Passively managed funds are under attack again. Last summer Carl Icahn famously blasted fixed income ETFs and this month, Bill Ackman devotes one third of Pershing Square’s annual letter to investors to criticizing index funds.
To start, the letter suggests that as asset flow to index funds accelerates it creates momentum in the indexes they seek to represent which raises the bar for hedge funds benchmarking to those indexes. Violins. Returns are down among activist managers and when looking at individual stocks, excess gain from activist campaigns dropped significantly from 2012 to 2015. S&P’s US Activist Interest Index is down 31% in the last year.
His primary claim is that index funds have no incentive to pursue good governance at companies within their portfolio and cannot have the bandwidth to make intelligent proxy decisions. “Index funds managers are not compensated for investment performance, but rather for growing assets under management. They are principally judged on the basis of how closely they track index performance and how low their fees are. While index fund managers are, of course, fiduciaries for their investors, the job of overseeing the governance of the tens of thousands of companies for which they are major shareholders is an incredibly burdensome and almost impossible job. Imagine having to read 20,000 proxy statements which arrive in February and March and having to vote them by May when you have not likely read the annual report, spent little time, if any, with the management or board members, and haven’t been schooled in the industries which comprise the index.”
He cites the example of Dupont when last year index managers who owned 18% of the stock voted against board members proposed by Trian Capital Management. He also says that the lack of index fund support for Pershing Square’s teaming with Valeant to buy Allergan shows how those firms “did not take this issue [corporate governance] seriously.”
This is an extremely thin argument, especially the case involving Valeant in which the legality of Pershing Square’s actions were broadly questioned. In reality, index fund companies are getting much more involved in governance and are engaged with corporations and their boards. Evidence is everywhere. BlackRock, State Street and Vanguard are members of the Shareholder-Director Exchange, a group formed to enhance shareholder-director engagement.
Recently, Doug Braunstein of Hudson Executive Capital called Michelle Edkins, BlackRock’s head of corporate governance, the most powerful person in corporate America because of BlackRock’s ability to influence corporate boardrooms.
The assertion that index managers are not motivated by performance is wrong. If indexes keep going up, assets will keep flowing in. The index manager is constrained in terms of allocation of the portfolio and cannot sell an underperformer. This creates a powerful incentive to ensure that index constituents perform. Governance is the steering wheel whereby passive investors can influence performance. This makes them natural allies of activists, not disinterested bystanders as Ackman might have us believe.
Larry Fink CEO of BlackRock which manages $2.7 trillion in index funds wrote an open letter to 500 CEOs encouraging a new focus on clear long-term vision, strategic direction and credible metrics against which to assess performance. “At BlackRock we want companies to be more transparent about their long-term strategies so that we can measure them over a long cycle. If a company gives us a five-year or a 10-year business plan, we can measure throughout the period to see if it’s living up to the plan. Is it investing the way it said it would? Is it repaying capital to shareholders?” he asks.
To me this is about getting leverage on corporations and holding them accountable.
As index fund managers ramp up their focus on governance, there is broad opportunity for activists to tap into that growing sector for support because to a large extent, their interests are aligned. What activists have to worry about is the possibility that index funds diverge from hedge funds and forge their own path in advancing the governance principles they perceive as enhancing long term corporate performance. Braunstein predicts that in five years every public company will have an investor member on its board.
The SDX is one example of how index fund managers are pursuing a governance agenda independent of activists. Last month another step in going it alone was taken when it was announced that BlackRock is among the founders of Focusing Capital on the Long Term, a group of large global investors which also founded the S&P Long-Term Value Creation Global Index.
The more media coverage an activist hedge fund gets, the more negative it becomes. That’s the key finding in my study of activists in the press.
Value Act, Jana Partners and Blue Harbour Group are the funds which score highest in terms of positive media sentiment. Their high scores for reputation are tempered, however, by the low volume of media coverage they receive. That said, these funds are well regarded in the press for their success in using constructive and typically non-confrontational approaches to engaging with management and boards.
The biggest names in the business (Pershing Square, Third Point, Elliott Management, Icahn and Trian) are on the other end of the spectrum. They receive enormous media attention but the sentiment in that coverage is much more negative. With greater attention comes greater scrutiny and the media are compelled to come up with new story lines about these funds. Tactics are questioned, managers’ personalities become news, wealth becomes a focus. Even when they score a victory the media coverage will often include reference to a past failure. The bigger the target or the bigger the campaign the greater the risk for negative publicity. Elliott’s fight with the Argentine government, Pershing Square’s campaigns on Allergan and Herbalife and Trian’s fight with Dupont have each been damaging to the managers’ reputation.
