financial system and corporate governance impacts of ... · the rapid rise of low cost equity...

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Financial System and Corporate Governance Impacts of Passive ManagementMaureen O’BrienVP Segal Marco AdvisorsJulian ReganSVP Segal Marco AdvisorsJune 12, 2018

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AgendaThe Rise of Passive Equity Management

Objectives and Uses of Passive Management

Market and Financial System Implications

Corporate Governance: Voting Trends Over Time By Passive Managers

Examples of Votes on Key Proposals By Passive Managers

Takeaways

Glossary

“This the new realty of today’s stock market: Funds that track financial indexes have become a dominant force, and they can act as accelerants, adding to the market’s rise and fall”

—New York Times, February 8, 2018

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Many Investors use a combination of passive and active investment strategies as a means of implementing their public markets asset allocation strategy.

Active Management: An investment strategy that seeks to earn a higher return than the benchmark index return by holding and trading a subset of securities in an index based on price discovery and the exercise of discretion in selecting securities.

Passive Management: An investment strategy that seeks to track the returns of an index, such as the S&P 500, rather outperforming it. A passive portfolio is typically implemented by holding the securities in an index in proportion to their weight.

BackgroundPassive vs. Active Investing Definitions

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Rise of Passive Equity Management (indexing) and Benefits The rapid rise of low cost equity indexing is helping investors implement

increasingly cost effective investment programs At the same time, however, asset flows to passive management are raising

questions about potential impacts on the U.S. financial system and the corporate governance movement.

Impact on Capital Allocation As passive management’s share of the U.S. equity market has grown to an

estimated 30% - 40%, investors and corporate boards are awakening to a market where capital flows to equity securities are almost as likely to be determined by index weights as by traditional measures of corporate performance.

Financial System and Corporate Governance Concerns Against this setting, a growing number of experts and academics are raising

concerns that concentration in the index fund industry, a decline in price discovery and the rise of exchange traded index funds (ETFs) are leading to concentrated control of U.S. public companies, contributing to market volatility and may lead to long-term changes in our markets.

Executive SummaryFinancial System Impacts of Passive Management

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BackgroundPassive Management Response to Concerns about Market Impacts

According to passive managers, data regarding passive management’s rising share of the U.S. equity market is inexact and may be overstated.

Contrary to concerns expressed by some industry experts, passive managers believe active management will continue to play a significant role in setting equity prices.

Growth in passively managed assets should create greater opportunity for active managers.

Due to the fact that portfolio turnover is largely limited to rebalancing to match index weights, passive equity managers are motivated to act as long-term owners of U.S. companies.

“…the question of whether the rise of passive investing is an existential threat to capitalism remains an open one.”

—Bloomberg, August 23, 2016

Passive Management Industry Response

$11.9 $17.4

$38.7

Index Funds Actively ManagedFunds

Remaining

BlackRock Estimate: Global Equity Ownership (Trillions)

Source: Reuters, October 3, 2017

Note: Sample information. Not all inclusive.

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Public and private retirement funds reportedly own 17% of the U.S. equity market

This does not include equities owned indirectly by public and private defined contribution plans that are held in mutual fund and other commingled investment vehicles

BackgroundOwnership of U.S. Equities

Source: Federal Reserve Board, Lionshares and Goldman Sachs Global ECS Research.

34%

20%

9%

8%

14%

3%

4%

8%

Households

Mutual Funds

Pension Funds (non-Public)

Government Retirement Funds

International Investors

Hedge Funds

ETFs

Other

Ownership of Corporate Equities (2013)

“The big pools of equity owners in the world today are the pension funds. They're the policemen, they're the firemen, they're the teachers, they're the civil servants…”

—Gary Cohn, White House Economic Advisor, September 1, 2017

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Most public pension funds utilize a combination of passive (indexed) and active investment strategies to implement their public equity allocations.

Indexing benefits public funds by enabling low cost exposure to markets where active management has been challenged to generate net-of-fee returns that exceed benchmarks.

Individual and institutional investors flows from active to passive equity management have increased dramatically since the financial crisis due in part to performance and fees.

BackgroundPublic Equity Ownership: Active vs. Passive Management

Source: U.S. Census Bureau.

