Popularity of passive investing posing governance, market challenges

THE exchange-traded fund (ETF) industry has seen exponential growth since the US sub-prime crisis of 2008 - according to one estimate, more than US$3.5 trillion in new cash has moved into ETFs over the past 10 years alone.

Some reports say money in ETFs has already surpassed actively managed funds. The reasons are easy to understand - if most active fund managers are unable to beat their benchmark indices consistently, then it makes sense for investors to search for passive alternatives by simply buying and holding those indices in the form of ETFs.

Yet with tremendous growth comes new challenges. First, liquidity. As market watchers have noted, overall US liquidity - equity trading volume as a share of market capitalisation - has been declining since 2009 probably because of the rise in popularity of investing in tracker funds.

In line with a fall in liquidity has come a rise in volatility, possibly because of the heavy concentration of ownership in index stocks. In the US, ETFs account for about one-third of daily trading - it is estimated that about 88 per cent of S&P 500 companies have big ETF providers Vanguard, BlackRock or State Street as the largest shareholder. Together, these investors own 18.7 per cent of all the shares in the S&P 500. If more and more investors are holding only stocks in the indices, then could this narrow, index-based ownership be the reason for the huge volatility seen in Wall Street's major indices over the past fortnight?

Apart from declining liquidity and rising volatility, just as concerning is the possibility that corporate governance could be compromised in a world where ETFs are gaining ground.

According to a Reuters report last October, money managers of large ETFs usually routinely voted in favour of proposals by company bosses and rarely demanded better performance. Most also did not question or challenge executive pay. The logic there is that passive investors are deemed to be also passive owners, who are not interested in being actively involved in the corporate governance of the companies they invest in.

Moreover, since index funds do not seek to outperform market indices and just passively reflect the underlying index performances, there is no financial incentive to ensure the underlying companies are well run.

To be sure, not all the research suggests that more ETFs lead to weaker governance. A 2018 working paper of the European Corporate Governance Institute, titled The New Titans of Wall Street, noted: "Passive investors are devoting greater sophistication and resources to engagement with their portfolio companies and are exploiting their comparative advantages - their size, breadth of portfolio and resulting economies of scale - to focus on issues with a broad market impact, such as potential corporate governance reforms, that have the potential to reduce the underperformance and mispricing of portfolio companies."

For now, perhaps the tentative conclusion is that the jury is still out on the effects of rising passive management on corporate governance. Passive managers, however, should recognise that their large shareholdings offer them tremendous potential to advance governance standards and act accordingly.