Thursday, January 7, 2016

A Subversive View of Institutional Investors and Governance

I read an interesting article about corporate governance today -- OK, to some people that might be an oxymoron, but the article summarizes some recent research which presents an interesting argument. It's also an argument I disagree with, and I've been thinking a bit about why.

The article outlines a rationale as to why banks have not been more competitive with each other to lower fees and grow market share. In a simplified/assumed scenario, the greater the number of banks, the lower their fees should be, because they'll be more competition. But that's not what the researchers find -- and they attribute that to the fact that a small set of institutions (e.g., Fidelity, State Street) own significant shares in ALL the major competitors.

The authors argue that these banks act in a way more like oligopolies than harsh competitors.

This line of thinking sounded familiar to me, because I thought I remembered a similar argument with regard to airline ticket prices (turns out it was the same researchers and summarized in another earlier Slate article).

So the author of this piece (not sure if the initial researchers agree) propose 'solutions' to this problem - specifically, that mutual funds should only be allowed to buy shares in one company in a given industry.

I think that's a little nuts, and I kind of think the whole line of thinking that institutional ownership drives oligopoly-like behavior doesn't seem right either. Why do I disagree? I'm glad you asked.

1 - The shareholders don't directly drive the strategy of the company: There's a big intermediary in the presumption that Fidelity et al are driving industries to conspire to keep prices artificially high, and that's a corporation's board of directors. Those are the men/women charged with overseeing management and ensuring they're doing the best they can. And while these institutional shareholders may be the same across multiple companies, the directors who oversee individual companies' management are most certainly not. Those directors are focused solely on the actions of their respective player, not in ensuring some secret industry cabal to keep prices high. True, institutions play a role in nominating/voting for directors - but to ignore the directors' agency and just assume they do everything some big shareholders want seems way to simplistic.

2 - Institutional shareholders aren't always monolithic: Yes, Fidelity as a whole might own a ton of an individual company's stock - but Fidelity isn't one entity with one single objective. Fidelity, and many major institutions, are comprised of many many different funds with different managers that run them. I'm not sure what kind of guidelines they have for exercising their votes, but do all Fidelity owners have to vote the same way? Seems unlikely.

3 - Large shareholders aren't the only ones who can push for changes: From this article's rationale, the best investors are activist investors, ones who are constantly pushing for change that adds value. Well, activists can successfully push for changes even without the large stakes of major institutions. Just look at the most recent activist situation in the news, Yahoo and Starboard. When Starboard first pushed for changes in 2014, it owned less than 1% of the company. Simply put, you don't need to be a huge owner to get your voice heard or get results. If an individual firm could be making more money, investors would absolutely be pushing for it.

The article also mentions the idea of institutional ownership, and the goal of it, is to allow individual investors to aggregate their power and exert control over firm management. I may have not been paying attention in finance class, but I don't think that's the goal of institutional investors at all. I would argue institutional investment vehicles (e.g., mutual funds) exist more to provide a single investor with an easy way to get diversified access to investments. I invest in mutual funds or ETFs so I can get exposure to a lot of companies/sectors/geographies...not because I want to make sure my voice is heard in the managerial decisions of the company.

The idea the authors put forward is an interesting one, but I don't think I agree with it. If you argue that firms aren't competitive enough in the banking or airline industry, I'd say you should probably focus more on mergers that allow those industries to become more concentrated, not the fact that largely passive investors end up holding an interest across many of the players.

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