In studying the media coverage activist managers’ preference for letting their campaign records do the talking become clear. Most managers do not directly engage with the press, but use letters to shareholders and CEOs/boards as proxies for media relations. Of course some managers do make the rounds on TV, do live events with reporters in attendance and even sit with journalists for in depth interviews. But for the most part, the activist industry wants their record to define them. This is a mistake and the activist scorecard is insufficient to build a consistent, positive reputation. Look at Starboard Value, a fund that has become more active in recent years and received more press, as a result. Their record in terms of wins and losses has been highly positive, yet, the sentiment in the media is more or less neutral.
That is because reputation has to be about more than wins and losses. The previous post in this blog focused on whether activism is good for our financial system. That is the big question and the fact that activists have been winning a lot more than they have been losing doesn’t provide the answer.
The research shows that certain funds would probably benefit from greater media exposure and that the name brand funds would benefit from picking their public battles more carefully and calibrating campaigns based on the associated reputational risk.
From the research one can also conclude that if the activists which get the largest share of voice in the media are viewed negatively, it creates a risk for the entire sector. The case still has to be made for activism: how activists improve corporate governance, accelerate corporate performance and advance the interests of other investors. Until that happens, the activist sector itself faces the risk that the media, the market and even regulators will decide that they are part of the problem rather than part of the solution.
It’s hard to imagine how the sun would shine more brightly (or hotly) on activist hedge funds. Pershing Square scored the top spot in Bloomberg’s annual performance ranking for the entire hedgefund industry with 32.8% return. Assets under management in the sector have surged to $120 billion, according to the Alternative Investment Management Association. Funds are taking on US blue chip companies with surprising frequency: Dupont, General Motors, Apple, BNY Mellon, and the list goes on. In step with this ascendancy, the media have started to take a holistic view of activist investing and the basic question is: are these guys good for the system?
Journalists understand that investors and the economy at large benefit from counterweights to entrenched corporate management and boards of directors. The media know that companies, especially large companies, can become complacent and sag under their own weight. The media recognize that it is good to shake up the system now and then. The media, however, are not sold on whether activist hedge funds are a productive, corrective force in the capital markets.
As a result, the reputation of activist hedge funds is at an inflection point at a time when they are at their most prominent, in terms of activity in the market and footprint in the media. Recent media coverage has been thoughtful about both sides of the activist coin. As a group, journalists believe in challenges to authority and are predisposed to accepting the basic thesis of activist investing. In the words of the editors of Bloomberg View, “crafting policies that aim to stifle shareholder dissent is a dumb idea…Suppressing it [the ability of shareholders to turn on managers] with corporate-governance rules that make it harder for shareholders to challenge managers would do far more harm than good.”
The Financial Times credits activists for “advancing the cause of shareholder democracy and good corporate governance, which was otherwise moving at a glacial pace in the hands of traditional institutional equity owners. That is one secular shift that investors can take comfort in, but it brings societal and market-wide benefits, not ones that accrue to activists specifically.”
The Economist echoes the view that other equity owners have done little to advance corporate performance and governance: “they [index managers such as BlackRock andVanguard] have not in the past felt much need to worry about how the firms they invest in are run. Alongside them are the managers of mutual funds and pension funds, such as Capital Group and Fidelity. They actively pick stocks and talk to bosses but their business is running diversified portfolios and they would rather sell their shares in a struggling firm than face the hassle of fixing it.”
However, hedge fund tactics frequently alienate would be allies in the media and fuel criticism of the activist sector, especially as the largest US companies come under pressure from activists. Stock buybacks are an example. About GM’s $5 billion buyback precipitated by Harry Wilson of MAEVA Group and other funds, the Deal Professor column at the New York Times calls the push for buybacks a “worrying trend” and writes, “the haste in which G.M. rushed to comply to Mr. Wilson’s demands, and they and other companies shed cash rather than fight, shows that the activist tide pushing the stock buyback may have gone too far. Let’s hope that it doesn’t wash our companies and shareholders.” The Economist called buybacks “corporate cocaine” and an influential paper from Harvard advocates banning them.
Buyback strategies have driven many of the recent campaigns focused on blue chip companies (a trend noted here more than two years ago). What’s unusual is that about a third of recent corporate targets were outperforming the market when the activist campaign began. Media have questioned the utility of this, especially given the distraction created for management and boards. The Times comments, “trying to break up great companies only weakens one of America’s greatest competitive advantages: the leadership, strength, and adaptability of its global companies. The activists should keep their focus on the underperformers, and work to build the next set of great companies…”
It is too early to judge what Main Street thinks about campaigns to pressure major corporations that by many measures are doing well, but anecdotal evidence shows that small investors give the benefit of the doubt to management. See the comments to this story about Dupont and Trian. If investors tire of a perpetual war with activists, one idea that could gain traction is tenured voting, a way of giving long-term shareholders more voting power than new shareholders. The Wall Street Journal recognizes tenured voting as “providing a bulwark against short-termers who roam the markets, looking to force buybacks or an untimely company sale.”
