Although institutional investors play a major role in our public equity markets, far less is known about the governance of those investor entities than about investee corporations. These investors are critical to individuals, equity markets, publicly held companies, the economy — and to the troubling (and conceptually difficult) issue of good versus bad short-termism in investor and investee behavior. Put simply, the fundamental issue is whether institutional investors are part of the problem or part of the solution within the current state of market capitalism. By institutional investors we mean, at a minimum, pension funds, mutual funds, insurance companies, hedge funds and endowments of non-profit entities like universities and foundations. Recent developments in public policy treat shareholders (primarily institutional investors) as part of the “solution.” The Dodd-Frank Act in the United States and the Stewardship Code in the United Kingdom, for instance, essentially place big bets that institutions can and will police the market with new powers and responsibilities. While this is a worthy objective, it rests on unexamined and unsophisticated assumptions.
In a new paper, Are Institutional Investors Part of the Problem or Part of the Solution?, we attempt to outline major descriptive and prescriptive issues relating to these institutional investors (the paper is available from Yale’s Millstein Center here, and from the Committee for Economic Development here). We call for much greater intellectual and institutional effort in addressing these vital but under-analyzed questions. Set out below is the essence of our argument for much more sophisticated analysis of the governance of institutional investors — based on development of much more robust data bases about the critical elements of investor governance and performance.
Over the last twenty years, institutional investors have owned an increasing share of public equity markets — more than 70 percent of the largest 1,000 companies in the United States in 2009, for example. Over the past two years, in response to failures of some boards of directors and business leaders, shareholders, including institutional investors, have been given increased powers to participate in — or have disclosures about — discrete spheres of governance in publicly held corporations. Moreover, during this same period, and in multiple jurisdictions, there have been increasing calls from both the public and private sectors for institutional investors to play a broad “stewardship” role by “engaging” with investee companies to “help achieve long-term sustainable value” and to help curb the excessive risk taking seen as a factor in the financial crisis.
But with these shifts in market and legal powers have come questions about institutional investors which are similar to those raised in the recent past about the corporations in which they invest. These questions relate to goals, strategies, governance, performance and accountability and, importantly, the separation of ownership and control (i.e. agency problems). They boil down to a bedrock query: do investors have the capacity to perform the role now expected of them?
Policymakers who championed the transfer of enhanced powers to investors went well beyond available knowledge in crafting such a response to the financial crisis. This leap of faith is perhaps understandable in light of the severity of the 2008 market seizures and the political pressures that arose in their wake. But there is no mistaking that the approach represents, in effect, a big bet that investor institutions can and will exercise their new rights responsibly, and that such behavior will make markets more sustainable, less prone to error, and more in sync with the interests of capital providers.
Moves to further empower investors lend urgency to the need to deepen knowledge of investor governance and behavior. Three organizations — the Committee for Economic Development, The Millstein Center for Corporate Governance and Performance at the Yale School of Management, and the Aspen Institute Business and Society Program — agreed to explore this issue, especially because the level of available research effort and prescriptive analysis lags behind the voluminous writing on publicly held corporations. The trio convened a research roundtable in January 2011 with academics, think-tank analysts, leading practitioners and former regulators. The purpose was to identify salient areas for future research and analysis.
Our paper outlining the empirical and normative issues posed by institutional investors proceeds from three fundamental and potentially interrelated questions which were identified as central at the research roundtable.
First, do such investors adequately advance the goals of the individuals who give institutions their money—whether those individuals are pension fund beneficiaries, mutual fund investors, insurance beneficiaries or hedge fund investors? The question is the classic “principal/agent” problem: do those who manage trillions of dollars of other people’s money advance the interests of the ultimate beneficiaries — who may be dispersed and disengaged — or their own interests? This question has special salience today because of the many different steps in the investment chain. Agents abound. For example, one common sequence is that an individual contributes money to a pension fund; the trustees and executives, after being advised by an investment consultant, then allocate those monies to both internal and external fund managers, or to managers of fund of funds who in turn distribute the monies to yet other asset managers.
Second, do institutional investors contribute significantly to “undesirable short-termism” in their publicly held investee companies? A number of commentators have argued that institutional investors put pressure on boards of directors and business leaders for increases in short-term share price at the expense of balanced long-term investment, risk management and integrity because of investor strategy (beat composite indices, for instance), compensation (say, for performance during quarter or year) and other competitive factors (e.g. continually outperform peer investors, not just indices). Such pressure from investment managers arguably helped cause financial institutions to assume high leverage in an overheated housing market to keep stock price rising in lockstep with other financial service companies. Given these factors, commentators have said: “Unsurprisingly, investment managers focus on delivering short-term returns….pressuring investee companies to maximize their near-term profits.”
