July 2012
Why passive fund managers should become non-executive directors
The first half of 2012 has seen some major changes in the attitudes of investors towards the way Britain’s companies are run. Overhanging the topic is the review by Professor Kay on corporate governance and the workings of the UK equity market that is due out later this summer. Whatever that recommends it is clear that the relationship between the owners of the companies and their managers is ripe for change.
A number of factors have acted to work against active involvement by owners in the management of UK listed companies. One of the more important is increasing foreign ownership. It is estimated that about 40% of the equity is now held outside the UK. This is not necessarily a bad thing as some US shareholders, such as Calpers, are quite active. Another factor has been the steady rise in nominee holdings through intermediaries rather than direct holdings. While this reduces administration costs, and is often a result of using tax wrappers such as ISAs and SIPPS, it makes it harder for individuals to vote, or even be aware of forthcoming AGMs. Perhaps even more important has been the rise in passive investing. Whilst this effectively allows fund managers to wash their hands of any stock-picking decisions, there is no reason for corporate governance and stewardship duties to be neglected as a result.
Unsurprisingly it now seems that executives regard this inert money (both passive and nominee-derived) as tame capital that allows them full discretion in their activities without censure by the owners. It is true that some active fund managers do use their influence but because it is behind the scenes it is hard to know how successful it is. Judging by the votes at this year’s AGMs and the subsequent pay deals their powers seem limited.
Much of the furore has been about executive pay. While it is galling to see executives rewarded handsomely for average performance, the real damage to shareholder wealth actually comes from poor decision making by the board or, worse, a lack of awareness of dubious business practices. In the case of Barclays the £1,000m charge it took for PPI miss-selling last year far exceeds the £44m stated in the 2011 accounts as the total remuneration of the Board.
What Barclays will finally charge to its accounts, i.e. to shareholders, this year for the LIBOR scandal won’t be known until 2013. Already it has cost them a £290m fine, before any litigation costs that might arise, which is substantially larger than the total compensation to the Board. Clearly wayward management, not pay, has a larger impact on shareholder's wealth, though pay tends to generate more heat. Wayward management does highlight two distinct failures evident in present banking executive's pay policy. Firstly executives’ pay has failed to reflect the reality of falling share prices and shrinking returns on capital of the last few years, and secondly, the failure of bonuses to reflect performance against longer term measures. As the PPI scandal demonstrates, the real profitability of financial products can take many years to emerge, once adjustments for fines or write-offs are included.
Non-executive directors are there to represent shareholders but in fact these days seem to reflect business interests rather than the owners. We think it is time current shareholders are represented on the board to monitor executives and ensure the business is not compromised by events such as LIBOR or PPI.
Active fund managers will not be keen to have board representation because they will be vulnerable to conflicts of interest every time they trade. That argument does not apply to passive funds because the process they use, whether based on market capitalisation or some fundamental measure, will dictate their actions.
At the heart of this issue is that passive investors are long term shareholders. The portfolio turnover ratio for The Munro Fund is 3% so the average holding period is many decades. That is in sharp contrast to the gradually shortening tenure of Chief Executives whose incentives may not always be aligned with the owners.
Our case is that passive shareholders should be non-executive directors of the listed companies. It is important to note though that not all passive investors are the same. Those using ETFs, especially synthetic ETFs, may not hold the underlying stock at all or have lent it out. This disenfranchises them and makes them ineligible for representation. Something investors should be aware of when selecting a passive vehicle for long term savings.
It is unlikely that this idea will be welcomed by many. Executives will not like an outsider who will be looking over their shoulders. Active funds won’t like the idea of being relegated to second tier in terms of corporate access. Finally, the other non-executives may resent the introduction of someone who may put a dent in their lifestyle and expose their somnambulant approach to corporate governance. We just hope that enough shareholders think it a good idea for someone they appoint to monitor their capital.
(The S & W Munro UK Fund is a physical long-only smart-beta fund that invests in the FTSE 350 Index and complies with The Stewardship Code.)