Mutual Fund Development

To trace the origin of the pooled investment vehicle we call the mutual fund we again look to the Dutch Republic. The first known such fund was formed in 1773, by Amsterdam-based businessman Abraham van Ketwich who created a trust named Eendragt Maakt Magt (“unity creates strength”). His aim was to provide small investors with an opportunity to diversify, which continues to be an important advantage provided by mutual funds today.

Mutual funds were introduced to the United States in the booming 1890s, as closed-end funds with a fixed number of shares, in which the value of the shares traded above, at, or below the funds’ net asset values. The first open-end mutual fund with redeemable shares was established in 1924 as the Massachusetts Investors Trust and is still in existence today. In 1928, Scudder, Stevens and Clark launched the first no-load fund, a fund which did not charge a commission to the buyer. The Wellington Fund, the first mutual fund to include stocks and bonds, as opposed to direct investments in business and trade, was also launched in 1928.

By 1929, the industry claimed $27 billion in total assets according to Investment Company Institute data. As a point of reference, by 1970, there were approximately 360 funds with $48 billion in assets. At the end of 2016, mutual fund assets worldwide totaled $40.4 trillion, according to the Investment Company Institute, and the largest pool of such funds is based in the United States, with $18.9 trillion in assets.

The Investment Company Act of 1940, a Depression era piece of legislation that was delayed by several years of study, was enacted to define coved investment companies and detail the process required to govern them. Mutual funds are simple enough: they typically take the form of a trust with perpetual life. Because their shares are offered to the public, they must be registered with the SEC just like a public company. The complexity comes in because the fund does not typically have its own employees. It contracts for services from its investment manager, often the creator of the fund, and from administrators and transfer agents and underwriters, who sell the shares.

The interest of the investment manager is generally in increasing its own profits, which may not always be consistent with the best interests of the fund shareholders. To protect shareholders from this conflict, the ’40 Act spells out the requirements for the fund’s board, and mandated that a certain percentage of directors, then 40 percent, needed to be disinterested.

This was important as investment manager employees could also be fund directors as well as administrators, transfer agents, and underwriters. These people wearing many hats needed an impartial voice responsible only for the health and wealth of the fund. To the best of my knowledge this was not only the first instance of independent directors being specified but also the first clear directive setting forth the processes board members were responsible for undertaking.

In 1971, Wells Fargo Bank established the first index fund, a concept that fund luminary John Bogle used as a foundation on which to build The Vanguard Group, renowned for its low-cost index funds. Index funds hold portfolios built to match the components of a specified market index, such as the Standard & Poor’s 500 Index (S&P 500). Its attractions include broad market exposure, low operating expenses, low portfolio turnover, and the ability to avoid the cost of active management, which rarely achieves consistent results that match or exceed the index.

The 1970s also saw the rise of the no-load fund, funds that charge no upfront commission to investors. This new way of doing business had an enormous impact on the way mutual funds were sold and would make a major contribution to the industry’s success. With the 1980s and 1990s growth of assets, previously obscure fund managers became superstars; Max Heine, Michael Price and Peter Lynch, the mutual fund industry’s top gunslingers, became household names and money poured into the retail fund industry at a stunning pace.

In 1993 I was building a no load mutual fund complex. While credited by Lipper Analytical Services with growing assets to $1 billion faster than any non-bank complex in history, I confess to having had considerable help from what was to me an unexpected source. One Thursday afternoon, we received a call from a radio station warning us that their Sunday show would be highlighting our funds and to plan for extra help answering the phones.

Mystified, I made contingency plans just in case. Lo and behold, during the show our phones started to ring and by the time the flood was over we had substantially increased the size of our fund complex. And this happened again and again. Thankfully our funds continued to perform during that crazy year, even with that huge influx of new money.

Comments from Mutual Fund Leader John C. Bogle

John Bogle offers valuable insight in the Reflections column in the Financial Analysts Journal in 2005. I include most of his commentary below, as I find it compelling, and his authority in making such observations is difficult to dispute.

