Fund Managers Need to Be Better Owners

It's clear that the fund industry as a whole has not done a great job as owners of public companies. Consider that the enormous growth in money managed by mutual funds during the 1990s occurred at the same time that executive compensation skyrocketed, companies increasingly tried to manage quarterly earnings, and corporate fraud grew to an unprecedented scale. To be sure, those problems are mostly the fault of corporate America--not fund managers. Still it happened under the fund industry's watch.

It's obvious that the fund industry's short-termism, as evidenced by high turnover and bonuses based on one-year returns, led too many fund managers to ignore long-term problems like soaring compensation, excessive option grants, and earnings massaging. After all, if all you care about is the company making next quarter's earnings target you don't much care what corners were cut to get there. To be sure, some fund managers do take a long-term view and have long been great stewards, but most do not.

Mutual funds have a number of ways of influencing management of the companies whose shares they control. They can have informal discussions in which they make their views known. They can vote proxies for or against management on key votes such as mergers, executive compensation, and director nominees. Finally, on rare occasions they can go public with their displeasure and lead efforts to block a merger or force out a CEO.

While the overlap between fund growth and corporate misbehavior was apparent, the evidence that funds played a role was circumstantial. However, a recent study has drawn a very direct link that should make fund companies and fund directors think long and hard.

The study by Lily Qiu, assistant professor of Brown University, looked at the link between mergers and different owners such as mutual funds and public pension funds. (The study was first reported in the New York Times.) Specifically she looked at mergers that added value and those that destroyed it from 1992 to 1999 and examined ownership of the firm in each case. She controlled for factors such as company size.

The results were striking. She found that public pension funds were more likely to be owners of companies that did value adding mergers and less likely to own those that destroyed value. Conversely, mutual funds were more likely to own companies that destroyed value. In fact of all the types of owners including banks, insurance companies, independent advisers, and pension funds, mutual funds were the worst owners as measured by value destroying mergers.

What went wrong?
Although short-termism was likely the main reason mutual funds were substandard owners, I suspect another reason was the conflict of interests. Fund companies are eager to get 401(k) business from the very same companies that are in the fund portfolios. Thus, some tread too cautiously when it comes to holding corporate management accountable.

In addition, some fund companies are owned by investment banks, which are likely to pursue extremely lucrative deals with those same companies. In fact, they could be the ones advising a company on a merger. Would a fund manager from the same company have the guts to oppose a merger that was recommended by another part of his parent company? I'm sure some do but others don't.

I heard from a fund manager who works at a recently acquired fund company. He said he was taking a more aggressive stance in opposing a company's management team than he would have even dared to do when his fund company was owned by an investment bank.

Fund managers aren't the only culprits here. Proxy voting is something that fund boards are trusted to oversee. It's clear from this study that some directors were asleep at the switch. Directors need to review proxy votes and set strict policies that ensure fundholder interests are served by those votes, and they should compare how their firm voted its proxies versus those from the firms that are the most ethical best long-term stewards.

Since the time period examined in the study quite a lot has happened to the fund industry. It has been beset with its own scandal, and the SEC moved to require that fund companies disclose how they vote their proxies. As a result, many fund companies and directors have come to do a better job overseeing proxy votes.

In fact, it would make for a great follow up study to examine proxy votes across the industry and see how the industry is doing on votes around mergers and executive compensation. I'd be particularly interested to see the breakdown by fund company.

The fund industry controls a big piece of corporate America on behalf of fund investors. It's time to weed out the absentee landlords.