Is the rise of ESG being undermined by passive investing?
The gradual spread of environmental, social and governance (ESG) principles has gained increasing traction in listed equities. Most major fund managers today espouse their sustainability credentials.
However, the rise of ESG into investing orthodoxy is creating points of friction. One particular area of potential concern is the concurrent growth of passive investing.
Index-based investing has been expanding for years, to the point that passive funds accounted for 31% of open-ended funds worldwide last year, according to Statista. The use of either index-tracking funds or exchange-traded funds to get exposure to markets for minimal costs appeals to cost-conscious asset owners and retail investors, particularly in markets like the US where it has been difficult to find an information edge.
But passive funds’ lack of dynamic decision-making and thriftiness does not always make them a good fit for ESG, which is research-intensive by definition and ultimately judgmental on company decisions. Indeed, outright contradictions can emerge.
Japanese electronics conglomerate Toshiba offers the latest example.
On Thursday (March 18) Singapore-based activist fund house Effissimo (with the support of major asset owners including Calpers) succeeded in a vote at an extraordinary general meeting to investigate what Effissimo said was voter suppression around Toshiba’s last annual general meeting, in June 2020.
As reported by the Financial Times, Toshiba chief executive Nobuaki Kurumatani had faced major opposition to his reappointment vote at the AGM. Effissimo alleges that the company mounted a shareholder pressure campaign to support him.
This included Toshiba appointing Goldman Sachs to persuade proxy investor firms and shareholders to vote in favour, and allegedly asking Hiromichi Mizuno, the former chief investment officer of Japan’s Government Pension Investment Fund (and an outspoken advocate of ESG), to shore up the support of the US’s Harvard University.
Government officials may also have reached out to foreign shareholders to inquire about their planned votes at the AGM, according to Reuters. Kurumatani was ultimately reappointed with 58% of the vote (Harvard University's endowment abstained).
What does the EGM probe vote on these allegations have to do with passive investors? Essentially, their absence allowed it to succeed.
Japan has made strides improving shareholder engagement in the years since it became the first Asian country to introduce an investor stewardship code in 2014. And this resulted it recording the most number of activist shareholder proposals during last year's AGM season, around June. However, Japanese corporates continue to broadly enjoy the unquestioning support of passive funds and local fund houses for their AGM proposals.
But Toshiba lost most index investors in 2017 when the Tokyo Stock Exchange moved its listing to its second section as a punishment after its liabilities exceeded assets. The move placed it outside the Nikkei and Topix indexes that passive funds typically follow. It was this lack of passive fund investor votes that helped Effissimo to build sufficient support to force through an investigation on alleged wrongdoing, despite it going expressly against company wishes.
That is the root of the problem. Passive funds and their proxy voting advisers would probably have hindered this legitimate governance request, had they been there. But they should not end up as obstacles to better company scrutiny, unwitting or otherwise.
PASSIVE PROXY PRESSURE
Concerns about the potential for passive funds to impede effective shareholder governance have been mounting, with concerns especially centring on the heavy reliance of many investors on proxy voting firms.
A study by the American Council for Capital Formation in 2018 found that 175 managers, with over $5 trillion in assets, voted with their proxy adviser recommendations over 95% of the time. Essentially, these investors outsourced their voting, even though the firms are not driven by the same fiduciary responsibilities.
Concerns over the voting responsibilities of passive fund managers are becoming particularly poignant, given the vocal embrace of ESG principles by the world’s largest passive fund managers, including BlackRock, Vanguard and State Street Global Advisors.
Adherence to ESG should require more of investors than reflexively asking companies to hire a few more women onto their boards and release carbon emission information; they should also assess voting requirements, prioritise transparency, weigh company proposals and be willing to punish executives who make bad decisions.
How can passive funds more assertively embrace ESG when voting? One way would be for ESG agencies, including the United Nations Principles for Responsible Investing – the signatory status of which is often seen as the kitemark for fund managers – to actively assess the voting records of passive fund managers on issues of stewardship, responsibility and environmental standards.
PRI and other ESG-aligned associations could then opt to publicly criticise passive funds whose voting records do not support claims to follow ESG, or who effectively outsource almost all of their voting decision-making to proxy firms. Repeat offenders could have their signatory status stripped.
In addition, major ESG-aligned passive funds could invite questions on their voting decisions once a year to the media, asset owners and even corporates. Funds will be less likely to beat their chests about ESG yet not vote for it if such hypocrisy can be called out by asset owners, environmental advocates or astute journalists.
Passive fund managers may argue that their low fund fee structure means they lack the resources to conduct enough research actively to vote on the hundreds or thousands of companies into which they invest. There is likely merit to such claims, but cheapness should not be the overriding priority of ESG-compliant vehicles.
The funds could explain to major asset owners and retail investors that they need to charge an extra basis point or two to support a thorough commitment to ESG values – including doing research to take consequential votes.
Alternatively, the fund houses could keep prices as they are and stop claiming to be full proponents of ESG values – and see how many asset owners are still willing to support that stance.
Richard Morrow is the editor of AsianInvestor. This article reflects his opinion.