The Future of Shareholder Activism Won’t Be Led by Hedge Funds

Targeting systemic risks like climate change doesn’t make financial sense for small, concentrated funds, a Columbia law professor argues.

Brendan Thorne/Bloomberg

Brendan Thorne/Bloomberg

Shareholder activism is in for a dramatic shift as investors move away from the classic approach of targeting improvements at a single company and instead work to benefit their entire portfolios. But the activist hedge funds that have historically led proxy campaigns may not be the best suited to lead that charge, according to new research.

Presently, there are two main types of shareholder activism: the more traditional firm-specific activism, which targets a specific company and demands change to benefit that company, and systemic risk activism, which aims to reduce systemic risk in the larger market. According to Columbia University School of Law professor John Coffee, firm-specific activism may be phased out by systemic risk activism in the coming years, as investors emphasize issues like climate change and diversity and inclusion. However, for all but the top-three index managers — State Street, BlackRock, and Vanguard — systemic risk campaigns may be a losing proposition.

“If you’re running a proxy campaign, telling the company’s shareholders to vote, and forcing the company to cut back on its principal business of high carbon fuels, you are actually running a campaign to decrease the stock price of the company,” Coffee told Institutional Investor. “There is a dilemma here in trying to run a campaign that benefits the portfolio, but hurts the target company’s stock.”

According to Coffee, there’s a stronger investment case for systemic risk activism at firms like State Street, BlackRock, and Vanguard, which own wide swaths of the market.

“Just three of them own 23.5 percent of the S&P 500. If you throw on some of the biggest pension funds, you have six or seven institutions that own the majority of the index,” he said. “This is a new change, and it means that these funds don’t just own a portfolio; they own the entire market.”

In his new paper, Coffee asks the question of who will lead systematic risk campaigns, noting that the institutions that run these types of campaigns are often vulnerable to significant loss when the target company’s stock price tumbles — something that would disproportionately hurt activist hedge funds as a result of their smaller portfolios. For instance, while an index fund may own stocks in thousands of companies, a hedge fund or a mutual fund may only hold shares of 10.

In this new environment, Coffee said, activist hedge funds are inadequate and largely incapable of leading systemic risk activism. Because hedge and mutual fund portfolios aren’t as diversified as index funds, if one of their stocks plummets, their portfolios might go down with it. Also, smaller funds may not have the capacity to fund proxy campaigns, which can be costly, particularly with the added loss of the targeted company’s stock value.

As one example, Coffee said that an investor wishing to advance the value of his entire portfolio could realistically start an activist effort that causes an oil company like Exxon Mobile to lose 10 percent of its value. If the move causes 10,000 other portfolio exposures to gain 1 percent, those gains will greatly outweigh the Exxon loss. For the big three firms, this kind of tradeoff is possible.

“But a hedge fund can’t do that,” he said. “A portfolio of only 13 stocks — most of them high tech — is not going to let you realize that benefit of the market-wide improvement.”

Coffee isn’t the first person to draw attention to this new direction in activist investing, and, according to him, he won’t be the last. For the time being, Coffee expects that systematic risk campaigns and firm-specific activism will continue to coexist.