2,466

3,785

2009 2017

Exhibit 1100 Largest Public Pension Funds

Assets (Billions)

47.6%

23.2% 24.9%

4.3%

Public Equities Fixed Income Alternatives /Real Estate

Cash/Other

Exhibit 2Public Funds:

FY 2016 Average Asset Allocation

Source: National Association of State Retirement Administrators (NASRA).

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Demand for active management varies across investors depending on tolerance for tracking error, time horizon, market efficiency and return, risk and cost objectives.

A recent study found that over half of global non-corporate pension funds manage 40% or more of their equities passively.

BackgroundPassive vs. Active Equity Management

Investment Program Roles Active Passive Strategy to achieve equity market exposure (beta) ● ●Potential to add return above benchmark (alpha) ●Lower cost ●Return objective: outperform benchmark return ●Return objective: match benchmark return ●Exposes investor to tracking error ●Limited tracking error relative to index ●

“In many ways, this stampede toward passive investing…is uncharted territory.” —New York Times, February 9, 2018

Note: Sources include BlackRock/Economist Intelligence Unit, March 2018.

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By matching holdings and weights to an index (e.g. Russell 1000), passive management minimizes costs, while limiting or eliminating tracking error

Public pension funds have utilized indexing to gain exposure to more efficient parts of the capital markets at a low costs for decades

What is new are the trillions in asset flows from active management to traditional index funds and to index exchange traded funds (ETFs)

The Rise of Passive Management Capital Flows

286

200

(400)

Index Fund ETFs

Index Fund Flows

Active Mutual Funds

Net Mutual Fund Flows (Billions)

2016 (est)

Source: Bloomberg.com, U.S. ETFs 2017 Outlook

“Most of today’s 1,800 ETFs are less diversified, carry greater risk, and are used largely for rapid-fire trading – speculation, pure and simple.”

—John C. Bogle CFA Publications, January/February 2016

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Indexed mutual fund assets increased from $55 billion or 4% in 1995 to $4 trillion or 34% in 2015 due in part to active management performance following the crisis.

A Moody’s study predicted that passively managed assets will exceed actively managed assets by 2024.

The Rise of Passive Management Growth of Equity Index Mutual Funds

EQUITY INDEX FUNDS MARKET SHARE*

0%4%

16%

34%

1985 1995 2005 2015Source: CFA Publications. John C. Bogle. January/February 2016

“…perhaps we shouldn’t be shocked if an investment method that encourages us to use as little discernment as possible ends up being too good to be true.”

—Is Passive Investment Actively Hurting the U.S. Economy? The New Yorker, March 9, 2016

Source: Fichtner, Heemskerk and Garcia-Bernardo, Cambridge University Press, April 25, 2017.

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In the wake of the global financial crisis, most active equity managers have been challenged to outperform their benchmark index amid rising markets (Exhibit 1).

Proponents of active management and industry research supports the case that active management performs better in down markets (Exhibit 2).

The Rise of Passive Management Historical Performance

84.2% 80.5%

63.0%

85.0% 86.3%

44.4%

91.1% 88.8%

47.7%

5 Yr 3 Yr 1 Yr

% Active Managers Underperforming Benchmark Periods Ended 2017

U.S. Large Cap Core U.S. Mid Cap Core U.S. Small Cap Core60%

32%

Down Markets Up Markets

U.S. Equity Active Funds OutperformanceFebruary 1, 1998 - January 31, 2018

Source: Morningstar, February 28, 2018Source: SPIVA Scorecard

Exhibit 1 Exhibit 2

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Reasons for recent active manager underperformance include fees, market efficiency, low interest rates, stock price correlations driven by macroeconomic factors (e.g. monetary policy) and benchmark constraints, among other reasons.

According to an October 2015 CFA publication survey, the top reason for active managers’ underperformance was higher fees relative to passive (see above).

