QUIET ABOUT BEING PASSIVE: How Index and ESG Are Changing the - - PowerPoint PPT Presentation

THERE’S NOTHING QUIET ABOUT BEING PASSIVE:

How Index and ESG Are Changing the Institutional Investment Landscape

Jan January ry 2018 2018

The “Ripple Effects” of Index Ownership

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In Index In Investin ing = = Catalyst of

• f Chan

anged Behavior Index ownership has created a dramatic shift in the behavioral paradigms that govern today’s capital markets Four Primary Impacts of Index Growth (“4 R’s”):

• Redefining “Buy & Hold”
• Revolutionizing SRI & ESG
• Revising the Activist Mindset
• Reforming Legislation (Both Explicit & Implicit):

Expanding the 4 R’s

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• Redefining “buy and hold.” Index investors, by definition, lack the ability to divest a stock if it meets the index’s
• criteria. This can lead to a considerably longer investment time horizon, where capital gains may not be realized for

years or even decades. As a result, the index investor’s perspective focuses on those catalysts that will generate the best returns over the long term. While the lack of divestment discretion limits the index investor’s options to actively influence returns, their sizeable holdings can be wielded in creative ways to replace divestment with engagement.

• Revolutionizing SRI and ESG. With empirical evidence indicating a strong correlation between weak corporate

governance and poor profitability, a focus on SRI (Sustainable and Responsible Investment) and ESG (Environmental, Social and Corporate Governance) aligns with the index investor’s longer-term investment interests and tendency towards loss aversion. As a result, governance is increasingly being viewed as a proxy for long-term cost of capital. The importance of ESG is further underscored by the formation of the Investor Stewardship Group (ISG) in January.

• Revising the activist mindset. Without divestment discretion, index funds are turning to ESG as a means to exert
• control. Increasingly, index investors are partnering with active managers to engage on governance matters and

facilitate long-term changes at their portfolio companies. As a result, activist vulnerability is no longer isolated to the known activist names in a company’s ownership profile, as index holdings are now acting as a tailwind to activist demands.

• Reforming legislation. Combining the impacts of MiFID II, the Brokaw Law, Corporate Governance Reform and

Transparency Act and other reforms with the ever-shrinking set of buy-side and sell-side analysts, investors are increasingly adopting a generalist mindset. Unfortunately, this is happening just as information flow is constricting, thus raising the risk of undue reliance on misinformation or bias. Investors will increasingly rely on governance, which unites the generalist’s primary concerns: a healthy balance sheet, sound capital allocation, etc.

The Landscape Continues to Evolve…

5

We have observed a distinct shift in the behavioral paradigm that governs institutional investing:

• Traditional Models: How investors should make investment decisions
• Will soon become somewhat obsolete – based in “old” interaction data
• Never had to account for MiFID II, ESG or Index investing
• Less

Less peo people le coverin ing mor

• re sto

tock resulting in great weight place on individual perception and emotions

• Behavioral Models: Explains and in

interprets ob

• bse

serv rved de decis ision mak aking and tendencies

• How will the investment community adjust?
• The Importance of Behavioral Finance
• What is

s mor

• re important – fact

acts or

• r bia

biases?

• Investors are loss averse & display “Bounded Rationality”
• Investors exhib

ibit consis istent bia biases in expectations and methodologies

There's Nothing Quiet About Being Passive - December 2017

Redefining “Buy & Hold”

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Understanding the adjustment by active management is an exercise of behavioral finance

Key Investor

• r Bi

Biase ases:

• Los

Loss Aversio ion = the fear of loss is a far greater influence than joy of winning

• Co

Cons nserv rvatis ism = place more emphasis on info utilized for the ori

• rigi

ginal recommendation

• Co

Confir firmatio ion = seeking info and utilizing new info that justifies original opinion Ov Overcomin ing g Bi Bias as = Objectively listen to what the empirical data says! Co Contin inued Co Contractio ion of

• f the

the Sel Sell / / Buy Buy Side Side – Enh Enhancin ing bi bias amo among g bo both th the the act activ ive AND AND pass passiv ive worl

• rld
• Fewer people covering more stocks
• “Illusion of Control” Bias (Active) – “I buy what I understand or what I can control”
• Anchoring Bias (Passive) – Governance data is already available (ISS/ Glass Lewis Dilemma)

Fee eedback Dyn Dynamic ic:

• Active - Used to be a Recommendation…Now it is a more of a calculated demand
• Passive – Engagement is the on
• nly option

The Agent – Principal Dilemma

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Di Directional l trend of

• f investor te

tendencie ies s – man anagement cla clamoring for

• r gr

greater control

• The continued contraction of both the sell- and buy-side has nar

narrowed acti active man anagement to tole lerance ba bands. s.

