Demystifying The Index Funds

index fundsThe record level of global assets flowing out of “actively managed” investments and into
index funds – more than $1 trillion over the past three years – has concentrated
significant voting power at U.S. public companies with just a few key institutional
investors. Index funds are awakening to their influence and the responsibilities
associated with their place at the top of the shareholder register, and are increasingly
driving the voting results of M&A transactions, proxy fights, compensation and other key
corporate proposals. They also are elevating the prominence of environmental, social
and corporate governance (ESG) issues.

At the same time, hedge fund activists are adjusting their tactics and trying to build
relationships with the index funds. While index funds have historically tended to be more
patient than their actively managed counterparts in supporting companies, this trend
cannot be taken for granted.

These shifts are rapidly changing the investor relations function. Major strategic
outcomes – those involving a shareholder vote – will increasingly be decided by a few
investors who might have little prior exposure to any given board and management
team. The index funds are substantially growing their staffs to increase the levels of
engagement with public companies.

The rise of passive investing has thus elevated index fund-focused investor relations –
“Index IR” – to a board and C-Suite imperative. Advance preparation and a refreshed
approach to investor relations (with active participation by independent directors) are
essential to achieving successful outcomes.

We provide here our current assessment of the shifting power dynamic associated with
the rise of index funds, key considerations around index funds and activism and
Evercore’s Top 10 Insights for Shareholder Engagement in 2018:

Index Funds’ Priorities

The major index fund managers – in particular BlackRock, State Street Global Advisors
and Vanguard – now collectively manage over $13 trillion in assets. Historically the
realm of the back office, the “investment stewardship” functions in these funds are now
the primary interface with U.S. public companies. Many companies have found some
index investors to be unresponsive to requests for meetings. That dynamic will likely
change as these stewardship groups are expected to dramatically increase in size, and
top management at these index funds have heightened their focus on increased
engagement. The index funds cite commercial demand and fiduciary obligations as
rationale to increase their dedicated resources to corporate governance.

“Proxy voting records show that in a contested election, actively managed funds are much more likely than index funds to support an activist’s proposal.”

Perhaps as a result of this increased focus, index funds have become more outspoken
on their priorities which often differ from traditional investment considerations. Index
funds want to discuss corporate purpose, long-term strategy and corporate governance
matters, all in the name of long-term value creation. They are prioritizing issues such as
ESG, climate risk and human capital management. They want to know, for example,
how the board operates, its composition and tenure, board and management
succession planning processes and how the board achieves diversity.

In line with these priorities, engagement with independent board members is now
expected by index funds. Although management is still the primary point of contact for
investors, more companies report making an independent director available for
engagement with shareholders, although such director engagement principally occurs
with index funds. These discussions are no longer narrowly focused on specific voting
items such as Say-on-Pay.

Activists and Index Funds

Proxy voting records show that in a contested election, actively managed funds are
much more likely than index funds to support an activist’s proposal. Index funds do not
have the same performance pressures, and may be more skeptical of an activist’s
proposal because they do not have the option to sell if the activist’s plan does not work
out. However, index funds will occasionally support activist campaigns. Index funds’
governance personnel typically work closely with their internal “active” colleagues on
voting issues requiring valuation analysis, like proxy fights and M&A. This means that
performance pressures may indirectly filter into the voting decisions of index funds.

Further, activists are increasingly gaining seats at the table of mainstream investor
initiatives, in a bid for exposure and legitimacy. For example, the Investor Stewardship
Group (ISG), representing over $20 trillion in assets under management, launched in
early 2017 to create basic standards of investment stewardship and corporate
governance for U.S. investors and boards. BlackRock, State Street Global Advisors
and Vanguard were among the founding signatories of the ISG, an organization that
also includes activist hedge funds. Moreover, representatives from four prominent activist hedge funds now sit with the three primary index fund managers and other funds
on the important Council of Institutional Investors (CII) Corporate Governance Advisory
Council13. These new “partnerships” create multiple opportunities throughout the year
for activists to have numerous interactions with the index funds, strengthen their
relationships and possibly gain support for their campaigns – all while companies
generally do not have similar frequent opportunities to interact with index funds.

We are also seeing some combinations of traditional activists with ESG activists. For
example, JANA Partners LLC and California State Teachers’ Retirement System
recently sent a joint letter to Apple urging the company to develop new software tools to
help parents limit their children’s phone use, citing the potential for consumer
backlash. A skeptic might conclude that this newfound interest of activists in ESG
issues is motivated by the activists’ desire to garner favor with index funds, who have
highlighted ESG issues as important to their constituencies. This new ESG activism
also potentially introduces a new suite of wedge issues that might help activists in their
traditional campaigns.

It is clear that traditional corporate IR needs to evolve in light of these trends. Here are
10 issues for boards and management teams to consider in navigating the changing
shareholder world in 2018 and beyond.

Zach Oleksiuk
Zach Oleksiuk is a Managing Director in Evercore’s Strategic Shareholder Advisory Business. Zach was previously Head of Americas for BlackRock Investment Stewardship and worked at Institutional Shareholder Services (ISS) in various roles.