The Rise of Passive Management Reasons for Active Manager Underperformance

24%18%

15%13%

10%10%

5%5%

Higher Expenses of Active Management

Benchmark, stylebox and tracking error constraints

Managers cannnot compete with market intellegence

Active managers' short-termism

Concentration of top performing stocks

Other

Lack of thorough analytical due diligence

Active managers' lack of opinion diverstity

CFA SurveyReasons for Active Manager Underperformance

Sources: CFA Institute, Jason Voss, CFA, October 2015

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By constructing a portfolio that matches or replicates index holdings, passive management provides market exposure at a fraction of the cost of active management (Exhibits 1 and 2).

In contrast to passive managers, active managers engage in price discovery, analyzing factors such as balance sheets, earnings growth, strength of management, discounted cash flows, dividend yields, debt coverage ratios and other inputs to support portfolio decisions.

Price discovery requires investment manager skill sets and resources and plays an important role in determining the allocation of capital through financial markets and the economy.

The Rise of Passive Management Investment Management Fees

0.82%

0.09%

Active Equity Mutual Funds

Passive Equity Mutual Funds

Mutual Funds Average Expense Ratio: 2016

Exhibit 1

Source: Investment Company Institute

Exhibit 2

0.50%

0.06%

Active U.S. Large Cap ValueManage (sample)

Passive U.S. Large CapValue Manager (sample)

Hypothetical Management Fees (%): Active vs. Passive

Sample. For illustrative purposes only.

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A Bank of America report found that index funds’ ownership of the U.S. equity market nearly doubled between 2009 and 2017 from 19% to 37% (Exhibit 1)

In 2016, mutual fund investors added $428.7 billion to passive (indexed) funds and withdrew $285.2 billion from active funds (Exhibit 2).

A Moody’s study predicted that passively managed assets will exceed actively managed assets by 2024

The Rise of Passive Management Passive vs. Active Equity Ownership

Source: Reuters, BlackRock, October 3, 2017

19%

37%

2009

2017

Passive Ownership of U.S. Equity Funds

Source: Reuters, Bank of America, October 3, 2017

428.7

(285.2)

Passive Funds Active Funds

Mutual Fund Inflows / (Outflows)Billions: 2016

Exhibit 1 Exhibit 2

“By design passive investors, passive funds invest in all securities included in the index they track…A higher share of passive investors could therefore weaken market discipline and alter the incentives of corporate and sovereign issuers to act in the interest of investors.”

— BIS Quarterly Review, March 2018

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The index fund industry is highly concentrated among three firms, BlackRock, State Street Global Advisors and Vanguard, who reportedly manage approximately 80% of indexed assets

Due to concentration of market share among the top three indexers, these firms (the “big three”) are now collectively the largest owners at 40% of U.S. public companies

The “big three” collectively are reportedly the largest owner of 90% of S&P 500 companies.

Market and Financial System Impacts Largest Managers of Indexed Assets

3,682,536 3,301,070

1,934,329

Black Rock Vanguard SSgA

The Largest Managers of Indexed AssetsJune 30, 2017 ($ Millions)

“...what may be good for investors individually, may not be good for the economy and the market as a whole.”

—Fortune, December 30, 2015

Source: Pensions & Investments, October 2, 2017

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Market and Financial System Impacts Asset Flows to Index Fund ETFs


“Exchange-traded funds are leading a passive revolution, as investors dump active mutual funds and pile into index funds and ETFs.”

—Bloomberg.com, US ETFs 2017 Outlook

3.396

4.569

December 2016 November 2017

Global ETF Assets(Trillions)

Source: MarketWatch, September 27, 2017

14% 22%31%

86%78%

69%

2011 2016 2022E

Market Share of Global ETFs

Passive Funds Active Funds

Source: Ernst & Young, Global ETF Research 2017

Exhibit 1 Exhibit 2

Global ETF assets grew by over $1.1 trillion or 34% in less than a year (Exhibit 1).

Index funds’ share of Global ETFs is expected to grow to 31% by 2022 (Exhibit 2).

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The trend in asset flows to passive management raises debate about broader market tradeoffs between active and passive management that extent beyond investor impacts.

Some industry experts are concerned that continued growth in indexing may contribute to a self-perpetuating market bubble and/or heightened volatility if carried to an extreme

Concentrated ownership among index fund managers, where three firms control approximately 80% - 90% of the market, also raises concerns about impacts to corporate governance

The three firms also reportedly manage 82% of U.S. exchange traded funds (ETFs).

