14
THE SILENCE OF THE FUNDS: MUTUAL FUND INVESTMENT POLICIES AND CORPORATE GOVERNANCE
The Corporate Governance and Shareholders
Rights Committee
The New York Society of Securities Analysts
October 20, 1999
WHEN I WROTE my Princeton thesis on the mutual fund industry nearly 50 years ago (!), I explored the funds’ role in corporate governance. While funds were quite hesitant to make their votes count in those ancient days (“If you don't like the management, sell the stock”), I was able to find a number of examples of fund activism. The most notable was the Montgomery Ward case of 1949, in which mutual funds joined in the effort to remove Chairman Sewell Avery from his job. (The effort followed by just a few years the famous removal of Mr. Avery from his office in his desk chair by a pair of soldiers.)
My thesis reflected my then-as-now idealism, and I predicted that it was only a matter of time until mutual funds exercised their duties as corporate citizens, “basing their investments on enterprise rather than speculation … and exerting influence on corporate policy, often in a decisive manner, and in the best interest of investment company shareholders.” In 1951, when I wrote those words, mutual funds owned less than 3% of the stock of U.S. corporations, and I expected their voice would strengthen in tandem with their muscle.
Alas, I could hardly have been more mistaken. Now, a half-century later, even though mutual funds own about 23% of all stocks, and mutual fund managers (who also typically provide investment management services to pension plans and other institutions) control some 35% of all stocks—making them by far the controlling force in corporate America—the strong voice I expected is barely a whisper. Switching metaphors and putting a reverse twist on the saying that “the spirit is willing but the flesh is weak,” the mutual fund flesh is strong but the spirit is unwilling.
As far as I can tell, while the managers of most large fund groups carefully review corporate proxies, they endorse the proposals of corporate management almost without exception. But simply voting—usually doing just as they are asked—in accordance with management's recommendations, too often without adequate review, is a far cry from not only activism and advocacy, but from the very process of corporate governance. Mutual funds have failed to live up to their responsibility of corporate citizenship.
Why Are Mutual Funds Passive Participants in Corporate Governance?
The reasons for this passivity are not hard to fathom. First, funds are essentially short-term investors. In the two decades after I wrote my Princeton thesis, annualized portfolio turnover of the average equity mutual fund averaged less than 20%. This year turnover is at an all-time high of 112%. For the highest decile of funds, the average turnover is 166%; for the lowest decile (excluding index funds), 64%. That shocking 112% turnover means that a fund with $1 billion of assets buys $1.12 billion of portfolio securities and sells $1.12 billion—$2.24 billion of transactions in a single year. Put another way, the typical holding of an average mutual fund lasts for but 326 days. Such turnover has nothing whatsoever to do with long-term investing. But it has everything to do with short-term speculation. And when speculation is the name of the game, it is the price of a stock that matters, not its value. As Columbia Law School Professor Louis Lowenstein has said, fund managers “exhibit a persistent emphasis on momentary stock prices. The subtleties and nuances of a particular business utterly escape them.” Pure and simple, most mutual fund managers don't care about corporate governance.
One might ask: To what avail is this hyperventilating level of portfolio turnover? It is costly, for the croupiers of the financial marketplace have wide rakes. And it is even more tax inefficient than it appears. While realizing capital gains at all is expensive for fund shareholders, funds realize something like one-third of their gains on a short-term basis, taxable as ordinary income at rates up to 40%. And while the capital gain tax on a stock held for one year or more consumes 20% of the gains, that 20-cent drag on each dollar would drop to just eight cents of present value were the gain deferred for 15 years. But few funds hold any shares for a period of that length.
Further, with fund managers owning some 35% of all shares outstanding, much of their trading—likely more than half—is done with other fund managers. Such transactions clearly cannot advance the interests of fund investors as a group. Indeed, the presence of the croupiers in the stock market casino inevitably reduces the returns that fund shareholders receive. But the fundamental point is that funds following short-term investment policies based on anticipated changes in stock prices are hardly good candidates to become responsible participants in a corporate governance process in which shareholder value is the watchword. (I'm speaking of fundamental investment value here, and not the kind of speculative shareholder value that has become a euphemism for raising, by fair means or foul, the price of stock.)
