Martin Steward explores how the Stewardship Code merely describes an investment strategy or style that, like any other, must stand on its capacity to add value to an investment process.

While it couldn't compete with the firestorm ignited by Zembla's questionable scaremongering about Dutch pensions, comments on the UK Stewardship Code from ex-APG corporate governance head Paul Frentrop that we published in the February 2011 issue of IPE also caused something of a stir.
Sometimes something seems so obviously right (in both logical and moral terms) that anyone questioning the facts on the ground faces uproar. Recently, the UK government got everyone from Archbishops to actors up in arms by suggesting that it might make sense to take some of Britain's forests out of the hands of the Forestry Commission and sell them into private ownership.

No one took a step back to observe that much of Britain's loveliest and most diverse woodland is already in private hands or that vast acres of Forestry Commission land is dedicated to soulless grids of spruce monocultures. Similarly, since the financial crisis, it is even more deeply socially unacceptable than before to suggest capital markets should be populated by anyone other than 'long-term' investors who 'engage' with management because they see companies as something to be 'owned' rather than 'traded'. If you defend the 'short-term traders', it is assumed you must be one of the 'gamblers' who live to exploit the 'casino economy'.
When someone like Frentrop points out that all institutional investors should be "grateful" that global equity markets exhibited remarkably resilient liquidity through the crisis, by extension he implies that they should also be grateful to all those short-sellers, momentum-followers, options traders, tactical deep value investors and other assorted hedge fund types who provided that liquidity. But stewardship as the UK Code defines it is neither practical nor relevant to most of those short-termist liquidity providers. And as Frentrop observed, the existence of that liquidity "discourages monitoring and stewardship by reducing the cost of exit for unhappy shareholders". Stewardship has to stand or fall purely on its capacity to add value to an investment process.
That is upsetting to those who equate 'long-term, engaged ownership' with 'responsible investing'. As one analyst from a prominent ESG-specialist financial services firm put it in an email to me: "I suppose it is disheartening for a genuine expert such as Paul to come to such conclusions."
Frentrop's comments prompted Peter Montagnon, senior investment adviser at the UK's Financial Reporting Council, which drafted the Stewardship Code, to respond in the forthcoming March 2011 issue of IPE. Montagnon takes issue with Frentrop's presentation of "a stark choice between engagement and liquidity". The ultimate engagement strategy is private equity, he observes, where he concedes that liquidity is very restricted.
He says: "We need both options: private equity, which allows owners to manage companies tightly, and diversified markets, which are good at raising capital. A flourishing capital market thus requires a wide range of participants with different approaches. We need traders who provide liquidity. We need activists who will be catalysts for change at companies, and we also need investors who will work to ensure that the market delivers for their clients in the long term. The banking crisis was a stark reminder that we have neglected the latter requirement."
Montagnon's assumption is that pension funds ought to occupy that third role: the Stewardship Code reintroduces "a longer-term perspective that much better matches the time horizons of savers like pension funds", as he puts it.
Leaving aside the vexed question of what precisely the time horizon of a pension fund is, it is interesting to note that Montagnon describes this third investment role as ensuring that "the market delivers for their clients in the long term". Not, you will notice, 'companies', but 'the market'. This is important. Companies create value, and the market is where that value is traded and realised. And as Montagnon notes, the market would not exist without different types of owner (with different time horizons and different ideas about value) coming together in an environment of robust liquidity.

But pension funds are not one type of owner: they are not only subject to a very wide variety of investment time horizons and cash flows between them, they must also each inhabit several of the different 'roles' that are played in the market in order to be properly diversified allocators of their (large amounts) of capital and risk. If anything, risk management and diversification lessons learned during the crisis will probably push them a little further along the spectrum toward greater liquidity and away from long-term buy-and-hold, and demographics and decumulation will push them further still.
That is why Montagnon is right to say their role is to extract value from 'the market'. It's really very obvious that that is what they do: they hold broadly diversified (mostly passive) portfolios of global equity and allocate among a wide range of strategies, from venture capital with its 10-year horizons to statistical arbitrage with its 10-second horizons.
But surely that informs against the Stewardship Code, which, with what Frentrop rightly characterises as its air of 'duty' and its 'comply or explain' framework, carries the unmistakable suggestion that its formulation of what institutional investment should look like is somehow morally correct. In its preface, the Code sets out good practice on engagement with investee companies "to which the FRC believes institutional investors should aspire".
For some participants, the Code makes perfect sense - indeed, it simply articulates precisely the strategy they bring to buying, owning and selling companies. They don't need convincing. For others, it is utterly irrelevant. Between those extremes, there may be a large pool of investment activity that could benefit economically from applying the principles in the Code.

It is equally true that, for a large proportion of that pool, applying the principles would be possible, but a waste of time and (pension fund members') money. What does this tell us? Again, that the Code describes an investment strategy or style that has to stand purely on its capacity to add value to an investment process. It is perfectly valid - just as growth or value or convertible bond arbitrage are perfectly valid - but no-one ever suggests that pension funds or their advisers should 'explain' why they don't 'comply' with a Code that says convertible bond arbitrage represents 'good practice' to which they should 'aspire'.