The UK's Stewardship Code leaves something to be desired. For example, what exactly is good stewardship? Nina Röhrbein reports

The UK's Stewardship Code was unveiled in July and is one of the most important documents in corporate governance, focusing on investors rather than companies. Similar initiatives are now under way at a European level and this has again drawn attention to the age-old discussion about whether the responsibility lies with institutional investors or fund managers.

"Stewardship is higher up trustees' agenda than it was a year or two ago," says Peter Butler, CEO and founding partner of Governance for Owners (GO). "However, they are still trying to define what good stewardship means. Much of the writing on stewardship is aimed at fund managers but good stewardship has to be the responsibility of asset owners because they need to live up to their fiduciary responsibility."

"The code has led many fund management companies to review what they do for their clients," says Colin Melvin, chief executive of Hermes Equity Ownership Services (EOS)."Several have hired new staff to look at governance while pension fund trustees are considering how to manage their emerging responsibilities as company owners and use their ownership rights to improve the companies they invest in to their own benefit."

Pension funds generally have three choices in approach to governance: instructing their fund managers to do the governance for them; undertaking the engagement internally, or using a third party. "The large majority of pension funds delegate their corporate governance activities to their fund managers, as the fund management process and voting and engagement form a natural marriage," says Emma Hunt, senior investment consultant at Towers Watson. "Until today, the oversight of those activities has been light. It used to be an implicit, passive delegation process. But with clients starting to pay attention to voting and engagement, this is changing. They are now more explicit in their statement of investment policies, active reporting and manager monitoring processes."

GO also prefers ‘co-sourcing' to the complete outsourcing of governance, whereby every pension fund still has an executive with some responsibility for governance who ensures the work outsourced to a third party is undertaken.

But outsourcing governance to fund managers has been of variable success, according to Melvin. "A fund manager with concentrated investments in illiquid securities, such as emerging markets or small caps, tends to be interested in the quality of management and stewardship of the companies he invests in because he cannot easily sell the shares," he says. "Unfortunately, most pension fund assets are invested in liquid markets where there is much less interest in stewardship among the fund managers because they are much happier to sell the shares than to engage with the companies. Therefore, a strategy of simply outsourcing to the fund manager is only going to work for the small portion of the portfolio invested in illiquid securities and unlikely to work across full portfolios. Consequently, most pension funds that have tried this approach have been disappointed."

Due to internal resource restraints, few pension funds have tried the direct approach. The UK's Universities Superannuation Scheme (USS) - the country's second largest - is one of the funds that has been able to do this.

Going through a third party provider means pension funds can, by paying a fee, benefit from a large resource and can usually do more than a single fund management company could on its own.

Many larger pension funds subscribe to more than one service provider and use two different opinions from, for example, an international and a local provider to form their own, says Jean-Nicolas Caprasse, European governance head at Institutional Shareholder Services (ISS), part of MSCI. They select their third party providers based on reputation, size and track record.

The general problem is that pension funds always assumed governance would be undertaken by the fund manager. "We have a complete standoff because it is going to cost fund managers more to do good stewardship but they have always maintained they are not being paid for the full role of stewardship," says Butler. "To move away from this fundamental debate, pension funds will have to pay more to whoever does the work. If they believe it is not worth it, we get into the issue of the short-term bias of the markets and whether benefits need to be enhanced or introduced for long-term equity ownership."

But Hunt says: "A year ago, some fund managers hinted that, if clients required greater levels of voting, engagement and reporting, they would have to pay for it through overall higher management fees. But those conversations have died down when it comes to simple voting and engagement activities. For deeper levels of intervention, as in the engagement overlay services, it may be different."

Due to improved efficiency, the financial cost of good quality corporate governance has not increased for pension funds, she believes, although additional time resource is needed to ensure appropriate oversight of this work. Market participants generally differ in their perception of fees as a problem.

According to Butler, pension funds do not spend enough on governance. "Investment management fees can be anything from a few to 200 basis points, but pension funds often only spend a fraction of a basis point on stewardship services," he says. "With pension funds being shamed and bullied into doing more by governments and regulators, it increases the danger of a box-ticking approach to governance. A lot of work is already being duplicated. Pension funds need to realise it is better to engage well with 15 or 20 companies and create added value than write a letter that nobody reads to 2,000."

Hermes EOS has not found fees to be a problem. A typical range, Melvin says, would be between half a basis point and three basis points for pension funds and slightly more for fund management companies, depending on their size, the market and the number of unique positions held. In tough environments, pension funds should try to avoid increasing their overall cost by re-balancing it in favour of increased engagement and monitoring, suggests Caprasse.

Nowadays at least 99% of votes cast are electronic, according to Caprasse. Pension funds rely on the research undertaken by an external provider to form their own opinion and then access an electronic voting platform to log their votes.

"Electronic voting services have reached a very good standard over the last 10 years," says Hunt. "The reporting that can result from these voting platforms has also improved immensely, which makes the whole process much more efficient and much easier to manage."

The danger with an electronic voting service is that it is a commodity product, says Butler, which is why pension funds have to maintain an overview and a mechanism for following up to avoid abuse. "If an owner withholds a vote it is only going to be effective if an explanation is given to the board of directors, otherwise the whole thing is a bit of a waste of time," he says. "You also have to be wary of any one proxy agent being able to deliver a vote that can actually change the result without the shareowner reviewing the circumstances."

"If there is a concern, it is better to go to the company directly and engage," agrees Melvin. "Voting the shares is the minimum requirement and they are best used as a lever for change. Electronic governance forums can work well for sharing ideas, such as the UN PRI clearinghouse for engagement, which has been effective on policy and thematic work. The problem with many of these electronic platforms is that they lack that face-to-face interaction, which is most valuable in engendering trust and bringing about change. In their informality they can also slow down a corporate engagement considerably because an informal group has to ask repeatedly about wording of letters and the timing of sending them out. By the time it has even just agreed the initial letter, it may have lost a window of opportunity."

While pension funds have systems in place for managing their assets, their accounts and their administration, a system for managing their governance procedures is often still lacking, according to Alister Esam, CEO of online governance service provider eShare. "Managing everything just with Outlook, Excel and Word is very time and cost-inefficient and often does not allow trustees to see what is happening as different people maintain spreadsheets separately," he says. "Initially the idea of using technology to address this area was alien to people but interest has steadily grown over the last five years."