A second obstacle to mutual fund activism is the commercial nature of the mutual fund business. We've become a marketing business. Investment managers seek corporate clients, for that is where the big money is … and where the big profits lie for the managers. Corporate 401(k) thrift plans have been among the driving forces in generating new fund assets since the mid-1990s, and corporate pension funds—absent the need for all of that complex and costly subaccounting—are also considered plums by fund managers. Given the drive for corporate customers, the reluctance of fund managers to risk the opprobrium of potential clients by leaping enthusiastically into the controversial areas of corporate governance is hardly astonishing, though it is discouraging.
A third obstacle, or so it has been alleged by the fund industry, is that corporate activism would be an expensive process for the funds to undertake. And in a sense, it would be. TIAA-CREF, whose stock and bond portfolio totals some $300 billion, is unique in this industry in taking on the responsibilities of corporate activism, spending an amount approaching $1 million per year on the implementation of its splendid—and productive—corporate governance program. This expenditure, however, amounts to but 0.003% (3/1000ths of a basis point) of its invested assets. The benefits generated to TIAA-CREF's participants have been measured in hundreds of millions of dollars.
While small-fund managers could hardly spend the resources necessary for a broad-gauge program, they could at least engage their security analysts in some kind of serious review of the governance of their major corporate holdings. Given the fund industry's $6 trillion of assets, an industry-wide governance effort that entailed just 1/1000th of a basis point would produce an annual commitment of $60 million for an active corporate governance program—far in excess of what such a program would require. Even those dollars, however, would be but a drop in the bucket relative to today's near-$60 billion annual fund expenditures on management fees, marketing fees, and operating costs. Even if the governance costs were paid by the funds themselves rather than by their managers (a peculiar notion in and of itself), the change in fund expense ratios would be invisible. So, to paraphrase the adage: “Money is not the object.”
A fourth and final obstacle might be described as a “people-who-live-in-glass-houses syndrome.” The mutual fund governance system has itself come under severe and well-deserved criticism. Where else in corporate America is there a parallel for the control of a giant publicly held financial corporation by a small outside firm—with its own shareholders—whose principal business is providing the giant corporation with all of the services required to conduct its affairs? Nowhere else, as far as I can tell. And it is that structure that has led to the steady rise in mutual fund expense ratios, generating huge rewards to the shareholders of fund managers at the expense of fund shareholders. It is easier to understand than to accept the reluctance of fund managers to throw stones from their own glass houses at the management of the corporations whose shares they own by becoming corporate activists.
The Effects of Passivity
What are the consequences of a corporate governance system where the owners fail to exercise control? Where mutual funds are silent. Where corporate pension plans are muted. Where individual investors are powerless. Where only a few state and local government pension funds have the voting power and the willpower to make a difference. This is the very problem that Adolph Berle and Gardiner Means confronted in 1933 when they wrote The Modern Corporation and Private Property. Their concern was essentially that corporate governance problems would develop as ownership and management were separated. While it took a long time for their prophecy to be realized, it is starkly before us today. But the institutional forces that might resolve the problems surrounding today's separation of corporate ownership and corporate control has yet to emerge.
What Berle and Means could not have imagined, however, is that a new arbiter of this separation would emerge: The financial markets. Specifically, the stock market itself has become the arbiter of conflicts of interests between management—who seek, I suppose, high compensation, perquisites, job security, and control over the corporation's affairs—and owners—who want, and arguably deserve, the maximization of true shareholder value. Even as President Clinton's campaign manager James Carville wanted to manage our nation's economy by being reincarnated, “not as the President or the Pope, but as the Bond Market,” so a seemingly benevolent despot named “the Stock Market” is the driving force that now bridges the gap between ownership and control in corporate America. And the stock market not only demands efficiency, presses for lower costs, and insists on rationalizing business strategy, but also places a high premium on managed earnings. Given these mixed motivations, however, the stock market is proving to be an imperfect mechanism for this task.
