Back to Drew's Views
March 3, 2022
Previous
Next

The Politics of Passive Investing

Asset Pricing
Passive vs Active

Most of us in the finance world are well aware of the evolution of “passive” equity investing over the years, and have witnessed its tremendous growth.

And some of us have asked questions about it. We’ve asked is it all good? Is it mostly good? Are some aspects perhaps bad? Are some really bad?

It is a subject that has kindled fierce deliberation. The debate is about its impact on market efficiency, on price discovery, on asset pricing, and elsewhere. I’ve probably written half-a-dozen blog posts about the influence of passive flows on pricing, the impact on Ben Graham’s voting machine, and on the implications for alpha generation in an increasingly passive world.

But over two years ago, I started reading some other things about passive investing that I didn’t pay enough attention to at the time. Possibly because I couldn’t have imagined how political things might become, nor that a low-cost marketer of benchmark-mimicking index funds could conceivably start to express its political will as if it were the desire of its underlying investors.

Anyway, there are a handful of folks in the finance world whom I try to read everything they put out. Matt Levine at Bloomberg is one of them. Let’s face it, he is smarter than most of us, and writes better than, well, all of us?

In January of 2020, he responded to this article in The New York Times, which described how the “climate crisis” would “reshape finance”, and how BlackRock would lead the charge.

In his prototypically concise and lucid manner, Levine’s piece in response suggested (or predicted?):

‍“The right model of BlackRock is probably that it is mostly an aggregator of preferences, but it is also, at the margin, a shaper of preferences. It passively reflects what investors want generally, but it has some ability to push those investors to want different things.”

BlackRock founder and CEO Larry Fink’s 2020 annual letter had just been published as well, where he suggested that BlackRock would exit investments that “present(ed) a high sustainability-related risk” which people thought at the time was code for coal-related businesses, maybe miners, and possibly even oil companies. Levine wondered at the time if “BlackRock’s decision to send a strongly worded letter about environmental sustainability (would) reshape how corporate America does business?”

Levine has written much about BlackRock and Fink since, which unfortunately is paywalled. Yet (I think) even before Matt, John Coates at Harvard was asking similar questions about the future of corporate governance, wondering if indexing “threaten(s) to permanently entangle business with the state and create organizations controlled by a number of individuals with unsurpassed power.” John even suggested something he called a “Problem of Twelve” where he proposed that “in the near future roughly twelve individuals will have practical power of the majority of US public companies.”

John, and then Matt, were ahead of their time, but fast forward to 2022 and a lot of other folks are now wondering about it all too, especially after Fink published his most recent annual letter last month.

Using a title that surely made Michael Burry giggle, BlackRock chose “The Power of Capitalism” as the title to their piece. Burry, of The Big Short fame, believes that passive investing can potentially create bubbles (by driving share prices higher than they were actually worth). Even grandmaster Peter Lynch – who was not in The Big Short – has suggested this “move to passive is a mistake” and that “people are missing the boat.”

And way back in 2016, Inigo Fraser-Jenkins, an analyst at Bernstein, wrote that passive investing is “worse than Marxism.” His piece was ridiculed (by passive managers, academics, and investors, mostly) as hyperbole at the time, but let’s take a closer look at what he wrote:

‍“Ultimately this comes to the social function of active investment. Its primary role in this respect is capital allocation and as such it is a force for social good. A Marxist economy where investment is centrally planned is a plausible alternative but less efficient. However, a supposedly capitalist economy where the only investment is passive is worse than either a centrally planned economy or an economy with active market led capital management.”

Here he suggests that the active investor or manager can use their capital allocation for social good (in fact he seems to suggest not only that they can, but they should). And he continues:

‍“Environmental, social and governance (ESG) forms a crucial part of any defence of active (management). If an asset owner or government sets an ESG target they are, implicitly at least, espousing a belief in the power of active capital allocation as a force for good. Also, in the rush to passive some active decisions are being made but no longer explicitly recognised as such. We raise the question of who should have fiduciary responsibility for factor allocation?”

If I am reading it correctly, it seems that Inigo believed that passive managers (such as Vanguard or BlackRock) would effectively (and necessarily) abdicate the responsibility previously held by active managers. After all, the index fund providers, as purely passive managers, were just mirroring an index. Consequently, Inigo predicted a reduction in the importance of active management as a force for the positive change he hoped for.

