Discussions of stewardship often assume that engaged investing can be integrated with current investment practices. Paul Frentrop says that we need to think again
Financial crises are fertile ground for new legislation. The accounting scandals of the late 1980s gave rise to Cadbury's corporate governance code. The dotcom crisis spawned cross-border migration of governance codes throughout continental Europe and blessed the US with Sarbanes-Oxley.
This latest crisis has brought banker bonus limitations to Europe and added the Dodd-Frank law to the US financial regulatory armoury. And in the UK a completely new regulatory flower has blossomed: stewardship.
The UK's analysis of the causes of the downfall of the banks was diametrically opposed to the thinking in continental Europe, where the public was told that aggressive shareholders demanding ever higher returns on equity had driven bank managers to take ever greater risks. In the UK, however, it was the shareholders who were blamed for not doing enough, allowing banks to take undue risks like buying other banks or investing in mortgage-backed securities.
This kind of inappropriate behaviour by company executives could have been prevented, went the argument, if institutional shareholders had held regular chats with boards to discuss things like risk appetite, corporate culture, executive pay and board composition. Banks and other companies shepherded by good stewards will not run astray. This message, carved into the UK Stewardship Code, is eagerly proselytised by specialised asset managers — the same asset managers who, for a few dollars more, offer engagement services as part of their menu of investment magic.
But in Europe, trustees are not immediately inclined to ask themselves, "Are we good stewards? Did we help boards to create long-term shareholder value?"
In the world of institutional investment ‘Judgement Day' occurs monthly and the doors to ‘Heaven' only open for those whose returns exceed their allotted benchmark. Performance is always relative and relative performance targets do not square with stewardship. For starters, the numbers do not add up. To stay out of asset management ‘Hell' the investor has to stay close to the benchmark and index hugging demands derivatives or a very dispersed portfolio. The MSCI World index consists of more than 1,500 companies. Is it possible for the owner of so many companies dispersed across the globe to engage with them all? No - but engagement is the key to stewardship.
And this gives rise to another question: Why invest in a company that needs engagement? Should a prudent steward not first engage the company and only buy the shares after the board shows itself receptive to his ideas?
A third, supreme, paradox of engagement is deeply rooted in the nature of the institutional investor. He has to offer investment results better than the market average. His target is relative outperformance. And there are only two ways to deliver such performance: Either pick, buy and hold only the right shares, or constantly adjust your portfolio. Buy and hold demands insight into the present and future prospects of individual companies and nerves of steel from trustees who must be prepared to endure long periods of underperformance for eventual outperformance.
So, instead, investors have to do a lot of short-term trading. They buy the shares of a company when they are ‘undervalued'. When the company performs well investors will sell the shares, especially when the market overshoots and ‘overvalues' the company. That is the fiduciary duty of the institutional asset manager towards his beneficiaries. The duty of an institutional investor towards beneficiaries supersedes his duties as a steward of companies.
Every successful company will see his stewards consistently sell and break off the engagement. There is no ‘loyalty' to be expected from institutional investors who are the managers of other people's money. Even institutional investors with long-term obligations are short-term investors in listed equity. When investors talk about integrating engagement into their investment policy that means, for the most part, that the asset manager will inform the governance department that he sold the shares, so the governance people can stop engaging the board. It is in this inglorious way that stewardship ends.
Company directors are well aware of this harsh reality. That makes them cool to discussions with their present institutional shareholders, who might sell when the board underperforms - and definitely will sell the moment the share price surpasses their ‘target'. Rational directors will, instead, focus their time and efforts on those institutional investors who are not yet shareholders in the company, but might be enticed to buy. The incentives to do so are abundant. Parties holding or selling do not help the stock price, but the appetite of new investors will. It will underpin the share price and so improve total shareholder return relative to the peer group, which will, in turn, be good for the variable portion of the board's remuneration. So the investors who get the ear of the board are not the company's current shareholders, but rather its potential shareholders - unless they hold a controlling stake, existing shareholders are not the most effective stewards.
Both company boards and institutional investors are trapped in a whirling dance of relative performance measurement, which forces them to change partners at every turn.That is why, for the last few decades, turnover of listed shares has grown so much faster than the number of shares listed. This perpetual dance of the traders is far removed from the dark and static world of company law where boards preside over annual shareholder meetings where accounts are approved and proposals adopted. Proponents of stewardship aim to meet the twain, putting more control in the hands of the ‘long-term' shareholders from the static realm, not realising that most investment returns are made in the dynamic trading realm where liquidity rules.
But liquidity and governance are the two faces of the same coin. The incentives to stewardship depend on the liquidity of the market for shares. Stock market liquidity discourages monitoring and stewardship by reducing the cost of exit for unhappy shareholders. A positive conclusion that can be drawn from the most recent financial crisis is that stock markets - unlike interbank trade and even euro government bond markets - operated with perfect liquidity; no central bank had to buy shares to keep the stock market going. Institutional investors and their beneficiaries should be grateful for that. One cannot ask for more - and certainly not for both liquidity and stewardship at the same time.
In private equity, investors have to be stewards because they are locked in. After nurturing the company to governance maturity, the private equity investor will exit through the stock market, and the board will have to fend for itself without shareholder support or stewardship. Out in the open market, cold-hearted, distant investors count on liquidity to realise the ‘outperformance' they promised their clients. And in this harsh climate, no steward can survive.
Those who truly want stewardship must give up liquidity. Institutional investors who want to be stewards have to change their investment policy. The number of stocks in their portfolio must be reduced. Their percentage of shares in the companies they invest in then must be higher. The turnover in their portfolios will be small. Their performance may significantly deviate from the major market indices and in periods that those periods they underperform they will have to maintain the trust of their investors.
In fact, he who promotes stewardship is not merely asking for improvements in corporate governance. Stewardship implies and demands a whole new system of institutional investor and pension fund governance.
Paul Frentrop is author of A History of Corporate Governance 1602-2002 (Deminor 2003) and an independent corporate governance adviser