A Conversation about Stewardship and the Investment Industry

Published December 10, 2017

By Mak Yuen Teen

Recently, I was at a dinner event and sat next to the chief investment officer of a regional institutional investor with a good reputation for applying stewardship principles in its investments. We had a wide-ranging discussion about how her organisation discharges its stewardship responsibilities, how some claim to be following stewardship principles but are merely paying lip service (like those claiming to practise sustainability and paying lip service, but that will be for another time), proxy advisory firms, indexed funds, investment in small caps, value proposition of fund managers and other topics.

I asked her if her organisation votes its shares in all its investee companies (answer is yes), how it engages with these companies (they do attend some AGMs and of course have one-to-one engagements) and whether it seeks board representation (generally no, so as to avoid confusing the director’s and investor’s role).

I then shared that I am a little cynical about the adoption of stewardship codes because some of those claiming to adhere to stewardship principles put aside these principles and lunge into companies with ordinary shares with different voting rights  or invest in companies even when it’s clear from some basic research that the companies’ corporate governance is awful – when they see an opportunity to make a quick return. I cited some examples. Disclosures around how investors applying stewardship principles also remain weak, especially in the region.

She said her organisation believes in active investment. I then asked whether her organisation invests in indexed funds, which is passive. She said they do but after screening out certain companies first. They call it ‘smart alpha’ – as opposed to ‘dumb beta’ I guess. What she said made sense to me as to how institutional investors and asset managers that truly believe in stewardship should approach indexing – rather than waiting or hoping that index creators will remove the need for them to make the choice by dropping certain companies from indices, like those with dual class ordinary shares or ordinary shares with no voting rights, they should just drop the companies themselves. Sure, it means that the fund performance may deviate from the overall index but if companies that subscribe to high corporate governance and sustainability standards are likely to outperform companies over the long term, this seems a sensible approach to take.

I have heard from major institutional investors and asset managers that being passive actually makes them focused on corporate governance because they have “no choice” but to invest in companies that are in an index and therefore have to monitor these investments. The counter-argument of course is that being invested in many companies, and with a relatively small stake in each, means that the investor will not be prepared to invest much in engaging with individual companies. Further, if companies know that these investors will invest in them as long as they remain in the index, would they take the investors’ views seriously (unless it reaches a tipping point where there is a significant risk of resolutions being rejected or directors removed)?. The empirical evidence on whether corporate governance improves or deteriorates with the presence of passive investors is mixed. For example, while a 2017 article by Schmidt and Fahlenbrach in the Journal of Financial Economics shows that exogoneous increases in passive ownership (measured by reconstitution of market indices) lead to poorer corporate governance and firm value, another 2016 article by Appel, Gormley and Keim in the same journal found that an increase in ownership by passive mutual funds lead to  improved corporate governance and long-term firm performance.

I then asked if her organisation uses proxy advisory firms. She said they do their own research and have set up teams in major investment markets to do that. We discussed the limitations of global proxy advisory firms in terms of local knowledge (except perhaps for the largest markets). I said I thought proxy advisory firms are sometimes too conservative in recommending voting against management resolutions (I might add that they may also lack timeliness in being too late to recommend voting against resolutions). I am not against proxy advisory firms. They perform a useful role but perhaps have become too big and too detached in some cases – and possibly conflicted at times with other services (but not as bad as major accountancy firms that seem to be morphing into consultancy firms with auditing appendages).

I then asked whether they invest in small caps. They do. I said I wished more institutional investors will invest in small caps to incentivise the small caps to improve their corporate governance and to provide checks and balances, something generally lacking today (other institutional investors and asset managers I have spoken to have a strong bias towards investing in companies that are in major market indices). I also said I wish there is better coverage of small caps by proxy advisory firms – perhaps homegrown ones. Of course it’s a chicken or egg problem as if institutional investors do not invest in smaller companies, there will be no demand for proxy advisory services for such firms.

Finally, we talked about the future of the asset management industry. I shared that some years ago, I probably offended some fund managers (nothing new there about offending someone) when I turned up on a panel they organised and said their days may be numbered. I said that with ETFs available at low cost, there’s no need to use them for diversification (when I studied finance, unit trusts/mutual funds can help those with relatively small amounts to invest to diversify because that was before we have widely-available ETFs). As for chasing alpha, research shows that on average, active managers can’t outperform benchmarks such as overall stock index after taking costs into account, and “star” fund managers often find their stars dimming as they can’t consistently beat others and the market. I said I could only see fund managers adding value through monitoring companies they invest in and using their influence to improve their corporate governance. Today, there are still many investors who are investing though fund managers who still rely on supposed superior stock picking and market timing to generate superior performance when research overwhelmingly shows that they will almost certainly be unable to do that on a consistent basis. One day, everybody will realise that there is only one Warren Buffett and the rest are either occasionally lucky or benefiting from investors’ ignorance.

I truly believe that the days are numbered for active fund managers who do not practise stewardship on behalf of their clients. And those institutional investors hiding behind a false stewardship facade will be found out. As a corporate governance advocate, that day can’t come soon enough.

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