Why it's time investors move beyond idiosyncratic to systematic stewardship

In the current market, competition can drive companies to externalise negative environmental and social impacts at a cost to the broader society. This speaks of a market failure where doing the right thing from a societal point of view is not rewarded by the market. 

With a fiduciary responsibility to help clients and beneficiaries meet their financial objectives, institutional investors have a duty to address risks that threaten the overall long-term value of portfolios. This can be done through the use of investment and stewardship powers, which for large diversified investors, who effectively own a slice of the whole market, primarily means focusing on asset stewardship to advocate for sound governance and business practices.

Historically, investment stewardship has been focused on individual company performance, but given how most investors carry portfolios consisting of hundreds, if not thousands, of holdings, it seems like a rather inefficient approach to improve risk-adjusted portfolio returns. Put another way, there's a limit to company-specific engagements, generally perceived as high-cost monitoring, as potential gains are substantially “idiosyncratic,” which is precisely the kind of risks diversification minimizes to begin with. Would it not be better if these investors focus on reducing non-diversifiable market-wide (systematic) risks? 

Index investing and stewardship

With research suggesting that 80% of average portfolio performance is due to overall economic development, the above choice seems fairly obvious. But, before we get on to the how, let’s first reflect and expand on this a bit. 

With index investing now managing approximately 40% of assets, the traditional view and approach to stewardship is changing. A study in 2019 of the stewardship activities of the big three index fund managers – BlackRock, Vanguard and State Street – found there was no engagement with 90% of investee companies over three years, with a further 5% of firms experiencing a single engagement. 

Research on the degree of activeness of the Big Three suggests they are engaged, but not quite as much as the active managers, with evidence pointing to low involvement in high-cost monitoring, but rather the use of low-cost ways to push broad-based changes (e.g. board gender diversity). Similar to universal owners, this can often be explained by a lack of influence due to limited ownership, inability to divest, exposure to primarily systemic and systematic risks, or simply a lack of time.

On the other hand, while these investors might be less able to do high-cost monitoring, their presence and support might increase the likelihood of success of more active investors’ engagements, especially so when there are ownership blocks present, which can also lower the expected costs of activism by others. This brings us to the next point. 

Points of intervention

Stewardship expectations have not only increased across asset classes but also in regard to how investors influence the functioning of financial markets. While public policy is recognised as a key lever to reign in companies’ negative externalities, it doesn't give investors a pass on the issue. They can still strive to improve the stability of both portfolio investments and broader market systems, as long as the points of intervention are guided by their unique circumstances.

As for implementation, it's generally about articulating merit-based expectations and following through on those using public discourse, proxy voting, and engagement. The below resources will help guide your thinking on the topic: 

• The academic paper ‘Systematic Stewardship’ by Professor Jeffrey Gordon: On voting, in summary, Jeffrey suggests large diversified investors may support ESG activist campaigns, such as Engine No. 1 on Exxon; support managers to fend off performance activists; implement relevant guidelines for voting on shareholder proposals, and; use firm-specific shareholder proposals or proxy contests.
• The U.N. convened Net Zero Asset Owner Alliance paper ‘Elevating Climate Diligence on Proxy Voting Approaches’ provides a foundation for asset owner engagement of asset managers, which partly sets out principles of merit-based, criteria-grounded voting programs. 
• The work by The Shareholder Commons, including research on social and environmental guardrails, case studies, and their Model System-Stewardship Investment Beliefs and Proxy Voting Policy.

As a final recommendation, collaboration with both the industry and civil society should be viewed as a central pillar of any engagement strategy. By seeking a balance between direct activities such as answering policy consultations with other, more indirect initiatives, efforts can have a catalytic effect on policy-making.

Effective stewardship requires deliberate effort 

Ultimately, effective stewardship, as reflected on by the UK FCA, can be boiled down to the key attributes of a clear purpose, constructive oversight, engagement and challenge, culture and institutional structures that support stewardship, and disclosure and transparency of stewardship activities and outcomes.

These attributes speak of investors' level of aspiration to drive change. However, until we reshape the system, we are making marginal gains. And reshaping the system requires a mindset shift from market participants, starting with the question: are we primarily focusing on idiosyncratic or systematic stewardship to address risks and opportunities across our portfolios?

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