The staggering increase in the size of the industry and the huge expansion in the number and types of funds are but the obvious manifestations of the radical changes in the mutual fund industry. It has also undergone a multifaceted change in character. In 1945, it was an industry engaged primarily in the profession of serving investors and striving to meet the standards of the recently enacted Investment Company Act of 1940, which established the policy that funds must be “organized, operated, and managed” in the interests of their share-holders rather than in the interests of their managers and distributors. It was an industry that focused primarily on stewardship. Today, in contrast, the industry is a vast and highly successful marketing business, an industry focused primarily on salesmanship. As countless independent commentators have observed, asset gathering has become the fund industry’s driving force. . .

The vast changes in fund objectives and policies have been accompanied by equally vast changes in how mutual funds are managed. In 1945, the major funds were managed almost entirely by investment committees. But the demonstrated wisdom of the collective was soon overwhelmed by the perceived brilliance of the individual. The Go-Go Era of the mid-1960s and the recent so-called New Economy bubble brought us hundreds of ferociously aggressive “performance funds,” and the new game seemed to call for free-wheeling individual talent. The term “investment committee” virtually vanished, and the “portfolio manager” gradually became the industry standard. . .

Together, the coming of more aggressive funds, the burgeoning emphasis on short-term performance, and the move from investment committee to portfolio manager had a profound impact on mutual fund investment strategies, most obviously in soaring portfolio turnover. . . In 1945, mutual fund managers did not talk about long-term investing; they simply did it. That’s what trusteeship is all about. But over the next 60 years, that basic tenet was turned on its head and short-term speculation became the order of the day.

Not that the long-term focus did not resist change. Indeed, between 1945 and 1965, annual portfolio turnover averaged a steady 17 percent, suggesting that the average fund held its average stock for about six years. But turnover then rose steadily; fund managers now turn their portfolios over at an average rate of 110 percent annually. Result: Compared with the six-year standard that prevailed for some two decades, the average stock is now held by the average fund for an average of only 11 months.

Moreover, turnover rates do not tell the full story of the role of mutual funds in the financial markets. The dollars involved are enormous. For example, at a 100 percent rate, today’s managers of $4 trillion in equity assets would sell $4 trillion of stocks in a single year and then reinvest that $4 trillion in other stocks, $8 trillion in all. Even though more competitive (and increasingly electronic) markets have slashed unit transaction costs, it is difficult to imagine that such turnover levels, in which trades often take place between two competing funds, can result in a net gain to fund shareholders collectively.

If a six-year holding period can be characterized as long-term investment, and if an 11-month holding period can be characterized as short-term speculation, mutual fund managers today are not investors. They are speculators. I do not use the word “speculation” lightly. Nearly 70 years ago, John Maynard Keynes contrasted speculation (“forecasting the psychology of the market”) with enterprise (“forecasting the prospective yield of an asset”) and predicted that the influence of speculation among professional investors would rise as they emulated the uninformed public—that is, seeking to anticipate changes in public opinion rather than focusing on earnings, dividends, and book values.

In my 1951 thesis on the mutual fund industry, I was bold enough to disagree with Keynes’ baleful prediction. As funds grew, I opined, they would move away from speculation and move toward enterprise by focusing, not on the momentary, short-term price of the share, but on the long-term intrinsic value of the corporation. As a result, I concluded, fund managers would supply the stock market “with a demand for securities that is steady, sophisticated, enlightened, and analytic.” I could not have been more wrong. Mutual funds, once stock owners, became stock traders and moved far away from what Warren Buffett describes as his favorite holding period: Forever.

In 1945, funds owned only slightly more than 1 percent of the shares of all U.S. corporations. Today, they own nearly 25 percent. They could wield a potent “big stick” but, with a few exceptions, have failed to do so. With their long record of passivity and lassitude about corporate governance issues, fund managers must accept a large share of the responsibility for the ethical failures in corporate governance.