I think he got at least part of this very right. He foresaw that ESG would become increasingly important, and worried that active managers would be effectively ceding their roles in forming policy, or in being a force for social good. This happened too.

But it looks like he was wrong about how these passive managers were going to behave, and what they were going to call themselves. They are not calling themselves Marxists.

Meanwhile, the Harvard professor (John Coates) was very correct about the entangling of goals of “the state” with the goals of a business.

Because today, in some ways, “the state” is Larry Fink, the founder, chairman, and CEO of BlackRock, manager of $10 trillion of assets. It’s Larry Fink suggesting that he is not a Marxist, but the opposite. It is Larry Fink intimating that the companies that happen to be included in major US benchmark indices like the S&P 500 are now beholden to his personal views; views which seem to be particularly motivated by his penchant for environmental issues.

Really?

He is messaging this all as “capitalism”.

So I want to ask a few questions.

I want to ask if what he proposes below falls under the definition of “capitalism” and, furthermore, if he indeed believes that he has implicitly been elected to proceed with his platform.

Moreover, what is Fink’s platform?

Well, his letter is addressed to the CEOs of the companies that presumably have some sort of weight in the indices that track their performance, and which BlackRock attempts to mirror with its very popular, low-cost passive products, thus giving Fink - he believes – an extremely important role in policy formation for these particular companies.

In this year’s letter, he starts off magnanimously, perhaps slightly camouflaging his intentions, and suggests that “...truly great companies, crucially, recognize the importance of engaging with and delivering for their key stakeholders.”

Okay, it is the increasingly topical “stakeholders not stockholders” reference, but no big surprises there. Nearly everyone is doing that these days, hoping that they are saying the right things, trying not to upset anybody.

He continues on, suggesting that “a company must create value for and be valued by its full range of stakeholders in order to deliver long-term value for its shareholders.”

So far, I think, it isn’t terrible. If by “stakeholders” Fink means employees, customers, and shareholders, then okay, it is at least possible, maybe even probable, that engaging with and delivery for key stakeholders could produce the optimal long-term value for shareholders. If employees are happy, there is less turnover, and perhaps better production, and so forth.

But then he suggests that these stakeholders “need to know where we stand on the societal issues intrinsic to our companies’ long-term success” and that “putting your company’s purpose at the foundation of your relationships with your stakeholders is critical” to doing so.

I guess there are two implicit suggestions here:

1)   Fink is hinting that a company’s purpose is not necessarily to maximize shareholder value, and

2)   What Fink thinks is more important needs to become more important to these CEOs, or else

He then continues, and gets down to what Fink thinks is more important.

‍“Most stakeholders – from shareholders, to employees, to customers, to communities, and regulators – now expect companies to play a role in decarbonizing the global economy. Few things will impact capital allocation decisions – and thereby the long-term value of your company – more than how effectively you navigate the global energy transition in the years ahead.”

‍“The tectonic shift towards sustainable investing is still accelerating. Whether it is capital being deployed into new ventures focused on energy innovation, or capital transferring from traditional indexes into more customized portfolios and products, we will see more money in motion.”

‍“Engineers and scientists are working around the clock on how to decarbonize cement, steel, and plastics; shipping, trucking, and aviation; agriculture, energy, and construction. I believe the decarbonizing of the global economy is going to create the greatest investment opportunity of our lifetime.”

‍“It will also leave behind the companies that don’t adapt, regardless of what industry they are in.”

For a passive index manager, these are some strong words and grandiose claims.

In terms of the impact on “stakeholders”, I am not sure that the seven or 11 million Americans working for energy producers or automobile manufacturers would necessarily agree with Fink. Nor am I sure that residential customers in upstate New York would rather switch from natural gas to solar power, or that farmers in Indiana want to pay 400% more for fertilizer. Maybe some community doesn't want wind farms or charging stations.

But maybe they do. And that is fine. Heck it might even be great! And if shareholders want to make investments in companies that are aligned with their values, and employees want to work for political places with shared political goals, or customers want to see higher costs or lower profit margins, all because they get some sort of extra utility from doing so, then that is absolutely their prerogative.

