Imagine it is 2006, and a savvy and perspicacious Chief Investment Officer of a large pension fund foresees a looming threat to the stability in the financial markets. Having lost confidence in the banks, what can she do? Unlike hedge funds or active managers, she cannot short or even exit the shares of the financial sector because her fund is so large that it must hold every name in the public markets. Even if she could, she knows that the coming financial crisis will impose pain on every sector of her portfolio. When the financial crisis does arrive, the CIO may feel herself helpless to avoid the risk to her fund’s stability or her beneficiaries’ well-being.
Our hypothetical pension fund represents a class of investors known as “universal owners.” By its strictest definition, a universal owner is an institutional investor, usually a pension fund, endowment, foundation or sovereign wealth fund, with two distinguishing characteristics: it is large enough to own every company in the market, and it has long-term liabilities so that its investment time horizon stretches into decades. The defining characteristic of a universal owner is that they are exposed to the entire market, and have limited ability to control the investment performance of their equity portfolios through stock selection.
The list of universal owners includes some of the most recognized names in the financial world – such as the California Public Employees’ Retirement System, Norges Bank, TIAA-CREF, and hundreds of investors like them. Many smaller investors who own passive funds, such as index funds or ETFs, share interests in common with universal owners despite not meeting the definition precisely. Any investor who owns the entire market in perpetuity, or at least for a long time, should be thinking like a universal owner.
For this reason, some universal owners have for many years sought influence over corporate governance to ensure that portfolio companies make decisions in the long-term interests of shareholders, rather than in the interests of managers. Where once corporate governance departments within institutional investors treated proxy voting primarily as an administrative function, today many investors use proxy votes as a tool of management accountability and a platform to monitor and engage corporate management on their governance policy and practice. These investors consider this engagement to be a responsibility of ownership. If exit is not an option, voice becomes a critical investment tool.
However, agency problems persist even at companies that are fully committed to shareholder value. At least in the short term, companies can earn profits imposing costs on the market as a whole. For example, the Supreme Court’s decision in Citizens United has empowered companies with greater influence over election results than ever before. Companies may use this power to promote public policies in the interests of their own shareholders — such as preferential tax treatment or lax environmental regulations — regardless of the impact on the economy and market.
These decisions may be rational from the perspective of management, but could be harmful to their investors who are universal owners. Similar conflicts arise related to climate change, employment policies, lending practices, discrimination and many other areas of concern. As in the case of the global financial crisis, public policy is often not sufficient to protect the market from externalities caused by a few companies. And unlike companies, institutional investors who own the entire market cannot externalize their costs, because those costs will appear elsewhere in their portfolio.
Agency conflicts may also arise if universal ownership thinking flourishes within a small governance or proxy voting group while being ignored by investment management. Many companies complain that shareholders ask for information about environmental, social and governance (ESG) factors but do not use them to make investment decisions.
Most investment managers have little inherent incentive to consider the impact of company behavior on the entire market. Unlike universal owners, investment managers are usually evaluated on relative performance against market indices. Investment managers also trade in and out of individual names, and can choose concentrated portfolios that do not necessarily reflect the overall market. Whether markets are weak or strong, investment managers succeed if they perform better than their benchmark.
Some institutional investors have begun to encourage managers to consider ESG in their investment analysis, where these issues have the potential to affect the long-term performance of companies. However, both internal and external managers are usually selected and compensated based on relatively short-term measures of performance. This creates incentives for managers to emphasize short-term factors in stock selection, while ESG issues are often relevant only over longer time horizons. Funds should take care that manager incentives are consistent with the principles of universal ownership.
Finally, in order to be credible advocates for good corporate governance, funds should hold themselves to high standards of internal governance appropriate for their own operations. Fund governance practices should manage potential conflicts of interest and emphasize the fulfillment of fiduciary obligations.
Funds that employ transparent and accountable governance practices for their own organizations will be in a better position to demand them of portfolio companies and external investment managers in effect, giving our fictional CIO more power to act today than she ever dreamed of nearly a decade ago.
In short, universal owners, or other investors who are exposed to the market as a whole, should be asking themselves the following questions:
- Are we well-informed about the issues and concerns that may affect our investment portfolio over the life of our liabilities?
- Are we actively engaged with portfolio companies to ensure that boards and management reflect our interests over the long term, or do we outsource this function to our asset managers?
- If we engage companies directly, are our investment management practices (or those of our external managers) consistent with the questions we are asking of management?
- If our asset managers vote proxies or engage companies on our behalf, are we satisfied that they are holding portfolio companies accountable to our long-term interests as universal owners?
- Are our investment managers compensated and evaluated in a way that aligns their incentives with our interests as universal owners?
- Are we well-informed about how our investment managers incorporate ESG into their investment practices?
- Do we, or our asset managers, devote sufficient resources to research and corporate engagement on ESG?
- Do we hold ourselves to high standards of governance, consistent with our fiduciary duty?