. . . long term didn’t seem to be relevant. By 2002, the redemption rate had soared to 41 percent of assets, an average holding period of slightly more than three years. The time horizon for the typical fund investor had tumbled by fully 80 percent.

Part of the astonishing telescoping of holding periods can be traced to opportunistic, gullible, and emotional fund investors as well as the change in the character of our financial markets (especially in the boom and bust of the stock market bubble during 1997–2002). But by departing from the industry’s time-honored tenet of “we sell what we make” and jumping on the “we make what will sell” bandwagon—that is, creating new funds to match the market fads of the moment—this industry must also assume much responsibility for the soaring investment activity of fund investors.

In 1945, the average expense ratio (total management fees and operating expenses as a percentage of fund assets) for the largest 25 funds, with aggregate assets of but $700 million, was 0.76 percent, generating aggregate costs of $4.7 million for fund investors. Six decades later, in 2004, the assets of the equity funds managed by the 25 largest fund complexes had soared to $2.5 trillion, but the average expense ratio had soared by 105 percent to 1.56 percent, generating costs of $31 billion. In other words, while their assets were rising 3,600-fold, costs were rising 6,600-fold. (The dollar amount of direct fund expenses borne by shareholders of all equity funds has risen from an estimated $5 million annually in the 1940s to something like $35 billion in 2004, or 7,000-fold.) Despite the substantial economies of scale that exist in mutual fund management, fund investors have not only not shared in these economies, they have actually incurred higher costs of ownership.

Sixty years ago, the mutual fund industry placed its emphasis on fund management as a profession— the trusteeship of other people’s money. Today, there is much evidence that salesmanship has superseded trusteeship as our industry’s prime focus. What was it that caused this sea change? Perhaps trusteeship was essential for an industry whose birth in 1924 was quickly followed by tough times— the Depression and then World War II. Perhaps salesmanship became the winning strategy in the easy times thereafter, an era of almost unremitting economic prosperity. Probably, however, the most powerful force behind the change was that mutual fund management emerged as one of the most profitable businesses in our nation. Entrepreneurs could make big money managing mutual funds.

In 1958, the whole dynamic of entrepreneurship in the fund industry changed. Until then, a trustee could make a tidy profit by managing money but could not capitalize that profit by selling shares of the management company to outside investors. The SEC held that the sale of a management company represented payment for the sale of a fiduciary office, an illegal appropriation of fund assets. If such sales were allowed, the SEC feared, it would lead to “trafficking” in advisory contracts, a gross abuse of the trust of fund shareholders. But a California management company challenged the regulatory agency’s position. The SEC went to court—and lost.

Thus, as 1958 ended, the gates that had prevented public ownership since the industry began 34 years earlier came tumbling down. A rush of initial public offerings followed, with the shares of a dozen management companies quickly brought to market. Investors bought management company shares for the same reasons that they bought shares of Microsoft Corporation and IBM Corporation and, for that matter, Enron: Because they thought their earnings would grow and their stock prices would rise accordingly.

The IPOs were just the beginning. Publicly held and even privately held management

companies were acquired by giant banks and insurance companies that were eager to take the new opportunity to buy into the burgeoning fund business at a healthy premium (averaging ten times book value or more). The term “trafficking” was not far off the mark; there have been at least forty such acquisitions during the past decade alone, and the ownership of some fund firms has been transferred numerous times. Today, among the fifty largest fund managers, only eight remain privately held (plus mutually owned Vanguard). Six firms are publicly held, and the remaining thirty-five management companies are owned by giant financial conglomerates— twenty-two by banks and insurance companies, six by major brokerage firms, and seven by foreign financial institutions.

