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The not-so-passive passenger

Quill account manager Tom Climie explores the trend towards greater engagement among passive investment vehicles

A few years ago, having recently left school I went on a road trip through Europe. I had not yet passed my driving test so assumed I would have the luxury of just being a passenger. But that wasn’t to be the case! I was required to participate in the journey by guiding us down through France to Barcelona and back across the south of France via Aix-en-Provence. I did so with mixed success but we made it back to England in one piece and right on schedule. 

The proliferation and ever increasing popularity of passive investment strategies means passive fund managers now own over 20% of the UK stock market either through tracker funds or ETFs (Asset Management in the UK 2014-15). One might be forgiven for assuming that they are simple passengers on the investment journey, as I wished I was on my road trip. With a focus on index replication rather than the underlying constituents they ride along with the research, price discovery and market movements created by the active managers.

This brings me to my introduction because passive managers are being encouraged to adopt greater engagement tactics, and are increasingly doing so. Although the average holding period of UK equities is now less than a year, down from a period of eight years in the mid-60s, it is the passive managers who are the long-term holders of UK companies. Whereas active managers can completely sell-out of a company, a passive investor cannot and must own a business until it drops out of the index, which could take some time to happen. Issues such as stewardship and good corporate governance are therefore of real importance to passive managers. 

To stretch my road trip analogy to an extreme, although passive managers don’t drive the car it is in their best interest to have a good journey.  A number of studies, in particular some very thorough research by Deutsche Asset & Wealth Management and Hamburg University (ESG and financial performance: aggregated evidence from more than 200 empirical studies), have confirmed that there is a positive relationship between ESG credentials and corporate financial performance. It makes sense: well-run businesses with good corporate governance will avoid major scandals which can negatively affect the share price for a sustained period of time.

So, for passive fund managers, who by their nature are long-term holders of businesses, participating in the investment journey through stewardship and increased engagement can lead to better outcomes for all. It is certainly a view shared by some of the big indexers while Professor John Kay, one of Britain’s leading minds on economics, has also urged greater engagement from passive managers suggesting it is even in their best interests (The Kay review of UK equity markets and long-term decision making).  The model of the active passenger is to be welcomed!