August 14, 2017

Monday Morning Memo: ETFs, Corporate Governance, and Shareholder Rights

by Detlef Glow

In the aftermath of the financial crisis of 2008 it became obvious that good corporate governance is a key factor in protecting markets and shareholders (owners) of companies from large drawdowns caused by scandal, greed, or other factors of a bad corporate culture. In this regard it is not surprising that corporate governance has become one of the key factors for selecting stocks for all kind of investors, especially investors who are looking for sustainable or socially responsible investments that focus on corporate governance (reflected by the G in ESG [environmental, social, governance] investing).

The only part of the asset management industry that apparently has had no opinion on corporate governance is the ETF industry, since the strategy of ETFs is only to replicate the risk/return profile of their underlying market index. The ETF industry has been blamed for accumulating millions of voting rights but not executing them at annual shareholder meetings.

Although ETF managers previously didn’t have opinions of companies and markets, the situation is changing. Several ETF promoters have reacted to this critique and are now participating in voting pools (in some cases with their parent or sister companies) to have their voting rights used during shareholder meetings, since this helps to increase overall corporate governance.

But ETFs tracking “plain-vanilla” indices such as the S&P 500 can’t ban companies with bad corporate governance from their existing portfolios. Still, it is quite positive that the index promoter S&P has banned all companies from the eligible universe for the S&P 500 (and other indices of this index family) that do not treat all shareholders the same. Companies such as Alphabet, Facebook, or Snap wouldn’t be eligible for the index if they went public now. Unfortunately, S&P will not use these rules for current constituents of the indices, so this means the new rules won’t put any pressure to increase corporate governance on companies that are already in the indices. Even though this is only a first step, it is a clear signal to the leadership teams of companies that the financial markets are no longer tolerating bad corporate governance with regard to the voting rights of shareholders. The FTSE Russell has also introduced some restrictions for the eligibility of companies for its indices with regard to voting rights for shareholders.

From my point of view these announcements by FTSE Russell and S&P are just one clue that investors are rethinking their investing behavior and their service providers’ adopting these changes to their business models. So, it should be no surprise if we see other index promoters announcing similar or even stricter rules as ESG becomes slowly but surely more important to investors around the globe. Personally, I would appreciate more of these kinds of rules, even applying them to existing constituents of the respective indices. This may cause some heavy reshufflings, but it would help increase corporate governance even more.

The views expressed are the views of the author, not necessarily those of Thomson Reuters.

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