Institutional Investors as a Force for ChangePublished: October 23, 2002 in Knowledge@Wharton
Institutional investors who hold clients’ money for retirement or other long-term goals could be a powerful force in developing corporate governance policies to benefit shareholders over time. But these investors have been hesitant to take a proactive role, executives from several large investment firms said during a panel on “The Role of Institutional Investors.”
According to Richard Herring, co-director of the Financial Institutions Center, 45 years ago, 90% of public company shares were owned by individuals. Now, more than half are held by institutional investors and 20% of all shares are held by 10 institutions. “It’s a system of heavily concentrated institutional holdings. The question arises whether these institutional shareholders will perform an active role in corporate governance,” he said.
Wharton finance professor Andrew Metrick presented research indicating that good governance translates into good business. He noted that the takeover battles of the 1980s and subsequent changes in governance during the 1990s provided the environment for a long-range experiment to find an answer to “The big question: How much power should shareholders yield to managers?”
If shareholders yield too much power, they risk being cheated out of their investment, said Metrick. “On the other hand, if shareholders have all the power, what’s the point of having professional management? Where is the right balance?”
Metrick and researchers at Harvard ranked 1,500 companies on 24 corporate governance measures throughout the 1990s and built an index according to whether the firm was more focused on shareholders or self-preservation of management. Then they compared the companies’ financial performance and found that firms with stronger shareholder rights also had higher overall firm value, higher profits, higher sales growth, lower capital expenditures and fewer acquisitions.
Metrick said $1 invested in a portfolio of the most “Democratic” companies on September 1, 1990 would have grown to $7.01 by December 31, 1999. During the same period, $1 invested in the “Dictator Portfolio” would have grown to $3.39. The “Democracy Portfolio” generated returns of 23.3% annualized while the “Dictator Portfolio” returned 14%. However, Metrick said he is not planning to rush out and start a Democracy mutual fund because the 1990s were an unusual period of change following the takeover battles of the 1980s.
Robert Chappell, chairman and chief executive officer of the Penn Mutual Life Insurance Co., told the conference that as an institutional investor he approaches stock like a vacation home. He prefers to rent, rather than buy. “We have a good time but at the end of the summer we pack up our gear and walk away from it.”
His firm’s strategy is to buy stocks it thinks have room to appreciate and then sell when they reach expected targets. As a result, Penn Mutual does not go out of its way to get involved in long-term issues. “Once we lose faith in the management or the trajectory of that company, we sell it.”
Chappell said the company has a policy to vote proxies in the best interest of its clients, but it does not take a very active role in corporate governance in the companies whose stock it owns. It uses a proxy service to sort through issues, and usually votes with management. If Penn Mutual didn’t like management, Chappell noted, it probably wouldn’t own the stock.
With 50% of corporate shares owned by institutions and mutual funds, it would be hard for Penn Mutual to have much impact on a company, Chappell pointed out, adding that in many cases the firm only owns a stock for a short period. Unless an issue arises in that narrow window of time Penn Mutual might not even be able to vote or take other action. “We are strictly passive,” he said. “We don’t feel so much engaged or wedded to (a stock) that we’re going to spend time trying to change its behavior … Is that the right thing to do? It’s a debate.”
Retirement “Piggy Banks”
Andrew Clearfield, director of international corporate governance at TIAA-CREF, the powerful pension fund, said it has only been in recent years that the stock market was viewed as an appropriate place for long-term savings.
Traditionally stock market investing had been the preserve of wealthy, sophisticated individuals with an understanding of the markets and, often, access to corporate management. The market was also for speculators, prepared to lose big to win big. But in the 1980s individual investors began to come into the markets, hoping to reap better returns for their retirement. The trend accelerated with the popularity of 401(k) savings plans.
However even though the market was changing, regulators, governments and companies still held the old view of market players. Clearfield said TIAA-CREF had to educate them about the new investors so they would understand “the share price was the reflection of some person’s piggybank.”
Even at TIAA-CREF, which is one of the more active investors, there is resistance to getting involved in corporate governance crusades. “I’m amazed at the number of my colleagues who are unwilling to aid and are hostile,” he said. One reason for the reluctance, he suggested, is that investment professionals tend to be quantitative types and the effects of corporate governance are not easily measured. He also noted that analysts build alliances with managers at the companies they cover and don’t want to risk losing access if TIAA-CREF goes to battle with a firm’s management over a governance issue.
In addition, he said, institutional investors hesitate to get involved in governance battles because it takes time and is costly. Cost “is taken to justify not getting involved in voting proxies or doing any work in corporate governance. This is why there has been a shocking lack of participation on the part of institutional investors.”
Investment firms are also unwilling to stick their necks out because their competitors will benefit from change, too, as “free riders.” Finally, he said, individual fund mangers are under extreme pressure to perform on an annual basis, with bonuses tied to performance benchmarks.
Clearfield suggested firms should recognize the role good governance plays in long-term returns and create more funds to benefit from governance-based investing.
Jail Time vs. Journal Coverage
Robert Mills, managing director and chief financial officer of UBS Warburg, sits on both sides of the investment divide as an institutional investor managing long-term assets but also as an investment banker representing firms. “Clearly we don’t have the involvement that TIAA-CREF has, but I see it as a growing trend.”
New disclosure rules stemming from the recent financial scandals will not have much impact on his company, he added, because it was in compliance on most of them anyway. He supports the new rules for directors, but in return for the greater responsibility, “it needs to be a real job that involves real time, real knowledge and real compensation.”
According to Mills, the addition of jail time with the Sarbanes-Oxley Act is not even that great a deterrence. If he committed fraud, a tougher punishment would be explaining the story about it in the Wall Street Journal to his son.
While the new rules may have minimal effect, he sees no hastily drafted blunders: “Corporate governance is like chicken soup. It won’t hurt but I don’t know if will help,” he said.
Hasung Jang, director of the Asian Institute of Corporate Finance, which promotes good governance measures in Asia, noted that in emerging markets there is a new focus on electing independent directors, which is a major change in Asian business structures.
When it comes to working with institutional investors, he said overseas investors operating country funds are more responsive than others. That is because they are locked into that country and cannot simply sell and buy shares elsewhere if they dislike governance systems in the country or in individual firms. He said hedge funds are also responsive.
But, he added, he has had less support from investment banking firms – and their emerging market analysts – which are more focused on short-term operational results and potential investment banking business than long-term corporate governance. And he warned that their deals may ultimately lack credibility: “Too often corporate governance risk is more important than operating risk,” he noted.