Why The Stock Market Needs Activist Investors

Rarely do proxy fights look as similar to a Rocky sequel than the mine continuing to play out between Nelson Peltz and Procter & Gamble. Weeks after P&G declared the effort by Peltz to gain a board seat a failure, he jumped off the mat to land a knockout punch after an independent tally discovered that Peltz’s hedge fund, Trian, had in fact won the fight.

While P&G continues to review the results, it appears that Peltz, with an unofficial winning margin of .0016% of outstanding shares, will have a spot on the board. It’s an unlikely victory in the most expensive activist battle to date, at the largest company yet to be targeted by an activist.

For P&G investors, though, it doesn’t mean immediate results will follow. Fortune and FactSet recently looked at how companies facing activist investor campaigns performed since 2012. The research found that two years following an activist win, companies had a median stock price loss of 2.4%, while companies that fend off such campaigns saw their shares rise 10.9%. There are many factors that could explain the results, not least that the companies that tend to attract activist campaigns often face problems that take longer than two years to solve. Still, it’s interesting that evidence of weak returns hasn’t kept the number of activist campaigns from growing (the number of campaigns in 2017 so far is 18% than the number in 2012), or dimmed other shareholders’ enthusiasm for them.

activist investors

Activists vs. passive investing

The explanation for activisms’ increase might lie in how we invest.

It’s no secret that investors have begun shifting their emphasis to passive investing in index funds or ETFs, and away from actively managed funds. Last year, passive funds saw $506 billion in net inflows, while $341 billion left active hands. And Moody’s Investors Service predicts that passive investing, which currently accounts for 29% of U.S. assets under investment management, will surpass active strategies no later than 2024. It’s a transition that’s bringing trillions of dollars under the umbrellas of the management companies that run the index funds and ETFs.

These funds, however, are typically bound by rigid rules when it comes to where you can invest. If you buy an S&P 500 index fund, your money will typically be invested in each of the companies within that index, regardless of whether certain names perform poorly—or are poorly run. Investments are doled out schematically, without a need to evaluate a company’s culture or strategies or plans. And some researchers argue that the growing dominance of that style of investing means that, at many companies, the biggest investors don’t have much of an incentive to dig deep into why a specific company is underperforming, and how they might fix it.

Because of the way index investing works, big management groups like Vanguard or BlackRock wind up taking gigantic stakes in sectors, not just an individual company. It’s sometimes called horizontal investing or common ownership, because the companies have nearly the same exposure to a number of names within one sector. In P&G’s case, three companies (or subsidiaries) – Vanguard, State Street and BlackRock – are among its five largest investors. The same three firms have similar status in P&G’s closest competitors, like Colgate-Palmolive or Kimberly-Clark.

This isn’t unique to P&G. Indeed, researchers have estimated that either Vanguard, State Street, or BlackRock is the largest shareholder in 40% of U.S. public companies.

Some researchers think that this cross-ownership makes companies in the same industry less likely to compete strenuously with each other. Studies have found that horizontal or cross ownership of airlines has been correlated with consistent price increases and a shrinking likelihood that one carrier will undercut the other’s profits with aggressive discounts. Research has found that the same goes for banking fees. “The omission to explicitly demand or incentivize tougher competition between portfolio firms may allow managers to enjoy a ‘quiet life,’ and thus cause an equilibrium with reduced competition and sustained high margins,” write researchers Jose Azar, Martin C. Schmalz, and Isabel Tec in their recent findings on the anti-competitive impact of common ownership. The sector may benefit, but individual companies don’t look to maximize their own value or seek market share gains.

Breaking from the pack

Activist investors, in contrast, are more likely to dig into a specific company and determine “how to improve it,” says Ali Dibadj, a Bernstein analyst. They tend to make concentrated bets in an individual company, then become the vociferous voice telling management that changes must occur. (For an example of a company that’s been particularly successful in doing so, see Fortune‘s new story about Elliott Management.)

Activists see a real threat in too much passive ownership. “The Japanese system of cross corporate ownership, the keiretsu, has been blamed for decades of Japanese corporate underperformance and economic malaise,” activist Bill Ackman, the founder of Pershing Square hedge fund, wrote in 2015. “Large passive ownership of Corporate America by index funds risks a similar outcome without the counterbalancing force of large active investors.”

Index funds, of course, can benefit if an activist campaign boosts performance at a company they own. And these firms sometimes vote in activists’ favor: In fact, BlackRock and State Street reportedly sided with Peltz in the P&G fight. But the P&G case does highlight some reasons why individual investors may embrace an activist. Peltz, after all, isn’t a top shareholder in any of P&G’s competitors, so he’ll focus on what P&G needs to improve itself, as opposed to how the overall sector performs.

Of course, if there aren’t more voices doing the same, that may be an unfortunate side effect of the value we find in index investing.