But what if the owners of the company, the shareholders, just want to save for their retirement in the lowest cost vehicle possible, one that basically mimics a mathematically-weighted index of stock prices defined by rules like market capitalization and free float?

Should the ultimate boss of the manager selling them these indexed products then create power for himself to force companies in the referenced index to pursue efforts that may potentially reduce shareholder value? What if they potentially reduce employment?

Are the shareholders giving a passive manager power of attorney over their political views?

Is Fink effectively assuming that he has this power, and that he can lean on the companies to pursue policies that he believes in personally, simply because they are members of a stock market index?

Here’s more from the letter:

‍“As part of that focus, we are asking companies to set short-, medium-, and long-term targets for greenhouse gas reductions.”

Moreover, he proclaims:

‍“Capitalism has the power to shape society and act as a powerful catalyst for change. But businesses can’t do this alone, and they cannot be the climate police.”

‍“Transparency around your company’s planning for a net zero world is an important element of that. But it’s just one of many disclosures we and other investors ask companies to make.”

‍“As stewards of our clients’ capital, we ask businesses to demonstrate how they’re going to deliver on their responsibility to shareholders, including through sound environmental, social, and governance practices and policies.”

To me, that’s pretty gangster.

In other words, if these CEOs don’t toe the line of the manager of the index-mimicking passive vehicle in which countless investors from a myriad of backgrounds have invested their IRAs and 401Ks, they will face some sort of disciplinary measure, I guess? Will BlackRock encourage S&P to redefine what constitutes index eligibility? Will BlackRock create indices that exclude those that don’t agree with Fink’s personal goals? Will BlackRock get, and use, leverage on these CEOs to get what Fink wants?  

Gangster, indeed.

To be clear, I am not saying that Fink’s goals aren’t great. I am not saying they aren’t bad either. I am just asking if it should matter what he wants?

FOOTNOTES

Download PDF

Topics

Asset Pricing
Passive vs Active

DISCLAIMER

The views and opinions expressed in this post are those of the post’s author and do not necessarily reflect the views of Albert Bridge Capital, or its affiliates. This post has been provided solely for informational purposes and does not constitute an offer or solicitation of an offer or any advice or recommendation to purchase any securities or other financial instruments and may not be construed as such. The author makes no representations as to the accuracy or completeness of any information in this post or found by following any link in this post.

YOU MIGHT ALSO LIKE

Text Link

Heading

Lorem ipsum dolor sit amet, consectetur adipiscing elit. Suspendisse varius enim in eros elementum tristique. Duis cursus, mi quis viverra ornare, eros dolor interdum nulla, ut commodo diam libero vitae erat. Aenean faucibus nibh et justo cursus id rutrum lorem imperdiet. Nunc ut sem vitae risus tristique posuere.

Text Link
Text Link

Sell in May and Go Away?

Turns out there may actually be something to the old Sell in May and Go Away adage - at least over the last 80+ years.

Markets
Asset Pricing
Read More
Text Link

Stock Market History, Illuminated

Some year-end charts and tables asking some big questions about what comes next.

Asset Pricing
Factors
Markets
Valuation
Read More
Text Link

Do Short Term Flows Permanently Affect Share Prices?

I’d like to think that prices can get out of whack for some period of time, and in that window, the nimble, unbiased, fundamental stock picker can take advantage of overreactions and underreactions. If they don't, then the M&M propositions truly hold, and I don’t have a meaningful job. However, if this paper is right, and it is only flows that matter, then while the M&M theorems are overturned, I don't have a meaningful job either. If it is all about flows, then I shouldn't play the game.

Asset Pricing
Behavioural Finance
Passive vs Active
Valuation
Read More
Text Link

Archegos, Disclosure, and Price Discovery

This had a lot to do with bad banking, but most to do with an overzealous client. Meanwhile, it had very little to do with holdings disclosure. Sure, our kneejerk reaction is (always) for more regulation, because we want to believe that some regulatory response will immediately solve all our future problems. But we should question this intuition.

Asset Pricing
Portfolio Management
Markets
Read More
Text Link

On Unlimited Upside

He implies that a biased sample of self-selected winners suggest that it is a mistake to ever sell any shares in any companies that you think are “winners” either historically or prospectively. That sure would be nice, wouldn't it?

