A brewing confrontation between financial titans and regulators could reshape passive investing. For ESG and impact investors, the knock-on effects could reshape how passive index funds engage with companies across industries and limit (for better or for worse) their influence on corporate behavior.
As we were all rolling into the holiday quiet, the FDIC took aim at one of the industry’s biggest passive players – Vanguard. In a signed agreement between the two parties, various measures were outlined to ensure Vanguard remains a “truly” passive investor in FDIC-supervised institutions. It restricts Vanguard from influencing management, policy, or board decisions of these institutions and requires disclosure of holdings exceeding specific ownership thresholds. In contrast, competitor BlackRock is pushing back, requesting an extension until March to respond to similar regulatory pressures.
This brewing confrontation between financial titans and regulators marks a critical moment in the evolution of passive investing. On the one hand, markets increasingly recognize that long-term value creation requires considering broader risks and impacts. Many argue that asset managers using their influence to encourage corporate responsibility isn’t activism – it’s prudent risk management. On the other, managers have a fundamental duty to provide low-cost market exposure while maximizing returns within stated objectives. The new framework aims to ensure index funds maintain this focus without straying into activism that could conflict with their core mandate.
While this FDIC agreement specifically applies to banking institutions and their subs, it could serve as a template for forthcoming policy shifts across other heavily regulated industries. For example, the SEC could adopt comparable frameworks for passive investors in energy companies, potentially limiting index funds’ ability to influence corporate policies around carbon emissions and renewable energy transitions. Similar approaches might emerge in regulated utilities, telecommunications, or healthcare sectors, where federal oversight bodies could restrict passive investors’ voting rights or engagement activities.
If this type of regulator intervention continues we could see even farther-reaching implications, including redefining what “passive” means, creating oversight mechanisms to monitor investor engagement, restricting proxy voting rights in certain sectors and requiring detailed reporting on investor-management interactions.
Passive investing and ESG
Total assets in US passive mutual funds and ETFs for the first time last year surpassed those in active ones, according to Morningstar. For many investors, passive investment strategies remain the primary – and sometimes only – way to engage in the capital markets. So how we think about the way that values show up in these strategies is critical for so many of us.
The first ESG index – the Domini 400 Social Index – was launched in 1990, designed to help socially conscious investors consider how social and environmental factors might impact their investment choices. Since then, the ecosystem of ESG-integrated and/or aligned strategies has exploded, so much so that the SEC was forced to jump into the fray, updating the Names Rule in 2023 to specifically address the plethora of products and strategies that had added “ESG” to their name.
One of the biggest points of tension between ESG and passive investing, has been how to do both. Definitionally, a passive strategy requires a benchmark to orient towards. If it intends to be “sustainable” it requires the integration of environmental, social or governance factors. Often (though not always), managers start with traditional indexes, applying filters based on ESG criteria that sort out (or sort in) issuers. Some passive managers go further, using proxies and broader shareholder activism to reflect the product values across all decision-making.
Drawing a line
There is no clear answer as to where to draw the line between passive investing and active stewardship, how to balance fiduciary duty with evolving perspectives on risk, or how market-based solutions can best coexist with regulatory oversight. But the knock-on effects could reshape how passive index funds engage with companies across industries and limit (for better or for worse) their influence on corporate behavior.
While signs of government intervention of market-based approaches rightly gives us pause (particularly given the worrying movement to ignore climate change and its impact on both the planet and markets), there may be an opportunity here.
We know from our work that there are some organizations that engage in passive investing and active stewardship, and do both well. Does the narrowing of the aperture mean that true values-based investors who champion robust methodology, active engagement, and deliver risk-adjusted returns will have their moment in the sun? Certainly we could imagine that these types of regulations will preserve the distinction between passive and active strategies, even allowing investors to choose vehicles more closely aligned with their goals and encouraging further innovation in ESG products (if folks are willing to pay for it).
The implications stretch far beyond Vanguard’s acquiescence and BlackRock’s resistance. As regulators and market participants grapple with the proper role of passive giants in corporate governance, these FDIC actions could serve as a template for reshaping how index funds engage with companies across all regulated industries. The stakes? Nothing less than the future of passive investing itself.
Rehana Nathoo is the founder of Spectrum Impact, which helps organizations build future-forward impact investing and ESG strategies.
Eric Stephenson co-chairs the Cordes Foundation, which champions transformative change at the intersection of gender equity and sustainable business.
