Monday, 19 May 2014

Why do companies get away with acting badly? Here is my way to effect change!

Corporate governance is important and can really affect share valuations.  The problem is that as individuals we can make very little difference (even if we do vote at shareholder meetings).  Retail shareholders typically do not have sufficient influence to change the way in which a company acts - as we are dwarfed by institutions.

Why don't most institutions hold companies account for their actions?

Large institutions can definitely make a difference.  However they often don't pull companies up for their bad actions or behaviours for various reasons:

  1. The want access to the companies
    • Institutional investors are researching these companies day in and day out and one of the ways they do this is by access to the company's board and management teams
    • There is always the risk that you lose this access by 'rocking the boat' too often and voting against what the board and management teams want to do
  2. They make money when some of these companies do badly
    • The performance of a fund manager is often measured on a relative basis versus an index
    • Even if a fund manager holds shares in a company which has bad corporate governance practices and can therefore make a difference through their voting, if they are underweight the stock they get rewarded (in performance terms) if that stock does badly
  3. They get no positive benefit from holding companies to account
    • If you invest in managed funds, ask yourself "when was the last time I made a decision about which fund manager to invest in based on how activist they were in terms of looking after my investments?"
    • The fact is that the clients of fund managers do not care enough about corporate governance to make the fund managers care.  As a result fund managers just focus on making more money 
      • If the return of a stock is likely to be impacted by corporate governance issues then they will be underweight the stock which creates the issue outlined above

The case for index funds to be corporate governance hawks

Index funds are the one actor in the whole share market who has the best incentives to
be corporate governance hawks
  1. They don't care about access - their investments are determined by market movements and they don't need to do research so companies can't blackmail them that way
  2. They are not trying to outperform - although they are not focused on absolute return, they have no disincentive to encourage management to act in the right way
  3. They are large enough to make a difference - this is the most important point!  Companies, boards and management teams often get away with acting badly or making bad decisions because no one cares enough to act or if they do care they are too small to make a difference.  Index funds can and should make a difference when it comes to corporate governance issues and given their rise in terms of size and importance they can truly affect companies decisions in order to get the best returns from the market

The challenge is getting index funds to care enough to act

The challenge is getting index funds to care enough to do this.  Index funds are typically very low cost operations - hiring someone to deal with corporate governance issues is another cost for them.  However given the billions they manage, there should be some reward for them doing the right thing by investors - they should be caring about corporate governance issues and voting their shares in a way which reflects best practice corporate governance.

Note that index funds do have some perverse incentives.  Occasionally index funds will have some perverse incentives - they want to keep themselves relevant so are unlikely to vote in favour of a takeover in a sector if they are a sector based index fund and the takeover makes the sector irrelevant.  On the whole though - they don't have the number of perverse incentives that other institutions have.

Perhaps I am hoping too much for the index fund sector but as an investor in this sector I am calling on all index funds to take a more active role in corporate governance.  As an investor you should care about this and there should be a reward for index funds who take an active role in corporate governance terms.

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  1. The index fund is gaining more traction from the Australian market I feel, correct me if I am wrong..

    Do you ever see the index funds dominating companies? What about the impact of small caps?

    1. Index funds are definitely gaining traction and that is why they can be so important and relevant in the corporate governance space.

      The problem will be is if they sit there as passive investors because then companies will have almost a free reign to act without oversight (if they believe index funds will do nothing)

  2. Well would they be buying into large companies?
    If that's the case you would want to make sure the index funds are actively using their influence at Annual Shareholder meetings right?

    1. Index funds, by their very nature, would hold larger positions in the larger companies. And yes I would really like for them to actively use their position at Annual General Meetings. However I don't think that they do this yet (and certainly don't do it enough).

      I definitely thing that they should be spending more time voting and exercising the significant power they have at shareholder meetings.