In 2018, the founder of investment management group Vanguard warned in the Wall Street Journal of the risk that “a handful of giant institutional investors will one day hold voting control of virtually every large U.S. corporation.” He predicted that this dominance of corporate governance and financial markets would become a major public-policy concern.
Two years later, the top three index managers (BlackRock, Vanguard and State Street) managed US$19-trillion, holding roughly one-10th of the world’s quoted securities. According to a Harvard study, their average combined stake in S&P 500 companies quadrupled to 20.5 per cent in 2017 from 5.2 per cent in 1998. The study predicted their voting power could increase to 40 per cent by 2040.
Combined with other major institutional investors (including large public-sector pension plans and sovereign wealth funds), they manage the lion’s share of individual savings, typically invested for longer-term objectives such as retirement income and family health and educational costs. Passive investing, such as index tracking, is particularly suited to this longer-term horizon. Buying the overall market, instead of picking individual securities, mitigates risk through diversification, while reducing the costs of investment dramatically improves returns over time.
As their outsized impact on public and corporate governance, economic competitiveness, financial-market stability and social well-being has grown, these major asset managers have become more visible in attempting to influence corporate conduct – professing to use their market power to encourage sustainable business practices in order to better ensure long-term outcomes for their investors and society as a whole. Regrettably, the rhetoric of such investor stewardship hasn’t yet been sufficiently matched by their actions.
For example, BlackRock has signalled its intention to engage with companies on climate-related business risks – pointing to the clear link between sustainability factors and investment risk and returns. Despite their admonition and growing overall investor support for climate-related shareholder resolutions, BlackRock (along with other major asset managers) declined support for 75 per cent or more of climate-relevant resolutions last year. This lack of support on resolutions relating to lobbying, energy-transition plans and other climate issues remains a key barrier to effective investor stewardship.
Likewise, while claiming to work behind the scenes to encourage companies to adopt cleaner technologies, BlackRock still owns more than US$43-billion of assets tied to thermal coal. BlackRock, Vanguard and State Street have more than US$660-billion invested in companies whose businesses are inconsistent with a Paris Agreement–aligned economy. BlackRock’s investments in such companies have shrunk by more than half over the past decade. The value of oil stocks held by BlackRock has withered to 2.36 per cent today from 12 per cent in 2012. While some of this is a result of divestment, more than 90 per cent is because of value erosion. How can we accelerate this transition – and spare clients the massive value destruction currently under way?
The gap between the “talk” and the “walk” is partly structural. Active stewardship is inconsistent with the business model of these investor behemoths – managing costs by investing passively. One response should be to think of indexing as more than a mechanical exercise. Rather than taking indexes as a proxy for the market, large passive investors could be more intentional – designing indexes that are aligned with sustainable business practices and that specifically address stewardship responsibilities.
Consider, for example, the inclusion of tobacco stocks in most major indexes. For those investors not focused on maximizing short-term returns, one would think this investment inappropriate. For the investor giants doubly so, as their actions signal how markets are prepared to allocate capital.
Passive investing isn’t neutral. Investors in pension funds choose the default option more than 90 per cent of the time, and many plan providers simply default to the mainstream index funds offered by the large asset managers. So why not build indexes where the default choice would be a portfolio without tobacco? This would dramatically alter market incentives, removing the concern of passive investment managers to avoid “tracking error” (i.e. deviating from the index against which their performance is measured). The same logic applies to companies that create other harmful externalities that threaten social and economic sustainability. These companies comprise less than 10 per cent of the investable universe.
Regulators should facilitate such initiatives by recognizing such indexes for reporting purposes (so that investment managers can choose to report their performance relative to such an index). The fact that (according to BlackRock) last year 81 per cent of a globally representative selection of sustainable indexes outperformed their parent benchmarks should give everyone some comfort. Investors would be free to opt out, subject to explaining their reasons for doing so.
Leadership by the largest investors would encourage others to invest in such purposeful indexes, triggering a virtuous cycle and creating long-term value for clients and beneficiaries in a way that benefits the economy, the environment and society.
As with many decisions in life, inertia and default choices matter. Those institutions that effectively “own the market” for the long-term should be market-shapers rather than market-takers. To do otherwise conflicts with their duties and the public interest.
Edward Waitzer is a former chair of the Ontario Securities Commission and chair and professor emeritus at Osgoode Hall Law School and the Schulich School of Business.
Toby Heaps is publisher of Corporate Knights.