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The benefits of engagement for passive investors

The passive investor by his or her very nature is an owner – not a trader – of the companies he invests in. Selling out of a poorly performing company is not an option. Depending on the index he is tracking, the passive investor will be widely invested – typically in hundreds, if not thousands of companies – and therefore is also interested in the long-term sustainability of the wider economy in which he participates. This goes beyond the direct value of the companies he invests in to so-called externalities such as pollution and bribery and corruption which can detrimentally impact the functioning of the real economy.

Value add

Based on its 10-year experience of engagement, Hermes EOS knows that shareholder engagement with policy-makers and companies provides the passive investor with an effective tool to add value and manage risk in the companies he owns. It also allows the passive investor to meet his fiduciary responsibilities and become an active owner of public and private companies. Depending on the ethos of the passive investor or those of his clients, by acting as a responsible steward of investee companies, engagement also helps to safeguard a fund’s reputation and further the broader aims of its beneficiaries.

Public policy engagements

Public policy engagement seeks to reduce environmental, social and governance (ESG) risk in the economy as a whole by improving standards across a country, sector or globally. Just a few examples of public policy engagement we have participated in and continue to contribute to include

▪ the development of a corporate governance code in Japan

▪ the introduction of a global carbon price, working with stock exchanges around the world to require company disclosure of ESG metrics

▪ boosting the protection of minority shareholder rights in Brazil

▪ the introduction of stewardship codes in Japan and Malaysia, and

▪ setting a professional code of conduct for bankers in the UK.

The value of successful public policy engagements can be broken down into two main categories: Firstly, a lower cost of capital from the reduced risk in investments in a sector, country or globally. Secondly, successful engagement may correct an externality, in other words a cost not currently borne by direct investments but one that will be carried by the economy as a whole and therefore ultimately by the passive investor.

Corporate engagements

The goal of corporate engagement is to achieve beneficial change relating to risk management and value creation. The basic premise is that companies with informed and involved shareholders are more likely to achieve superior long-term performance than those without. Indeed, a Hermes Investment Management paper “Does it just make you feel good, or is it actually good for your portfolio?” from January 2014 shows that over the last five years well-governed companies tended to outperform poorly governed companies by over 30 basis points per month. Engagement with companies can be on any material issue where there is a significant misalignment between the company’s actions and the interests of long-term shareholders. These typically include concerns such as board composition, executive remuneration, carbon exposure, water stress, supply chain, labour rights, bribery and corruption, conduct, risk management, culture, capital allocation and business strategy.

Relationships matter

Hermes EOS takes a holistic approach to company engagement – addressing all engagement issues, including social and environmental, in the context of the business strategy and performance – as our track record demonstrates that this is most likely to achieve credibility with management and yield positive results. In addition, key to effective company engagement is for the investor to build a strong long-term relationship of trust with the company, while at the same time holding the board accountable for its actions. Constructively working with boards and management in private is the most effective way of achieving positive change. Where no progress is made over an extended time period, however, Hermes EOS will use the press and other public forums to drive change, typically by speaking at AGMs or EGMs, or by filing shareholder resolutions.

An example: engaging with banks

The value of corporate engagement to a passive investor is not simply about making well-performing companies less risky. It is also about reducing the value destruction of the poor performing company which the passive investor is unable to sell and therefore mitigate losses as a responsible owner. For example, significant value destruction in banks occurred following the financial crisis. Acting on behalf of the owners of the banks and also recognising the importance for the proper functioning of the wider economy, Hermes EOS has been engaging with banks globally on board composition, conduct and culture, executive remuneration and business portfolio strategy to ensure that shareholders achieve a sustainable economic return from their bank investments and that the likelihood of a repeat of the crisis is minimised. While progress has been made with positive changes to the balance of power on boards, greater business focus on economically viable business units and the espousal of more responsible conduct, a lot still remains to do on the implementation of cultural change, executive remuneration and the delivery of sustainable economic returns.

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Paul Voute, Executive Director - Head of Distribution, CEMEA