It would be surprising if this shift in control of the mutual fund industry from private to public hands, largely those of giant financial conglomerates, had not accelerated the industry’s change from profession to business. Such staggering aggregations of managed assets—often hundreds of billions of dollars under a single roof—surely serves both to facilitate the marketing of a fund complex’s brand name in the consumer goods market and to build its market share. Conglomeration does not seem likely to make the money management process more effective, however, nor to drive investor costs down, nor to enhance the industry’s original notion of stewardship and service.

For 78 years—from its start back in 1924 through 2002—the mutual fund industry was free of major taint or scandal. But as asset gathering became the name of the game, as return on managers’ capital challenged return on fund shareholders’ capital as the preeminent goal, as conglomeration became the dominant structure, and as stewardship took a back-seat to salesmanship, many fund managers were not only all too willing to accept substantial investments from short-term investors and allow those investors to capitalize on price differentials in international time zones (as well as engage in other unrelated but profitable activities), they were also willing to abet and even institutionalize these practices.

To improve their own earnings, managers put their own interests ahead of the interests of their fund shareholders. They allowed short-term traders in their funds to earn illicit higher returns at a direct, dollar-for-dollar cost to their fellow investors holding for the long term. Brought to light by New York Attorney General Eliot L. Spitzer in September 2003, the industry’s first major scandal went well beyond a few bad apples. More than a score of firms, managing a total $1.6 trillion of fund assets, including some of the oldest, largest, and once most respected firms in the industry, have been implicated in wrongdoing. This scandal exemplifies the extent to which salesmanship has triumphed over stewardship.

Clearly, the mutual fund industry of 2005 is different not only in degree but in kind from the industry of 60 years earlier—infinitely larger and more diverse, with more speculative funds focused on ever-shorter investment horizons. It is less aware of its responsibility for corporate citizenship; its funds are held by investors for shorter time periods; and it is far more focused on asset gathering and marketing. The fund industry is increasingly operated as a business rather than a profession and, despite the awesome increase in its asset base, has far higher unit costs. The culmination of these changes is a scandal that crystallizes the extent to which the interest of the managers have superseded the interest of fund shareholders.

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The Growth of Passive Investing

Following that beautifully articulated discussion of the development of the mutual fund industry from Mr. Bogle, we need to explore the tremendous growth since he wrote that article in the use of ETFs, an acronym for electronically traded funds. ETFs currently account for nearly a quarter of U.S. stock-market trading volume. ETFs have attracted more than $2 trillion in net new inflows globally over the past 8 years, and worldwide ETF assets have grown to $3.4 trillion over the same period, according to ETFGI, a London-based consultancy.

Looked at another way, Vanguard, the firm Mr. Bogle built, now owns 5 percent or more of 491 of the 500 companies listed in the Fortune 500 due in large part to its ETF assets. This reach is extraordinary, and Vanguard is not the largest ETF sponsor. At a July 2015 conference, according to the Financial Times, billionaire activist investor Carl Icahn called BlackRock a “very dangerous company” while sitting next to Larry Fink, co-founder and chief executive of what has become, in large part due to its dominance in the ETF sector, the world’s largest asset manager. (Mr. Bogle, by the way, has publicly stated that he is not a fan of ETFs.)

While Mr. Fink dismissed his comment as “flat out wrong,” several weeks later, ETFs were at the center of one of the wildest days of trading in U.S. stock market history. More than 20 percent of all U.S.-listed ETFs were forced to stop trading on August 24 after the Dow Jones Industrial Average dropped nearly 1,100 points in the first few minutes of the day and then rebounded by almost 600 points minutes later. Many ETFs traded well below their net asset value, which prompted concern that investors in them were unprotected. While the long-term impact on ETF growth has not seemed significant, this ETF “flash crash” drew attention from exchanges, regulators, and academics as to the potential unforeseen risks that such large market participation by ETFs might entail.

Itzhak Ben-David, finance professor at Ohio State University, sees the additional liquidity provided by ETFs as a “double-edged sword” since it can disappear so easily, and says ETFs can increase volatility in the pricing of the stocks they own. He believes they raise volatility at an overall market level. In 2015, SEC commissioner Luis Aguilar, raised concerns among providers when he asked: “Should we consider curtailing the growth of ETFs?”