• The growth in index money has resulted in extremely concentrated positions and undesired

exposures to “poor” equities The “Agent – Principal” Dilemma Applies to Passive Money Too

• The perc

perceived misa salignment between the incentives of management and the best interests

• f shareholders

Ind Index mon

• ney doe

does no not t pos posse sess th the luxury ry of

• f tim

imed dis discretion an and has has VE VERY lon

• ng tim

ime hor horizons

• Index cannot practice divestment / Only active managers have luxury of discretion
• Focus is less on “management” and mor
• re on
• n control
• Key question = What avenues of control are available for a passive or active manager?

How To Interpret ESG/SRI

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Although broad, the ESG Framework is a set of parameters that ultimately allows the relative comparison of respective discount/hurdle rates and risk premiums/discounts ESG/SRI primary focus = the relative strength of corporate governance

• Do the values preached and strategies presented by management align with the bes

best lon

• ng-

term interests ts of the shareholders?

Index money = 401(k) money, Pensions, Insurance and Endowments

Empirical Evidence – ESG dir irectly ly affects Cos Cost of

• f Ca

Capital

• Empirically proven that stric

icter governance results in:

• Less latitude afforded to management (think “free cash dilemma”)
• Sma

Small ller ri risk per per un unit of

• f cash fl

flow

• Strong correlation between weaker corporate governance and poor profitability

ESG – What To Really Focus On…

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ESG – “Little ‘E’, Little ‘S’, BIG ‘G’ –100% of index funds are ESG focused (explicitly or implicitly) –Engagement is their only option to enact change ESG is is more of

• f a cos
• st

t of

• f capit

ital is issue e th than it it is is id ideo eologic ical –Governance is a proxy for

• r risk

risk that gauges the long term focus on management –Emotions and biases continually weig eighted hea eavi vier than facts! Mechanics of Index & Influence over sub-advisors forcing th the e Act ctiv ives to hop on the ESG bandwagon

• Buy High / Sell Low – major issue during market cor
• rrecti

tions

• Vanguard Windsor Fund example

How ISS and Glass-Lewis can potentially skew investor perspective

“The Vanguard Precedent”

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A variety of global institutions are now beginning to require greater ESG transparency:

• State Street = Governance Focus
• Vanguard = Climate Change
• SEB Blacklist
• Norges omission of Oil & Gas

This move has less to do with the ideological and focuses almost entirely on the lon long g term erm cos

• st of
• f capit

ital Determining whether or not management has accounted and planned for any adverse catalyst that can potentially eat away at future returns

Understanding the ISG

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The In Inves estor Stewardship ip Group (ISG (ISG) ) is a group of leading institutional investors and mega-mutual fund advisors who have established the Framework for US Stewardship and Governance. The Framework provides a set of basic principles of investment stewardship for institutional investors and corporate governance for public companies based in the United States.

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Connecting the Dots: Long-term Wealth Maximization and ESG

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Objective: ‘Institutional investors are accountable to those whose money they invest’

As stewards, the objective of investment management centers on wea ealth maximization over the very ery long-term:

• What other objective could be practically and logically applied to a U.S. public pension fund serving

tens or hundreds of thousands of beneficiaries or a mega-mutual fund advisor contractually managing the savings of millions of people at one time?

• The only reasonable path is for an investor steward to assume that the overwhelming majority of a

very large number simply wa want the the bes est t LON ONG TE TERM re return poss

• ssible for
• r the

the ri risk taken, resulting in the maximization of their wealth.

