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Passive Problems

14 May 2019 by Anthony Hilton

Passive Problems

Fund managers are using various investing strategies in order to beat the market

The switch from active to passive investing is huge. Passive management means that investors simply buy a fund which replicates the index. Active management in contrast tries to find those shares which will outperform, and buy them. In theory active managers should beat the trackers all ends up. But it does not work like that. In practice it is indexing which is all the rage.

Jack Bogle, the founder of Vanguard who died this year was the man who put tracking on the map. He wrote his thesis on passive management at university in the late 1950s but it was almost 20 years before he put his ideas into practice. He launched in the mid-1970s and had a princely $14 million in 1976. Even in 1982 he only took $100 million and it was not till 1988 that he reached $1billion and by 1996 he had raised $10 billion. Today his main fund is worth $400 billion.

Passive investing is also behind ETFs or Exchange Traded Funds. These were first pioneered by the Toronto Stock Exchange in 1990. However for many, the father of ETFs is Nate Most, who launched his S&P 500 product in 1993 at State Street, the US bank. It has grown to $265 billion, and the overall ETF universe is now an astonishing $5 trillion.

The ETF and index funds together are $10 trillion or as much as the private equity and hedge funds combined, and roughly 30% of the US fund management universe. Particularly in recent years active management has been knocked for six. The same thing is happening in the UK, albeit a bit more slowly. Even Warren Buffett, perhaps the world’s greatest investor, recommends trackers to everybody who cares to listen. Indeed he took a ten year bet with hedge fund manager Protege Partners to prove that the hedgies with their active management would underperform.

His annual management letter in May 2018 said that the tracker delivered a performance of 126% whereas the active managers returned 36%. However there is a difficulty in passive, pointed out by the Institute of Business Ethics in its submission to the Financial Reporting Council’s proposals on shareholder engagement. Passive investors cannot sell out of a share, even if they dearly want to.

IBE’s response builds on Legal & General Chair Sir John Kingman’s recommendations about the FRC to Government after the latest audit scandals. Kingman sought to intervene in troubled companies including the right to commission and publish independent reports, review dividend policy and to replace the auditor. One possible reason for this was that the FRC was being asked to accept this obligation because shareholders have consistently over the years failed to do so effectively.

This criticism is not entirely fair however. Some active institutional investors like Aberdeen Standard were perfectly aware of the difficulties facing Carillion, the poster child of corporate failure. It sold out. But as a passive investor, L&G could not sell out, even though it was also perfectly aware of the problems and apparently engaging on them. The more pension fund money goes into passive funds, the more beneficiaries are at risk through this inability to sell out.

Even active shareholders have difficulties. They have strong existing powers including the right to dismiss the board. But their ability to use these powers effectively is sometimes limited because of the fragmented nature of market ownership - and because of the growing prevalence of passive investment where investors are locked in and cannot sell.

The IBE’s suggestion is that the FRC, or its successor (or the FCA if it takes over regulation of stewardship) should have access to a sanction in the form of a recommendation to index providers that companies with seriously flawed governance and unresponsive boards should be declared unsuitable for inclusion in indices.

The index providers would be told that it was no longer safe to compel passive funds to hold the company. Of course, exclusion from the index would lead at once to a serious loss of value, but the point is that the sanction would be a deterrent. Boards would know as soon as the FRC appeared that there would be real trouble if they did not respond and this would be a huge incentive on them to address problems. The FRC would be prompted into such action by investors and or auditors.

Arguably, by the time this stage was reached, the share price would have fallen and much value would have been lost. However, the threat of such a sanction might be enough to concentrate minds and prompt earlier action, especially if the initial intervention by the FRC, or its successor was on a confidential basis. 

The problem having to hold shares is a growing issue as trackers get even more traction in the markets. The IBE’s comments are one way of addressing this. It deserves to be listened to.

Anthony Hilton is Financial Editor of the London Evening Standard

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