Complaints that investors only look for short-term gains are nothing new. As early as 1990 an Economist article proclaimed: “The old bugbear of businessmen — that fund managers are too obsessed with the short term, and unwilling to buy shares in companies with ambitious research projects — is back on the prowl.”
Recently, the turnover of shares in listed companies has grown to numbers far exceeding those of 1990. Does this change in investor behavior influence the behavior of managers in listed firms?
The institutional innovation of freely tradable shares, traceable to Holland in the 17th century, made it possible for companies such as the Dutch East India Company to have longer investment horizons than individual investors. Listing shares ensured that an investor could recoup his money from other investors and that, as a result, companies didn’t have to repay individual investors. Seen in this light, one might assume that investor short-termism would have little influence on board decisions at listed companies and much more influence on board decisions at privately held companies. General opinion, however, disagrees.
Since the recent banking crisis, there has been increasing demand for investors to become long-term shareholders. ‘Stewardship’ is the term used to underscore the responsibility of institutional investors to behave as good corporate citizens. European Governance Codes that once aimed at restoring investor confidence in listed companies by setting standards for board behavior, now focus on the ‘best practices’ of institutional investor behavior instead. Institutional investors are supposed to ‘engage’ the boards of the companies they invest in, to enter into constructive dialogues and discuss long-term company strategy.
Corporate governance theory can shed some light on what is and what isn’t possible with respect to such policies. Corporate governance research has tended to focus on the agency-relation that supposedly exists between shareholders and managers. New to this theoretical concept was the notion that the company should no longer be seen as a “black box” — a theoretical unit of production designed only to optimize profits — as is seen in neo-classical economic theory. Conflicts of interest within the firm, long the exclusive domain of lawyers, began to attract the attention of economists seeking to understand and explain decision making within a company. Since the 1980’s the concept of the principal-agent relation has proven a useful tool to investigate whether better governance leads to better company performance.
It should be noted, however, that within this traditional corporate governance approach, a new notion of the ‘black box’ has been introduced. This time the shareholder is assumed to be nothing more than a theoretical construct — one focused exclusively on optimizing capital returns. In reality however, shareholder decision-making is influenced by many different stimuli. This is especially true now that the shareholder has changed shape. Instead of being a private individual, he has become an institutional investor, one that manages other people’s money.
The importance of this fundamental shift cannot be overstated. The Bank for International Settlements described this dramatic change in its 1997/1998 Annual Report, calling the collectivization of asset management one of the most far-reaching changes within the capitalist financial system. Today, portfolio managers, whose motivation and behavior differ greatly from those of the ‘old fashioned individual investor,’ hold most of the shares. In fact, one can see that an agency relation exists between portfolio managers and the ultimate beneficiaries of their actions — private investors in mutual funds and participants in pension funds. The interests of the portfolio manager differ from those of the beneficiary. Managers want high fees even if higher fees mean lower returns for the beneficiary. The behavior of the portfolio manager may be more influenced by the targets set for his remuneration. This will, in turn, influence his behavior as a shareholder in listed companies.
As a result of the rise of the institutional investor two, rather than one, agency relations should be considered in corporate governance research. The first one is the traditional one, where the shareholder is the principal and the company director is the agent. In the second agency relationship, however, the principal is the ultimate beneficiary of an institutional investor and the agent is the portfolio manager.
So the portfolio manager — the modern shareholder — fulfills two roles that must both be taken into consideration. Traditional corporate governance research only recognizes the shareholder as the principal. But it is hard, if not impossible, to understand actual shareholder behavior without realizing that in 2013 most shareholders act as agents, assuming the behavior of an agent is driven by the nature of his agency relationship.
Investigating this second agency relation — the one in which portfolio managers are the agent — can shed light on many aspects of both corporate governance and in capital markets. Such an approach can also help us to form hypotheses that explain why shareholders seem so focused on short-term results.
The full lecture is available for download here.