• Thus

Thus, every de decisio ion by y the these ins nstit itutio ions, whe whether it t invol

• lves ho

how w to

• investment the

the fund funds und under the the steward’s control, shareholder voting, or corporate governance advocacy, is to be guided by this

• b
• bjectiv

ive.

Key Con Consid ideratio ion: What are the long term risk catalysts that should substantially eat away at long term

returns?

Revised Mindset of the Activist

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“The inability of passive institutions to sell poorly performing stocks in their portfolios (due to their mandate to closely track underlying indexes) might make them willing and influential partners in an activist campaign…we sh show tha hat the he le leve vel l

• f pa

pass ssiv ive owne nersh ship ip is is si sign gnif ific ican antly rel elat ated to the he go goal als s of act activ ivis ist cam ampa paig igns ns…activists are more successful in obtaining

• ut

utcomes s rela lated to corporate governance or control, l, whic hich h ar are topic pics s tha hat receive consid nsiderable le attentio ion in in the he pr proxy voting guidelines of passive institutions”

– Standing on the Shoulders of Giants – The Effect of Passive Investors on Activism

“Because passive investors are unwilling to divest their positions in poorly performing stocks, which would lead to fund pe perform rmance de devia iating ing from the he be bench nchmark rk, the hey may place place an an even n greater weig ight than han act activ ive fund und mana anagers on

• n

ensuring effective governance in the firms they own…Corporate managers’ knowledge that these pa pass ssiv ive in inve vestors ar are e no not lik likel ely to se sell ll the heir ir sh share ares s an anytim ime so soon n may ay al also so gi give ve the he vi views s of pa pass ssiv ive in inve vestors gr grea eater wei eigh ght tha han n tho hose se of act activ ive man anag

• agers. The size of passive investors’ ownership stakes may facilitate activist investors’ efforts to rally support

for their demands.”

– Passive But Powerful – How Index Funds Exercise Their Clout

Revised Mindset of the Activist

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“Activism” is not a collection of people, it is a dis istin tinct philos ilosophy

Empirical Evidence Indicates “Thought Convergence” between Index, SRI/ESG, Activism and Long-Only Actives

• Critical Analysis - “Standing on the Shoulders of Giants” – Appel, Gormley and Keim

– Passive ownership is significantly related to the goals of activist campaigns

Mini inimal Utili tilization of

• f Der

eriv ivatives

• Approximately 75% of Activist Targets in 2016 were Small Caps (< $1B)

– Not enough liquidity in the small cap market / Less Relative Transparency – Corporate governance typically does not evolve with market cap – Inexperienced Boards / Perceived misallocation of capital

• Key liquidity event = Index Rebalancing

Th The Key to

• Vul

ulnerabil ilit ity:

• Holistic and objective evaluation of economic profile and corporate governance

What Constitutes An Activist Target?

The Mechanics of Share Accumulation

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Ind Index Rebalancing:

• Very “messy” to sort through due to the “Domino Effect”
• Takes a relatively long time for the dust to settle
• Calendar-based positive liquidity/volume event

Key Em Empirical Con Conclusio ion:

“While activists screen firms on the basis of fundamentals, they pick specific targets at a particular time by exploiting institutional liquidity shocks – our various analyses of activist targeting and daily share accumulation all lead to the conclusion that a liquidity channel is at work – uninformed institutional investors (index) selling provides camouflage for informed (activist) purchases, allowing the activist to quickly accumulate target shares and gain once he makes intentions public. These trading gains help cover the activist’s monitoring costs, making a campaign financially viable”

• “Institutional Trading & Hedge Fund Activism,” Journal of Financial Economics (August 2016)

What Constitutes an Activist Target?

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Co Comprehensiv ive, rela lativ ive and ob

• bjective evalu

luati tion of:

• f:
• Economic Profile
• External Corporate Governance Profile (ISS, Glass/Lewis, MSCI)
• Alternative capital deployment strategies
• Alternative capital structure scenarios
• Sum of the Parts Analysis

An evalu luation overla laps with ith how to

• attract addit

itional in index mon

• ney:
• Key Consideration = Does Performance align with PERCEIVED Potential?
• Everything else is simply just misdirection and noise!!

