Exit, Voice, and Loyalty in ESG

May 30, 2019

In 1970, Harvard economist Albert Hirschman published “Exit, Voice, and Loyalty.” The book featured the subtitle “Responses to Decline in Firms, Organizations, and States” and discussed the interplay of exit and voice in reversing, or helping hasten, an organization’s decline. While primarily intended as a work of political economy, it can be of relevance to the investment industry, particularly around activist shareholders and environmental, social, and governance (ESG) concerns.

The book describes exit and voice as the economic and political option, respectively. Exit is where consumers “stop buying the firm’s products or some members leave the organization.” This creates a direct effect on revenue and ideally spurs the firm to action. With voice, consumers and members express their concern to management or management’s representatives. In the investment world, exit would be akin to selling a security, whereas voice could be participating in shareholder meetings, voting on proposals, or meeting directly with management. Both options feature important interplay. Exit can be an unclear signal, leaving a firm uncertain as to the source of, or potential solution for, consumer satisfaction. Voice, conversely, may not have as much weight if members cannot credibly threaten to leave an organization.

Exit and voice have strong parallels within active and passive styles of investment. As passive managers will continue to hold securities in a company until an index is reconstituted, they are limited to voice if they wish to see a firm alter its behavior. Active managers meanwhile face much greater turnover in securities and much shorter time horizons, causing exit to be a frequently-used option. Both active and passive managers can make the case that they are best suited to employing this approach to ESG investing. Passive managers can argue that their long-term horizon makes them the most influential investors. They will be ideal as partners to ESG-sympathetic firms and can help identify and address social problems. Active managers may point out that voice loses its potency without a threat to exit. If active managers can credibly commit to longer-term holdings than typical active funds, they may be able to better incorporate both exit and voice.

The heavy presence of actively-managed funds in the ’40 Act space suggests there is much more room for a voice-focused approach. As of April 2019, active socially-responsible fund assets stood at $346.8 billion, accounting for 94% of the marketplace. The marketplace includes a wide spectrum of behavior and can range between managers who use these factors as a screen and those who treat it as a core part of their investment philosophy. Among ESG Mandate funds (for whom these factors are a central part), passive funds experienced an improved market share, but still well within the minority at 17%.

Passive funds have steadily increased market share among socially-responsible funds, but remain a small part of the overall market.

The activist shareholder approach does reemphasize a conflict at the heart of socially responsible investing: is it meant to drive social change or does the manager believe these factors will lead to higher returns? The ability to choose between exit and voice will force active managers to weigh the balance on an ongoing basis, potentially undercutting opportunities to act as activist shareholders. Passive managers may be able to construct indexes that allow them to more effectively stick to their guns.

ESG assets remain a small part of the overall industry, though industry players often tout their appeal to growing investor demographics. Managers that can demonstrate their ability to create industry-wide change may find themselves better suited to attracting assets from socially-minded investors.

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