Managed Earnings
Today, we live in a world of managed earnings. While it is corporate executives who do the managing, they do so with at least the tacit approval of corporate directors and auditors, and with the enthusiastic endorsement of institutional investors with short-term time horizons, even speculators and arbitrageurs, rather than in response to the demands of long-term investors. Like it or not, corporate strategy and financial accounting alike focus on meeting the earnings expectations of “the Street” quarter after quarter. The desideratum is steady earnings growth—manage it to at least the 12% level if you can—and at all costs avoid falling short of the earnings expectations at which the corporation has hinted, or whispered, or “ballparked” before the year began. If all else fails, obscure the real results by merging, taking a big one-time write-off, and relying on pooling-of-interest accounting (although that procedure will soon become unavailable). All of this creative financial engineering apparently serves to inflate stock prices, enrich managers, and to deliver to institutional investors what they want.
But if the stock market is to be the arbiter of value, it will do its job best, in my judgment, if it sets its valuations based on punctiliously accurate corporate financial reporting and a focus on the long-term prospects of the corporations it values. However, the market's direction seems quite the opposite, and there is much room for improvement. For while the accounting practices of America's corporations may well be the envy of the world, our nation's financial environment has become permeated with the concept of managed earnings. The accepted idea is to smooth reported earnings, often by aiding security analysts to establish earnings expectations for the year, and then, each quarter, reporting earnings that “meet expectations,” or, better yet, “exceed expectations.” Failure to meet expectations may be preceded by lower “whisper earnings,” which must, in turn, be met. It is an illusory world that ignores the normal ups and downs of business revenues and expenses, a world in which “negative earnings surprises” are to be avoided at all costs.
Managed earnings are reflected in the values of America's most respected companies. Microsoft, for all its rapid growth and essentially conservative practices that tend to understate reported earnings, focuses on producing steady quarter-after-quarter gains, even as it prominently discloses “below the line” the huge dilution of earnings resulting from its usage of stock options to reward officers and employees. The odd failure of accounting principles to include stock option costs as compensation, of course, can result in a large overstatement of bottom-line income (prompting Warren Buffett's questions: “If options aren't a form of compensation, what are they? If compensation isn't an expense, what is it? And, if expenses shouldn't go in the calculation of earnings, where in the world should they go?”). But forget that nuance. “The bottom line”—ignoring option dilution—is the number that Wall Street accepts as reality.
General Electric, with or without accounting gimmickry surely one of America's most successful companies, also produces regular double-digit quarterly earnings growth. While many of its businesses are cyclical, analysts have somehow been able to forecast its earnings within 2% of actual for the past ten quarters in a row, an accuracy said to be a 1-in-50 billion chance. It is creative financial engineering that fosters this remarkable precision.
American Express, another blue-chip stock, also regularly meets the market's growth expectations. In this year's second quarter, the firm securitized a pool of credit card receivables in order to produce the expected earnings. When at a meeting with management one analyst raised doubts about the practice, the company's chairman defended the smoothing of earnings, and then took a poll of the security analysts in attendance. The vote: Ten to one in favor of avoiding the decline in reported earnings. A landslide! Wall Street clearly endorses the managed earnings that corporate America targets.
I share SEC Chairman Arthur Levitt's concern that earnings management has gone too far. He cites abuses in huge restructuring changes, creative acquisition accounting, “cookie jar” reserves, excessive “immaterial” items, and premature recognition of revenue. And I surely agree with the Chairman that “almost everyone in the financial community shares responsibility [with corporate management] for fostering this climate.” It is, in a perverse sense, a happy conspiracy. But I believe that no corporation can manage its earnings forever, and that managed earnings misrepresent the inherently cyclical nature of business. Even as we begin to take for granted that fluctuating earnings are steady and ever-growing, we ought to recognize that, somewhere down the road, there lies a day of reckoning that will not be pleasant.
Short-Term or Long-Term?