While the jury is out on how ETFs, passively managed in accordance with the composition of identified market indices, will perform in adverse market conditions, their presence as competitors for mutual funds cannot be ignored since they are so large and growing.

Retirement Assets Shift into Mutual Funds

Economist Paul Krugman wrote in November 2013: “Today, however, workers who have any retirement plan at all generally have defined-contribution plans—basically, 401(k)’s—in which employers put money into a tax-sheltered account that’s supposed to end up big enough to retire on. The trouble is that at this point it’s clear that the shift to 401(k)’s was a gigantic failure. Employers took advantage of the switch to surreptitiously cut benefits; investment returns have been far lower than workers were told to expect; and, to be fair, many people haven’t managed their money wisely. As a result, we’re looking at a looming retirement crisis, with tens of millions of Americans facing a sharp decline in living standards at the end of their working lives. For many, the only thing protecting them from abject penury will be Social Security.”

A 2014 Gallup poll indicated that 21 percent of investors had either taken an early withdrawal of their 401(k) defined contribution retirement plan or a loan against it over the previous five years; while both options are possible, they are not the intended purpose of 401k plans and can have substantial costs in taxes, fees and a smaller retirement fund.

Public Sector Pension Plans

Public pension plans got their start with various promises, informal and legislated, made to veterans of the Revolutionary War and, more extensively, the Civil War. They expanded and began to be offered by a number of state and local governments during the late 19th century. Unlike the private sector, in the public sector once an employee is hired their pension benefit terms cannot be changed. Retirement age in the public sector is usually lower than in the private sector.

Public sector pensions are offered by federal, state and local levels of government. Like private plans, employer contributions to these plans typically vest after some period of time. These plans may be defined-benefit or defined-contribution pension plans, but the former have been most widely used by public agencies in the U.S. throughout the late twentieth century.

Federal civilian pensions were offered under the Civil Service Retirement System (CSRS), formed in 1920. CSRS provided retirement, disability and survivor benefits for most civilian employees in the federal government, until the creation of a new federal agency, the Federal Employees Retirement System (FERS), in 1987.

Some have grown to be extremely large, led by the California Public Employees Retirement System, aka CalPERS, holds over $300 billion as of December 31, 2016, and California State Teachers Retirement System holds just under $200 billion. The only larger U.S. plan is the Federal Retirement Thrift Plan at $485 billion. The world’s largest pension fund is the Government Pension Investment Fund in Japan, at $1.2 trillion, followed by the Government Pension Fund in Norway, at $893 billion.

These figures are drawn from the Pensions & Investments/Willis Towers Watson 300 Analysis for the year 2016, which offers the further, somewhat daunting observation that the capital is becoming even more concentrated at the very top, with the largest twenty funds in the world accounting for 40.3 percent of the assets of the Willis Towers Watson 300 ranking.

The Growing Pension Crisis

Both private sector and public-sector plans are governed by identified plan fiduciaries, who oversee the investment of the corpus that is managed on behalf of plan beneficiaries. Annual hurdle rates are established based on the demographics of the covered population, the amount available to invest and a projected return, and the amount projected to be needed to fund obligations to beneficiaries. Though these assumptions are not simple and depend on actuarial tables to calculate them, many plans have had difficulty funding their plans at a rate sufficient to meet projected payouts, and thus are considered underfunded. This is conspicuously the case with some public pension funds.

It is not simple to develop agreement on the amount by which pension plans may be under or overfunded, as there are many assumptions that may differ from one analyst to the next. If a higher investment return is assumed, for example, relatively lower contributions may be required of those paying into the system. Critics have argued that investment return assumptions are artificially inflated, to reduce the required contribution amounts by individuals and governments paying into the pension system.

