Bill Ackman is a really entertaining hedge fund manager. For his crusade against Herbalife if nothing else. But his recent letter to investors,
in which he adequately explained why Pershing Square Capital was down 20% last year, included a swipe at passive investing.
Passive investing has taken off in recent years. For those of us unable to sit on our Bloomberg Terminals all day, throw legions of ivy league grads at data collection and predictive modelling, corner or move markets through letter writing (obviously I’m not describing anyone in particular here), something like an exchange traded fund is a godsend.
But Ackman raises a really interesting point in the letter. The boom in index funds (a type of exchange traded fund), vehicles that essentially buy and hold shares in certain companies and sectors, means passive investors hold considerable voting power. Power that many of the investors are il-equipped to wield, and that many of the funds are either disinclined or too under-staffed to handle for them.
From the letter:
Scroll through the ownership registry of corporate America and the top three holders are typically Vanguard, Blackrock, and State Street. As the biggest managers of index funds, they often cumulatively own 12%, and as much as 20%, of nearly every public company.
As index fund ownership grows as a percentage of shares outstanding, the voting power of index fund managers increases. While on the one hand, one might believe this is good for America as these “permanent” owners should think very long term compared with the many investors whose average holding period is less than one year. On the other hand, there are significant drawbacks. Index funds managers are not compensated for investment performance, but rather for growing assets under management. They are principally judged on the basis of how closely they track index performance and how low their fees are.
… the job of overseeing the governance of the tens of thousands of companies for which they are major shareholders is an incredibly burdensome and almost impossible job. Imagine having to read 20,000 proxy statements which arrive in February and March and having to vote them by May when you have not likely read the annual report, spent little time, if any, with the management or board members, and haven’t been schooled in the industries which comprise the index. Consider how difficult this job would be when even the largest index funds have a hierarchy of only 20 or so people (one per ~1,000 companies) in their governance departments which determine how proxies for these companies should be voted.
Now obviously, as an activist investor, Ackman is incentivised to outrage at a large voting block that can’t easily be swayed by his calls for dividends, share buybacks and board appointments. He doesn’t disappoint:
In 2015, the three largest index fund managers, who owned 18% of Dupont’s stock, voted against Nelson Peltz and his firm’s (Trian’s) candidates for the board of directors, in what was described at the time as a major defeat for shareholder activism.
…Within 90 days of the vote, the company missed earnings and exhibited continued business deterioration. As a result, the CEO “retired voluntarily” and the company shortly thereafter announced a merger with Dow Chemical to address problems that Trian had identified.
But despite the self-serving nature of the argument, there is something in it. Index funds are not staffed to be activists and are incentivised for long-term accumulation. This can go a few ways – index funds won’t be pushing for short term gains, but they also won’t be paying that close attention.
Although, preliminary research does suggest companies with higher passive ownership exhibit better corporate governance. They tend to have more independent directors, for example.
Shall be interesting to see how this plays out.
If you want to go deeper, I suggest a recent piece on passive investment in the Financial Times (subscription).