The Future of Corporate Governance Part I: The Problem of Twelve
John Coates
Preface
The US is moving towards a concentrated control by twelve or less actors with unsurpassed power having control over the largest companies partially due to the rise of indexing.
It’s common knowledge that individuals controlling index funds have weak incentives to use the control as their inputs don’t lead to meaningful changes in returns. So why bother with insisting on improving shareholder returns and changing governance?
In fact, index funds replace dispersed shareholders with even less incentives (or the ability to bring about any change), so index funds actually shift towards more shareholder power, not less.
Index funds actually have the power to impact corporate decisions, and their sizeable holdings also mean the opportunity for control. The larger these funds become – the more control over companies they receive, also shaping their policies, etc.
Globalization increased the time to IPO requiring the proper scale to become IPO-able.
Indexation
Can be active and passive on several dimensions (activities: buying, selling, voting, analysing, etc.) and levels (ownership: corporations, trusts, layers of ownership).
o Debt: investors can receive the principal + interest, foreclosure of collateral, triggering bankruptcy, enforce restraints on the borrower’s behaviour.
o Equity: vote for directors and major corporate transactions, sue to enforce fiduciary duties, obtain an open-ended set of info, initiate governance actions (bylaws amendments, proxy fights, etc.), use the threats of the above to obtain access to and influence policies or actions via directors and officers.
Investments can be layered via investment funds (i.e. indirect ownership by an individual), which can also be layered. This means that an investor in the fund has some say about the fund’s activities but doesn’t have a say about the activities of any company in the fund’s portfolio. So the only thing an indirect investor can do is sell the shares of the fund (or choose to buy more if they like what’s going on).
Investors into pension plans, which invest into index funds, have even less say about the activities of the index funds and can’t actually quit them without quitting the pension plan altogether (where allowed).
This reflects the “separation of ownership from ownership” with individuals having practically zero say in anything they invest into.
Passive investment became popular when “open-ended” funds emerged allowing issuing and redeeming stock on demand at net value. Not to be confused: passive investment in mutual funds only applies to the end beneficiary, not the fund management.
The story is different for index funds, which were designed as truly passive, merely tracking the preferred index and constantly rebalancing when needed.
Index funds are a small part of the entire market [MK: collectively owning 10% of the market as of 2019], hence they don’t hold sizeable equity positions in any individual firm to justify shareholder actions: the costs to change the governance will be borne by the index fund, but the benefits will accrue to all shareholders in the firm. Simply doesn’t make sense to waste money.
The 10% figure may be understated, though, as one can track the index without calling themselves “index funds” – this applies to pension funds, insurance companies, non-profits. Shares can be held directly by these investors, so they don’t make it into the statistics. Foreign investors (20% for the US) have a higher indexing rate due to the information asymmetry between their home markets and the US.
Some “active” funds are in fact index funds with over- or under-weighting certain stocks thus creating a bragging right to call themselves “active”.
The core reason why index funds emerged was the commonly held belief that “alpha” (i.e. the risk-adjusted return net of management fees above the market return) is not consistently achievable. It took indexing 20+ years to take off (i.e. very slow for a winning idea) due to the legal environment and the old technology. Once the tech took off – managing indexing became increasingly cheaper thus increasing the returns.
As a conclusion, the real % of shares in the US companies owned by index funds [MK: this paper was written before the stratospheric growth of RobinHood] is between 20% and 30%. They benefit from economies of scale (fixed costs spread around higher amount of assets under management, lowering transaction costs by netting someone’s sale against someone else’s purchase), don’t incur brand damage when the market goes down and are very competitive (newcomers won’t be able to differentiate themselves).
In the US three funds: Vanguard, Black Rock and State Street collectively controlled 15% of the entire US market in 2017. Vanguard, State Street and Fidelity own 60% of all the 5%+ blocks of stock in S&P 500. [MK: ownership of 5%+ gives extra shareholder rights like proposing governance changes and adding items into the AGM agenda.]
Index funds can act in a coordinated way, and since many investors are passive, the actual control on a shareholder level is ~50% higher than the nominal shareholding. Collectively the group of index funds advised by proxy advisory firms can sway a vote in any direction they want. Above all, this means voting for Directors and having a say in the governance. Hence the “Problem of Twelve”: twelve heads of the most prominent index funds are technically able to control any company.
In practice, this is not so due to the fact that there’s no massive collusion, and since companies are run by CEOs who are hired by Boards, there’s enough separation of the firm’s activities from the indirect control by the index funds.