Third, can institutional investors become more effective “stewards” of publicly held investee corporations, and how does that “stewardship” role differ from the role of boards of directors to oversee the direction of companies? This issue arises in part from the criticism that institutional investors were passive in the face of problems which caused the credit crisis and the financial meltdown (as opposed to being an active cause of that meltdown through short-term pressures): “….a successful financial system requires the oversight of vigilant market participants… [w]hen pension funds, mutual funds, insurance funds and other major investors are silent, vigilance is absent….[s]uch passivity invites abuse.” This criticism of institutional investor passivity has arisen many times before the most recent crisis. But the stewardship aspiration also stems from a desire to articulate fully the roles and responsibilities of shareholders — embodied, in part, by recent policy initiatives such as the U.K. Stewardship Code and U.S. Dodd-Frank reforms. Such a stewardship role is different than simply selling a stock. As Roger Ferguson, President and CEO of TIAA-CREF, has said: “Better to engage management on governance and strategy issues before problems arise and shareholder value plummets.” But given the complexity of many corporate decisions — and difficulties directors themselves have in overseeing multi-factorial business tradeoffs — what is realistic in terms of time, effort and contribution in the relationship both from the “stewards” and from boards/management? Do the investor “stewards” relate to boards, to management, or to both — and at what level of detail and on what kind of decisions? The answers to these three fundamental questions about institutional investors will, of course, vary with type of investor. Answers will also turn on the interplay between factual research results and analysis of important prescriptive concepts and questions which, when articulated properly, provide the foundation for normative judgments about what are “proper” public policies or “proper” private ordering arrangements to address defined institutional investor “problems.”
The three issues also may be interrelated. For example, beneficial owners who contribute to pension funds may seek steady, long-term growth in their assets, not short-term, up-and-down volatility; fund managers may seek to exploit short-term volatility for their own benefit, even though it is inconsistent with the longer-term objectives of the beneficial owners; and such steady long-term growth may be consistent with a proper investor stewardship role with investee companies played by those who control other people’s money (the money of the beneficial owners). Even if the objectives of beneficial owners are, in fact, short-term, as with investors in some hedge funds, then those objectives may cause undesirable short-termism in investee companies and may preclude a serious stewardship role because of short time horizons (or because trading strategies are largely indifferent to governance concerns).
The paper is intended to spotlight knowledge gaps and identify practical remedies. It contends that addressing these fundamental questions is central to understanding even more fundamental issues relating to the state of market capitalism, issues for individual investors, the potential impact on equity markets, constraints on publicly held companies, and the health of the economy. It seeks to make the case that we need to have as much understanding about investor entities as we do about investee companies. It points the way analytically towards the variety of issues which need to be addressed in answering the three generic questions — without trying to bias the outcomes. It invites much greater attention to these critical questions from all across the intellectual and policy spectrum.
Our bottom line assertion: the increasingly important role of institutional investors in our economy and our public markets requires substantial new intellectual attention.
Our principle concern is that either public mandates or private efforts are needed to assemble a global database with fundamental empirical information about different types of institutional investors: in particular their goals, time frames, strategies, governance structures, governance processes, incentives, compensation practices, transparency, holding periods and market impact — and their view of fiduciary duties, accountability, and the stewardship role. Such a database is a necessary prerequisite for efforts to advance understanding of the critical role institutions increasingly play in the functioning of capital markets around the world.
Second, we hope analysts from all across the intellectual spectrum will engage in the three fundamental prescriptive questions which provided the framework for our paper. Do institutional investors carry out the goals of their individual beneficiaries? Do institutional investors contribute to “improper” short-termism? How can institutional investors play a stewardship role in support of longer-term corporate strategies which effectively counters improper short-termism and which meshes appropriately with the responsibilities of boards of directors and senior leaders of investee companies?
But we must emphasize that these intellectual challenges require institutional attention and support. We hope the paper can be the basis for workshops convened by regulators, think-tanks, business, law and public policy schools. But beyond conferences to energize work on this critical set of issues, it would certainly be appropriate — and definitely in the public interest — for academic institutions to establish capacity both to conduct and to collect descriptive and prescriptive research in a comprehensive and systematic way.
Study of the many issues raised in this paper (and many more outside of it) is surely appropriate. But it is also necessary to understand these problems holistically — to comprehend the systematic interrelationships that actions on one set of issues may have on other pertinent institutional investor problems. Although research is certainly being conducted on institutional investors in a variety of settings, we are not aware of academic or think-tank centers dedicated to a comprehensive approach to this vital area.
Surely the time for such a comprehensive approach has arrived. The hope for sound public policy or sound private ordering to address increasingly salient issues posed by institutional investors depends on this type of intellectual and institutional effort.
Benjamin W. Heineman, Jr. is a former GE senior vice president for law and public affairs and a senior fellow at Harvard University’s schools of law and government. Stephen M. Davis is the Executive Director of Yale University School of Management’s Millstein Center for Corporate Governance and Performance. This post is based on a paper by Mr. Heineman and Mr. Davis, available here or here.
This article was first published on the Harvard Law School Forum on Corporate Governance and Financial Regulation and is re-published with the authors’ permission.