For example, bond yields (the return on guaranteed investments) in the U.S. and elsewhere are low (and the U.S. and other stock markets did not consistently beat inflation between 2000 and 2010). But many pensions have annual investment return assumptions in the 7–8% p.a. range, which are closer to the pre-2000 average return. If these rates were lowered by 1–2 percentage points, the required pension contributions taken from salaries or via taxation would increase dramatically. By one estimate, each 1 percent reduction means 10 percent more in contributions. For example, if a pension program reduced its investment return rate assumption from 8% p.a. to 7% p.a., a person contributing $100 per month to their pension would be required to contribute $110.

In addition, the International Monetary Fund reported in April 2012 that developed countries may be underestimating the impact of longevity on their public and private pension calculations. The IMF estimated that if individuals live three years longer than expected, the incremental costs could approach 50 percent of 2010 GDP in advanced economies and 25 percent in emerging economies. In the United States, this would represent a 9 percent increase in pension obligations. The IMF recommendations included raising the retirement age commensurate with life expectancy.

Whatever the estimated shortfall, economists in general agree there is a looming pension crisis as we face the predicted difficulty in paying for corporate, state, and federal pensions in the world, due to a difference between pension obligations and the resources set aside to fund them. There is significant debate regarding the magnitude and importance of the problem, as well as the solutions.

For example, as of 2008, the estimates for the underfunding of the United States state pension programs ranged from $1 trillion using a discount rate of 8 percent to $3.23 trillion using U.S. Treasury bond yields as the discount rate. The ratio of workers to pensioners (the “support ratio”) is declining in much of the developed world. This is due to two demographic factors: increased life expectancy coupled with a fixed retirement age, and a decrease in the fertility rate. Increased life expectancy (with fixed retirement age) increases the number of retirees at any time, since individuals are retired for a longer fraction of their lives, while decreases in the fertility rate decrease the number of workers.

Investing by Public and Private Plan Fiduciaries

Why dwell on retirement funding in this book? All board members need a general understanding of current and prior methods of providing for the future of corporate workers. More crucially, however, this background on the situation of existing public and private employers may help give context to how and why pension investors have invested as they have, and to the demands they may make as investors in company stock. In particular, these pressures help to explain the growth in their investment in strategies such as private equity and hedge funds, which are presented as strategies that not only offer attractive returns, but tout that their returns are uncorrelated with the broad market indices.

Looking back at how fiduciary investing standards evolved, English law got off to a bad start with respect to investing by trusts. With spectacularly bad timing, in 1719 Parliament authorized trustees, also known as fiduciaries, to invest in shares of the South Sea Company. Some of them did, and when the South Sea “Bubble” burst the next year, share prices declined by 90 percent.

Parliament reacted in fright and developed a restricted list of presumably proper trust investments: initially government bonds, and later well-secured first mortgages. Lord St. Leonard’s Act in 1859 added English East India stock, and across the decades, some dribbles of legislation approved various other issues. Only in 1961 was the English statute amended to allow trustees to invest in equities more generally, and even then, the investment was subject to a ceiling of half of the trust fund.

Developments in American law led away from legal lists, however, and were forged in Massachusetts. In 1830, in the celebrated case of Harvard College v. Amory, the Supreme Judicial Court adopted what came to be known as the prudent man rule. Trustees, said the Massachusetts court, should “observe how men of prudence... manage their own affairs, not in regard to speculation, but in regard to the permanent disposition of their funds, considering the probable income, as well as the probable safety of the capital to be invested.”

The Massachusetts rule represented a great advance by abandoning the attempt to specify approved types of investment. Prudence is another word for reasonableness, and the prudent man rule echoed the contemporaneously developed reasonable man rule in the law of negligence. The standard of prudent investing was the standard of industry practice or what other trustees similarly situated were doing.

