How Is This Research Useful to Practitioners?
The last several decades have seen a dramatic rise in institutional ownership across the globe. Simultaneously, the share of stock held by private individuals has gradually decreased. The managers of investment funds are far more powerful than individuals in the execution of the control function over corporate managers. Nevertheless, certain agency problems seem to prevent the full realization of the potential benefits of increased concentration.
According to the encyclopedic definition, agency problems are inherent in any relationship in which one party is expected to act in the best interest of another. In the case of listed companies, the agency problem is about the conflict between the owners (shareholders) and hired management. In the case of institutional investors, the conflict arises between the contributor to the fund and the investment manager. The scope of the problem is closely tied to the type of institutional investor; such investors come in a great variety of legal forms and business models, resulting in different scopes of both declared and factual engagements in stewardship activities. This difference is actually a measure of the agency problem.
The authors find that investment managers generally capture only a small fraction of the benefits that arise from their stewardship activities. At the same time, they need to incur the entire cost of such activities and cannot charge it to the portfolio. It seems unlikely that competition with other investment managers will lead to a reduction of this gap, especially in the case of index funds, where increased stewardship is not reflected in the relative performance measurement because it improves the performance of both the fund and the benchmark at the same time.
According the authors, institutional investors allocate a limited number of staff to execute stewardship functions on several thousand companies, effectively reducing the time available for monitoring a single company to less than one person-workday a year, on average. Finally, investment managers may be further biased by private incentives—for example, obtaining business from corporations that encourage them to side excessively with corporate managers.
The authors find that the incentives to engage in stewardship activities are particularly weak in the case of passive index funds and are substantially stronger in the case of actively managed hedge funds. Their general conclusion is that despite increased concentration, the scope of shareholder intervention effectively remains too small.
This research should be of interest to several groups of investment market participants, including (1) individuals and entities whose assets are pooled and then invested in a portfolio of securities managed by an institutional intermediary and (2) regulators willing to structurally strengthen shareholder engagement in the monitoring of listed companies across the economy.
How Did the Authors Conduct This Research?
A generalist expectation of shareholders is that they monitor corporate performance. Doing so should ultimately lead to an improved allocation of funds, thus promoting the most effective businesses from the perspective of the whole economy. Any impediment to this process constitutes a threat to the economic balance. Individual investors are unable to execute their control prerogative because of the insufficient share of stock they own. There is a growing recognition of the power of institutional investors as well as an increasing expectation that they will use their power to improve the governance of the companies in their portfolios.
This research brings to light a crucial issue for the investment industry, offering a new and insightful perspective for understanding the ownership engagement of institutional investors. A superficial assumption would be that their increased presence in the investment market should result in tighter control over corporate actions. The authors raise several questions regarding this presupposition, present ideas that could increase the scope of such control, and note potential adverse consequences.