Vanguard, Trian And The Problem With ‘Passive’ Index Funds
Index funds are the major shareholders in many large- and medium-sized public companies, but their passive investment nature offers few checks on those companies’ executives, says Luis Viceira.
On August 31, 2016, many investors celebrated the 40th birthday of one of the world’s most successful financial instruments: the mutual index fund, created by Vanguard founder John C. Bogle.
Index funds, which automatically track an index of stocks such as the S&P 500, lowered the cost of investing, especially for smaller investors, and ultimately created greater returns than most professionally managed mutual funds could deliver. That has made index, or passive, funds wildly popular: For the 12-month period ending May 2016, according to the Wall Street Journal, $409 billion was invested in index funds while $310 billion exited actively managed funds.
But have they become too popular? Researchers and analysts are increasingly concerned that managers in companies with a large number of passive fund investors can too easily operate outside the scrutiny of engaged shareholders.
“Do we need to get shareholders more engaged? What shape should the separation of management and ownership take in the twenty-first century?”
“We are now in a situation where index investors are the major shareholders in most of the large- and medium-sized public companies in the United States,” says Luis M. Viceira, the George E. Bates Professor and senior associate dean for International Development at Harvard Business School. “That raises the question, who is exercising control in these corporations?”
In traditional mutual funds, powerful fund managers representing thousands or tens of thousands of individual investors are able to wield great influence on management teams of companies in their investment portfolios. By contrast, index funds almost run on autopilot—with no active investor analyzing companies, rewarding those that make good financial decisions and punishing those with shaky corporate governance.
“When you think of the factors that have made capitalism such a successful model for economic growth, the separation between management and ownership, with the ability to disperse ownership and risk over many shareholders that comes with it, is one of them,” says Viceira.
Healthy corporate governance, such as the presence of engaged independent board members and other measures, is vital for this separation to work well. “But if management is not under shareholders’ control,” continues Viceira, “it may act in its own best interest, and not on behalf of the shareholders. When investors become too passive, we might see inefficiencies at the corporate decision-making level kicking in.”
The question for today, he says, is whether the pendulum has shifted too far toward passive investing in a way that hurts the long-term financial performance of firms.
“Do we need to get shareholders more engaged? What shape should the separation of management and ownership take in the twenty-first century? These are hugely important questions playing out live right now,” he says.
The case of Vanguard
Viceira explores these questions in two recent case studies, including The Vanguard Group, Inc. in 2015: Celebrating 40. Co-written with HBS finance professor Adi Sunderam along with Allison M. Ciechanover (HBS MBA 2002), director of the HBS California Research Center, the case looks at the current state of Vanguard, which has a 78 percent share of the asset class it created.
Vanguard’s index funds have obvious appeal to investors, especially smaller ones. Their passive approach makes these funds less expensive to maintain than active mutual funds, and their operating costs as a percent of assets under management tend to decline with size. That translates to lower fees for clients.
“But there is a hidden cost,” says Viceira. “Index funds by definition don’t look at what is happening in the corporations they own.” That is less important when index funds are a minority of a company’s ownership—investors can count on more active shareholders to scrutinize the firm’s financials and engage with corporate management. “But when [index funds] become the largest shareholders, they need to take a stand,” he says.
And for the first time, this appears to be happening. Large index funds such as BlackRock and Vanguard have become aware that staying out of corporate governance is not in the best interest of their investors.
For example, Vanguard has participated in proxy votes at shareholder meetings. While it has mostly voted in accordance with recommendations by management, in some key areas it has parted ways. It has supported shareholder resolutions concerning governance and compensation issues 75 percent and 92 percent of the time, respectively. Vanguard has also met with some 1,000 executives from companies it invests in.
In 2015, CEO Bill McNabb signaled his recognition of the increased role Vanguard has to play in a letter to some 500 publicly traded companies, spelling out corporate governance principles that it would advocate. (See illustration.) BlackRock CEO Larry Fink followed in 2016 with a letter to chief executives of large US and European companies urging them to focus on long-term value creation, and for boards to actively engage with management in long-term strategic planning.
Vanguard Corporate Governance Principles
Source: Letter by F. William McNabb II to the independent leaders of the boards of directors, February 27, 2015, Vanguard.com.
“The letters from the CEOs of two main index investing companies suggest that index managers are fully aware of their significant influence on capital markets, as well as their responsibilities to their investors and to capital markets—and to the US economy more generally,” says Viceira. “After all, they are true long-term investors, as they stay invested in a company as long as it is part of an index, regardless of its performance.”
This is not the only way shareholders are reengaging with management to take more corporate control. Private equity investing allows investors to take a problematic public company private, fix those problems, and then take it public again. Says Viceira: “Investors in those funds benefit from that process, as they tend to buy the company at a discount from the market and sell it back later to the market for a premium once the company has been turned around.”
But private equity is not a tool that benefits small investors, who usually don’t have access to those funds. An alternative in more recent times is what Viceira calls “private equity in public markets.” In these cases, investment funds adopt processes similar to private equity firms but without taking a public company private. Their strategy usually involves identifying a company going through governance or management issues, coming up with a plan to fix those issues, and then making a large investment in the equity of the company to gain a voice on its board to exercise control and oversight, as well as advocate for change. Since the company remains public, smaller investors retain an opportunity to participate in any value creation or bail out if need be.
Will index funds become more engaged?
This evolving power relationship between largely hands-off investors such as index funds and investors focused on shorter-term management change is discussed in Viceira’s two-part case Trian Partners and DuPont, co-written with Dhruva Kaul and Peter Lee.
Investment management group Trian’s strategy is to invest in undervalued companies and work with management to restructure and increase value for the long term. (Trian defines itself as “highly engaged shareholders” rather than “activist investors,” seeing typical activist funds more focused on short-term value creation than on the long term.)
In the case of the diversified conglomerate DuPont, Trian identified a host of problems including a structure that generated excessive costs, suboptimal financial management, and an unsatisfactory history of capital allocations, acquisitions, and divestitures. But Trian’s $1.8 billion stake in DuPont was worth only 2.7 percent, making it easy for the management team to reject reform proposals.
So Trian, recognizing the growing power of index funds, tried to persuade three index investors in DuPont—Vanguard, BlackRock, and State Street—to support its management reform package. All three funds refused to go along, although the assent of just one of them would have tipped the balance in favor of Trian’s plan.
As Viceira, Kaul, and Lee describe in the second part of the case, however, even though Trian lost the battle, it eventually won the war. The close vote shook up DuPont’s complacent managers and shareholders, and the company, with the help of investors, eventually brokered a deal to merge with rival Dow and split the combined company into three stand-alone businesses.
“The case documents a fascinating dynamic between index investors, who are true long-term investors, and this breed of investment funds focused on creating value by promoting change at the corporate level,” Viceira says.
As the case illustrates, the reluctance of passive investors to join the fight delayed the effective restructuring. “Right now the index funds are saying [that they] are not here to directly intervene in boards,” says Viceira. “Instead, they are promoting better corporate governance, voting for rules that make boards better run, but they are not trying to have a direct influence on the decisions management takes.”
As passive investors become larger and larger owners of companies, however, the future health of these businesses may depend on those investors taking a more active role in determining the management of the companies they own.
In the near future, Viceira hopes to sponsor a conference at Harvard that will bring together index fund managers, institutional investors, long-term shareholder activists, and company directors and heads to engage in charting the course for what it means to be an engaged shareholder in the twenty-first century.
“There are serious questions about the future of dispersed ownership and the separation between management and ownership,” says Viceira. “The way we answer these questions may literally determine the future of capitalism.”