Market and Financial System Impacts Largest Managers of Indexed Assets and ETFs

“The last time we had this this degree of concentrated financial power was in the Morgan days.” — Edward Rock, NYU School of Law

Exhibit 1The Largest Managers of Indexed Assets

June 30, 2017 ($ Millions)

3,682,536 3,301,070

1,934,329

Black Rock Vanguard SSgASource: Pensions & Investments, October 2, 2017

$ Billion % of Total

BlackRock 1,176 39%

Vanguard 734 25%

State Street 540 18%

Top 3 Total 2,652 82%

Exhibit 2U.S. – Listed ETF Assets

U.S. Market Share (June 2017)

Source: Forbes, ETF.Com, August 24, 2017

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Market and Financial System Impacts The Role of Price Discovery


Some experts believe the rise of indexing may result in stocks moving up and down in tandem more frequently, diminishing the market’s role in allocating capital effectively across securities.

Other publications have raised concerns about indexing’s impact on competition, since passive equity managers tend to own tend to own more than one company in an industry.

Rising cash flows into stocks based on market capitalization only, rather than strength of management and innovative ideas, may misallocate capital to the detriment of the economy.

Passive Management and Price Discovery

“Only 77% of the average S&P component’s shares trade on fundamentals now, compared with 95% a decade ago.” — MarketWatch, September 27, 2017

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Market and Financial System Impacts Risk and Volatility


Index fund ETFs are increasingly used for active trading strategies that have potential to exaggerate market lows and highs during periods of heightened buying and selling.

Exchange traded index funds reportedly accounted for 38% of total equity trading on some days during the week of February 5, 2018.

Firms have claimed that flows to passive management may contribute a self-perpetuating market bubble, since capital is allocated indiscriminately, rather than based on fundamentals.

Concerns about Market Volatility

“This week, as markets shuddered, exchange-traded index funds wereresponsible for 38% of total stock trading….”

—New York Times, February 9, 2016

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Corporate Governance ImpactsVoting Record

96%92%

97%

64%

20%

30%

19%

30%

96%92%

97%

64%

22%

34%

16%

30%

BlackRock State Street Global Advisers Vanguard Segal Marco

Percentage of Proxy Votes in FavorManagement Proposals 2017 Shareholder Proposals 2017 Management Proposals 2016 Shareholder Proposals 2016

Source: Fund Votes.com

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2017 AFL-CIO Key Vote Survey

BlackRock: 9 of 29 = 31%

State Street Global Advisors: 13 of 27 = 48%

Vanguard: 10 of 29 = 34%

Segal Marco: 29 of 29 = 100%

2016 AFL-CIO Key Vote Survey

BlackRock: 7 of 31= 23%




Corporate Governance Impacts Voting Records

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2017 NCPERS Key Vote Survey

BlackRock: 3 of 9 = 33%




Corporate Governance Impacts Voting Records

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Phony-accounts scandal in September: 2M fake accounts 5,300 people fired for ethics violations, board told of only 230 Division head ran group like a sales organization, not a financial institution Company paid $185M in fines

Claw-backs on CEO ($69M) and former head of community banking ($66M). Neither is currently employed at Wells Fargo

Date: April 25, 2017

Result: Four director nominees received less than 60% support

Corporate Governance Impacts 2017 Wells Fargo Board of Directors

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Segal Marco John S. Chen Lloyd H. Dean Enrique Hernandez, Jr. Cynthia H. Milligan Federico F. Peña Stephen W. Sanger Susan G. Swenson John D. Baker II Elizabeth A. Duke Donald M. James Karen B. Peetz James H. Quigley Ronald L. Sargent Timothy J. Sloan Suzanne M. Vautrinot

Corporate Governance Impacts Votes Against Wells Fargo Board Members

Lloyd H. DeanElizabeth A. DukeJames H. Quigley

BlackRock

SSGA

Cynthia H. Milligan Enrique Hernandez, Jr.Federico F. PenaStephen W. Sanger

Vanguard

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Corporate Governance Impacts Pace of turnover on Wells Fargo Board

John S. ChenLloyd H. DeanEnrique Hernandez, Jr.Cynthia H. MilliganFederico F. PeñaStephen W. SangerSusan G. Swenson

