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How passive investors conduct stewardship

How passive investors conduct stewardship

Imagine how different things would be if you could change the returns generated by a stock in your portfolio. And imagine what it would be like if you could increase the total returns for yourself and all of your fellow investors, despite holding the stock passively.

Finally, imagine your efforts materially improving the way the company does business – whether in a remote village or a booming megacity.

Well, these things are no longer just fantasies. Active ownership of listed companies, through shareholder engagement and the use of voting rights, is fast turning into an important tool for achieving environmental, social and governance (ESG) stewardship targets among asset managers and private banks.

However, the principles of corporate engagement – which have long set the most passionate of active ESG investors apart – are not being followed quite so arduously by the growing number of passive investors. Indeed, last year, billionaire activist investor Paul Singer argued that ‘passive investing is in danger of devouring capitalism’ because index fund providers have less incentive to push companies for change.

As holdings in exchange-traded funds (ETFs) continue to rise around the world, the question of how passive investors can carry out their stewardship duties is becoming all the more relevant. At the end of April, global assets invested in ETFs increased to $4.96 trillion, marking 51 months of consecutive net inflows. Collectively, BlackRock, Vanguard and State Street – the three biggest ETF providers – now manage about $2.5 trillion in assets.

Capacity for change

In passive investing, the capacity for conducting stewardship-related engagement is often determined by the size of the manager’s investment team, said Naoko Ueno, head of Asia research at proxy voting firm Glass Lewis.

Glass Lewis is one of the two main proxy voting advisory services, the other being Institutional Shareholder Services. These firms are used by investors around the world when it comes to voting on shareholder resolutions at firms’ annual general meetings (AGMs). Glass Lewis covers 15 markets in Asia alone. Proxy voting is typically required on controversial issues where company management and shareholders do not agree, and firms such as Glass Lewis can help to guide ESG-minded investors in preparation for the AGM votes.

Engagement activities tend to be underdeveloped in Asia, with varying standards and regulations across Asian markets. It’s an area where additional pressure from investors may be necessary, Ueno said. The situation is made more complex by poor non-financial information disclosure in most Asian firms, which particularly affects voting on ESG matters.

On the one hand, large index asset managers that have the resources to invest in stewardship activities are becoming increasingly influential as a result of their engagement and proxy voting, Ueno said. ‘However, not all passive managers are operating on a scale that allows them to monitor every aspect of all their investee companies,’ she noted. ‘As a result, they generally don’t have dedicated stewardship, ESG or governance teams.’

While most Japanese asset managers tend to have dedicated responsible investment teams, those in Singapore and Hong Kong typically lack that sort of setup. ‘As such, private banks and family offices tend to have limited resources for stewardship activities,’ Ueno added.

Passive investors in Asian companies probably use some sort of independent screening criteria to identify ‘poorly run’ companies, she said. These could include performance measures for the relevant sector, as well as for environmental, social and governance issues.

‘It depends on the firm, but investors may contact companies directly and have engagement meetings when companies are on their roadshows or engagement calls, or they simply send letters to companies about their concerns,’ she explained. ‘In Japan, at the AGMs, the growth of non-trivial shareholder proposals shows the significant increase in shareholder activism.’

Depending on the industry, investors sometimes demand ESG disclosure and then seek the implementation of standardised disclosure guidelines, such as those developed by the Sustainability Accounting Standards Board or the Task Force on Climate-related Financial Disclosures, Ueno said.

Lessons for Asia

James Gifford, the former executive director of the UN Principles for Responsible Investment, did his PhD on shareholder engagement in Europe and the US. He believes that investors around the world – including in Asia – need to learn one key lesson.

‘What I’ve found to be the most effective shareholder engagement is something similar to free consulting,’ said Gifford, who is now head of impact investing at UBS Global Wealth Management. ‘In the sustainability and ESG space, it’s very much about persuasion, finding the business case for sustainability and demonstrating to the company why they should do these practices for good business reasons.’

Gifford added that academic research has now found ample evidence that sustainable companies outperform their peers. For instance, a 2015 study by Elroy Dimson, Oğuzhan Karakaş and Xi Li in The Review of Financial Studies found that US companies that engaged with an investment manager between 1999 and 2009 showed significant market outperformance following ESG engagement. The average one-year abnormal return after an initial engagement was 1.8%, growing to 4.4% after successful engagements.

UBS recently launched a 100% sustainable portfolio for its wealthy clients in Asia, which includes a shareholder engagement strategy. However, most of UBS’ Asian clients have not yet thought about shareholder engagement as a way of tackling ESG issues, Gifford said.

‘We are educating clients about the business and investment benefits of shareholder engagement. We expect to embed this in a lot more strategies.’

This article was published in the June issue of the Citywire Private Wealth magazine.

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