The risks of passivity in overseeing your assets
By Robert Turner & Paul Baker and Chloe Lim & Mark Uttley, Simmons+Simmons
Published: 31 January 2020
This article explores the practical challenges, faced by asset managers of all types, arising out of recent regulatory reform and scrutiny; the changes in social and political expectations; and opportunities and threats as litigation is increasingly being viewed as an asset class.
This article illustrates these practical challenges across three current themes in the asset management industry:
- Stewardship and governance;
- Corporate actions; and
Stewardship and governance
In the last decade, there has been a huge shift from assets being managed using active strategies to managers employing passive strategies. Morningstar, the data provider, reports that out of mutual funds and ETFs that buy US stocks, 48% of those US stocks were held by passive funds in 2018. Not only have investors looked to passive strategies as a cheaper way of investing but, in the market circumstances, studies have also found that these passive funds have outperformed active funds over time. Morningstar looked at almost 10,000 European active and passive funds over a ten year period, splitting these into 49 different categories, of which there were only two where the majority of active funds performed better than their passive peers. The shift in favour of passive management has led to reduced emphasis on price discovery – except perhaps in the developing activist market.
In parallel, there has been increasing interest in and criticism of the role that asset managers play (or don’t play) in stewardship and governance of the companies in which they have invested. Notably, the last few years has witnessed the integration of environmental, social and governance criteria (“ESG”) in investment decisions becoming mainstream, with ESG being increasingly seen as not simply a method of screening out companies whose business conflicts with the asset owner’s beliefs (e.g. guns, alcohol, adult entertainment), but instead a source of risk management (e.g. poor governance or poor environmental practices may at some stage manifest in events that destroy shareholder value) or a source of alpha. The FT reported in August this year that, according to Morningstar, the AUM in ESG mutual funds has almost doubled to $1.8 trillion. In the EU, the recently implemented Shareholder Rights Directive II (2017/828) has created an obligation for asset managers to develop and disclose an engagement policy which includes how they monitor investee companies on a number of issues, including ESG. In addition, the EU is in the process of developing further rules relating to the disclosure of ESG risks and opportunities. There have also been calls from the pension trustee community for the FCA to intervene by developing ESG policies that fund managers have to implement.
The upshot of this is that even passive managers are expected by investors, regulators and the general public to exercise increasingly active scrutiny over the companies in which they invest and be a force for change where required.
However, the market in which passive managers operate in is highly competitive on cost. The costs of stewardship and governance are borne out both in terms of the time and money needed to scrutinise investee companies and engaging with management and other shareholders on governance issues. How managers deal with the trade-off between stewardship and their own costs and profitability will be a key consideration over the next few years, and one which could come to define the market. The danger is that stewardship and the cost of stewardship is left to some, with others preferring the competitive cost advantage of not engaging over doing the right thing.
At the same time, of course, active managers have come under considerable scrutiny in recent years on costs with concern being raised in some quarters that, after fees are taken into account, investors would be better off investing in passive tracker funds. While the cost adjusted performance of passive funds has been assisted by generally buoyant equities markets in the decade since the financial crisis, this has not stopped regulatory intervention. At times, some regulators could be said to have come close to giving financial advice itself to the effect that passive management offers better value.
In the UK, the FCA fired the starting gun in 2015 with its Asset Management Market Study, and further to market consultations, eventually arrived at the concept of funds needing to perform an “assessment of value” for investors. Fund manager directors are now required to assess whether a fund provides value to investors on an annual basis. Managers will have to consider the costs of stewardship activities against this new regulatory framework and there is a clear tension between the pressure on fees and expectations on stewardship; squeezing profit margins even further. Managers will need to develop suitable policies for stewardship activities and ensure that the value of these activities is recorded. However, given that stewardship activities can take a number of years to come to fruition, there are clearly issues with how this fits into the FCA’s annual value for money reporting cycle.
One aspect of stewardship is whether and how managers participate in corporate actions. Corporate actions can relate to a number of different topics. We touch upon shareholder actions and scrip dividends (where issuers provide shareholders with an option to receive additional shares instead of a cash dividend) here.
