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Jim Woolery has seen a lot of historic upheavals in his 30 years on Wall Street––the financial crisis that ushered in the Dodd-Frank strictures on formerly free-wheeling banks, the rise of powerful hedge funds that doomed mergers and bounced CEOs, and the flood of investor money from traditional mutual funds to super-low-cost index funds and ETFs.

Now, Woolery predicts a counter-revolution where America’s old-line active managers, the Fidelities and T. Rowe Prices of this world, increasingly do what they’ve seldom done before, take a vocal, assertive role in opposing mergers, demanding share buybacks, and lobbying for fresh leadership. “Active managers, also known as “long-only” investors, are losing ground to passive funds, so they need to prove they’re doing a lot more for the fees investors are paying,” says Woolery. “They’re doing that by going from ‘active’ stock pickers to a more assertive and vocal stance on strategy and governance. Finally, the biggest cohort that owns the stock and benefits when their companies perform better stopped yawning and started flexing their muscles.”

Woolery, 50, is at the center of the movement as a specialist in advising companies on how to deal with the new paradigm. He’s an attorney who heads the M&A practice in New York for Atlanta law firm King & Spalding, and formerly served as co-head of North American Mergers and Acquisitions at J.P. Morgan Chase. He’s advised on $1 trillion in deals, representing the Dell board of directors in the transaction that took the computer-maker private, TXU in the largest LBO in history, and Medco Health in its purchase of Express Scripts, as well as marshaling Clorox’s successful defense versus Carl Icahn. He also advised the TSYS on its mega-merger with Global Payments.

Woolery sees three main roles for the active managers. First, a major fund can attack on its own by publicly opposing a merger, say, and rally support from hedge funds and the proxy advisors that frequently determine how the “passive” vehicles, index funds and ETFs will vote. T. Rowe Price, for example, jumped in to oppose Occidental’s merger with Anadarko. Second, a T. Rowe or Neuberger Berman can act as Solomon when a hedge fund demands radical change and the active manager wants a more modest shift, as Neuberger did in brokering a compromise between Cruiser and Ashland Global. Third, the active fund can act as a crucial “swing vote” in proxy contests by siding, for example, with hedge funds in opposition to management and passive funds, the route several big traditional players took in supporting Trian’s bid for a board seat at DuPont. “None of those actions would have taken place five years ago,” says Woolery.

Woolery predicts that this revolution will change the way companies plot their big strategic moves. “It will make it a lot harder for companies to spring surprises on their shareholders and get the deal done, like a high-priced merger,” he says. “In the past, the active funds would just go along. Now, unless the move is aligned with what the company’s been telling those funds, and what the portfolio managers are seeking, some of the funds will fight to stop the merger or the comp plan, or leveraging up the balance sheet to buy back tons of stock.”

In Woolery’s view, we’ve been living in a world where the BlackRocks keep gaining power on one side, and the Jeff Smiths and Bill Ackmans agitate on the other, and the a group of famous, old-line names in middle that sit quietly by.

Now, the silent actives by necessity are starting to make noise.

To grasp the impact of the active funds’ new aggressiveness, it’s important to understand that only two of the three big fund categories, hedge funds and actively managed funds, have an economic interest in how companies perform, while the largest, the passive contingent consisting of index funds and ETFs, by design simply track either the broad market, or the overall performance of their category. So the active funds’ move off the sidelines and into the melee should be a huge boost to putting more power in the hands of shareholders. “This phenomenon of active managers finally taking their vote seriously is good for the markets. They’re the group that best understands each company’s fundamentals,” says Woolery. “It marks an historic moment in the annals of shareholder engagement.”

Active managers are losing ground

Since the financial crisis, actively managed funds have, on average, badly underperformed ETFs and index funds, leading to a huge shift in market share towards low-cost passive management. In the process, that trend has placed a much larger proportion of shareholder votes in the hands of the BlackRocks and Vanguards. In the past five years, 76% of all actively managed funds failed to beat their benchmarks, and in the last 15 years, more than half of the industry’s players disappeared. The share of equity assets invested each year in passive funds more than doubled between 2006 and 2017, jumping from 20% to 44.6%. According to Morningstar, total equity assets held in index funds and ETFs surpassed the amount invested in active funds for the first time in August, and the lead keeps growing.

The reason for the shift is obvious: Index funds and ETFs deliver better returns just by mimicking the market, chiefly because their fees and trading costs are so much lower. Active funds generate $120 billion a year in revenues by charging fees of 1% or more, while their passive rivals collect one-tenth that amount, $11 billion, charging an average of .1%.

At the same time investors were sending a much bigger portion of their savings to passive funds, the industry’s biggest players devoured competitors, so that the field is now dominated by three giants, Vanguard, BlackRock and State Street. That triumvirate now owns in excess of 20% of the shares in the S&P 500. In contrast, the eight largest specialists in active management, a cohort encompassing by Capital Group, Fidelity, T. Rowe Price and Wellington, hold around 12% of the S&P. The third and heretofore most combative force by far, the hedge funds, own approximately 4%.

