By Abe M. Friedman – Chief Executive Officer, CamberView Partners
In early January, activist hedge fund JANA Partners and the California State Teachers’ Retirement System (CalSTRS) announced a remarkable partnership. Together, the two investors sent a letter to the board of Apple Inc. asking the company to take steps to combat what they termed the ‘unintentional negative consequences’ of the overuse of technology by children and teenagers.
What makes this new shareholder campaign unique is not the actual request, but what it signifies – the fully-fledged emergence of environmental, social and governance (ESG) topics into the mainstream of almost all areas of investing, including activism. Understanding the forces that helped to create this phenomenon, and how it has grown alongside the rise of passive investing and shareholder engagement, is instructive in determining where this trend may go next.
ESG and the rise of passive investing
While the origins of incorporating ESG factors, such as climate risk, diversity and human capital management, into investing, lie in the world of socially responsible investing, it is the emergence of index investing that has catapulted these topics into the mainstream. Here’s why: as assets shifted into passive strategies over the last decade, shareholder registers have been reshaped. According to a recent Morningstar report, global assets under management in traditional index funds and electronically traded funds (ETFs) have grown to $8.1trillion, up from $1.8trillion a decade ago. This has corresponded with a dramatic rise in total market share of passive funds over the same time period: 17 per cent to 36 per cent in the United States, 17 per cent to 42 per cent in Japan and seven per cent to 16 per cent in Europe.
This market shift has led to a concentration of assets under management within passive strategies of three major global players – BlackRock, State Street Global Advisors and Vanguard – which now collectively manage more than $14trillion. These large passive funds, which take in hundreds of billions in new assets annually, are in an ever-present fight for market share amid downward pressure on fees. Because competing solely on costs has become increasingly difficult, index investors must continue to differentiate themselves by identifying topics that matter to the asset owners deciding which index asset manager can be trusted as the best steward of capital.
ESG and shareholder engagement
It is this competitive dynamic that has helped to jumpstart one of the main drivers of the rise in prominence of ESG topics in investing: the growth of shareholder engagement. The current push for more disclosure and engagement on governance in the US can be tied to a series of external events that brought the importance of risk management into stark relief. The oversight failures of accounting firms and a handful of public companies in the early 2000s followed by the financial crisis spurred increased investor interest in understanding how boards were overseeing business risks. Importantly, Dodd-Frank reforms brought about the advent of say-on-pay, a new platform for annual votes on executive compensation.
It was the sensitivity of boards and management teams to votes on compensation that triggered an uptick in outreach by issuers seeking to understand the perspectives of their investors. Over time, those conversations became more frequent (in 2017 nearly three-quarters of the S&P 500 disclosed that they engaged with shareholders in their proxy statement) and also more robust. Discussions also began to include other issues of interest to investors, such as board independence and composition, climate risk, political spending and employee working standards.
The evolving landscape
The landscape of engagement and ESG matters has continued to evolve. Today, index investment firms hold increasingly prominent positions in shareholder registers. With no option to sell the shares they hold as long as a company remains in the index, index investors are facing pressure from regulators and the markets to demonstrate that they are looking out for investors’ interests. The past several years have seen an uptick in CEO letters and other communications from the big three investors on the importance of managing ESG risk topics as well as commitments to enhance the size and breadth of investment stewardship teams. As these engagement strategies have become ‘best practices’, the impetus for smaller asset managers to beef up their own engagement efforts on ESG topics has also increased.
“As activists have become increasingly focussed on winning the support of proxy voting teams at institutional investors in their campaigns, they have become more adept at incorporating messages that speak to the concerns of this bloc of voters”
With several years of engagement now under the belts of many issuers and investors, the equation has begun to shift yet again. In instances in which issuers’ response to engagement is viewed as ineffective by investors, there are now consequences at the ballot box. For example, while shareholder resolutions on environmental topics for many years failed to garner more than 20 per cent of votes cast, in 2017 climate change disclosure resolutions passed for the first time at several major energy companies.
Large institutional investors are making their voices heard in other ways, too. Last year, State Street Global Advisors voted against directors at 400 companies it believed had not made efforts to increase board diversity and the New York City Pension Funds began a new campaign seeking enhanced disclosure of the diversity, traits and skills of board directors. In 2018, issuers can expect even greater support for these types of disclosures from investors across the spectrum.
ESG goes beyond mainstream investing
To better understand what new directions ESG topics in investing may take, the JANA/ CalSTRS example is illuminating. Hedge fund activists have traditionally focussed almost exclusively on economic issues in their campaigns. However, most activist campaigns are also driven by a ‘hook’ – an easy-to-grasp reason why a company would benefit from that investor’s intervention. Over the past several years, one trend in activism has been the rise of governance topics used as hooks – excessive CEO compensation, voting thresholds and the independence of directors are common issues that are layered on top of existing economic criticisms. As activists have become increasingly focussed on winning the support of proxy voting teams at institutional investors in their campaigns, they have become more adept at incorporating messages that speak to the concerns of this bloc of voters.
While several activist campaigns in recent years have focussed on criticisms of board oversight of environmental and social topics, the JANA/CalSTRS partnership signalled the opening of a new front. Not only was this an activism campaign co-led by an institutional investor focussed solely on a social topic, but it also served as the launch of a first-of-its-kind sustainability-focussed activist fund. As activist market participants come under pressure to satisfy commitments to clients and organisations, such as the Principles for Responsible Investment, around ESG goals, and seek to more effectively position themselves and build relationships with a broader group of investors, these tactics may become increasingly common.
With the 2018 proxy season fast approaching, a few trends are clear. Institutional investors will continue to put ESG topics front and centre with their portfolio companies. Issuers will need to be prepared for further escalation of this pressure by clearly demonstrating the rigour with which management and the board evaluate, disclose and manage ESG risks through proactive engagement. Activists will continue to explore new avenues to gain leverage over companies while satisfying the demands of their own investors. Where the sustainability trend heads next will be determined by the dynamic intersection of passive investing, engagement and activism.
About the Author:
Abe M. Friedman is the Chief Executive Officer and a founder of CamberView Partners. Before founding CamberView, Mr. Friedman was Managing Director and Global Head of Corporate Governance and Responsible Investment at BlackRock, served as Global Head of Corporate Governance at Barclays Global Investors and was a founder of Glass Lewis.
