While bankers and brokers remain everyone’s favorite culprits for causing the great financial crisis two years ago, a less likely suspect—the institutional-investor community—is increasingly coming under scrutiny. These investors, in particular pension funds, insurance companies, and investment-management firms, are major market players around the world. In the United Kingdom, for example, they own and manage more than 70 percent of the stock market. Now, politicians and regulators say that such institutions must share the blame for enabling the crisis through passive corporate governance and a focus on short-term returns.
The European Union recently charged that the financial crisis has shaken the assumption that shareholders can be relied on to act as responsible owners. Former US vice president Al Gore and David Blood, cofounders of an investment fund dedicated to long-term investing, have criticized the common practice, among asset owners, of reviewing and rewarding their asset managers based on short-term performance. Indeed, a movement is afoot in Canada, France, the Netherlands, the United Kingdom, and other markets to encourage institutional investors to become better “stewards” of the companies they invest in, by adopting a more active and long-term stance.
Asset owners (including pension funds, insurance companies, sovereign-wealth funds, and endowments) and asset managers (such as mutual funds and other money managers) should take these calls seriously. By rethinking their approaches to portfolio diversification, engagement with boards, and compensation, they could usher in a new ownership culture that would not only benefit their customers but also placate regulators, which are poised to intervene if voluntary progress is slow.
Reforming the ownership approach of institutions won’t be easy. Many have poorly aligned incentive structures. They must tackle other structural impediments too. One is increasing portfolio diversification, which makes it difficult to allocate the necessary time and resources to monitor and engage with companies. Another is a growing distance between the professionals who manage the money and the asset owners, representing hundreds of millions of people who depend on the former for their long-term savings and financial security when they retire.
The case for stewardship
Stewardship is not about asserting control over boards and management. The recently issued UK Stewardship Code,1 which was developed by the UK investment industry, contains voluntary guidelines to enhance the dialogue between institutional investors and companies to help improve long-term returns to shareholders. The code makes clear that compliance with it “does not constitute an invitation to manage the affairs of investee companies.” Rather, investors must accept a responsibility to engage with boards and management in an intelligent, substantive, and constructive fashion. Governance issues such as board effectiveness, executive remuneration, and succession planning should be high on the agenda, alongside matters such as strategy and risk.
Just as important, investors should not pressure a company to deliver short-term returns. Moreover, they should take the time to understand the key drivers of its long-term performance rather than simply seeking granular data points to plug into their models. Good stewardship on the part of institutional investors—often a corporation’s most important shareholders—could have a real, positive impact by liberating executives from the market’s focus on quarterly results and the high-risk strategies that can result. Consider debt levels: in the run-up to the financial crisis, some investors looking for better returns insisted that companies take on high levels of debt, which did not serve them well when the crisis struck and in the deleveraging phase that continues today.
Many corporations might benefit from more attentive stewardship by large shareholders. When institutional investors buy or sell stock, and when they exercise their voting rights, they affect management’s freedom in structuring a company’s board, paying its executives, and investing in projects that pay back only in the long term. Recently, UK supermarket chain Tesco complained to the Financial Reporting Council (FRC), an independent UK regulator, about “unengaged fund managers increasingly delegating voting decisions, either internally to governance departments or through an unquestioning following of the recommendations of shareholder representative bodies.”2
Toward better investment practices
Fortunately, some farsighted institutional investors have overcome the structural barriers, in the investment industry, that stand in the way of taking more active ownership and a long-term perspective. These investors do things differently, and evidence suggests the following practices can produce better results.
Revamp performance metrics
An asset owner typically reviews its fund managers each quarter and measures its portfolio’s performance against established benchmarks such as the FTSE 100 or MSCI World Index. This practice can help ensure that managers are not rewarded undeservingly in a bull market or punished inequitably in a market downturn. But it also tends to encourage a focus on short-term results, which in turn discourages an active interest in how companies are governed and managed.
Asset owners can encourage long-term thinking and active ownership by lengthening the period for performance reviews and reducing the emphasis on relative returns. This approach is particularly important when external investment managers are involved. It might mean that asset managers are evaluated over a five- to seven-year time horizon, with annual reviews that focus on a fund manager’s investment process and on whether the portfolio (by such measures as types of assets, turnover level, valuation ratios, and so forth) reflects the fund’s philosophy.
To measure performance quantitatively, it may be sensible to supplement comparisons to market indexes with other metrics, such as internal rates of return for exited investments. Some asset owners have embraced this approach. One US public-pension fund, having committed itself to a three-year investment, refused to meet the asset manager during the first year to discuss results, believing that a full review of performance should occur only after the second year.
Reduce intermediaries, increase expertise
Instilling an ownership mind-set in investment management is further complicated by the increasing prevalence of external asset managers, investment consultants, and “funds of funds” (funds that invest in other funds rather than in securities directly). These intermediaries form layers between the ultimate beneficiaries and the companies they invest in.
This “separation of ownership from ownership” has introduced serious agency problems, according to Leo E. Strine, vice chancellor of the Chancery Court in Delaware, where a majority of S&P 500 companies are incorporated. Strine says the institutionalization of ownership “presents its own risks to both individual investors and more generally to the best interests of our nation.”3 Of course, it doesn’t help that intermediaries along the ownership chain are typically evaluated using short-term performance metrics.
