The substantial increase in activism on corporate governance issues by large institutional shareholders and asset managers qua investors has been hard to miss. Now, joining the ranks of these other enormous asset managers and passive institutional investors—such as BlackRock and State Street (see, e.g., this PubCo post, this PubCo post and this PubCo post)—Vanguard has recently announced, in its Investment Stewardship Report for 2017, that it too has been taking a more active role in advocating for effective corporate governance at its portfolio investments. But what has triggered this shift? After all, it’s not as though these institutional investors are new to the sport—they’ve been shareholders for many, many years, but mostly of the low-key variety. Why this noisy advocacy now?

This just-published paper, “Voice Versus Exit: The Causes and Consequence of Increasing Shareholder Concentration,” by an academic at the University of Edinburgh, attempts to answer that question. Its central thesis: that the concentration of share ownership, which has reduced the ability of investors to sell the shares of underperforming companies, has left institutional investors “no choice” other “than to become active stewards of the companies they invest in if they are to fulfil their fiduciary duties towards their clients.”

SideBar

Among the issues Vanguard indicates in its 2017 Report that it intends to promote are independent and diverse boards, annual board elections by majority vote, performance-linked compensation, effective risk oversight and disclosure (including climate risk) and, in some cases where appropriate, proxy access and the right of shareholders to call special meetings. For example, Vanguard reported that, this year, for the first time, its funds supported a number of climate-related shareholder resolutions opposed by company management and are “discussing climate risk with company management and boards more than ever before.” Vanguard’s shareholders, its investment stewardship officer advised, “can expect us to speak out when we detect threats to our shareholders’ economic interests. For example, you will see us address traditional governance issues such as misaligned executive compensation packages, unequal shareholder voting rights, and ineffective boards. Increasingly, you will also see us take more public positions on select governance topics such as climate risk disclosure and gender diversity on boards. We take positions on these matters not because they are inherently good or noble, but because they are tied to the long-term economic value of your funds’ investments. We express our views in our meetings with individual companies, in our public advocacy, and ultimately in the way we vote proxies on behalf of Vanguard funds.”

The author applies to the conduct of institutional investors a 1970 theory developed by A. Hirschman with regard to the behavior of consumers who are unhappy with a company’s products. They can choose either “exit” or “voice.” Exit refers to the unhappy consumer’s option to stop buying a company’s goods, while voice refers to the consumer’s ability to register complaints about the product with management. This concept may strike some of you as stunningly obvious applied to consumer goods, but it’s a bit more interesting in the context of shareholders, as applied by the author here. In that context, investors unhappy with a company’s performance can “exit,” that is, sell the company’s shares (or, take the “Wall Street Walk”) or use their “voice”—engage with company management, make public statements in the press, submit shareholder proposals or make appearances at the annual shareholders meeting.

Increasingly, individual investors have delegated the management of their assets to institutional investors—to take advantage of their expertise or for access or diversification. Contributing to this growth has been the declining costs of fund management products, particularly in light of the growth of index funds and other passive investments. For example, the paper reports, in 1998, there were only 16 ETFs in the U.S., but, by 2017, there were 1,716, with passive funds accounting for 33.3% of the U.S. market in 2016. What has been the impact of this shift? According to the author, the

“popularity of equity funds has resulted in the ownership structure of companies being turned on its head. While in 1970 it was individual investors that controlled around 80% of all outstanding shares in the United States, today institutional investors own around 73% of the outstanding shares of the top 1000 US companies by market capitalization….Also much of what remains as individual ownership today is in fact ownership by senior management. This change in ownership structure has had profound consequences for the corporate governance of firms.”

Before the 1980s, the author contends, the plethora of individual shareholders faced difficulty acting collectively “to co-ordinate their views on company policy.” However, the increased concentration of ownership and centralization of decision-making resulting from the rise of “fiduciary capitalism”—a “capital market in which large institutional investors purchase shares on behalf of ultimate owners to whom they have fiduciary responsibilities,” with these intermediaries exercising power on behalf of the owners—has increased the ability of shareholders to exercise power. Concentration of ownership in the U.S. is substantial, with “the top 5 investors controlling 47% of assets at year-end 2016, up from 36% in 2005, while the share of assets managed by the top 10 firms has increased from 47% in 2005 to 58% at year-end 2016.”

At the same time, the author maintains, the concentration of ownership has introduced a new challenge: “it is increasingly difficult for these institutions to sell their positions in a company without substantial negative price effects.” In addition, the requirements applicable to index funds to track their indices impose additional constraints on their ability to sell. These constraints have affected the liquidity and sales of shares. From 2004 to 2016, “the asset-weighted turnover has fallen from 51% to just 34% and… half of all equity fund assets had a turnover rate of less than 26%. “ The author posits that the “reason for the decline in the asset-weighted turnover is the increasing concentration of assets amongst the largest funds.” The increased concentration and consequent limitations on liquidity amplify the market impact of any substantial sale, with the result that higher costs may make particular sales prohibitive for some funds. The author concludes that, “for more than 50% of the US equity asset base, exit is already unavailable today.” As a consequence, he argues, “[w]hile under fiduciary capitalism investors have greater influence over company strategy, if this influence does not suffice to achieve the desired effect in corporate policies, then investors may find themselves in a situation where they have little say and no ability to sell.” That is, less opportunity to exit, but more opportunities for voice, which may or may not be effective.

With this limitation on exit from underperforming companies, the author contends, institutional investors are compelled to “become active stewards” of the companies in which they invest, sometimes “at the expense of corporate management as well as other stakeholders.” Data from EY shows that “company-investor engagement on governance topics has increased substantially over the past years. While just 6% of S&P 500 companies reported investor engagement as recent as 2010, this rose to 23% by 2012, 50% in 2014, 56% in 2015 and reached 66% as of June 2016.” In its 2017 report, Vanguard reported that, over the 12-month period covered by the report, it had “nearly 1,000 engagements with almost 700 companies.” The author also suggests that, in light of the increase in the exercise of shareholder power, it’s possible that “shareholders will have greater success at the earlier stage of private engagement thereby requiring less escalation of engagement practices.” Using executive compensation as a measure of “shareholder value orientation,” the author suggests that the decrease over time in the proportion of base salary as compensation relative to longer-term performance-based awards reflects the impact of investor engagement.

The author concludes that “[g]overnments and the public appear supportive of a more active stewardship role for institutional investors.” However, the consequences of this shift are not yet known: “What consequence these changes will have on companies will depend to a large extent on how the large asset managers perceive their role within the financial system evolving. While there has been criticism of excessive focus on short-term shareholder returns…, increased ownership concentration amongst the largest global institutional investors has the potential to benefit companies…. Investors unable to exit may exhibit Hirschman’s third concept of ‘loyalty.’” Still, the author concludes that it is “unlikely that institutional investors can become truly patient providers of capital.” Institutional investors’ stewardship activities can, however, “function as a standardisation force in corporate governance ‘best practice’ and have resulted in corporate governance frameworks globally assimilating.”