Closely tied to all of this creative financial accounting is the stock market's focus on short-term events—aberrations rather than long-term valuations. The most fundamental tenet of investing, in my view, is owning businesses and holding them, for the long term, even “forever,” which is said to be Warren Buffett's favorite holding period. But today most investors seem to be doing the opposite, buying pieces of paper and trading them back and forth, with one another and with alacrity. It almost goes without saying that playing such games in the stock market casino increases the proportion of the market's returns that is arrogated by the croupiers, and reduces the residual proportion of the market's returns that remains for the gamblers. Where, indeed, are the customers’ yachts, or, in today's coin of the realm, the customers’ jets? In such an environment, it would seem obvious that the successful strategy is to buy stocks and hold them, never again entering the casino.
And yet short-term speculation, not long-term investing, is the order of the day. Turnover in the stock market now approaches 100% per year, five times the 20% level of the 1960s and 1970s, and closing in on the 1929 high of 112%. Make no mistake about it, however: The speculators of 1929 were largely individuals; in 1999 the speculators are largely institutions. Alas, Lord Keynes was right: “Professional investors, unable to offset the mass psychology of a large number of ignorant individuals, will strive to foresee changes in the public valuation of stocks.”
Reversing Course I. Index Funds
What finally will make institutional managers reverse this counter-productive flight from long-term investing and toward short-term speculation? What will make these managers head in the more sensible direction of focusing on fundamental corporate values? First, I think, will be the growth of indexing investment strategies at the expense of active management strategies. The ultimate index strategy is owning the stock market and holding it forever—by definition a more rewarding strategy than rapidly trading stocks in the marketplace. Put another way, the investor who stays out of the casino earns the market's return, while the investor who enters the casino shares the market's return with the croupiers, earning less in proportion to his level of trading activity. While the rapid growth in the use of index strategies by pension funds during the 1980s has virtually dried up during the 1990s, still, some 20% of pension assets are now indexed. But during the 1990s, index mutual funds have enjoyed strong growth, coming from virtually nowhere to account for nearly 10% of equity fund assets today.
Since the mid-1980s, the indexed portion of pension and mutual fund assets combined has grown from 12% to nearly 20%. So, the management of one-fifth of all institutional assets has nothing to do with trading and speculation, and everything to do with long-term investment fundamentals. Since these institutions act as owners of businesses, not traders of pieces of paper, their sole recourse to improving shareholder value is to be active participants in the corporate governance process.
With time, I expect that the success of indexing strategies will cause active managers to lengthen their own time horizons. In an increasingly institutionalized financial system, the stock market is populated with skilled, highly trained, and increasingly experienced professionals who are, finally, competing with one another on an ever-more-level playing field. As they face the increasing costs and challenges of outsmarting an ever-more-efficient market, they will surely come to question their ability to add value by their feverish trading, and recognize that a strong focus on governance will be one of the few remaining ways to further enhance fundamental shareholder value.
Reversing Course II. The Ticking Time Bomb of Executive Compensation
The second reason that institutional managers will at last look to fundamentals is that, for all of this short-term focus and approval of managed earnings, they can no longer afford to ignore what I believe is a ticking time bomb on corporate America's balance sheet: The soaring use of executive stock options. Part of the problem is the nature of the options themselves. Options provide corporate managers with incentive-related increases in stock market prices rather than increases in the fundamental value of the enterprise. And in this great bull market, the rewards are staggering. Compensation of chief executives, largely through stock options, has risen to 419 times the compensation for the average worker, compared with 85 times in 1990 and just 40 times in 1980. At some point, this extreme distortion of traditional norms alters the nation's social equilibrium.
Yes, stock options align the interests of management and shareholders. But consider these negatives: First, the very relationship between stock price and stock value may be distorted, as I believe it is today. Second, despite the fact that any business which merely reinvests all or part of its earnings should grow in value during any given period, options offer a free ride to managers who put up no capital and take no risk. Third, a rising stock market, unlike the proverbial rising tide, may not lift all boats equally, but it provides enormous rewards even to those who manage companies whose stocks lag the market. Fourth, even if the stock market were deemed the ultimate arbiter of success, it rewards any success, irrespective of performance relative to a company's peer group. In short, the fact that there is no “hurdle rate” for the prices at which options are exercisable fails to provide valid incentives and creates rewards where there are no risks. The amount of potential earnings dilution is huge. One analyst estimates that reported earnings on the S&P 500 Index would be reduced by 50% when diluted by the exercise of existing options, raising today's adjusted price-earnings ratio to more than 60 times. Corporate shareholders are giving too much, and getting too little in return.