– Fortune

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Investing your money in a tracker fund

The rising popularity of “passive” investing has seen savers put hundreds of billions of pounds into cheap tracker funds. These funds allow you to invest in the FTSE 100, for example, for less than 0.1pc a year. There is a general assumption that, relative to stock picking, tracking an index is a simple task that can be run entirely by computers. But what exactly happens to your money when you put it into a tracker fund? Telegraph Money spent a day at the London offices of Vanguard, the world’s second largest asset manager – and a major proponent of passive investing – to find out. It’s not all computers – but there aren’t many people

Vanguard’s trading floor is not a row of computers. The desks are occupied by people, albeit just a small number of them managing an astronomical amount of money. The space is compact – and quiet. Vanguard’s equity index group, the people involved in actually running its stock index tracking funds, consists of 60 people: 35 portfolio managers, plus traders, analysts and those in leadership positions. Between them they run £1.9 trillion, spread across a few hundred portfolios. That equates to £32bn per person. There is no one set manager per portfolio, and responsibilities regularly rotate.

tracker fund

On the bond side, more people are required. In the fixed-income group there are 160 people managing £900bn. There are still only 45 portfolio managers, but more than 100 traders and research analysts are needed. These teams are spread across the company’s US, European and Australia-Pacific regions, surrounded by the thousands of other staff who make up the Vanguard machine. The end investor is discussed frequently, but handling incomprehensibly large amounts of money is part of the day-to-day. One member of the foreign exchange team said she put through more than £100bn in currency orders last month.

What actually happens to my cash?

A surprising amount of spadework is involved in following an index. Say you give Vanguard £1,000 to put into a fund that tracks an index of 100 stocks or 100 bonds. It’s easy to imagine a computer algorithm splitting up that £1,000 neatly and buying £10 worth of each stock or bond. Then, as the index changes, the algorithm makes the necessary updates. For a host of reasons, including transaction costs, access to certain markets and liquidity, that isn’t possible or efficient.

Instead, your money is pooled with all of the other money the firm takes in. Portfolio managers then work out – with the help of many digital tools – the most efficient way to invest that cash to keep a tracker fund in line with the index in terms of performance and risk, while keeping trading costs to a minimum. While active managers compete on performance, passive managers compete on “tracking error” – the accuracy with which their fund tracks the relevant index – and at Vanguard their pay is based on it too. A tracker fund can deviate from an index for a number of reasons, including trading costs and accounting technicalities.

In some cases, a tracker’s holdings may not actually match the index exactly. Its job is to deliver the same performance as the index without taking extra risk, which can be possible without exactly replicating it. Melissa Tuttle, a senior equity portfolio manager, said her team tended to use incoming cash to top up holdings that had ended up “underweight” compared with the index. Their aim is always to fully invest new cash. Events such as the FTSE 100’s quarterly review, when companies enter and leave the index, also have to be anticipated, and predictions made. Combining trades together keeps transaction costs down. If 11 different Vanguard trackers need to buy HSBC shares, there is little point in them doing so separately.

Portfolio managers put in orders, which are then carried out in whichever region the stock in question is listed in. If a manager in London needs to buy Apple stock, the order is sent to the US team and bundled with any other Apple orders. That said, Vanguard is clearly pushing to automate as much as possible. “It’s fair to say we’re growing systems now, rather than people,” said Dr Alla Kolganova, head of equities for Europe. With shares, 95pc of trading is carried out electronically, with a high degree of automation. There is still 5pc where a portfolio manager may have to go hunting for a broker, however – particularly in the more difficult-to-access markets such as the Middle East. In some cases, this could still mean picking up the phone.

On the bond side, things are different.

Paul Malloy, Vanguard’s head of fixed income in Europe, said only 5pc of bond trading had been significantly automated – largely for small trades in highly liquid government bonds. The other 95pc is still done “over the counter” – meaning between two parties away from a stock exchange. “Bigger trades, or trades in less liquid areas such as corporate bonds or emerging markets, still require picking up the phone or some sort of electronic auction. There’s still someone on the other side,” Mr Malloy said.

He added that, thanks to the sheer number of bonds being issued and the number that have relatively little trading activity, buying every single bond issued by every single company in an index would incur huge costs. Instead, his team buy samples that represent the index, balancing tracking error, risk and cost. “You need to own about half the bonds in an index, representing about 95pc of the companies. We don’t need to own every JP Morgan bond to track the index – I can pick the one I like best. It’s a lot like active management, but you’re controlling risk and cost to avoid losing value, rather than trying to add value,” he said.

Risk

Sitting between the equity managers and the bond managers – both passive and active – is the risk team. Brian Wimmer, head of risk management for Europe, said there is a slim initial tolerance for a fund being out of line with its benchmark index. If that figure is breached “a conversation starts” – and there is then an absolute maximum tolerance allowed. This team is also in charge of ensuring that no financial regulations are breached. Colour-coded systems are used to keep track. Today, everything is running smoothly for the firm’s LifeStrategy range of ready-made portfolios.

When something is out of line, analysis tools enable a risk manager to look at where that error is coming from, and action can be taken to push things back into line. One option at Vanguard’s disposal is to suggest changes to an index itself, through its relationships with index providers, when it thinks improvements can be made.

– Telegraph

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