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Cloaked in Mystery, ETFs Arrive as Investor Kingpins

By Louis M. Thompson, Jr., Compliance Week Columnist — August 18, 2009

The world of investor relations began shrinking several years ago with the decline of sell-side analyst research. Today, the game changer is the buy-side’s growing move away from analyzing individual companies in their portfolios and toward the use of asset management. This should alarm any investor relations officer, senior managers, and boards of directors.

The significant decline in sell-side research has relegated a majority of listed companies to be “orphan stocks” with no research coverage. This began with the $1.4 billion global settlement with 10 major brokerage firms engineered by then-New York Attorney General Eliot Spitzer, and it was followed closely by a key provision in the Sarbanes-Oxley Act that forced the separation of equity research from investment banking. Once sell-side analysts could no longer receive large bonuses for bringing corporate business to the investment banking side of their firms, sell-side analysts migrated to the buy-side and boutique independent research firms.

The brain-drain from the sell-side continues today. Firms like Goldman Sachs and Morgan Stanley are now banks with incentive bonuses going to those who do merger and acquisition deals, not those conducting equity research.

Now we’ve entered an era where index funds often outperform actively managed funds—and the new player at this inflection point is the exchange traded funds. Ever fewer fund managers make investment decisions based on the analysts’ “buy list.” Instead, they invest in ETFs that trade like a stock, have lower trading costs, and are tax efficient and more transparent.

More than 700 ETFs exist today, largely traded on the New York Stock Exchange, Nasdaq, and the American Stock Exchange. With the anticipated merger of the NYSE and Amex in September, the combination will dominate the ETF trading world. Just how big is that world? Well, 40 percent of daily trading activity on U.S. exchanges is now in ETFs! And that percentage is increasing significantly each year.

So why should investor relations officers care about all this ETF business? Because the asset manager investing in an ETF no longer has a need to talk with the IRO or senior management to gain information or insight. You, and your CEO, and your board are now out of the loop.

Moreover, the company has little or no control over whether it is selected for a particular ETF. Those ETFs that are not based on a specific index (like the S&P 500, for example) are selected using various algorithmic formulae peculiar to that specific fund. There are numerous industry-based funds such as oil and gas, biotech, health care, and so forth. But just because an ETF for your industry exists, that doesn’t mean your company is included in it.

With the decline of sell-side research coverage and the growing trend toward asset managers using ETFs and other index funds, the audience who wants to hear the company story is shrinking, quickly and considerably.

There’s more. ETF sponsors are now playing a significant role in proxy voting. A just-published study of proxy voting by ETFs in the 2008 proxy season found that the three largest ETF sponsors—Barclays Global Investors, State Street, and Vanguard—are less likely to vote against management on management and shareholder proposals than the smaller funds. However, they tend to withhold votes from incumbent directors more often than the smaller funds.

The authors of the study, Scott A. Fenn of Proxy Governance and Bradley A. Robinson (his professional affiliation was not listed) concluded: “This likely indicates the use of ‘withhold’ votes against directors as a substitute method of expressing dissatisfaction with certain management practices, rather than voting against management on specific proposals.”

With the decline of sell-side research coverage and the growing trend toward asset managers using ETFs and other index funds, the audience who wants to hear the company story is shrinking, quickly and considerably.

Larger ETF sponsors are more likely to rely on their own written proxy voting guidelines than smaller firms, which tend to vote according to input from the proxy advisory firms. In the latter case, funds that rely on proxy advisory firms tend to vote against management more often. The study also found that firms with their own guidelines tend to look at companies on a case-by-case basis, and voting decisions are made on specific facts and circumstances.

Here are some actions that companies can take to deal with this trend toward asset management:

  1. All of this suggests that the IRO and corporate secretary need to work together closely, recognizing that in a few cases, the IRO and the corporate secretary are one in the same person. The IRO needs to make an even greater effort to get senior management before institutional investors so they can hear the vision for the company and the strategy to enhance shareholder value. At the same time, the portfolio managers are making an all-important assessment of the quality of management that they consider when making their investment decision.
  2. The corporate secretary should meet with those who vote the proxies for investment funds (who are not the people managing the investment portfolios) to explain the company’s position on various proxy proposals and issues it deals with. Ideally, the IRO should accompany the corporate secretary in these meetings. These meetings should occur prior to the proxy season, not in the heat of it. Ultimately, the judgment of the portfolio manager as to the quality of management and the company’s strategy will be fed to the person(s) voting the proxies to aid in their decision whether to vote for or against management and the board of directors.
  3. With the decline of sell-side research and the shrinking audience on the buy-side, brokerage firm analysts will start offering to arrange meetings between companies and their buy-side clients. Words of caution: More often than not, the institutional investors they select are short-term investors, because the sell-side firms benefit from commissions generated by turnover of a company’s stock. IROs should carefully select the firms they or their senior managers meet with, and insist on meeting with firms that are more long-term investors.
  4. The institutional investors who actively manage their portfolios by analyzing individual companies want greater access to senior management. This presents an opportunity to communicate the company story and expose senior managers to the buy-side.
  5. While asset managers are using algorithms or an index to generate an ETF with no verbal communication with the company, the company still has an important governance role to meet with those in the sponsoring firms who vote the proxies. The way an ETF is created may seem like a “faceless” process, and to a degree it is—but one should not forget that ETF sponsors do make important governance decisions, where face-to-face meetings between the company and those voting the proxies can be critical.
  6. Meet with the more long-term hedge funds because they use ETFs in their hedging strategy and also vote the proxies. Some are more long-term investors than many of the mutual funds.

Finally, IROs need to explain to their senior management and their boards of directors the communication and governance implications of this rapidly emerging trend in asset management and the role of ETFs in this process. Forewarned is forearmed, and by taking the above actions you will be adapting to these changes in investor relations and corporate governance.

About the Author

Louis Thompson Jr., a partner with Beacon Advisors, Inc., is an internationally recognized expert on corporate governance and disclosure, having served for more than two decades as president and chief executive officer of the National Investor Relations Institute until his retirement in 2007. An adviser to the Securities and Exchange Commission and the New York Stock Exchange, Thompson is currently serving a second term on the NYSE Individual Investor Advisory Committee.

Prior to joining NIRI, Thompson was assistant White House press secretary to President Gerald Ford.

A veteran of the U.S. Command in Vietnam and the Office of the Secretary of Defense, Thompson has held executive communications positions for a number of organizations, including the American Enterprise Institute for Public Policy Research, and he served on the board of directors for the National Council for Economic Education.

A former journalist and news anchor, Thompson remains chairman of the advisory council for the Greenlee School of Journalism and Communication at Iowa State University, where he was the 2001 recipient of the James W. Schwartz Award for Distinguished Service in Journalism and Communication conferred by the Greenlee School.

Thompson is a former member of the Harvard University New Foundations Working Group on corporate governance.

Now a member of the board of directors at Hanley & Associates, a consulting firm that provides management access to institutions through non-deal roadshows, Thompson can be reached at

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