Streams of recommendations have begun to flow from bodies tasked with remedying the persistent problem of institutional investor passivity and short-termism. While the suggestions of the Institutional Shareholders’ Committee (ISC) and Walker Review are generally sensible, they are incomplete because significant asset owner issues remain unresolved. Until the root causes – particularly the inability of pension funds and other institutional asset owners to robustly monitor asset managers and the misalignment of interest between the two parties – are tackled head-on, reforms in this area will have limited impact.
Current reform efforts assume that asset owners maintain a strong interest in, and possess capabilities to meaningfully evaluate, their fund managers’ corporate governance activities. Many don’t.
To fulfill obligations under the Myners Principles to monitor fund managers’ adherence to the ISC Statement of Principles on the Responsibilities of Institutional Shareholders and Agents, many asset owners ask their investment managers the following annually: “Does your firm comply with the ISC Principles?” It is disconcerting that a perfunctory “yes” is often a sufficient response. Equally worrying, this exercise frequently transpires between the owner’s pension consultants and the manager’s client relationship team. Little or no effort is made by pension fund trustees or staff to speak directly with investment firm personnel who vote and engage on their behalf to discuss successful and problematic interventions, sufficiency of allocated resources, and areas for improvement.
Accordingly, reform efforts should ensure that corporate governance rises in importance for asset owners. In an era of growing pension deficits and when investment strategies are being overhauled, this is certainly a tall order. However, if we believe that good corporate governance is value accretive in the long-run, then pension funds – with liabilities spanning decades – must take a greater interest and build stronger capabilities in this area. Policymakers can assist by exploring ways to make monitoring and engagement cost-effective for asset owners, such as through collective mechanisms.
In addition, asset owners must better align the interests of their investment managers with their own. Firstly, asset owners need to strengthen alignment in time horizon. Presently, many owners evaluate their fund managers’ performance quarterly. It is unsurprising, therefore, that asset managers focus on delivering short-term returns, including through pressuring investee companies to maximize near-term profits. Steps to lengthen the time horizons of asset managers could include extending the timeframe used to evaluate performance, spreading fee payments over multiple years, and limiting portfolio churn. These measures may then spur asset managers to engage with investee companies more actively and on longer-term matters (such as strategy and corporate governance), and to go against the herd in frothy markets.
Secondly, asset owners must pay careful attention that asset manager fee structures do not incentivize harmful behavior or create undesirable ripple effects. Some pension funds have insisted on paying no management fees – usually expressed as a percentage of assets under management – but have allowed asset managers to earn a financial return through stock lending. From an alignment of interest perspective, this is highly problematic because it removes the asset manager’s incentive to maximize portfolio value while creating severe conflicts of interest. For instance, when the recall of shares for voting purposes is normally warranted, such as in a proxy contest, the fund manager may be reluctant to recall because it would be deprived of its primary source of revenue. Similarly, asset owners need to be cognizant that fee arrangements for asset managers – such as the “two and twenty” structure – could spread in form and quantum to other sectors, including at their investee companies.
Thirdly, asset owners must ensure coherence of their investment approach across all asset classes. For example, it may be inconsistent, and indeed harmful, for a pension fund with a largely passive equity portfolio to allocate assets to investment managers that employ short-term tactics – such as compelling companies to increase leverage to abnormally high levels or shorting shares aggressively – that may threaten the long-term performance and viability of their core passive holdings.
Lastly, asset owners should be wary of extending the intermediation chain – for example, by investing through a fund of funds – because it may weaken the sense of ownership and accountability between the ultimate investor and investee company.
True shareholder reform must start at the top of the investment chain. Only when asset owners begin to take corporate governance seriously and align the interests of their asset managers with their own can the aspirations of the ISC and Walker Review be realized.