Practical Implications of Indexing
As mentioned above, index funds don’t hire enough staff to deeply look into the governance of hundreds of companies. Nor they can quietly engage in collusion due to the requirement to disclose the “agreements and understandings” to the SEC leading to PR implications.
As mentioned above, index funds don’t want to sponsor the “free-rider” benefits by other investors by actively engaging in changing the governance of the target firm. Their low cost structure specifically doesn’t have funds earmarked for such activities.
Index providers, however, can avoid the accusations of collusion by a standard practice of developing policies and positions: what governance they want all of their target companies to have (i.e. the overarching policies not naming individual firms): board composition, CEO remuneration rules, disclosure rules, etc. Funds are allowed to voice their policies and get other funds to modify their policies accordingly.
Such policies, when made public, give a strong signal to the firm about how the investors want it to be governed, as well as to other funds. Funds exchange valuable signals by analyzing the governance policies of other institutional investors into the target firms on management, performance and strategy. The signals become self-coordinated and on a practical level impact the ways firms of certain sizes (and included in certain indices) are run.
Developing policies is not cheap, but the cost can be spread out among the entire size of AUM thus reducing the costs of applying a policy. However, as policies between different index funds start converging, the shareholder votes increasingly start correlating.
“Engagements” or meetings between the firm’s representatives and the fund’s staff are used to convey the fund’s position on major issues (i.e. how it will vote in case of mergers, activist campaigns, control contests, director nominations, etc.). These are valuable signals for the management to be seriously taken into account. The flow of information from the CEO to the fund is limited as per the disclosure requirements (material information must be disclosed to the public at the same time as it occurs, i.e. the duty of continuous disclosure). Lowering the rank of the person from the fund and increasing their numbers may disperse the pressure exerted by the fund on the company.
Such major issues are when index funds have the most power and their votes are pivotal. A sponsor of a liquidity event (be it a hedge fund or a CEO) needs to have the support of the index funds. [MK: If a liquidity event (sale or merger) is proposed by a sponsor before the CEO tenure is over, the CEO needs to make sure her golden parachute is well in place and is fully operational.]
It’s tempting to think that in firms with a sole owner there are no agency costs, because the sole owner installs the Board, which installs the CEO, who hires the C suite, etc. In practice, the owner is only able to make a very limited set of decisions as they can’t possibly know all the implications of a lower-level decision. [MK: and let’s not forget that successful top-down decisions are all but a myth.] Large index funds don’t have complete control, but are in better position of managing the governance, but in any case, the involvement of the sole owner or a large investor is ensuring that the firm is governed by the right Board and that the C suite is the best the firm can get.
The Value of Control
Control by investment funds leads to the income arising from the dividend flow, realizations in mergers and the management fees.
Activism can have private costs, say, opposing corporate managers can harm asset managers by taking their, say, pension fund management to a different provider. The larger the index fund ownership becomes, the less this becomes an issue.
Many companies go public with a dual class share structure, with existing shareholders maintaining control for years after the IPO. Index funds get their control positions as a side effect without putting an effort.
Many retired ex-CEOs end up in politics as respected figures. Index fund managers, due to their association with their portfolio companies, get into a position to exploit their contacts for the personal gain. (One of the solutions may include prohibiting ex-top managers of index funds from taking a public office for a specified period of time).
Possible Harms of Indexation
Index funds accumulate an increasing number of votes in the public companies, and an impact on their governance has societal, economic and political effect.
It’s been found that indexation leads to the increased correlation of asset returns (i.e. smaller actual diversification) leaving to increased volatility.
Indexation may have blunted price signals (i.e. ignores valuable information).
Indexation can transmit non-fundamental shocks to stock prices due to rebalancing, including new firms into the index or removing them. It becomes even more financially lucrative to possess the information about the potential inclusion of a firm into the index.
Index inclusion likely inflates valuations of the included firms at the expense of the ones that didn’t make the cut.
Index funds need to demonstrate their own governance values around legitimacy and accountability. The funds may be required to disclose their own governance, policies on conflicts of interest and their voting activities. Enforcing such policies (especially voluntary ones) is far from easy, and the unwanted side effect is that they de-facto encourage active involvement in the portfolio firms via stated policies, thus delivering higher transparency at the cost of higher use of index funds’ power.
Trying to address this issue by making other investors more active may have one of the two unintended consequences: either one of the shareholders would try to extract private benefits (e.g. demand a special dividend) or the management would become more entrenched as there won’t be the unity of governance and control.