- Many index funds give investors access to "exit" strategies (divestment).
- No major funds give investors access to "voice" strategies (engagement).
- Exit's effectiveness requires participation of all market participants
- Voice can lead to immediate and permanent reforms
Voice vs. Exit
In the previous two posts, we explored two ways that socially responsible index funds can influence corporate behavior. Exit, or divestment, involves denying capital to bad behaving firms. Voice, or engagement, invovles using shareholder rights to push companies to change.
This post explains why the engagement strategy should not be disregarded by investors concerned about the impact of their savings.
Limitations of Exit
When a large fund chooses not to invest in a firm for some reason other than the underlying financials, the firm's share price will be artifically deflated. According to the efficient market hypothesis, other investors will take advantage of this price distortion by buying shares of the underpriced firm until the price is no longer artificially low.
This principle of markets limits the effectiveness of divestment as a strategy. For exit to work, it doesn't matter how virtuous you and your index fund are. You need every other market participant (even the algorithms!) to overlook the underpriced stock.
Historically, divestment campaigns achieved success not by restricting access to capital but by shaming firms with bad behavior. Climate change is such a politically contentious issue that it is a risky bet that a shame campaign will capture the public attention where other attempts have had only modest success.
Benefits of Voice
A high-profile shareholder engagement action can have a similar shame effect, but it can also lead directly to reforms without needing to caputure public attention. Firms are ultimately answerable to their shareholders, and if shareholders can credibly signal a demand for lower emissions, directors and executives will take immediate action.
Shareholder engagement is the natural way to align excectives' priorities with those of the company's owners. Shareholders can appoint climate change scientists to boards of directors, tie executive bonuses to sustainability metrics, and ask firms for greater emissions disclosure.
These shareholder campaigns are already very close to being successful. Many resolutions fail with 30-49% of the vote. The only thing blocking climate-change resolutions from passing is a lack of support from the big index fund providers, who together own about 20% of every company.
Getting these firms to support climate-change-related resolutions, or replacing them with index funds that will support emissions, can immediately lead to lower emissions without relying on public opinion or politicians to get their act together on climate change.