The Politics of Passive Investing

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.

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?