David Swensen, the head of Yale University’s endowment, is one institutional investor critical of funds of funds. Individuals responsible for making investment allocations, he says, “should know where the money is going. If you can’t do it yourself, you shouldn’t do it.”4
Where possible, pension funds and other long-term asset owners should strengthen their internal capabilities. A recent study of Canadian pension funds, undertaken by Canada’s Globe and Mail5 newspaper, found that a greater reliance on in-house investment managers had brought about stronger performance. In the past decade, the nine largest Canadian public-sector pension funds averaged annual returns of 5.5 percent, compared with 3.2 percent for their eight largest US counterparts, which invest in similar assets but employ outside managers more extensively. In-house investment managers, who breathe the culture of the pension funds they serve every day, are likely to add more value than outside agents, who may not feel the same sense of long-term mission as a result of sheer physical distance and the need to serve a broad set of investor clients. In countries with many small pension schemes, such as the United Kingdom, consolidation would be one way to build scale and thereby strengthen the ability of pension funds to recruit investment talent.
Rationalize portfolio holdings
Many investment professionals view portfolio diversification as one of the surest ways to achieve good market returns and reduce portfolio volatility. However, the practice of constructing stock portfolios around the market benchmarks that fund managers are measured against often takes diversification too far. One UK pension fund, for example, holds shares in most of the 700-plus companies in the UK All Share Index. Such diversification makes it very difficult to pursue resource-intensive engagements with boards of directors, which can yield more meaningful insights than scanning annual reports.
Two large Dutch pension funds are contemplating shrinking their equity portfolios by 90 percent, to 300 to 400 holdings, to improve their capacity to be active owners. In Canada, Ontario Teachers’ Pension Plan, which has delivered average annual returns of 9.7 percent since 1990 (compared with 7.6 percent for its benchmark), uses an in-house team to manage a concentrated portfolio. Its top ten stocks—including three long-term, “relational investing” holdings in which the pension plan holds up to 35 percent of the equity—constitute nearly 30 percent of the Can$31 billion allocated to listed equities.
Institutional investors that concentrate their holdings have an added incentive to monitor investee companies well, since the performance of each holding has more impact on the returns for both the firm and individual fund managers. This strategy doesn’t necessarily increase risk. Academic studies have shown that diversification’s principal benefit—to reduce portfolio volatility—diminishes rapidly when a portfolio has more than 50 stocks.6
A slimmer portfolio will also likely instill stronger investment discipline. Legendary investor Warren Buffett has noted that “a policy of portfolio concentration may well decrease risk if it raises, as it should, both the intensity with which an investor thinks about a business and the comfort level he must feel with its economic characteristics before buying into it.”
Refine the passive-investing model
Passive funds, which seek to replicate a broad market index, face an even tougher stewardship challenge because of their low-cost business model. These funds have enjoyed a resurgence of interest among retail and institutional investors in many markets because of their low fees and outperformance of actively managed funds. Since they are betting on long-term gains in the broad equity market and have very little room to shift their holdings, passive funds should have good reason to engage actively with companies in their index. Yet a recent study of UK investment firms7 revealed that passive-fund managers allocated the fewest resources to stewardship activities, as measured by the ratio of the number of stocks held to the size of the staff devoted to such activities.
For passive funds, better stewardship may need to take more modest forms than the resource-intensive approach possible in actively managed funds with a relatively small number of holdings. That said, passive investors should still raise their game. Global professional-services firm Towers Watson8 predicts that passive investing’s share of institutional investments will grow from 25 to 33 percent today to around 50 percent over the next ten years.
As investment houses expand their offerings of passive products, they should supplement the traditional marketing focus on low costs with an emphasis on good stewardship, perhaps charging clients for the expenses incurred in scaling up monitoring and engagement resources. In addition, firms that construct market indexes can help by reducing the number of companies in the largest ones or by developing benchmarks that provide a broadly equivalent exposure to each market segment but contain fewer companies.
At a minimum, passive funds should undertake regular, low-intensity engagements with portfolio companies. As an incentive to passive-investment managers, asset owners may offer fees for good stewardship and revise the metrics used to evaluate performance.9
The likelihood of change
In most countries today, the reform of institutional investing relies on voluntary action, but regulators seem poised to act if progress is slow. Unless investors start behaving as well-informed and responsible owners, the pendulum could even swing from calls for more active ownership to regulations that limit shareholder rights. Lady Hogg, chair of FRC, recently expressed her concern: “To prevent these [shareholder] rights being overridden by international regulators, shareholders need to be able to demonstrate they’re used responsibly and effectively.”10
Will institutional investors act? There are inherent tensions. Stewardship makes the greatest sense for asset owners with long time horizons. For asset managers, stewardship means that they would have to expend greater effort and resources, and in that sense some may not welcome it. The key to success, however, is to change the entrenched management practices that impede a longer-term, more actively engaged investment stance. If, for instance, asset owners would encourage longer-term investment strategies by evaluating performance differently, then asset managers too might welcome stewardship.