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Editor's Letter: July/August 2017

Can passive owners be active shareholders?

The move to low-cost passive investing strategies is considered, at this point, an unqualified good, the investing strategy of the angels.

Likewise, quantitative investment strategies, “investing by algorithm,” or factor-based investing, etc.—all have increased in popularity as investors see access to the markets primarily through a lens putting “passive versus active” approaches into two separate camps. Those under the “active” label are viewed with suspicion, expensive and mediocre, while those under the “passive” banner are the best way investors can access the markets, unmolested by greedy asset managers. After all, none of these “active” investment managers can reliably “beat the market.”

I agree with those who point out that the debate should not be between active versus passive strategies, as the definitions aren’t so clearly defined. The S&P 500 Index is an active strategy—a committee of human beings makes decisions on what companies belong in the index based on a number of factors—most heavily, market capitalization, but also on things like liquidity and financial viability.

But this kind of investing has a downside. I’ve recently been reading What They Do With Your Money by Stephen Davis of Harvard Law School’s program on corporate governance, Jon Lukomnik of the Investor Responsibility Research Center, and David Pitt-Watson of the London Business School.

They make the point that index-based investing separates the owners of a business (the investors) from the management performance of a CEO or executive team. “When a large number of investors are locked into a list of stocks, portfolio companies receive less-robust signals of confidence or discontent through the marketplace. Index funds can’t buy shares to reward good management or dump them when a CEO has gone awry. This raises the question, can a system that makes it economically 'rational' for owners not to act like owners really maximize value?”

In the authors’ view, the market incentives for corporate executives are all designed to reward short-term performance at the expense of long-term returns—egregious pay packages based on short-term goals or excessive use of stock as compensation, which dilutes holdings of current shareholders. Passive investment managers, either from traditional indices or “smart beta” indices, and even algorithmic traders, have poor records of keeping tabs on such executives by acting as stewards of capital and owners of businesses.

“More and more investors own shares through mutual funds, often investing in S&P 500 index funds. Individual investors are not in a position to sell their stakes in a specific company,” writes Rosanna Landis Weaver from the nonprofit corporate-accountability foundation As You Sow. And, while the asset managers are doing a better job holding executives accountable (BlackRock, in particular, gets high praise), “the funds themselves are subject to a number of conflicts of interest and to what economists refer to with the oxymoronic-sounding term ‘rational apathy,’ to reflect the expense of oversight in comparison to a pro rata share of any benefits.” In other words, for managers of passive index funds, being active shareholders just isn’t worth the time.

Despite this, I still think low-cost index funds are the place to be for most investors’ core positions. In theory, I’m encouraged by the rise of environmental, social and governance investment strategies. They may help managers devise low-cost indexes that do a better job of weeding out companies that favor managers over owners or short-term financial goals over long-term returns.

But it’s not quite there yet. Is there an easy way to buy the S&P 500, but just tweak it to remove companies that have, say, dual-stock ownership structures or out-of-whack CEO pay packages, while still being low cost? It’s not the technology that is standing in the way. Maybe soon we will get low-cost investment strategies that no longer let corporate executives get a free pass from their “passive” owners.


David Armstrong


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