Then there are the cases of obvious excess that occur with alarming regularity in the the activist sector. Herbalife: a very public case of hedge fund on hedge fund violence. Valeant: a fine line between innovation and insider trading. Now, we have Stake ‘n Shake and its activist counterattack to an activist campaign. The Journal quotes activist specialist Greg Taxin: “One could fairly worry that this [Stake n’ Shake] proxy fight represents the jump-the-shark moment for activism. Serious activism can improve performance and enable more efficient capital markets. This isn’t that.”
We are at an inflection point in the evolution of activist investing. No hedge fund has created a broader narrative about the role of activism in our market system. The jury is still out on whether activists are the market watchdogs they claim to be. The risk is that hedge fund tactics create a backlash and that corporations, with the support of institutions, small investors and even the courts, succeed in changing rules that whittle away at the activist toolbox (proxies, disclosure and short selling, etc) in order to further entrench management.
The SEC acknowledges that there is a debate bout whether activists are good for the market and the economy. While not taking a side (yet), Major Jo White said, “I do think it is time [for activists] to step away from gamesmanship and inflammatory rhetoric that can harm companies and shareholders alike.”
The Economist suggests two possible paths. Activists “could mature to become a complement to the investment-management industry—a specialist group of funds that intervene in the small number of firms that do not live up to their potential, with the co-operation of other shareholders. Alternatively it could overreach—and in so doing force index funds and money managers into taking a closer interest in the firms they own. If that is the way things go, activists could eventually become redundant.”
No better time than the present (even if it’s already March) for a review of the year that was in the world of hedge fund media. Three story lines were recurring and continue to be extremely relevant this year: activist funds taking on “big game” in the form of global corporations; whether or not “real money” asset managers will stay on the sidelines or join forces with activists; and, the ongoing saga involving Herbalife.
Trend #1: 2013 was the year that activist funds upped the ante and consistently turned up the heat on global corporations. Hess, Apple, Sony, and Pepsi were/are targets of a who’s who of activist investing: Elliott Management, Greenlight Capital, Third Point, and Trian, respectively. Elliott won board seats at Hess, Apple started a share buyback plan and increased its dividend, Third Point has lost money on Sony buy continues to call for the company to make “difficult decisions” and spin off parts of the company, and Trian is still arguing for Pepsi to spin off its beverage business and bulk up in snack foods. Not a bad track record, given size of these corporations.
Expect more of this big game hunting by activist funds. Indeed, investment banks and the largest law firms are increasingly advising corporate clients on how to cope with, and better yet, avert activist attention. It remains to be seen how corporations can begin to think like an activist (in attempts to avoid being targeted). If they do, it should result in higher profits, sharper strategy and better governance. According to a Conference Board Report, as of September 2013, hedge funds were “somewhat victorious” in 19 of 24 proxy contests initiated to that point last year, suggesting that shareholders are also starting to think like an activist.
Trend #2: Pension funds and other traditional asset managers are beginning to engage more with corporate boards and activists. Called “sleeping giants” by this blog, pension funds are where the muscle is. The enduring question is do they have the stomach to advocate forcefully for change aimed and boosting share prices. Calpers and Calstrs have long focused on good corporate governance and evidence is mounting that other pension funds are ready to be more proactive with corporate boards. Nell Minow, the co-founder of the governance advisory firm GMI Ratings, says there has been “a shift in tactics” among big pension funds “from shareholder proposals to engagement and director replacement.”
The newly-formed Shareholder-Director Exchange is a group comprised of corporations and asset mangers that developed a “protocol” for institutional investors and board members to follow when either side wants to talk to the other. While the SDX operates within the traditional realm of corporation-shareholder relations, pension funds want more engagement and presumably more accountability from boards. Activists are not part of the SDX, but if I were an activist, I would view this as promising for my strategies (more on this next time).
Trend #3: What is going on with Herbalife? Herbalife was the biggest headline getter in 2013 and it produced an almost a non-stop series of tabloid quality story lines that included the likes of Pershing Square, George Soros, Third Point, Perry Capital and others. The saga continues and now the government is investigating Herbalife (chalk one up for Pershing Square). Net net, no one really knows what’s the deal with Herbalife. The longs won out in 2013, but it’s a new year.