By James Saft
(Reuters) - Lousy incentives for corporate stewardship is a flaw at the heart of our system of delegated asset management.
What’s more, index funds, which are rapidly becoming the dominant force in investment management, have the lowest incentive to spend money to chivy the companies whose shares they hold to perform better.
The upshot is that companies in the U.S. are increasingly free to act without proper shareholder oversight, theoretically leading to more executive self-dealing, lower investment returns and lower economic growth.
Activist hedge fund investors are part of this ecosystem, and can do excellent work in holding corporate feet to the fire, but they are, while growing, relatively few in number and will tend to have a short-to-medium-term outlook.
“Investment managers of mutual funds - both index funds and actively managed funds - have incentives to under-spend on stewardship and to side excessively with managers of corporations,” Lucian Bebchuk and Scott Hirst, both of Harvard Law School, and Alma Cohen of Tel Aviv University write in a newly revised study. (https://papers.ssrn.com/sol3/papers.cfm?abstract_id=2982617)
“We show that these incentives are especially acute for managers of index funds, and that the rise of such funds has system-wide adverse consequences for corporate governance.”
The nexus of the problem, as is so often the case, is a regulation intended to protect investors in mutual and similar funds from self-dealing by asset management companies themselves. Under these rules if a mutual fund spends a dollar on corporate governance issues - and the research and campaigns involved are labor intensive - they must bear those costs out of their fee income. So if a mutual fund wants to launch a proxy fight it bears the cost out of its fees.
In theory this allows some upside to activist stewardship for active fund managers, but not a lot. Given that the average active equity management fee is 79 basis points annually, active investors spending money on corporate governance only stand able to benefit by the amount it increases the value of the holdings times 0.79 percent, not a lot.
They also might attract new funds by outperforming against active peers based on corporate governance campaigns, but this too makes a weak tea. Active managers really only have an incentive to intervene and spend money beating up company management if they are overweight a company. This also means they have the opposite incentive if they are underweight.
RISE AND RISE OF INDEX FUNDS
That’s not even counting the conflicts of interest which fund families can have; as they provide corporations with pension and cash management services, angering them with a proxy fight isn’t always good business.
For index funds the self-interest math is even worse. If an index fund can drive up the value of a holding it will collect more fees, as fees are calculated on a percent of portfolio basis, but that is a tiny amount. The average equity index fund stands to make just 12 basis points annually on the increase in value of a holding if it goes higher due to better corporate governance.
But index funds, which own almost a third of the equity market, don’t differentiate themselves on performance; their selling proposition is a market return at a low price. So if one index fund family decides to spend a lot of money on corporate governance research and campaigns, their peers can get a free ride, enjoying the extra fee income as shares rise in value but funding none of the underlying costs.
Research by the Wall Street Journal in October found that Vanguard, BlackRock and State Street Global Advisors, who together control about $7.5 trillion in index fund assets, have between 40 and 50 employees dedicated to voting and stewardship activities. (https://www.wsj.com/articles/the-new-corporate-power-brokers-passive-investors-1477320101)
Those three, and a host of other institutional investors, as part of the Investor Stewardship Group, have launched a framework intended to set a baseline of investment stewardship and corporate governance guidelines. This takes effect Jan 1, 2018. (https://www.isgframework.org/)
This is welcome, but the underlying tension between profits at the asset manager level and stewardship issues remains.
“These agency problems limit the extent to which our corporate governance system is able to benefit from the increased concentration of shareholdings, and are a key impediment to improving the governance of publicly traded corporations,” Bebchuk, Cohen and Hirst write.
One welcome step would be a review of the regulations requiring investment firms to eat all of the costs of stewardship out of their fees.
With returns in equities potentially sub-par for the next decade or more due to demographic and other pressures, pressuring corporate America to run itself better may prove to be money well spent.