The recent news that Fidelity will offer a zero-fee index fund all but confirms what many investors have expected for some time: Passive investment products and ETFs have truly become the low-cost, autopilot investment option they were designed and intended to be.
The ETF industry has been enormously successful in attracting capital that puts investors’ money into investments without the usual expenses and forwards those benefits to investors in the form of returns. What has not been part of the ETF mandate has been using the voting and proxy powers that come with being a shareholder – until now.
As active investors ourselves, our focus is to find companies with unrealized value and, in select circumstances, work collaboratively with management and boards to extract that value for the benefit of all stakeholders. While it’s rare for us to be the only ones at the table, we have found ourselves increasingly noticing some significant players: ETF providers. Indeed, a theme we’re seeing repeatedly is the same few ETF providers, which together enjoy double-digit ownership holdings, quietly but firmly exerting their influence in the boardroom.
For years, institutional shareholders, including hedge funds, have sought to amass large stakes in companies to force boards and management to do what they feel is best to unlock value and drive returns by divesting assets, streamlining operations and, in many cases, replacing boards and management themselves and bringing in new people to run the company. ETFs were never part of this group. Sticking to their passive roots, they would simply track indexes and sectors, buying or selling shares to match the investment dollars they received.
The reason for this approach initially was that the ETF industry was relatively small. In 2008, ETF strategies had a collective $700 billion in assets under management. Today, that number has mushroomed to well over $4 trillion and is estimated to grow to more than $7 trillion in the next two years. This, in turn, has emboldened ETF providers to use their might to influence companies into doing what they feel is right.
Case in point is BlackRock CEO Larry Fink, who earlier this year penned a letter indicating he would use the full reach of his firm’s ETFs’ voting power to address social change – starting with pressing firearms retailers and manufacturers on their sales and manufacturing processes. At first blush, this might seem like a positive. Who wouldn’t like to see less gun violence in America? However, what if BlackRock’s social views don’t mimic the views of their investors?
Equally important, is a passive strategy that’s active in the boardroom still a passive strategy? I’d suggest that it’s not: Being actively engaged in the boardroom to effect change is the pinnacle of active management. BlackRock’s announcement was a watershed moment in the passive investment space. Their active involvement on any social issue places them directly on top of a slippery slope.
It also raises a larger dilemma of potential conflict of interest within BlackRock. Today, the company holds $4.1 trillion in passively managed products. It is well within its rights to use the voting influence of its products to achieve self-serving objectives.
In fairness, my concern is not specific to BlackRock. In 2017, the top three ETF providers controlled more than 70% of global ETF assets. Since I see the boardroom as a place where value can be either created or destroyed, this new market structure translates into an even bigger consideration: the potential consequences of the consolidation of voting power in equity markets.
Over the course of the past few years, the investment community has encouraged the creation of a few 800-pound gorillas and then unleashed them into boardrooms around the world. Up until now, these behemoths have been relatively docile. Now that they’re displaying a willingness to exert the full extent of their influence, perhaps it’s time for the rest of the financial system to pause and consider the long-term consequences of this evolutionary market change.
Talbot Babineau is president and CEO of IBV Capital, which he co-founded in 2014 after amassing more than a decade of value investing experience.