Financial System and Corporate Governance Impacts of Passive Management Maureen O’Brien VP Segal Marco Advisors Julian Regan SVP Segal Marco Advisors June 12, 2018 Copyright © 2018 by The Segal Group, Inc. All rights reserved. Agenda The 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 2 Background Passive vs. Active Investing Definitions 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. 3 Executive Summary Financial System Impacts of Passive Management 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. 4 Background Passive Management Response to Concerns about Market Impacts BlackRock Estimate: Global Equity Ownership (Trillions) $38.7 $11.9 $17.4 Index Funds Actively Managed Remaining Funds Source: Reuters, October 3, 2017 Passive Management Industry Response 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 Note: Sample information. Not all inclusive. 5 Background Ownership of U.S. Equities Ownership of Corporate Equities (2013) Other 8% ETFs 4% Hedge Funds 3% International Investors 14% Government Retirement Funds 8% Pension Funds (non-Public) 9% Mutual Funds 20% Households 34% Source: Federal Reserve Board, Lionshares and Goldman Sachs Global ECS Research. 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 “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 6 Background Public Equity Ownership: Active vs. Passive Management Exhibit 1 Exhibit 2 100 Largest Public Pension Funds Public Funds: Assets (Billions) FY 2016 Average Asset Allocation 3,785 47.6% 2,466 23.2% 24.9% 4.3% 2009 2017 Public Equities Fixed Income Alternatives / Cash/Other Real Estate Source: U.S. Census Bureau. Source: National Association of State Retirement Administrators (NASRA). 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. 7 Background Passive 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 ● 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. “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. 8 The Rise of Passive Management Capital Flows Net Mutual Fund Flows (Billions) 2016 (est) (400) Active Mutual Funds Index Fund Flows 200 Index Fund ETFs 286 Source: Bloomberg.com, U.S. ETFs 2017 Outlook 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) “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 9 The Rise of Passive Management Growth of Equity Index Mutual Funds EQUITY INDEX FUNDS MARKET SHARE* 34% 16% 4% 0% 1985 1995 2005 2015 Source: CFA Publications. John C. Bogle. January/February 2016 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. “…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. 10 The Rise of Passive Management Historical Performance Exhibit 1 Exhibit 2 % Active Managers Underperforming U.S. Equity Active Funds Outperformance Benchmark Periods Ended 2017 February 1, 1998 - January 31, 2018 U.S. Large Cap Core U.S. Mid Cap Core U.S. Small Cap Core 60% 91.1% 85.0% 86.3% 88.8% 84.2% 80.5% 63.0% 32% 44.4% 47.7% 5 Yr 3 Yr 1 Yr Down Markets Up Markets Source: SPIVA Scorecard Source: Morningstar, February 28, 2018 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). 11 The Rise of Passive Management Reasons for Active Manager Underperformance CFA Survey Reasons for Active Manager Underperformance Active managers' lack of opinion diverstity 5% Lack of thorough analytical due diligence 5% Other 10% Concentration of top performing stocks 10% Active managers' short-termism 13% Managers cannnot compete with market intellegence 15% Benchmark, stylebox and tracking error constraints 18% Higher Expenses of Active Management 24% Sources: CFA Institute, Jason Voss, CFA, October 2015 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). 12 The Rise of Passive Management Investment Management Fees Exhibit 1 Exhibit 2 Mutual Funds Hypothetical Management Fees (%): Average Expense Ratio: 2016 Active vs. Passive Passive