Continued Legislation Adjustment

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• Brokaw La

Law:

• Wants to “annihilate evil” and “bad” hedge funds…
• But clamors for short selling disclosure & transparency
• MiFI

iFID II: II:

• Permanently reshaping the soft dollar dynamic:
• Managers mus

ust pay pay sep separately for

• r res

research and advisory services received by banks and brokers

• Tax Reform
• The ultimate litmus test for the “new” emphasis on corporate governance and capital

deployment strategies

• HR

R 53 5311 11 – the Corporate Governance Reform and Transparency Act

Tax Reform - We Have Already Seen This Story…

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Tax reform, capital deployment and corporate governance case study:

• Americ

ican Job Jobs Cr Crea eation Act ct (2 (2004) - precedent for tax adjustment & repatriation

• Used tax reform as means to allow repatriation of overseas corporate cash

2011 Senate Report - Evaluated the “effectiveness” and results of the AJCA

• “Repatriating Offshore Funds – Majority Staff Report”
• Senate report found that an estimated 60-90% of funds were used to return

capital via buyback and divid ividend BE BEGS th the e ques esti tion – under the revised context and emphasis of today’s corporate governance, what is the expectation for a corporate’s given the current tax reform? Managemen ent t must understand how capit ital dep eplo loyment is is scru cruti tinized ed under th the e updated len lens of

• f cor
• rporate governance and adjust str

trategy acc ccordingly Aligning the best interests of the shareholders with management’s proposed use of “new” capital

FINALLY…

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HR 5311 – the Corporate Governance Reform and Transparency Act Index funds, activists, the shorts and long-onlys ALL over- emphasize the data provided by proxy solicitor

Protects investors and improves corporate governance of publicly- held companies by requiring proxy advisory firms to:

– register with the Securities and Exchanges Commission (SEC), – disclose potential conflicts of interest, – make publicly available their methodologies for formulating proxy recommendations and analyses

Why is this important?

• Proxy solicitors rarely have a complete understanding of the story
• Skews investor perception (usually towards the negative)

MiFID II – SMID v. LaMega

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The appeal of a SMID cap roadshow has been diminished The ramifications of MIFID II:

–Less coverage –Less understanding –Greater bias in research

How to overcome and plan if a SMID:

• SMID caps need to evolve more into their own internal corporate access teams
• Because of the continued contraction of the sell-side and ramifications of MiFID II,

the Generalist profile becomes even more important

Large and Megas – “cutting the fat” and combating the bias

• Less access to research = increased probability of misunderstanding
• Increased index exposure = much “bumpier” ride on the back-end so critical to lay

seeds with variety of value investors

Fewer People + More Stocks = Less Understanding

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22

Accordin ing to

• Kelly

lly Research: “Up to now, essentially, asset managers have paid a ‘bundled’ fee for these services, together with payments for actual execution…the amount of money spent by asset managers on research and advisory services will decrease. Estimates vary wildly on the level of decrease, from catastrophic to merely deeply impactful. That is highly likely to mean any or all of the following – fewer analysts, less coverage of virtually all stocks (particularly small and midcaps); and a thinner spread of research, so less in- depth stock by stock analysis.”

The Convergence of Mentalities

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• Fewer people covering more stocks
• Inability for divestment and the desire among index money to continue

performance

• A greater desire to micro-manage and express opinion
• Less reluctance to take action on a perceived inefficiency
• The pursuit of control – what mechanism provides an avenue for control

(ESG)

• Focus on recalibrating the dynamics of the board and/or management to

execute desired objectives

OK, Great…Now What?

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Establish a relationship with the corporate secretary and GC

• Review ISS, Glass-Lewis, MSCI reports
• “Cross-Coordinate” PMs and actively seek out governance contacts on the index side

If a “best-in-class” ESG program is the goal = aim for Dow Jones Sustainability Index Diversify the story - establish and present a variety of investment themes to the market, including a very distinct generalist profile Understand the “revised” activism and proactively gauge vulnerability

• Could be a function of economic profile and/or governance
• Case study – it is usually both

Never stop “laying seeds”

• Rather than hitting reset at every market cap threshold, establish messaging with “aspirational”

investors Never Stop Learning…the trend is constantly evolving

Questions / Discussion

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