A recent US study found that asset managers are failing to optimise corporate action decisions (such as scrip dividends, rights offerings and tender offers), apparently resulting in widespread losses. The authors say that in relation to scrip dividends alone, aggregate losses to beneficial owners exceed US$1bn a year. Against the backdrop of increasing pressure on asset managers to make optimal corporate action decisions, one can see the potential for increased regulatory and litigation risks as a result of investors and regulators scrutinising such decisions made by managers.
In jurisdictions where the class action regime requires participants to opt in, there is a risk of managers failing (without justification) to opt in to relevant actions and leaving money on the table. Having a blanket policy of not opting in or failing to opt in to a class action that would have ultimately resulted in a gain for investors could have serious implications, including investor claims and regulatory interest, particularly for managers trying to demonstrate that their fees represent value for money.
The growth of the litigation funding industry has also opened up opportunities for managers to bring their own claims without tying up as much capital or having to shoulder legal fees for complex claims which run over a period of years. This presents opportunities for managers to obtain value through investing in litigation as an asset class.
There is however a conflict here: the targets of the litigation funding industry are often asset managers - for instance, as set out below, one litigation funder has set aside £6.6bn for claims against asset managers relating to closet tracking. Looking to the future, it is very possible that we will see a number of funded claims against asset managers relating to a failure of stewardship or not providing value for money and the relationship between asset managers and litigation funders may become strained.
Transparency continues to be scrutinised by regulators. Linked to its value for money agenda, the FCA has devoted significant time to issues around the disclosure of fees and charges. Earlier this year, the FCA issued supervisory publications concerning the review of disclosure of costs by asset managers and retail intermediaries to retail customers, warning that firms should review their disclosure about costs and charges as a matter of priority. This followed the FCA’s Asset Management Market Study findings that weak price competition in the asset management sector was partly a result of ineffective disclosure of such information.
Disclosure of costs and charges goes hand in hand with “closet tracking”, where it is said that an actively managed fund charges a fee that is commensurate with active management but is, in practice, tracking a benchmark too closely to warrant an active fee. The logic being that an investor would therefore have been better off investing in a passive fund as, after costs, their return would be higher.
Several European regulators, including ESMA, the FCA, the Central Bank of Ireland and others have examined this issue, often using various metrics to identify potential closet trackers. The standard regulatory response has then been to contact managers of those funds and request further information, particularly relating to what was disclosed to investors about the strategy and the benchmark used. The CBI published its findings in July this year, noting there were cases where target outperformance against a benchmark was less than the fee charged, meaning that, even where the fund generated a top end return, investors in affected share classes would not realise a positive return compared to the benchmark.
Interestingly, the Norwegian Court of Appeal has recently given judgment on a closet tracking case between the unitholders in the DNB Norge securities fund and DNB Asset Management, allowing 180,000 investors to recover allegedly excessive fees (£30.4m) charged for an actively managed fund, because the product delivered was tracking its benchmark more closely than investors were entitled to expect. At its heart, the case is not about a tracker fund masquerading as an active fund and charging a higher fee (as over time, the fund had outperformed its benchmark). Rather, the case was about whether, on average and over time, the manager had, in the implementation of its investment judgement, demonstrated a sufficiently active approach to justify its fee relative to the investor information provided. For further analysis on the Norwegian case, see our article here. While there have been no equivalent cases in the UK, as noted above, one litigation funder has set aside £6.6bn in anticipation of claims arising from overcharging across the industry.
The challenge for asset managers is how to respond to the competing pressures to do more and charge less.
There are some relatively straightforward things that managers can do to try to mitigate some of the risks. For instance, having clearly documented policies for dealing with corporate actions, participating in class actions and the parameters of any stewardship activity, disclosing these to investors in the interests of transparency and in order to manage the expectations of investors of what they are getting in return for their fees (and so meeting the “value” expectations of the FCA).
There are also more involved and expensive responses, including hiring dedicated teams to look and engage with stewardship issues. However, this might be a luxury that is open only to the largest managers with the requisite resources.
As the first round of value for money reporting takes place in the UK, we expect that managers will need to consider carefully how they engage with and oversee their investment portfolio and demonstrate that what they do is in the interests of investors.
Simmons & Simmons LLP has a dedicated Contentious Asset Management team, consisting of dispute resolution specialists in the asset management sector. The Contentious Asset Management team is led by specialists Robert Turner and Paul Baker.
 Frenchman, Carr (2018) Corporate Actions: The case of the missing billions. (November 13, 2018)