2017 2018

Celeste ClarkTheodore Craver Jr.Maria MorrisJuan Pujadas

John D. Baker IIElizabeth A. DukeDonald M. JamesKaren B. PeetzJames H. QuigleyRonald L. SargentTimothy J. SloanSuzanne M. Vautrinot

2018 New Directors: 42017 Resignations: 7

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Proposal: Report on Incentive Pay and Risks of Material Losses Proponent: New York State Common Retirement Fund Meeting date: April 24 Vote result: 21.7% in favor Segal Marco vote: FOR

Sept. 2016: phony-accounts scandal 2M fake accounts Company paid $185M in fines Claw-backs on CEO ($69M) and former head of community banking ($66M)

July 2017: Collateral protection insurance scandal 570,000 customers overcharged for auto insurance $80 million paid in remediation to customers

Corporate Governance Impacts 2018 Ongoing Corporate Culture Concerns

“Many witnesses believed that incentive compensation plans overly emphasized sales performance, and many complained to Community Bank leadership that incentive plan goals were too high, too focused on sales and led to bad behavior.” —April 2017 Report

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Sponsor: Arjuna Capital

Dates: Facebook June 1, 2017Alphabet June 7, 2017

Segal Marco Vote Recommendation: FOR

Proposal: Issue a report reviewing the impact of current fake news flows and management systems on the democratic process, free speech, and a cohesive society, as well as reputational and operational risk from potential public policy developments

Corporate Governance Impacts Fake News at Facebook and Alphabet

BlackRockSSGAVanguard

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Sponsor: Segal Marco

Proposal: Allow franchisees the opportunity to elect a board representative


Date: May 24, 2017

McDonald’s aims for 95% of its stores to be franchise-owned (up from 85% now). It is passing on significant costs to the franchisees and has no representative with authority to convey challenges to the Board.

Corporate Governance Impacts McDonald’s Franchise Director


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Sponsor: The International Brotherhood of Teamsters General Fund

Proposal: Develop a plan for recapitalization to result in one vote per share for all outstanding common stock


Date: May 24, 2017

CEO owns a minority of shares but retains majority voting power

IRRC Institute 2016: companies with dual-class capital structures underperformed non-controlled companies over three-year, five-year, and ten-year periods.

Corporate Governance Impacts Eliminate Dual Class Stock at Swift Transportation


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Sponsor: Trowel Trades S&P 500 Say-on-Pay Investor Working Group Public Fund Participants: City of Philadelphia Public Employees

Retirement System Connecticut Retirement Plans and Trust Funds Firefighters’ Pension System of Kansas City,

Missouri, Trust Miami Firefighters’ Relief and Pension Fund New York City Pension Funds New York State Comptroller’s Office

Proposal: Consider pay throughout the firm when setting CEO pay


Date: June 1, 2017

Corporate Governance Impacts CEO Target Pay at SL Green Realty Corp.

Companies that agreed to policy:


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Sponsor: The City of Philadelphia Public Employees Retirement System

Proposal: Political Spending Disclosure


Date: May 31, 2017 Consistent vote support year over year has led to

incremental improvements in disclosure:– Board Oversight of political spending – Federal lobbying disclosure (2014, 2015): $15M – Global donations in 2016 (non-U.S.): $12M

Gaps in disclosure however remain

Corporate Governance Impacts Lobbying Disclosure at Chevron


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Sponsor: The City of Philadelphia Public Employees Retirement SystemProposal: Rooney Rule—make sure nominee pool is diverseSegal Marco Vote Recommendation: FORDate: April 27, 2017 Result: 62%McKinsey & Company 2015: companies in the top quartile for gender or racial and

ethnic diversity tend to report financial returns above their national industry medians.Credit Suisse 2016: Greater gender diversity in companies’ management

coincides with improved corporate financial performance and higher stock market valuations.

