Spices, silks, and porcelain are just a few of the things people associate with the Dutch East India Company. But the firm was also the first to be targeted by activist shareholders. In the 1600s, its investors filed a petition against the company and lobbied the public to push for better governance and for its finances to be managed more effectively.
Five centuries later, shareholders have become much more active and powerful. The perception is that active managers are the ones taking the activist lead and that passive funds may be silent when it comes to tackling firms on governance and environmental, social and governance (ESG) factors, but is that fair?
One reason for this perception is that active managers have the power to offload stocks of companies with poor governance or ESG records. However, passive managers lack this exit strategy as they need to invest in the same securities as their benchmarks. Likewise, active managers may prefer stocks of well-governed and responsible companies, which can in turn motivate companies to do more in these fields, so that they are chosen by these funds. But traditional passive managers lack this power, so, in theory, even companies with low ESG ratings could attract investments from these funds, simply by virtue of their inclusion in a benchmark.
When governance goes bad, portfolios can suffer. One of the most infamous cases of recent times concerns Carlos Ghosn – former chairman and CEO of the Renault-Nissan-Mitsubishi consortium – and his arrest under suspicion of financial misconduct in November last year. Long perceived as a successful and charismatic business leader, it came as a shock to the business community. Corporate governance and the dangers of leaving too much power unchecked in too few hands have been in the spotlight ever since. So, what can you do to try to get a more rigorous grip on governance in your portfolio?
If you hold a fund with hundreds – if not thousands – of stocks, you’d be forgiven for not having the time or expertise to carry out a thorough due diligence of each and every one of them based on their ESG metrics. The good news is, there are experts who have that kind of know-how. When choosing the strategy underlying our broad ESG ETFs, we chose to partner with index provider and ESG research specialist MSCI.
MSCI has over 40 years of experience in collecting, cleaning and standardising data on ESG policies. In building their best-in-class ESG Leaders benchmark series, their goal is to include companies with the highest ESG rating in each sector, with a 50% sector representation versus the broad parent index.
At this level already, neither Nissan nor Mitsubishi Motors made the cut for the ESG Leaders indices. They both had an MSCI ESG rating of CCC – the worst possible ranking. In Nissan’s case, this had mainly to do with weak governance practices, safety, and emission falsifications. Mitsubishi Motors’ score related to similar issues around poor business ethics, fraud, and a fuel test manipulation controversy.
Here’s where things get interesting. Renault, according to MSCI, still scores well in areas like safety and clean tech. So, while not securing the top AAA rating, it still fares relatively well with an A – which is enough for it to feature in European MSCI ESG Leaders indices.
It is possible to take it further, however, and adopt the MSCI’s ESG Trend Leaders series. Not only do these benchmarks require a high ESG score, they also take that score’s trend into account. If a company has improved its ESG score over a one-year period, it is more likely to be included in one of these indices. A downward trend reduces that likelihood.
Renault, as we’ve said, has a decent ESG score and was in fact rated AA at one stage, but because of ‘concerns over potential conflict of interests in the role held by the Chairman, Mr. Carlos Ghosn’1, and additional concerns over governance practices linked to its complex ownership structure, MSCI downgraded its rating before news of the scandal actually broke.
The key single risk factor identified by MSCI’s ESG research was corporate governance. The downward trend meant Renault was not present in the MSCI ESG Trend Leaders benchmarks tracked by the Lyxor World ESG and EMU ESG ETFs, meaning they were not exposed to the ensuing stock tumble. That’s not to say using MSCI ESG Trend Leaders is a perfect way to avoid issues of poor governance as there is always the risk that something could slip through the net. It could, however, give you a head start.
It’s not just about how Lyxor ESG funds operate; we also have a broader duty to the world around us. Unlike most other passive managers, we engage directly with companies to induce them to improve their sustainability practices.
We also look to influence companies to become more responsible by using the voting rights given to us as large shareholders. We are committed to promoting sound governance, so we work in tandem with Institutional Shareholder Services, one of the world’s largest proxy organisations, to make our voice heard more often than we otherwise could.
To date, we have voted on more than 2,600 resolutions and, from an assets-under-management perspective, we have voted on EUR 14 billion+ of equity positions. We have cast negative votes in 22% of resolutions and voted ‘against’ at least once in 77% of the general meetings we have attended. Most of those votes have involved executive pay as well as board composition, remuneration and issues of transparency. We plan to become even more activist.2
To sum up, passive managers don’t have to be silent; far from it. We can be as loud as active managers – if not more so – when it comes to keeping watch over companies and influencing management to act in the best interests of shareholders, society and the environment.
1 MSCI, November 2018. Past results are not a reliable indicator of future results.
2 Lyxor International Asset Management as of 31 December 2018. Included EUR 19.6 billion of assets under advisory.
The views expressed in this article are those of the author and may differ from the published views of Commerzbank Corporate Clients Research Department, the communication has been prepared separately of such department. No representations, guarantees or warranties are made by Commerzbank with regard to the accuracy, completeness or suitability of the data.