Asset Pricing
Behavioural Finance
Portfolio Management
Read More
Text Link

A Memo to Investors

I know, these are weird and trying times. It all makes you wonder what the point of stock-picking is. What is the purpose of kicking the tires, looking under the hood, and doing our jobs?

Stock Picking
Markets
Valuation
Asset Pricing
Behavioural Finance
Read More
Navigations
HomeTeamDrew's viewsPressContact
Disclaimers
Legal & regulatoryPrivacy policyCookies policy
How to get in Touch
info@albertbridgecapital.com

Subscribe to Drew's Views

No spam. Unsubscribe anytime.
Thank you! Your submission has been received!
Oops! Something went wrong while submitting the form.
© Albert Bridge Capital 2022
Website by SW10media.com
On the Relationship Between Gasoline Prices and Vehicle Demand
Sell in May and Go Away?
The Politics of Passive Investing
If Growth Stocks Sell Off Will They Bring Value Stocks Down with Them?
Stock Market History, Illuminated
Which One Are You?
Was Ben Graham a Quant?
Do Short Term Flows Permanently Affect Share Prices?
Just How Cheap is Europe vs. the US, and Should it Be?
Are American Companies Better than European Ones?
Rumpelstiltskin and Meme Stock Investing
Archegos, Disclosure, and Price Discovery
It's All About the Fundies
On Unlimited Upside
A Memo to Investors
Investors? Possibly you!
Avengers Assemble!
How Did This Even Happen?
Was “Value” Just a Hot Hand Thing?
The Hot-Hand Fallacy Fallacy Fallacy?
Cue the Camouflage
The Times that Try Stock-Pickers’ Souls
A Different Game?
Heads I Win
A New Ice Age?
Grandpa Stocks
Bubblicious?
On Negative Oil and Futures Prices
In Flew Enza
COVID-19 and Equity Markets
Regulators to the Rescue?
Perspective
We Don’t Make Pizzas
Ben Graham the Growth Investor?
Not a Bad Decade
On the Impact of the FAMANGs
Europe vs the US: Is it all about sector exposures?
Behavioural Finance is Finance
America’s Decade
Known Unknowns and Share Prices
Prediction, Publicity, and Paul the Octopus
Are Company Visits Good or Bad?
Everybody Was Kung Fu Fighting?
Voting Machines and Weighing Machines
The DCF is the Randy Watson of Valuation
The Sacrilegious Diaries: Measuring the Impact of Portfolio Turnover
Passively Irrational?
Imagine No Inflation
The Sacrilegious Diaries: The Benefits of Turnover
Stay in the Game
I’m Volatility?
Woody was Right
When You Can’t Wait For Tomorrow
James Harden and Alpha
Groundhog Day and Overnight Returns
Debiasing and Alpha
Peak “Peak Car” ?
The Right Way
The First Step to Regaining Credibility
The Futility of Market Timing
Visualizing the Arithmetic of Active Management
123 Years of the Dow
Sweet Emotion?
Share Buybacks, Bad Companies, and Bear Markets
Risk and Portfolio Theory
Keeping Calm and Carrying On
Reminiscences of a Stock Operator: The Volkswagen Chronicles, Ten Years Later
We’d Rather Not Sleep
Factor Timing, Should You Try?
The Mathematics of Maintaining Bet Size
The Grandfather of Behavioural Investing
On Sexual Chocolate and Semi-Annual Reporting
Island Economies and Risk
Build a Bear?
Data Science and Alpha
We’re all Value Investors
Hunting for Alpha
Career Risk, Alpha, and Contrarian Investing
Passive Flows and Wheelbarrows
God Bless the Shorts
Equilibrium Happens
Horses and Stocks
Peak Quality?
Bill Sharpe and Hank Aaron
Unwarrented
The Search for Excellence and the Loser’s Game
Fooled by Non-Randomness
Half Hearted Is Half Minded
Still Superman, but without the cape
122 year Dow Jones Histogram: Putting 2017 into context
Pegs, P/E'S and the Value Premium
Rick Barry and Lewis Carroll
Secular Winners and Value Investing
On Passive Flows, Smart Money, and Alpha
The Voting Machine
Prevous
Next
homeTeamdrew's viewspressCOntactDisclaimers