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Directors' Dilemma: Responding to the Rise of Passive Investing

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Directors' Dilemma: Responding to the Rise of Passive Investing

The recent decline in active single-stock investing raises important considerations for corporate boards of directors. The decline has been driven by a shift toward ‘passive investing’ and other forms of rule-based investing, such as index funds, factor-based investing, quantitative investing and exchange-traded funds (ETFs). The decline of active investing means that, in many cases, stock prices have become more correlated and more closely linked to a company’s ‘characteristics,’ such as its index membership, ETF inclusion or quantitative-factor attributes. As a result, companies’ stock prices have become less correlated to their own fundamental performance.

Accordingly, market scrutiny of fundamental corporate performance has diminished, and stock prices have become less informative than they once were. This can be problematic for boards of directors that utilize stock prices to assess company performance or to guide executive compensation decisions.

This does not mean that stock prices no longer matter – they do. Stock prices influence a company’s cost of capital, which affects its competitiveness, and they guide much of the economics around mergers and acquisitions, as well as secondary capital raisings. Stock prices also still do respond to changing company fundamentals, at least over time. But given the significantly lower turnover of passively managed investments and the extent to which equity prices now also move for other reasons, boards need to be able to separate ‘characteristic-driven’ or ‘flow-driven’ movements from fundamental ones in order to better evaluate underlying corporate performance.

In some cases, disentangling corporate operating performance from market performance will become easier if boards shift their focus away from the widely used performance metrics of share price and total shareholder return (or TSR, which measures a firm’s stock returns as well as its dividend payouts), which may not fully reflect underlying company fundamentals. To gain a clearer picture of a firm’s performance – particularly on a relative basis – boards may want to put greater emphasis on broader assessments, leveraging financial metrics that are both standardized and comparable across companies. In our view, this may include focusing more on metrics such as cash returns on cash invested for non-financial firms, or return on tangible common equity for financial companies.

In addition, when assessing relative performance, boards may want to heighten their scrutiny of the peer firms that are used to benchmark their own companies’ performance. For complex firms, boards might look more to ‘sum of the parts’ comparisons as they seek to assess the relative performance of specific business lines. This would help them to avoid overly broad comparisons that might mask key structural issues by conflating the performance of one business line with another.

It is worth noting that an overreliance on share price or on TSR to evaluate management performance can result in incentives that may not be aligned with shareholders’ long-term strategic interests. When share prices fail to appropriately price in fundamentals, companies can become more focused on near-term tactical decisionmaking rather than on what is strategically best for the value of the firm over the long term.

Through a period in which interest rates have been historically low and equity markets have posted record highs, there have been relatively few opportunities for active investors to identify differentiated investment ideas. Less-expensive rules-based investing has thrived in this environment. But the current market backdrop could change and become more supportive of active investing again. If it does, boards can help to ensure that their companies are well positioned for outperformance.

As directors consider their oversight roles and responsibilities in an evolving market, we offer a brief snapshot of today’s investing environment and the impact of rules-based investing on trading and stock-price movements. We then suggest a number of approaches that can help boards sharpen their assessments of company fundamentals, so that they can better assess relative performance. Finally, we discuss the natural tensions that exist between managing a company for the near-term stock price and managing a company to create long-term shareholder value.

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