Within the next seven years, passive investments, such as index and exchange-traded funds (ETFs), are set to outpace active investments and achieve a leading share in the U.S. market, according to a February 2017 report by Moody’s Investors Service. Moody’s says that passive investments currently account for $6 trillion in global assets and 28.5% of assets under management in the U.S.
Outside the U.S., the penetration of passive investments is slightly less dramatic, with an estimated 5% to15% of assets being managed this way, says Moody’s. The research report suggested that passive investing outside the U.S. has room to grow as markets mature and investors become more aware of non-active investment products.
The trajectory of growth in passive investments has put many IROs in a quandary. Should IROs make attempts to widen the share of actively managed funds on their rosters? Or should they take pains to meet with large holders that are index funds or ETFs, even though the fundamentals of a company’s story won’t spur them to increase or decrease their current holdings?
The rise of passive investing also has some profound implications for how the discipline of IR is practiced. For many IROs, a key takeaway is that with a smaller pot of active assets to vie for, it’s important that public companies up their IR games.
Paul Malcolmson, Director of IR for TMX Group, notes that most IROs dedicate the lion’s share of their time and effort to actively managed funds – and that’s how it should be. “When you’re going into a city with a bank, the bank knows its clients. They’re not going to put you in front of people who don’t have discretionary money and are not actively managing something.”
That said, Malcolmson is convinced that the smaller pot of actively managed funds out there is changing the way that IROs need to tell their stories to, and interact with, shareholders. “Some managers may have less to manage, and so there might be more competition for where they’ll invest that smaller amount of money,” he says.
Malcolmson notes that TMX Group now lists over 450 ETFs. “There’s no question,” he says, “that there’s a real trend toward passive investing.”
Getting to Know Passive Investors
The steady rise of passive forms of investing is a natural outgrowth of a Nobel-Prize-winning thesis called the Efficient Market Hypothesis, which has held sway for more than a century, explains Eric Kirzner, Finance Professor at the Rotman School of Management at the University of Toronto.
Kirzner notes that in the “age-old debate of passive versus active investing,” adherents to the Efficient Market Hypothesis believe that a securities price reflects all publicly available information and so there’s no real advantage to finding a money manager with exceptional stock-picking prowess.
“The logical extension of the Efficient Market Hypothesis is to just buy the index – and you’d be in good company,” says Kirzner. Active investing does have many passionate adherents, too. “Should everyone index?” asks Kirzner. “Why, of course not. There are active managers who will outperform, but the challenge is how to find them.”
Adam Cohen, Director of Finance and Investor Relations at AGF, an independent investment management company based in Toronto, is attuned to the differences between his company’s active and passive shareholders. He performs a shareholder ID exercise monthly and, among other things, looks at which investors are active and which are passive.
Regardless of which bucket a firm falls into, Cohen reaches out to managers who have taken a large position in AGF stock. “It’s like any form of client service,” he says. “You need to make sure that you provide value to your important stakeholders.”
Cohen notes that while many passive investors will decline the offer of a one-on-one meeting, reaching out to them is important nonetheless. What’s crucial, he says, is making sure that all fund managers have the IRO’s name and contact information, should questions arise. “The majority of passive investors decline a meeting; however, it’s important to leave the door open in case the situation changes.”
Another critical reason for IROs to reach out to passive investors is the benefits from better understanding the esoteric ETFs and index funds that are popping up all around them.
In a world that’s moved far beyond one index apiece for the TSX, the Dow and the S&P, IROs often find the parameters of each to be something of a mystery. Understanding these indices is important, though, says Cohen. “You need to understand the rules of these indices so that you can be in front of issues before they arise as there can be a significant impact on your stock’s volume,” he says.
Sylvia Groves, President and Creative Director for Governance Studio in Calgary, agrees. “There are more passive funds out there, and they’re starting to specialize,” she says. “There may be ones looking at ESG, or environmental, social and governance aspects, or they may be focused on another very particular area."
Carol Hansell, senior partner at Hansell LLP, notes that hybrid funds are increasingly popular. “The lines are blurring in terms of what’s an index firm and what’s not,” she says. “It’s really problematic to put any investment vehicle into a clear category by talking about ETFs or index funds” as if they’re monolithic, she says. “Often people within one of those categories can make their own decisions about how they manage, and so we’re seeing more of a hybrid kind of approach,” she adds.
Since passive funds don’t all look alike, the impetus for IROs to introduce themselves is growing. “Some of these funds have the power to make decisions and there’s lots of information they need,” says Hansell. “And even if they’re investing based on the index rather than selecting the investments themselves, they’re nevertheless impacted by the decisions that the company makes. They don’t want to be kept out of the loop.”
Hansell also emphasizes the need to learn from index funds because they are occupying an increasingly large percentage of the shareholder roster. “People think of the investor relations function as a function that is focused on disclosure and giving information out to investors. But a very important aspect of the IR professional’s job is understanding the investor base and what’s important to them. So the listening function for an IR professional is almost as important as the disclosure function.”
Knowing what attributes are keeping a company on an index or in an ETF can prove critical. If, for instance, a company’s market cap dips, that company might find itself unceremoniously dumped from one or more indices and the hit to the shareholder roster can be painful.
An Attitude Change?
Another reason to pay attention to passive investors is that they, too, cast votes and management might need their support in a close shareholder contest.
Hansell notes that while many ETFs vote with management, the size of the passive block is growing – and this is altering the dynamics for governance. “You want investors who are ideally supportive of the direction that management is taking,” she says, “and they’re more likely to be supportive if they’re connected when they want to be.”
Groves agrees: “Passive investors still have a vote. And it’s important to understand what their issues are, whether they’re going to agitate if something comes up...that they don’t like, and what they’d like to see out of governance.”
AGF’s Cohen points to another advantage of engaging with passive fund managers: the opportunity to learn more about – and perhaps even win – investment dollars from actively managed portfolios at the same firm.
“The very large investors – the CPPIBs and the Ontario Teachers’ [Pension Plan] – have a whole range of funds, just like BlackRock and Vanguard in the U.S.,” says Hansell. “Part of their investment strategy is to diversify the manner in which they hold assets, and so they’ll hold some in an active form and some in a passive form.” By meeting with the passive side of the business, an IRO can sometimes get valuable introductions to other portfolio managers inside the organization.
Finally, Hansell points out that passive investors can provide much-needed stability.
“ETFs typically own stocks for a long period of time,” says Hansell, “and when you get to index funds, they’re essentially permanent owners of the companies within an index. For that reason, you could make the argument that ETFs and index funds are more long term in their interests in a company [than are active investors].”
Hansell points out that many issuers have found themselves hamstrung when it comes to discussing strategies with slow-to-materialize payoffs or even ESG issues because many investors are far too preoccupied with quarterly results. “The more companies can rely on long-term investors, which might be passive investors who are holding the index, the more they can focus on the long term because they’re not being held as accountable for short-term results,” she concludes.