to sell their shares anytime soon may also give the views of passive investors greater weight than those of active managers. The size of passive investors ownership stakes may facilitate activist investors efforts to rally support for their demands. Passive But Powerful How Index Funds Exercise Their Clout 14

15 Revised Mindset of the Activist Activism is not a collection of people, it is a distinct philosophy Empirical Evidence Indicates Thought Convergence between Index, SRI/ESG, Activism and Long-Only Actives Critical Analysis - Standing on the Shoulders of Giants Appel, Gormley and Keim Passive ownership is significantly related to the goals of activist campaigns Minimal Utilization of Derivatives Approximately 75% of Activist Targets in 2016 were Small Caps (< $1B) Not enough liquidity in the small cap market / Less Relative Transparency Corporate governance typically does not evolve with market cap Inexperienced Boards / Perceived misallocation of capital Key liquidity event = Index Rebalancing The Key to Vulnerability: Holistic and objective evaluation of economic profile and corporate governance 15

16 What Constitutes An Activist Target? The Mechanics of Share Accumulation Index Rebalancing: Very messy to sort through due to the Domino Effect Takes a relatively long time for the dust to settle Calendar-based positive liquidity/volume event Key Empirical Conclusion: While activists screen firms on the basis of fundamentals, they pick specific targets at a particular time by exploiting institutional liquidity shocks our various analyses of activist targeting and daily share accumulation all lead to the conclusion that a liquidity channel is at work uninformed institutional investors (index) selling provides camouflage for informed (activist) purchases, allowing the activist to quickly accumulate target shares and gain once he makes intentions public. These trading gains help cover the activist s monitoring costs, making a campaign financially viable - Institutional Trading & Hedge Fund Activism, Journal of Financial Economics (August 2016) 16

17 What Constitutes an Activist Target? Comprehensive, relative and objective evaluation of: Economic Profile External Corporate Governance Profile (ISS, Glass/Lewis, MSCI) Alternative capital deployment strategies Alternative capital structure scenarios Sum of the Parts Analysis An evaluation overlaps with how to attract additional index money: Key Consideration = Does Performance align with PERCEIVED Potential? Everything else is simply just misdirection and noise!! 17

18 Continued Legislation Adjustment Brokaw Law: Wants to annihilate evil and bad hedge funds But clamors for short selling disclosure & transparency MiFID II: Permanently reshaping the soft dollar dynamic: Managers must pay separately for research and advisory services received by banks and brokers Tax Reform The ultimate litmus test for the new emphasis on corporate governance and capital deployment strategies HR 5311 the Corporate Governance Reform and Transparency Act 18

19 Tax Reform - We Have Already Seen This Story Tax reform, capital deployment and corporate governance case study: American Jobs Creation Act (2004) - precedent for tax adjustment & repatriation Used tax reform as means to allow repatriation of overseas corporate cash 2011 Senate Report - Evaluated the effectiveness and results of the AJCA Repatriating Offshore Funds Majority Staff Report Senate report found that an estimated 60-90% of funds were used to return capital via buyback and dividend BEGS the question under the revised context and emphasis of today s corporate governance, what is the expectation for a corporate s given the current tax reform? Management must understand how capital deployment is scrutinized under the updated lens of corporate governance and adjust strategy accordingly Aligning the best interests of the shareholders with management s proposed use of new capital 19

20 FINALLY HR 5311 the Corporate Governance Reform and Transparency Act Index funds, activists, the shorts and long-onlys ALL overemphasize the data provided by proxy solicitor Protects investors and improves corporate governance of publiclyheld companies by requiring proxy advisory firms to: register with the Securities and Exchanges Commission (SEC), disclose potential conflicts of interest, make publicly available their methodologies for formulating proxy recommendations and analyses Why is this important? Proxy solicitors rarely have a complete understanding of the story Skews investor perception (usually towards the negative) 20

21 MiFID II SMID v. LaMega The appeal of a SMID cap roadshow has been diminished The ramifications of MIFID II: Less coverage Less understanding Greater bias in research How to overcome and plan if a SMID: SMID caps need to evolve more into their own internal corporate access teams Because of the continued contraction of the sell-side and ramifications of MiFID II, the Generalist profile becomes even more important Large and Megas cutting the fat and combating the bias Less access to research = increased probability of misunderstanding Increased index exposure = much bumpier ride on the back-end so critical to lay seeds with variety of value investors 21

22 Fewer People + More Stocks = Less Understanding According to Kelly Research: Up to now, essentially, asset managers have paid a bundled fee for these services, together with payments for actual execution the amount of money spent by asset managers on research and advisory services will decrease. Estimates vary wildly on the level of decrease, from catastrophic to merely deeply impactful. That is highly likely to mean any or all of the following fewer analysts, less coverage of virtually all stocks (particularly small and midcaps); and a thinner spread of research, so less indepth stock by stock analysis. 22

23 The Convergence of Mentalities Fewer people covering more stocks Inability for divestment and the desire among index money to continue performance A greater desire to micro-manage and express opinion Less reluctance to take action on a perceived inefficiency The pursuit of control what mechanism provides an avenue for control (ESG) Focus on recalibrating the dynamics of the board and/or management to execute desired objectives 23

24 OK, Great Now What? Establish a relationship with the corporate secretary and GC Review ISS, Glass-Lewis, MSCI reports Cross-Coordinate PMs and actively seek out governance contacts on the index side If a best-in-class ESG program is the goal = aim for Dow Jones Sustainability Index Diversify the story - establish and present a variety of investment themes to the market, including a very distinct generalist profile Understand the revised activism and proactively gauge vulnerability Could be a function of economic profile and/or governance Case study it is usually both Never stop laying seeds Rather than hitting reset at every market cap threshold, establish messaging with aspirational investors Never Stop Learning the trend is constantly evolving 24

25 Questions / Discussion 25