Investment Managers act as agents for their clients investments, and cannot act as principals without their clients consent

There has been a lot of discussion about the power that investment managers have to act politically, whether that is around ESG, or in supporting the agendas of one political party or another.

As agents, investment managers can only act in their clients best interests, not their own belief systems.

There are two main ways investment managers implement their clients wishes. One is labelled “passive”, the other “active”.

Passive management involves replicating an index. The investment manager has tiny amounts of discretion to build and maintain a portfolio of investments that is exactly the same as an index, like the Russell 2,000, S&P500 or an investment grade bond index. Discretion is limited to areas like re-balancing the portfolio ahead of known changes to the underlying index and lending securities in the portfolio. Fees for passive management are a fraction of the fees charged for “active” investment management. In fact, one could argue that fees should be capped at a maximum level, since there is no incremental effort by the investment manager other than the processing of subscriptions and redemptions – every other facet is a fixed, not variable cost. Typical fees are less than 0.10% per annum and typically around a few basis points of 0.05% p.a. (a basis point is 0.01%).

Large investment managers of passive funds are BlackRock, Vanguard, State Street and a few others. Almost all Vanguard and State Street managed funds are passive. Half of BlackRock’s too (last I knew, some seven years ago). These managers have “products” that must clearly display fee structures, track record, entry and exit costs and notice periods etc. The products can be mutual funds, ETF’s or similar vehicles. They seek only to match the returns of a specified index and nothing else.

Probably around 75-90% of all investments are passively managed, for the simple reason that investment managers fail to consistently match their benchmarks AFTER FEES. Now, in my time as an investment manager of fixed income portfolios I did not consistently under-perform a benchmark, for the simple reason that fixed income indices back then, were dumb and easily gamed. Perhaps these indices have got a lot smarter. Who can say? Perhaps the investment journals have figured out a better way to achieve excess returns.

Active management is far more complex and expensive, but again, the investment manager acts within discretion given to him by clients or which are pre-specified within the terms and conditions of pooled vehicles (mutual funds, ETF’s or similar vehicles) that a client (or millions of clients) must agree to prior to investing.

Active management involves the pursuit of an objective to out-perform a benchmark. The benchmark can be a single market index (like the S&P500, or a European Investment Grade Corporate bond index or a combination of many indices. The active management discretion that may be used to pursue this objective is agreed to by both parties and is encapsulated in an investment management agreement. Typically the objective is expressed like this “To achieve a five years annual excess return over the benchmark of 0.75% per annum after fees, within an average annualized  ex-ante and ex-post tracking error of 1.5% per annum”. An active investment manager must deviate from the benchmark or index in order to exceed returns from that benchmark or index. The tracking error constraints limit the amount of deviation.

Ex-post = actual historic portfolio returns achieved.

Ex-ante measures how the historical correlation and risks of the holdings of the current (not how the holdings in the portfolio actually changed over time – just the characteristics of the current holdings) portfolio have behaved, relative to the benchmark.

The “success” or otherwise of an investment manager in meeting the clients expectations are usually expressed as an “information ratio”, which divides the excess return by the excess risk. The usual number for the Information Ratio of the vast majority of “active” discretionary funds seldom persists above 0.25 – that is, getting 40 basis points (0.40%) per annum over any three year period above the benchmark or index by taking 1.60% per annum of risk is quite an achievement. Care is needed over the treatment of fees and costs. Items like custody, trustee and bank charges are charged separately. Brokerage (the cost of the investment managers transactions)  is rarely if ever disclosed and is usually not even discussed by clients and their investment managers – it is part of the excess return (or under-performance).

The bottom line is that investment managers are in the business of making money for their clients within agreed parameters, for a fee.

Which brings us to the current debate.

For a bit of context, check out this document published on 3 September 2020.

Guidance: Supplement to Commission Guidance Regarding Proxy Voting Responsibilities of Investment Advisers (Conformed to Federal Register version) (sec.gov)

Here is an Investopedia article describing a proxy vote

What Is a Proxy Vote, and How Does It Work? With Examples (investopedia.com)

Referring back to the nine page Guidance document - Page 6 of 9 – says this:

“The Commission explained that an investment adviser may agree with its client to the scope of voting arrangements but that scoping the relationship requires the investment adviser to make full and fair disclosure and the client to provide informed consent.”

“Further, rule 206(4)-6 and Form ADV require an investment adviser to describe to clients its voting policies and procedures.”

“In light of the above, we believe that an investment adviser that uses automated voting should consider disclosing: (1) the extent of that use and under what circumstances it uses automated voting; and (2) how its policies and procedures address the use of automated voting..”

An investment manager cannot cast a vote at a company general meeting without INFORMED CONSENT – sound familiar?

Of course, an investment manager will have clients with many differing view points and beliefs, political or otherwise.

Where clients consent in advance to delegate all proxy voting to the investment manager, the discretion that the investment manager has to vote is apparent.

So, how are proxy votes actually determined, collected and voted? A passive manager could, theoretically vote at a company meeting and badger a company that is in the index in the same way that an active investment managers would. I suspect there is not much of this sort of thing happening.

Anyway, there are around a dozen companies that process proxy votes and it is here that debate could be profitable. These companies not only have the ability to send in proxy votes, they also collate the votes of hundreds if not thousands of proxy votes from the active and passive managers.

Here is a link to one such companies website.

About ISS | ISS (issgovernance.com)

And a link to a legal specialist

Voting by proxy | Legal Guidance | LexisNexis

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