Does paying passive managers to engage improve ESG performance?

‘Does paying passive managers to engage improve ESG performance?’ is a paper by Professors Marco Becht, Julian Franks, Hideaki Miyajima and Kazunori Suzuki. The paper is the recipient of a prestigious PRI (Principles for Responsible Investment) 2023 award.

Marco, Julian and Kazunori visited Oxera on 14 September 2023 to present their paper to, and discuss their findings with, a specially invited audience of industry insiders. We summarise the main points from the discussion below.

The paper’s findings are based on an elegant quasi-natural experiment. Some findings are the results of a difference-in-difference regression analysis, that shows the extent to which the treatment group of investees diverged from the control group after passive managers were paid to engage on Environmental, Social, and Governance (ESG) issues with the treatment group. Other findings are the result of an event study that shows the divergence between treatment and control groups after ‘passive managers’ rewarded companies that have high ESG scores, (i.e. the treatment group), with additional investment. Prior trends in the treatment and control groups were carefully analysed to avoid contamination of results. Sample sizes were large, as the co-operating passive manager was GPIF, Japan’s Government Pension Investment Fund.

A finding of particular interest is that, contrary to the earlier results of Berk and van Binsbergen that ESG divestitures do not have an impact on the cost of capital of targeted firms¹, entry into and exit from indices resulting from the actions of passive managers did result in abnormal stock price movements. It was further found that paying passive managers to engage on ESG did have real-world effects, specifically on Governance. These important findings mean that the paper also bears on a wider range of policy and commercial issues. We discuss some of these issues below and suggest that further debate and engagement on these is desirable.

The policy trade-off between encouraging passive investing because it can save resource costs and increase the accumulation of pensions, and discouraging passive investing because, as its share of the overall market increases, market efficiency is likely to decline

The findings suggest that the case for discouraging passive investing may be weaker than previously appreciated, given the influence that passive managers were able to achieve. There remains, however, an important public policy question about how to create incentives and a market design that will balance the individual private interest in saving costs and the broader public interest that costs need to be incurred to support research, trading and monitoring.

The issues are explored in ‘Does the growth of passive investing affect equity market performance?: A literature review’ by James et al, FCA, 2019.² In the BIS Quarterly Review, Sushko and Turner³ found that passive funds helped market stability in periods of stress, which is an important consideration, given the cost of crises.

What is meant by active and passive management

It seems fair to observe that the design of the experiment could be considered to undermine the notion that active and passive management need to be stark, polar opposites. Active managers could say that the results achieved by the passive managers in the experiment were driven by a degree of activism. For example, the paper assesses the effect of ‘tilting’, whereby GPIF invested more in companies that had improved ESG scores and entered the index.

This raises the question of whether a limited, hybrid model is socially attractive. For example, many funds could be largely passive, saving most of the costs of active management, but active with respect to corporate governance, thus providing an important market discipline on investees.

The extent to which passive funds can make themselves attractive to investors who care about ESG issues and may believe that active investing is the only form of investing that will drive forward the ESG agenda

An inference that might be drawn from the paper is that, if it is clear that passive managers can exert influence on ESG issues, why should those who care about ESG pay the higher costs of active management?

One answer to this is that most passive managers are not dishing out the treatments used in the experiment in the paper. Moreover, if they did, what would be the effects on their costs and performance?

Another answer is that the findings may be influenced by the structure of the national market in which the experiments took place. GPIF is the largest player in the Japanese equity market. It should be noted, however, that the authors make rigorous cross-country comparisons that take into account national trends.

How active managers need to differentiate themselves from passive managers in order to justify the higher charges that they typically levy

The answer to this partly depends on the strength of the case for the ability of passive managers to be influential, as discussed above. It is also worth considering the differences between how passive and active managers influence investees. The scale of votes cast by passive managers may make them influential. Active managers can and do engage directly with investee management on strategy and other important matters. This pre-emptive, targeted approach may be important.

Separately, it is worth noting that while passive investing is increasing its share of total investment in most countries, there is no sign yet of a tipping point at which active management becomes a niche activity. Therefore, to the extent that consumers understand the differing business models of active and passive managers, and the significance of seemingly small differences in the charges they levy, the market has provided evidence through revealed willingness-to-pay that a high proportion of consumers is still willing to pay for active management.

Nevertheless, active managers might consider whether they can make any of the services they offer more salient in the minds of consumers choosing their asset managers. For example, is it certain that itemised prices of a kind associated with unbundling of different services would suppress overall revenues, given this would clarify what the consumer gets from active managers? The relevance of the paper to unbundling is discussed below. It would also be interesting to see whether a mid-priced, hybrid model, as described above, attracted a high willingness-to-pay.

