Passive power 2

Shouldn't index-trackers think differently to active managers about executive pay?

My previous post about risk disclosures related to the scale of indexing indexing provoked a conversation last week about some of stewardship issues emerging from it. So in this post I’m rehashing a point I’ve mentioned before, but thought deserved a post of its own - executive pay.

Again I’ve said this before, but I think it’s important to treat active and passive management as really quite different beasts when thinking about stewardship in general and executive pay in particular.

The position of an an active investor is reasonably straightforward. The relative and absolute performance of their portfolio companies is what they live and die by. If there are, say, half a dozen companies in a particular sector and they have a position in only one or two of them then decisions about executive pay flow from this. Evidently they want the companies they hold to flourish rather than those that they don’t.

Therefore if they believe it is necessary to pay highly to recruit and retain the best talent they will be inclined to do so. They may consider that there are only a handful of people qualified and skilled enough to be suitable CEOs, for example. Therefore they will want those people working at the companies in which they have a position, rather than those to which they do not have exposure.

Obviously this is complicated by the fact that there is more than one investor and they will have different exposures. In our theoretical sector with half a dozen companies Investor A may only hold Company 1, and Company 2 in the sector, and Investor B may hold only Company 5 and Company 6. In which case both will potentially be tolerant of high pay demands at their respective portfolio companies and thus could feed a bidding war. But at least for the investors themselves the decisions are straightforward enough.

Additionally it should be relatively easy for a client to assess the manager’s reasoning. They may or may not share the view of the lack of available talent and the need to pay highly, even if this goes outside general principles of remuneration. But it will be easy to follow the rationale.

Passive managers are not in the same position. In the most simple version of the product they are primarily judged by their ability to deliver a market return at low-cost. If any individual stock or sector underperforms the manager will not be judged negatively for having chosen to hold it, they are holding it because the client asked them to by seeking exposure to a particular index.

Now presumably passive managers also believe they should act in their clients’ best interests by not supporting any value destructive behaviour by investee companies (although their ability to effectively monitor for this is obviously challenged by the sheer number of companies held).

But what should their orientation be towards executive pay? Why should they support paying more to secure executives at companies 1 and 2 but not 3, 4, 5 and 6? They could support paying more for executive talent at all companies. This would impose a portfolio-wide cost increase and would essentially be a bet on the idea that this would result in a market-wide improvement in performance.

This has been recognised by managers themselves. Way back in 2010 the then Conservative-Liberal Democrat coalition government undertook a consultation on short-termism titled A Long Term Focus for Corporate Britain which included some questions about executive pay. Blackrock’s submission included the following:

One of the difficulties we face as investors is that we (rightly) assess a company’s arguments for pay changes or increases in light of that company’s circumstances. Generally, companies do present strong arguments for the changes they wish to make. But our assessment tends not to take into account the impact it will have on the trend overall.

The word I would query here is the one in brackets. Shouldn’t a manager that holds the market think from that level down, not from the portfolio company up? If your mandate is deliver a market return then if there is a tension between what would be be beneficial to an individual company and what would be beneficial to the market as a whole, surely you should favour the latter. Perhaps paying more at companies 1 and 2 improves their performance relative to 3, 4, 5 and 6. But if restraining pay across the sector achieves a greater combined return across all six shouldn’t the manager choose the latter?

It would be fascinating to work this through as I think quite a lot of mainstream argument around executive pay involves a sort of fallacy of composition which is becoming more evident with the continued growth of indexing.

To flip the Blackrock argument perhaps what they should be saying is:

we (rightly) assess a company’s arguments for pay changes or increases in light of the impact it will have on the market overall rather than that company’s particular circumstances

I am doubtful that any investors are really approaching pay like this yet, though it would be surprising if some of these challenges have not been discussed internally within the big passive houses. Undoubtedly some have adopted market-wide guidelines for how pay should be structured to get away from trying to decide company by company, but that is not quite the same thing as thinking about executive pay from a market-level return perspective.

I’m also doubtful passive managers’ clients have thought much about this. And to the extent passive managers get challenged by clients on decisions on executive pay they likely reply using a company-level rather than market-level rationale.

I suspect one part of the problem is that companies would absolutely hate what a market-level approach to pay would entail. They already hate it when investors and their advisers don’t take account of their unique circumstances (which all companies seem to have when it comes to executive pay…) Imagine how they would react if the message was ‘yes, you might think you need to pay more to secure CEO X, but from our vantage point of holding 10,000 other companies, this would be net negative so we’re not going to support it’.

Likely it makes for an easier life to not open these questions up and instead default to taking the ‘let everyone pay a bit more if they don’t push it too far’ bet. While no-one is paying too much attention it’s an approach one can understand even if we think it’s flawed.

PS. In a future post I’ll try and dig into indexing and M&A decisions - another area where there are some big but relatively unexplored issues.