By 1950, twenty-two American states had adopted by statute a version of the Massachusetts rule. The prudent man rule, as applied by the courts, came to be encrusted with a strong emphasis on avoiding so-called “speculation,” as well as varying interpretations of its meaning. Investment practice nevertheless under the prudent man rule led rapidly to judicial approval of the use of corporate securities, both equities and bonds, in trust accounts. The GM pension plan, mentioned above, was thence free to invest in stocks.

As late as the 1959 restatement of the prudent man rule, we find the assertion that “the purchase of shares of stock on margin or purchase of bonds selling at a great discount because of uncertainty whether they will be paid on maturity” is speculative and imprudent. In some jurisdictions, investing in junior mortgages, no matter how well secured, was per se imprudent. The view crystallized that an investment in a “new and untried enterprise” was inherently speculative and imprudent.

Widely varying and occasionally ludicrous judicial applications of the notion of speculation continued in some jurisdictions into recent times. Trustees in the first half of the twentieth century, preoccupied with avoiding speculation and preserving capital, were inclined to emphasize long-term government and corporate bonds as the characteristic trust investment.

Experience with inflation during the 1960s and 1970s, which we will discuss shortly, taught, however, that holding bonds placed significant inflation risk on the bondholder. Investments in debt could therefore experience declines in real value as severe as in equities. We now know that, in inflation-adjusted terms, the long-term real rate of return on equities has greatly exceeded that of bonds. The Ibbotson studies estimate the inflation-adjusted rate of return on stocks since the 1920s at about 9 percent per year, as compared to about 3 percent for bonds.

The prudent man rule requires that each investment be judged on its own merits and that speculative or risky investments must be avoided. Margin accounts and short selling of uncovered securities are also prohibited. Its modern interpretation goes beyond the assessment of each asset individually to include the concept of due diligence and diversification. The logic is this: an asset may be too risky on its own, thus failing the prudent man rule, but may still be beneficial as a small proportion of the total portfolio. The prudent man rule implies that the fiduciary should perform enough due diligence to ensure that the portfolio meets the investment needs of its beneficial owners.

Shifting Patterns of Share Ownership in United States

In his 2016 book The Activist Director, attorney Ira Millstein estimates that pension funds at that time controlled more than $20 trillion in assets worldwide, and mutual fund holdings totaled over $16 trillion. Institutions like these own at least 60 percent of the largest one thousand U.S. corporations. Thus, even though the beneficial owners of the invested dollars are widely dispersed, the control of substantial investments in the majority of U.S. corporations is concentrated in the hands of a fairly small number of investment managers. He estimates the numbers to be fewer than a dozen intermediaries—firms like Blackrock, State Street, Fidelity, and Vanguard, and the largest pension fund managers.

The following comments from SEC Commissioner Luis Aguilar made on Institutional Investors: Power and Responsibility at Robinson College of Business, Georgia State University on April 19, 2013 offer some useful insight and estimated magnitude of the shift in our capital markets:

The proportion of U.S. public equities managed by institutions has risen steadily over the past six decades, from about 7 or 8% of market capitalization in 1950, to about 67% in 2010. The shift has come as more American families participate in the capital markets through pooled-investment vehicles, such as mutual funds and exchange traded funds (ETFs). Institutional investor ownership is an even more significant factor in the largest corporations: In 2009, institutional investors owned in the aggregate 73% of the outstanding equity in the 1,000 largest U.S. corporations.

The growth in the proportion of assets managed by institutional investors has been accompanied by a dramatic growth in the market capitalization of U.S. listed companies. For example, in 1950, the combined market value of all stocks listed on the New York Stock Exchange (NYSE) was about $94 billion. By 2012, however, the domestic market capitalization of the NYSE was more than $14 trillion, an increase of nearly 1,500%. This growth is even more impressive if you add the $4.5 trillion in market capitalization on the NASDAQ market, which did not exist until 1971. The bottom line is, that as a whole, institutional investors own a larger share of a larger market.

