23 June 2022

Why the meteoric rise in passive funds is bad for democracy – and the planet

From the simple question of who owns Britain emerges the question of how they own it.

A shift is under way in the UK’s corporate ownership landscape. Margaret Thatcher’s promise of a “shareholding democracy” has long been written off in light of the unequal distribution of share ownership – and even pension wealth – by households. But the past decade or two has also witnessed a dramatic reconcentration of ownership of UK PLC among a small cluster of giant asset management firms. And the consequences threaten to be every bit as profound.

As research by the think tank Common Wealth has shown, the US firms BlackRock and Vanguard (the two largest of the so-called “Big Three”) alone own more than 10 per cent of the FTSE 350’s aggregate market capitalisation (this figure is even greater for the FTSE 100). But this is more than just a story of corporate concentration, with the usual attendant concerns about competition and inequality. From the simple question of who owns Britain emerges the question of how they own it.

Key to the rise of “asset manager capitalism” is the meteoric growth of passive, “index-tracking” funds. Unlike active funds that try to beat the market by virtue of the fund manager’s judgement, these replicate the market, matching their portfolio to a given index – for instance, the generic FTSE 100 or something more focused like the S&P 500 Carbon Efficient Select Index. Piggy-backing on pre-existing indices, they deliver reliable returns for ultra-low fees. Passive funds now own a bigger share of the US stock market than their active counterparts, with the UK on track to follow suit swiftly.

Asset manager capitalism is defined by certain characteristics. Firstly, corporate ownership is unprecedentedly concentrated among a handful of top shareholders. Secondly, asset managers are invested across effectively all industries, firms, asset classes and regions. Thirdly, the shares they hold mean their position in any given company is strong enough to materially influence decision-making. Finally, they operate a fee-based revenue model based on a fraction of assets under management.

The upshot of this mix is an ownership regime with a chief interest in maximising assets – whether by minimising costs to take market share, or by promoting general asset price inflation – and takes little interest both in how capital is allocated and how any company within its diversified portfolio is governed. In other words, such an ownership regime takes no ethical stance on what those companies produce, how they are run, what they sell or what impact they have on the planet. In May, BlackRock, which manages both passive and active funds, said that it would probably vote to support fewer climate proposals from companies in its portfolio this year than it did in 2021. The reason given was that “we do not consider them to be consistent with our clients’ long-term financial interests”. But this indifference does carry a long-term cost, both socially and environmentally. As our recent research has revealed, while active fund managers have pivoted their UK equity portfolios away from fossil fuel firms over the past decade, passive funds have shown no such discrimination. As of 2021, passive funds based in the UK had racked up over 12 per cent of the industry’s aggregate market capitalisation – proportionally greater than in almost any other industry.

Meanwhile, a fledgling renewable energy industry lags far behind. As in equity, so in bond markets, where bond exchange-traded funds (ETFs) are disproportionately financing high-carbon activities, often directly through primary markets. Conversely, growth in passive investment encourages firms towards greater bond issuance, with longer maturities and lower spreads. In the case of high-carbon businesses, that means greater risk of asset stranding (in which assets are unable to generate returns on their original investment) and carbon lock-in for the rest of us.

At a governance level, the cost-cutting imperatives of the fee-based model of passive funds has resulted in an almost non-existent level of engagement with management outside of annual general meetings (AGMs), and a homogenously pro-management, anti-climate and anti-ESG (environmental, social and governance) voting record in the AGMs of companies that the funds have invested in, as evidenced by that recent BlackRock announcement.

At a time of ecological and social crisis, a true shareholder democracy demands that both the governance rights and the financial rewards of capital ownership (too often exercised at the expense of both labour and investment) be extended to all.

Our new report lays out a raft of short and medium-term recommendations to address these dysfunctions by meaningfully democratising our system of financial intermediation. In the immediate term, reform to the fiduciary duties of pension trustees and to proxy-voting rules is an urgent priority. This would ensure that governance decisions answer not to financial intermediaries but to beneficiaries’ interests beyond financial extraction. This includes statutory mandates to eliminate fossil fuel funding, putting an end to mere lip service.

But these measures alone are not enough in the context of the wild inequality in financial wealth and the state’s hollowed out capacity to steer the direction of the economy. In the medium term a “public asset manager”, or PAM, is needed to fundamentally broaden the range of beneficiaries to whom financial intermediation answers. A PAM would sit along existing asset managers, occupying the same position in the financial chain, but would be capitalised by state-mandated measures (such as scrip taxes and equity swaps for existing state subsidies). Its non-tradeable ownership stakes would be held on behalf of all adult citizens equally. In short, a PAM would be an asset management company owned by the people, for the people. How the profits of a PAM are distributed should be subject to public debate, but options could include a universal basic dividend or a one-off grant issued to everyone once they turn 18.

Such an institution would be radically redistributive – commandeering a stake 5 per cent the size of total UK private pension and net financial wealth would increase the corresponding wealth of the poorest half of the population by 14 per cent and reduce the wealthiest fifth’s by only 3 per cent. It would also ensure that the people always affected by corporate decision-making are consulted.

Perhaps above all it would ensure that the public – who through intellectual property (IP) protection, industry subsidies and so much more – co-create the value that private wealth is able to capture, finally participates no longer just in the risk-taking of economic enterprise, but in its rewards and governance, too. How much of the gains flowing from such stakes should be reinvested or paid out to citizens remains a matter for debate. Likewise, this institution could dovetail with existing and prospective public institutions such as a National Investment Bank.

Similar models to this, such as the sovereign wealth funds of Alaska, Norway, Australia and others, already exist. Today’s crisis is a public crisis, with private wealth in command of the economy. Restoring a degree of public wealth is necessary to any solution.