“We’ve seen a big consolidation of voting power, especially in favor the passive funds,” says Woolery. “This is like 1792 when two-dozen stockbrokers who controlled all the shares met under the buttonwood tree to form the New York Stock Exchange.” Woolery note that between 80% and 85% of the shares vote in a typical proxy contest, “So winning requires not 50.1%, but as little as 40.1%.” The Big Three passives, plus the top six active managers, now control about 30% of the S&P votes. “I tell companies that eight or nine funds control their destiny,” says Woolery. Hence, getting the newly engaged active funds on their side can prove a crucial counterweight to the power of the passive managers and hedge funds.

No longer outsourcing votes

Traditionally, the big active funds weren’t vocal either in demanding change, or taking public positions in most proxy votes. “Proxy voting was a back-office function, a cost center, it’s not where the cool kids hung out,” says Woolery. “It costs money to put your head up and look over the fence, and the funds kept their heads down.” In most cases, the active funds followed the recommendations of the two big proxy advisors, Institutional Shareholder Services and Glass Lewis, which generally took the same position. The proxy advisors often endorsed expensive acquisitions that hurt the actives’ performance by driving down the acquirer’s stock and were opposed by hedge funds, such as Heinz’s acquisition of Kraft and Cigna’s purchase of Express Scripts. Hence, the active managers generally didn’t take an independent stand on whether a move would enhance a portfolio company’s long-term value, leaving the decision to the proxy advisers.

While the actives had a big economic interest in how proxy voting turned out, the big passive funds don’t pick stocks and hold portfolios that buy or track an entire index, so their performance isn’t influenced by who gains or loses by blocking an acquisition or securing a big share buyback. The major purveyors of index funds and ETFs instead follow macro policy objectives like “ESG,” an acronym for an environmental, social and governance agenda. They employ big staffs and compete in campaigning for enlightened stewardship, a big priority for millennial investors, in what’s known as “the governance arms race.” “It’s not about buying and selling and beating the market because they mostly don’t trade,” says Woolery. “They follow detailed guidelines for voting on things like staggered boards, super-majority votes, which they opposed, and promoting gender diversity on boards, and ensuring that companies are environmentally responsible.”

So until recently, it’s been the third group, hedge funds led by Bill Ackman’s Pershing Square, Jeff Smith’s Starboard, and Nelson Peltz’s Trian that were the rebel champions of change. And because they practically handed their votes to the proxy advisors, the actives, along with the passive managers, frequently voted against the disruptors.

Active funds change their strategy

Now, the T. Rowe Prices, Neuberger Bermans and their brethren are breaking with tradition by launching or participating in campaigns for change. “The actives want to be voters in the New Hampshire primary, the leading voice in the campaign that determines the winner, in this case, what strategies companies adopt,” says Woolery. “They’re finally fighting back by trying to get the incremental dollar in returns, so that they can show what they’re doing for those fees, and win assets from the passives.” Hedge fund moguls agree. Keith Meister, a Carl Icahn protege who founded activist investment firm Corvex Management argues that the long-only managers will be just as engaged as the passives in years to come, and that “Every single active investor needs to justify why they’re investing actively as opposed to giving their money to this great product called BlackRock.”

One earmark of the shift is the buildup in compliance staff. “It’s just about the only area where they’re headcount is growing,” says Woolery. “A few years ago, one of the biggest active funds might have 15 people in compliance and now it’s not uncommon for 80 people to be working in those departments strategizing on proxy votes. The business model is changing, it’s like going from outsourcing production to building your own plant.” Those compliance folks are taking direction from portfolio managers who are typically looking for long-term gains. That distinguishes them from hedge fund titans whose attacks are generally who generally have a shorter time horizon. Hence, the active funds are choosing different allies in different battles, siding with activists when their salvos promise durable improvements in performance, and backing management when the attackers are disrupting a sound strategy that will take a few years to pay off.

Active managers have crossed swords with management, a gambit almost unheard of in the past. In a historic riposte, Wellington Management––one of five biggest long-only funds overseeing over $1 trillion in assets––announced on February 26 that it was opposing Bristol Myers-Squibb’s $74 billion bid for Celgene, arguing that Bristol was way overpaying. It was practically unheard of for a big long-only fund to intervene in a major merger, in this case, six weeks before the shareholder meeting. It’s also significant that Wellington partnered with a hedge fund, Jeff Smith’s Starboard, in seeking to kill the deal. As it turned out, ISS and Glass Lewis supported Bristol management and the deal was approved. But Wellington’s move, and the 25% of the vote it helped marshal against the transaction, caused an earthquake in the investment world. The actives keep coming. Shortly after the Bristol vote, T. Rowe Price strode forward to join Carl Icahn in protesting Occidental’s proposed acquisition of Anadarko.

