Don’t Take a Passive Approach to Passive Investors

Last week, we discussed the significance of following a methodical and well-planned approach to make the corporate access process more effective. This week, we turn our focus to the growing importance of passive investors and why IROs should adopt an active approach to engage with them.

The significance of passive investors is growing by the day thanks to their rising ownership of corporate America, their ability to influence a company’s business decisions, and the impact of their investment choices on active investors. 

• Passive funds now own more than half of the U.S. equity market. According to data from Morningstar, at the end of 1998 there were 6.5 times as many assets in actively managed U.S. equity funds as there were in index funds. Led by the low cost-driven rise in preference for passive funds, this ratio dipped below 5.0 by the end of 2000 and in August 2019 passive funds’ AUM of $4.27 trillion eclipsed active funds’ AUM of $4.25 trillion. Active U.S. equity funds saw $41.4 billion in outflows in 2019, the sixth year of net outflows during the decade-long bull market, while passive U.S. equity funds had $162.8 billion in inflows and finished the year with a 51.2% market share. The trend is visible at the global level too as assets managed by passive investment vehicles reached $11.4 trillion at the end of November 2019 and are estimated to grow to $12 trillion by the end of 2023. Given the meteoric rise in passive investing, such investors should be on IROs’ radar and a significant component of their targeting effort.
• Passive investors influence a company’s decision-making process through proxy voting. Passive investors use proxy votes to indicate their support or dissatisfaction for a company’s strategy and/or its management team as a means to protect their investment. The ‘Big Three’ index funds – BlackRock, Vanguard, and State Street Global Investors (SSGI) – collectively hold 25% of proxy votes in all S&P 500 companies. This number is expected to grow to 40% by 2040. Even though passive investors are “excessively deferential” to corporate managements and do not intervene too often if a company experiences a performance lag, their already-high and growing share in proxy voting means their ability to influence a portfolio company’s decision making is only going to grow. Therefore, management teams and IROs should proactively build strong relationships with these investors.
• Rebalancing by passive funds influences investment actions of active investors and traders. Passive portfolio management involves tracking the returns of an established benchmark like the S&P 500. It is typically implemented by holding each of the indices’ constituent securities in line with their representation in the index. This requires passive fund managers to rebalance their portfolio each time the weight of a security in the benchmark index increases or decreases. This rebalancing, when coupled with passive’s large AUM means that buying or selling by such funds results in outsized moves in the stocks they trade. And since heavy buying begets more buying and heavy selling leads to more selling, trades made by passive funds tend to have a direct impact (multiplier effect) on the moves of active participants, especially momentum investors and traders. Therefore, the ability of passive investors to influence stock prices is higher than what most corporations think, especially when considering that one of the Big Three index funds is the largest shareholder in ~90% of S&P 500 firms.

Given their growing importance, IROs should take the time to understand the selection criteria of indices and passive investors. Unlike active investors who focus on a company’s fundamentals, passive investors are focused on tracking returns at an index level rather than the idiosyncratic attributes of individual securities present in that index. Therefore, IROs should try to understand the selection criteria of the indices their company can be a part of – broader market or sector specific. Such criteria could include size (market cap), float, dividend pay-out policy, management pay, etc., and increasingly ESG/sustainability factors (read here, here, and here). Once such factors are identified, IROs should require their management teams to create policies that are in line with the selection criteria of passives given the benefits (higher liquidity, market cap, etc.) of being a part of an index.

Finally, IROs must develop an active plan to engage passive investors. This involves the following steps:

• Know what indices your company is a part of and when passive investors are increasing or decreasing exposure. Passive funds change their exposure to a specific stock if it is included/excluded from an index or if there is a change in the company’s weight based on criteria like dividend policy, etc. Therefore, being aware of which indices your company is a part of — and why — is an important part of the IR function. Equally important is tracking the change in the ownership of your stock by passive investors since such moves not only create big swings in market cap and liquidity but also have a big impact on the investment/trading decisions of active market participants (discussed earlier).
• Build strong relationships by listening to their voice. Passive investors care more about long-term relationships than short-term financial metrics. Therefore, when engaging with them, IROs need to move away from the traditional model of providing earnings and guidance and introduce more discussion on independence of board directors, sustainability, and management compensation to make the conversation more productive and earn/retain the interest of passive fund managers.
• Monitor third-party data about your company and present the information in a positive light. Given the data/machine-driven selection approach adopted by index creators, IROs should carefully monitor the traditional data (press releases, SEC filings, call transcripts, etc.) and alternative data (social, credit, web, geolocation, etc.) about their company on third-party platforms and make sure that the information is correct, standardized, and comparable. It is important to word press releases and call scripts in a manner that positions the company favorably. Finally, make sure that annual reports, proxies, and other key investor documents carry detailed explanations about your company’s strategy and decisions, boosting its chances of inclusion in the target index.

Next week, we will focus on the key takeaways from the BlackRock Investment Stewardship (BIS) 3rd Annual Director Dialogue Day.