Unbundling

Proponents of unbundling argue that it would enhance competition, help principals to discipline their agents and reduce over-consumption of bundled services. It has nevertheless faced significant opposition, for example on the basis that it would lead to important services such as research, which may be critical for market functioning, being under-consumed, leading to a significant cost in the form of lost positive externalities.

While the quasi-natural experiment documented in the paper fell well short of complete unbundling, the payment of a separate fee for active engagement put a form of unbundling into practice (or perhaps more accurately, added a new, separate service that previously did not exist). It is not obvious that this partial unbundling has had any negative consequences in the market.

Can passive investors influence innovation in firms and, if so, is there any justification for regulating this influence?

This is a topic of active debate, perhaps surprisingly for those whose starting point is that passive investors are just that: passive. In 2021 a review by the IMF concluded that passive investors tend to increase innovation activities, albeit in a risk-averse way—that is, by deeper exploitation of existing knowledge rather than through exploring new technologies.⁴

The paper by Becht et al. shows that passive investors can indeed hold a channel of influence on investees’ decisions, which indirectly offers some support for the IMF’s findings. This raises a question about the strength of the public interest in governance of such channels of influence, though presumably there is no reason to regulate passive managers in ways in which active managers are not regulated.

However, a developing theme in public policy is that risk-taking by regulated firms has fallen below socially optimal levels, leading to suppression of growth, because of regulatory impositions. Thus, one policy prescription put in place is a requirement that independent regulators (in the UK) take account of competitiveness and growth in carrying on certain functions. It is not yet clear how successful this policy will be.

Therefore, going forward, other policy prescriptions to address suppression of risk-taking may need to be considered. The paper by Becht et al. might contribute to the case for including passive asset managers within the scope of such policies, while the case for including active asset managers is more obvious. It is clear, however, that any such policies could be highly intrusive upon business models and lead to perverse effects.

Can passive investors influence governance in firms, and could this soften competition when the same passive manager invests in firms that are rivals in some of their product markets?

This is an analogous point to the previous one. In 2016, Appel et al.⁵ exploited variations in the proportions of passive institutional ownership found in the Russell 1000 and 2000 indices when firms shift between the two to show that passive investors can and do influence governance in firms. For example, passive investors reduced support for management proposals and supported shareholder initiatives.

Again, this is implicitly supported by the paper by Becht et al., which therefore reinforces the case for considering whether the influence of passive managers on corporate governance may conflict with the public interest and, if so, what, if anything, could usefully be done about it.

The underlying intuition here is that some passive managers are now so much bigger than active managers that they hold proportions of the shares of listed firms that are large enough to make the managers of the listed firms care considerably about how the associated voting rights are exercised.

While this impact on corporate governance may seem abstract, there is legitimate concern that, for example, it can bear upon how investee firms compete in markets across the economy. This may be important because passive managers do often hold shares in rival firms and have obvious incentives to soften competition between these firms, the obvious incentives being higher accounting profits—leading to higher dividends and/or higher share prices.

It should be noted, however, that Oxera has already considered carefully whether this situation is as yet leading to outcomes that are materially contrary to the public interest. The conclusion was that the evidence is limited and mixed, and precipitate regulation should be avoided.⁶

Index design and links to outcomes

Finally, an interesting aspect of the paper is its exploration of the complexities of the design of different types of indices. They are produced by different methodologies, and lead to different ESG scores and trends. Further research on how well different indices capture actual changes in, say, carbon emissions and other measures of pollution is clearly needed.

¹ Berk, J. and van Binsbergen, J. (2021), ‘The Impact of Impact Investing’, 21 August.

² James, K., Mittendorf, D., Pirrone, A. and Robles-Garcia, C. (2019), ‘Does the growth of passive investing affect equity market performance?: A literature review’, Financial Conduct Authority research note.

³ Sushko, V. and Turner, G. (2018), ‘The implications of passive investing for securities markets’, Bank for International Settlements Quarterly Review, 11 March.

⁴ Yang, Y. (2021), ‘Are Passive Institutional Investors Engaged Monitors or Risk-Averse Owners? Both!’, IMF Working Paper, 21/158, June.

⁵ Appel, I., Gormley, T. and Keim, D. (2016), ‘Passive investors, not passive owners’, Journal of Financial Economics, 121:1, July.

⁶ Oxera (2018), ‘The threat of common ownership: real or imagined?’, Agenda, October.