Corporate Governance Impacts Board Diversity at Cognex Corporation

BlackRockSSGA

Vanguard

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Sponsor: Connecticut Retirement Plans and Trust Fund Proposal: Every director subject to shareholder vote each year Segal Marco Vote Recommendation: FOR Date: May 31, 2017

A 2004 Harvard study by Lucian Bebchuk and Alma Cohen: staggered boards are associated with a lower firm value (as measured by Tobin’s Q) and found evidence that staggered boards may contribute to, not merely reflect, that lower value.

Board plagued by conflicts of interest; entrenchment concerns Tesla founder and CEO Elon Musk is also Tesla’s board chair. The lead independent director of Tesla’s board, Antonio Gracias, serves

on the board of SpaceX, also led by Musk, and served on the board of SolarCity, another Musk-founded firm that was recently acquired by Tesla.

Gracias is the CEO and majority owner of a limited partnership in which both Musk and his brother are limited partners.

Corporate Governance Impacts Declassify the Board of Directors of Tesla


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Sponsor: New York City Pension Funds

Proposal: Allow shareholders with a 3% stake held for 3 years to nominate a candidate to the board.


Date: April 27, 2017 Result: 59.4%Since 2014 half of the S&P500

has adopted proxy access, 342 companies in total.

Corporate Governance Impacts Proxy Access at IBM

CFA Institute found proxy access would:• benefit both the markets and corporate

boardrooms, with little cost or disruption.• has the potential to raise overall US market

capitalization by up to $140.3 billion if adopted market-wide. BlackRock

SSGAVanguard

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Executive Compensation Telsa’s $2.3B grant to founder Elon Must TJX Clawback Policy following investigation into working conditions of port

truckers

Diversity First Hawaii shareholder proposal on the Rooney Rule

Opioids Johnson & Johnson, McKesson shareholder proposal on legal exclusions Cardinal Health shareholder proposal on opioid risk report

Corporate Governance Wells Fargo shareholder proposal on unintended consequences of incentive pay Facebook governance on contents Marriott International majority voting standard

Activist Investing At Newell Brands, Starboard Value vs. Carl Ichan

Corporate Governance Impacts 2018 NCPERS Key Proxy Votes

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Corporate Governance Impacts Workforce Diversity and Pay Parity Votes

590

3,182

34

2015 Cumulative

1,522

6,297

277

2016 CumulativeAbstain Against For

527

13,278

1,755

2017 Cumulative

Total: 3,806 Total: 8,096 Total: 15,561

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1,675

24

2015 BlackRock

3,626

119

2016 BlackRockAgainst For

6,927

968

2017 BlackRock


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44

456

10

2015 SSGA

527

1,896

135

2017 SSGA

330

1,087

158

2016 SSGAAbstain Against For

Total: 510 Total: 1,575 Total: 2,558

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546

1,051

2015 Vanguard

1,1921,584

2016 VanguardAbstain Against For

4,456

652

2017 Vanguard


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Shareholder proposals that received majority support

Corporate Governance Impacts Workforce Diversity and Pay Parity High Votes

Company Proposal Year BlackRock SSGA VanguardHudson Pacific Properties, Inc.

Prepare a report regarding diversity on the board

2017 For Abstain For

Fleetcor Technologies Inc.

Board diversity and reporting

2016 Against For Against

Cognex Corp. Adopt policy for improving board diversity

2017 Against Against For

Joy Global Inc. Board diversity 2016 Against For AbstainEbay Inc. Gender pay equity 2016 Against Against Abstain

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Passive and active management are viable approaches to implementing an long-term investment strategies in public markets.

Passive management (indexing) benefits investors by enabling low cost exposure to markets where active management has been challenged to exceed benchmarks.

Due in part to active management results in rising markets that followed the crisis, passive management’s share of the U.S. equity market has grown to up to 40%.

Notwithstanding its benefits, the rise in passive management is causing concerns among experts about potential impacts to markets, economy and corporate governance.

Potential impacts include the diminishing role of price discovery in allocating capital, potential market volatility and concentrated ownership and control of U.S. companies.

Financial system and corporate governance impacts of asset flows from active to passive equity management warrant close monitoring and study.

Takeaways

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Presenters

Maureen O’BrienVice PresidentCorporate Governance [email protected]

Julian ReganSenior Vice President and Public Sector Market [email protected]

financial system and corporate governance impacts of ... · the rapid rise of low cost equity...

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