The most ominous aspect of the flawed option process is only now rearing its ugly head. Time and again, when a corporation's stock price tumbles, management reprices the options, all in the name of continuing to assure that its executives have incentives that are attainable. Understandable as it may be for corporate executives to see things in this way, the question is: What would an owner do? Is it fair to the stockholders—any more than to a sole owner of a corporation—to engage in wholesale repricing at a new low price, perhaps in a stock whose shares are temporarily depressed, or even the stock of a company whose prospects have remained stable over a decade but whose stock price has merely soared with a soaring market or plunged with a plunging market? When, as, and if, the stock market takes a big tumble—and all of that earnings management suggests that such a tumble lies ahead when the bubble breaks—the trickling stream of option repricing in recent years will become a torrent. If unopposed by stockholders, it will result in material earnings dilution, likely exacerbating the market decline. Institutional investors, beware. Indeed, be aware enough to tackle the issue head on.
Reversing Course III. Taking Action
My expectation—I hope not vain—is that fund managers will, well, come to their senses. Sooner or later—I pray sooner—they will gradually see the light and adopt long-term investment strategies. Then the industry's nearly single-minded focus on marketing, marketing, marketing will shift to a focus on the stewardship of the assets investors have entrusted to the funds. The issues I've discussed today regarding short-term speculation in the stock market, managed earnings, and executive stock options must be addressed. Mutual funds have the voting power to implement constructive change. It is high time for funds to make their ownership muscle felt by joining the pension funds of state and local governments and TIAA-CREF in actively participating in the process of corporate governance, with a view to enhancing shareholder value.
How to bring this force to bear? One means of doing so would be to have our Investment Company Institute take the lead in organizing an industry-wide corporate governance effort, and today I urge that such an effort begin. So far, however, the industry's efforts have focused not on the interests of investment companies and their shareholders (as the ICI name might seem to suggest), but on the interests of investment managers and their owners. However useful and productive the ICI's lobbying, regulatory, and marketing efforts may be to the managers, it is hard to discern that the interests of fund shareholders are at the top of its priority list. I'm not sure whether the ICI has ever held a roundtable or forum on the role of funds in corporate governance or on the responsibilities that funds may have as corporate owners. Yet today, with the huge voting power of mutual funds and their managers, the subject can no longer be ignored. It is high time for an industry-wide, ICI-sponsored effort.
Failing action there, however, there is no valid reason that the large fund groups could not meet on a regular basis to discuss corporate governance issues and the activities of particular corporations. Perhaps the Council of Institutional Investors—in which most large state and local government pension funds, but no mutual funds, actively participate—could serve as a role model. The voting power wielded by even a small group of large managers would surely catch the attention of corporate managers. For example, the funds and accounts managed by Fidelity, Vanguard, and Capital Group alone own 100 million to 200 million shares of most large companies, often representing 5% to 10% of each firm's voting control. While these managers have thus far seldom taken up corporate governance issues, were they to form a nucleus of activist firms, other like-minded funds would surely climb aboard the band-wagon. As I understand it, since 1992 SEC policy has been to permit greater communication among shareholders, so if the industry does not act, I urge all major firms that have a long-term investment philosophy and a sense of responsible corporate governance to band together and begin the task.
Way back in 1940, as I reported in my Princeton thesis, the SEC called on mutual funds to serve “the useful role of representatives of the greater number of inarticulate and ineffective individual investors in corporations in which investment companies are also interested.” Even though 60 years have elapsed since then, it is not too late to begin. The point is that mutual funds today are owners of huge blocks of stocks. Together, they can wield their power through the controlling influence they hold over corporate affairs. With this ownership comes not only rights, but responsibilities. If the role of this industry is to add value for its own shareholders, the sooner the effort toward enlightened corporate governance—toward working intelligently with corporate managers with no bias other than the interests of the shareholders—begins, the better it will be for investors, and for the financial markets.