Of course, institutional investors are not all the same. They come in many different forms and with many different characteristics. Among other things, institutional investors have different organizational and governance structures, and are subject to different regulatory requirements. The universe of institutional investors includes mutual funds and ETFs regulated by the SEC, as well as pension funds, insurance companies, and a wide variety of hedge funds and managed accounts, many of which are unregulated.

The growth in assets managed by institutions has also affected, and been affected by, the significant changes in market structure and trading technologies over the past few decades, including the development of the national market system, the proliferation of trading venues —including both dark pools and electronic trading platforms —and the advent of algorithmic and high-speed trading. These changes —largely driven by the trading of institutional investors —have resulted in huge increases in trading volumes. For example, in 1990, the average daily volume on the NYSE was 162 million shares. Today, just 23 years later, that average daily volume is approximately 2.6 billion shares - an increase of about 1,600%.

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The Perils and Possibilities of Concentrated Share Ownership

As Commissioner Aguilar observes, over the past few decades, the ownership of public corporations has been turned on its head. While private individuals owned approximately two-thirds of U.S. equities in 1970, today it is institutional investors like Blackrock, Vanguard, and State Street that control two-thirds of such shares. This increase in institutional assets, often referred to as fiduciary capitalism or mutual fund capitalism, came with the rise of pension funds and mutual funds. More recently, the popularity of a form of index fund, Exchange Traded Funds (ETFs) has accelerated the shift of assets from active to passive investment strategies.

The concentration of ownership and the growth of passive assets are now so great that corporate engagement is far more practical than divestment for the largest institutional investors. The size of investor positions create increased liquidity constraints which raise the cost of exit while the relative cost of engagement has fallen, as it is spread across a larger asset base. As a result, institutional investors are compelled to be more involved in corporate affairs.

Large-scale corporate engagement, or fiduciary capitalism, is still a relatively new phenomenon for many institutional investors. A study by Ernst & Young found that as recently as 2010 just 6 percent of S&P 500 companies reported any investor engagement. As of June 2016 the figure had increased to 66 percent.

There is also a regulatory reason for engagement. Even absent a change in the law, the definition of best practices in corporate governance continues to evolve, as does our understanding of fiduciary duty. In 2005, a report by law firm Fresh-fields stated that “integrating ESG considerations into an investment analysis . . . is clearly permissible and is arguably required in all jurisdictions.” By the time the 2015 United Nations report, “Fiduciary Duty in the 21st Century,” was released, thinking had gone much further. “Failing to consider long-term investment value drivers, which include environmental, social and governance issues, in investment practice is a failure of fiduciary duty.”

Although the investment horizons of passively managed mutual funds are in theory infinite, the investment behavior of their investors is not. As long as retail investors’ investment horizons remain short, daily pricing and liquidity are offered, and the performance of active managers is benchmarked daily, it is unlikely that institutional investors can become truly patient providers of capital.

The Rise of Proxy Advisor Power

These pressures on institutional investors to engage with managements of the companies in which they must invest as well as the increase in the size of global capital markets and in the speed at which money moves has seen ever greater standards of care develop since the end of World War II on the part of regulators, companies, and investors alike. Efforts to clarify understanding of the parties’ responsibilities and their role in driving increased value for their various beneficiaries are ongoing.

Capital markets came to be dominated by the professional institutional investor, investing on behalf others as discussed above. At each level, beneficial interest holders, the underlying investors, need explanations as to why certain actions, and thus gains or losses, occurred. Structured communication procedures such as annual reports, proxy statements, and filings with the SEC and other regulators evolved to help investors compare various investments on an apples-to-apples basis.

Managing this torrent of money and interpreting these communications and the growing body of related regulations has fueled the growth of professional investment advisors, trust companies, mutual funds, pension and investment consultants, attorneys, actuaries, accountants, and a fairly recent addition: the proxy advisor. Proxy advisors help institutional investors decide how to vote on the matters that require approval from shareholders of the public companies in which they hold investments.