But the actives will also protect management if they reckon that an activist’s demands are too extreme, and that management deserves more time to deliver. In mid-2018, hedge fund Cruiser assaulted Ashland Global, demanding that it name Cruiser’s slate of four new directors, and enact big reductions in operating costs and executive pay. The conflict appeared headed for an bitter proxy battle. But in late 2018, Neuberger Berman, owner of a 2.8% stake, intervened as a white knight. Neuberger succeeded brokering a deal where Ashland named two new board members, and a new lead director, and chose former Union Carbide CEO Bill Joyce as a consultant. Charles Kantor, senior portfolio manager at Neuberger, stated that he wanted to forestall leaving a vote that would have left “our fate in the hands of the proxy firms and index funds.”

Woolery participated in the transaction. “Neuberger cut the activists off at the pass,” he says. “Their role enabled a better deal for management.” Neuberger is intervening in other deals. In May, it launched a proxy fight against data analytics provider Verint Systems, urging shareholders to vote for its slate of three new directors. Shortly before the annual meeting, the two sides settled in middle ground, with Verint agreeing to name a new board member and provide greater disclosure on the performance of its operating units.

A looming question is how often the biggest shareholders, the ETFs and mutual funds, will side with the active managers. The aftermath of a landmark battle has made the passives more reluctant to oppose campaigns heavily favored by a combination of hedge funds and traditional money managers. In 2015, Nelson Peltz’s Trian challenged DuPont in a proxy contest, demanding that DuPont name Peltz––who advocated shrinking the huge headquarters staff and treating the businesses as entrepreneurial profit centers––to the board. Peltz won widespread support from the long-only funds and retail investors, and secured the backing of both ISS and Glass Lewis.

But DuPont, then headed by Ellen Kullman, lobbied hard for the passive managers’ vote. In a highly unusual move, all three giants, BlackRock, State Street and Vanguard, broke with the proxy advisers, and voted with management. That gamble backfired. Five months later, DuPont’s stock had cratered 30%, and Kullman abruptly retired, replaced by Ed Breen, who was strongly supported by Peltz, and rewarded shareholders by securing a successful merger with Dow, then splitting the chemical behemoth into three separate companies. “The passives got egg on their faces,” says Woolery. “The stock tanked and they got blamed.”

The legacy of that mishap, he says, is that the big passive managers are reluctant to use their enormous power to cast controversial votes where they stand virtually alone. “The tall blades of grass get cut,” says Woolery. “The big ETF and index fund managers get attacked when the actives move in and the passives use their power to block them. In the DuPont case, the shareholders went right and the index funds went left.” Woolery predicts that the passives will vote more frequently with the active funds in the future. “The active funds believe that, too,” he notes. As evidence, he cites that Vanguard and Wellington recently reached an agreement in which the Wellington will vote a significant portion of Vanguard’s shares. “Vanguard is essentially saying that an active manager in many situations can vote better than they can,” says Woolery.

A new era of communication

Woolery says that the dialogue between companies and active fund managers, the long-term investors who really know their financials, is minimal––and that a new era of close communication is dawning. “While top executives talk to portfolio managers, they often don’t understand the voting process inside the fund company, which includes people inside the firm they’ve never met.” And often the portfolio managers are unwilling to express a strong view on where the company should be going. “They’ll say things like, ‘You’re the CEO, you tell me,'” says Woolery. He says that top management needs to know its big active investors as well as its top customers, and that the funds should be explicit about what strategies they’ll endorse or resist. He adds that that companies should begin frequent conversations when times are good. “You want to get to know the portfolio managers and the voters on a sunny day. If you wait until a crisis, when the ox is in the ditch to make your case, that’s when the Bill Ackmans show up.”

These frank discussions, he says, will make it harder for companies to spring surprises. “Companies will need to do the right signaling,” he says. “This is about the next hundred deals. The active management business is under stress, and surprises magnify the stress.” He uses the example of a company that keeps assuring portfolio managers that it plans to grow organically and doesn’t need a merger, then announce a big acquisition. “They change their minds with no signal to you as a fund manager,” says Woolery. “You thought their strategy was a home run, and now they throw curve ball.”

Woolery adds that if a company wants to change direction, it needs to sell the new strategy to the funds. “They need to build a coalition for it, to get buy-in from the Wellingtons and T. Rowe Prices,” he says. “The days of taking the active managers for granted are over.”

The next few years will tell us if the new engagement turns the tables on passive investing, or whether the actives continue their long decline. What does this mean for corporate democracy? We’re seeing more shareholder influence, but held in fewer and fewer hands. A small group of organizations now have a tremendous amount of responsibility and their stewardship of that responsibility remains one American’s capitalism’s greatest know-unknowns.