Peter Montagnon, Senior investment adviser, Financial Reporting Council
“The Stewardship Code does not require all its adherents to behave like activists” Peter Montagnon Senior investment adviser, Financial Reporting Council
The new UK Stewardship Code has drawn both praise and criticism since it was introduced in summer 2010 - and the views taken by the various protagonists often seem to depend on what they understand by stewardship.
Some argue that stewardship as defined in the Code represents a whole new philosophy whereby investors should all become activists, buying into companies to push for change. Others claim that meaningful engagement is impossible for diversified portfolio investors that often have several thousand companies in their portfolios. There is an element of truth to these arguments, but the trouble is that they take a rather monolithic view and misunderstand what the Stewardship Code is actually trying to achieve.
Real life investors do not face a simple choice between trading to match or beat the index, or of becoming activists. In practice, plenty fall in between the two stools, many have been a bit confused about what their fiduciary duties are, and there are still a number of large long-term holders of equities who do not or cannot constantly trade in and out of their positions because of the size of those positions or their time horizons.
Just consider two practical situations. First, a number of investors in RBS voted in favour of the value-destroying bid for ABN-Amro and then continued to hold the shares. Some of them might have done so because they were tracking indices, which is a common investment strategy. The consequences for their clients, however, were very damaging.
Then, what about BP? Fund managers who crunch the numbers can easily conclude that this was a company whose strong cash flows made it a buy given the likely trajectory of the oil price. Yet they clearly did not consider the threat from BP’s failure to assess and manage the risks inherent in deep-sea drilling. Had they asked about this, their investment decision might have been different and their clients might have been better off.
The Stewardship Code is not, thus, about imposing an activist strategy on all investors, but rather about ensuring they recognise the risks they run if they do not put some effort into considering the broader picture, discussing it with the company and challenging where necessary. This is especially true where their investment model involves sticking close to an index, limiting their scope for selling.
It is also important that those who issue mandates to fund managers understand this, and that the mandates become clearer as a result. This is why we at the FRC have been pleased at the degree to which asset owners, like pension funds, have actively supported the Code.
Engagement is not free, but taking a more holistic view is not that expensive either, and trading has its costs. According to Paul Woolley of the London School of Economics, pension funds’ assets are being exchanged at a rate of 25 times in the life of the average liability for no collective advantage, but at a cost that reduces the end value of the pension by about 30%.
The real challenge is to get the right balance. In the February 2010 issue of IPE, Paul Frentrop argued that we are facing a stark choice between engagement and liquidity. The ultimate engagement strategy is private equity where the shareholders actually run the company and liquidity is very restricted. But we need both options: private equity that allows owners to manage companies tightly and diversified markets that are good at raising capital. Besides, without listed markets the exit route for private equity would be very limited.
The Stewardship Code simply aims to address some of the shortcomings in our approach to investment in listed markets which were revealed by the banking crisis. It is voluntary, but the Financial Services Authority requires all those who manage funds on behalf of others in the UK to state whether or not they apply it. This is useful because it causes everybody to think carefully about their approach to investment and tighten up where there is confusion or internal inconsistency. As it happens, some 140 institutions have signed up to the Code. We have to presume this decision is not taken lightly and that a very large number of investors recognise the merit of applying the Code’s principles.
So, how will the Code change behaviour? First, we hope it will improve the quality of investment decision-making so that institutions are less likely to fall into the kind of trap we saw in the cases of RBS and BP. Second, we hope for an improvement in the quality of dialogue so that companies will understand better what their shareholders expect of them. Third, we hope that asset owners and fund managers, will be clearer about their objectives and the approach needed to achieve them.
If the Code is successful, the world will not look that different, superficially, but there will have been a subtle and important change. We will have pulled back from the view prevalent in much of the market that shares are simply instruments to be traded, rather than instruments that confer ownership and reintroduced a longer-term perspective that much better matches the time horizons of savers like pension funds.
In the process we hope we will have established a critical mass of investors willing to accept the obligations of ownership in a way that will help secure the comply-or-explain approach to governance, which has stood the UK in good stead over the years. If we fail, policy makers will conclude that they cannot rely on shareholders to hold companies to account. There is then a real risk that companies and markets will become more heavily regulated and that the rights of shareholders will be steadily eroded.
It is important to remember that some policy thinking has become pretty radical in the wake of the banking crisis. In public documents last year the European Commission asked where the traditional corporate model of shareholder control of companies had failed, whether bank boards should have a legal duty of care to parties other than shareholders and whether regulators, not shareholders, should appoint auditors. If the answer to these questions is ‘yes’, we shall be living in a radically different world, where capital is more expensive, with all the attendant consequences for growth and prosperity.
Some investors, actively encouraged by investment bankers looking for dealing commission, did push banks and other companies to gear up in order to boost short-term returns. This was one aggravating factor in the crisis. But not all investors think like this and many recognise that they need a capital market which is fit for purpose in the long term.
The Stewardship Code is a rallying call to those who understand this. The investment industry must recognise that it is in its own long-term interest to have a well-functioning efficient capital market in which it can continue to invest clients’ money productively. That requires acknowledging that things can be made to work better, rather than the defeatism of those who believe nothing will ever change.
Finally, a word about activism. The Stewardship Code does not require all its adherents to behave like activists. There is a difference between being an activist and being an active investor, but activists have an important role to play, precisely because holders of widely diversified portfolios cannot be on top of every situation. Activists who scan the horizon looking for companies that need attention play a useful role in bringing these situations to the attention of mainstream investors who will ultimately decide whether there is a case to answer or not. We should be careful to avoid regulations that inhibit them in this role.
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. The Stewardship Code attempts to redress the balance. Markets will be healthier if we can make it work.