Compulsory stewardship by passive managers moves closer

Large passive fund managers will ultimately be compelled to provide "stewardship" of the companies in which they invest, in order to stem a shortfall in corporate governance, the chief executive of a major fund group has said.

Saker Nusseibeh, chief executive of London-based Hermes, which manages £28.6bn of assets and conducts engagement on behalf of a further £134bn, argues the move will be necessary to combat the growth of so-called "ownerless" corporations, whose shareholders largely act as "absentee landlords".

His comments come amid the rapid growth of passive vehicles, particularly exchange traded funds, even as investors and industry commentators are calling on asset managers to play a more active role in the oversight of listed companies.

"With this move to indexation, there is no one engaging with companies on behalf of shareholders. You have this increase in ownerless corporations," said Mr Nusseibeh.

Any move towards compulsion would be likely to raise costs for passive managers, partially erasing their cost advantage over active managers. Hermes Equity Ownership Services, which engages on behalf of the £134bn of assets Hermes does not manage itself, has 26 employees.

"I think at the end of the day they are going to have to provide stewardship services. That is a very expensive prospect. Then you cannot change one basis point [for an ETF]," says Mr Nusseibeh.

"[They would need] senior analysts and engagers. The cost structure is the same as active management. The cost of the index funds becomes exactly the same as the active funds," he adds. "That is not attractive to the [ETF] industry because it compresses margins."

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Thus far, the debate around the remedies that could be imposed on large asset managers or funds declared to be Sifis has centred on raising capital requirements or imposing "living wills", allowing them to be wound up safely in an emergency.

However, compelling a level of stewardship activity would stop the largest houses from acting as "free riders" - benefiting from the engagement activities of others but not contributing towards the cost.

The biggest managers have already made nods towards increasing their engagement. Last month BlackRock, the world's largest manager (and passive manager), with £4.8tn of assets, backed an initiative by the Canada Pension Plan Investment Board and McKinsey, the consultancy, designed to foster dialogue between companies and their long-term shareholders.

Bill McNabb, chief executive of Vanguard, the number-two manager (in both absolute AUM and passive assets), with $3.1tn in total, recently wrote to the chairmen of several hundred companies outlining proposals to strengthen the relationship between board directors and long-term shareholders.

Despite this, several industry figures see some merit in Mr Nusseibeh's suggestion.

Professor John Kay, author of the UK's 2012 Kay Review, which criticised the lack of engagement by asset managers with investee companies, says there is "something to be said" for stopping the biggest groups with the deepest pockets from being free riders.

"I want to put pressure on the larger managers to [engage]. I would not necessarily be opposed to some form of compulsion," says Prof Kay, although he adds he "would prefer to see it happening because people realise the benefits than because they are made to do it.

"What are we going to get if we are just going to judge the impact by expenditure rather than output?" he asks.

Prof Kay suggests it is in the interest of passive managers to engage. If they helped increase the value of their investee companies, this would raise their assets under management and thus their fee income. Moreover, given the economies of scale afforded by their size, the costs they would accrue per million dollars of assets would be tiny.

Amin Rajan, chief executive of Create Research, an asset management consultancy, says: "I can see the merits in Saker's argument. In principle, I would say it is a good idea, but the devil is in the detail.

<>"At some stage we need to really up the debate about governance. Even where there are active shareholders they are not able to make much difference because the number of shares they own is not enough to make much difference," he adds.

"ETFs really do sever the link between investors on one hand and the companies on the other."

Mr Rajan believes that compulsion is more likely in Europe, particularly Scandinavia, than in the US, where the largest asset managers are based but "shareholder engagement is not a big issue".

He also thinks it would be unfair if the large passive houses were forced to adopt stewardship services, but not large active managers that currently do little in this field.

Paul Lee, head of corporate governance at Aberdeen Asset Management and a former director of Hermes EOS, believes that, despite "pretty dramatic" improvements, asset managers as a whole are still not doing enough on stewardship.

Moreover, it is "hard to say with confidence" that the large passive houses "have enough resources to cover the waterfront", he adds.

Mr Lee is unconvinced a requirement to engage should be imposed on recalcitrant managers. He argues instead that clients should see engagement as a "normal part of running other people's money", something he believes is happening increasingly.

Mr Lee also sees a rationale for passive managers to beef up their stewardship activities. He views it as a way to differentiate themselves from their rivals and improve the "stickiness" of their assets.

Despite this, Mr Nusseibeh is determined to do all he can to ensure compulsion is introduced for the largest passive houses.

"That is my new crusade to change the industry. If it does not happen, then executives and institutions become remarkably powerful. Because of the rise of the indexers, there is nobody talking to them," he says.

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