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Rekenthaler Report

The Future of Fund Governance

What happens when so few own so much?

Last week, Jack Bogle gave a speech on corporate governance to the Public Company Accounting Oversight Board (no lion tamers they). As Bogle is the topic's longest-tenured authority, having studied the subject since the late 1940s, this column will mostly present his views (and research). However, I do offer a final thought.

Once upon a time, individual investors dominated the U.S. stock market. In 1945, they possessed 92% of its assets. As Bogle notes, this fact worried contemporary observers. Previously, most American wealth had rested in privately held companies, where the hired hands were closely watched by active, distrustful owners.

Then the hired hands were unshackled, as those companies became public. The most-powerful hired hand of all, the CEO, could largely do what he wished. Most shareholders would not dissent, and those who did could safely be ignored, as they lacked voting power.

Thus, while it is fashionable today to denounce institutional investors for being too soft on CEOs, the previous system had a similar effect. Nominally, the company's board of directors represented shareholders. In practice, boards mostly acted as extensions of management, with few if any outsiders being large enough to lodge effective protests.

Over time, the stock market's ownership structure changed. Pension and endowment funds, insurance pools, thrift funds, and, yes, mutual funds purchased ever-larger chunks of the stock market. By 1982, they had caught up with individuals, with each party holding half the market. Institutionalization, of course, continues. Today, Bogle estimates, institutions possess 73% of U.S. stock-market assets.

This evolution hasn't much affected corporate governance. Seventy years ago, most shareholders had better things to do with their lives than to appear at company meetings, pore over proxy statements, and attempt to influence CEOs' activities. That remains the case. True, today's shareholders are investment professionals, not amateurs. But their profession, as they commonly interpret the task, consists of finding the right securities and responding to their own set of shareholders (those who own their fund), not in overseeing CEOs.

Clever Foxes
The result has been predictable. Free to allocate their companies' resources as they see fit, with opposition unlikely to come from the board of directors or outside owners, CEOs have decided that no project is more deserving than … themselves. Bogle gives the figures, and they are remarkable indeed. Since 1980, the average inflation-adjusted compensation of public CEOs has risen by 560%. Average worker pay has risen by 14%.

It would be a mistake to conclude that the switch to institutional ownership caused this pay discrepancy. Individual investors, after all, held just as many shares as institutions when the trend began, and weren't far below 50% through the 1980s and early 1990s. They had enough power to block higher CEO pay packages if they truly cared--but they did not. Several factors led CEOs to coronate themselves; it would have happened with or without institutional involvement.

However, the institutions certainly aided and abetted CEOs. As Bogle writes, professional investment managers (in concert with Wall Street analysts) began to push CEOs in a new direction, by discouraging them from investing heavily in new development. The best corporate leader, by the definition of many institutions, was the executive who made the tough decisions, the cost-cutter who boosted flagging earnings by "limiting employees' compensation, laying off experienced and loyal workers, and slashing capital expenditures." Those were the CEOs who deserved to be paid the most.

(Some recently have taken this argument one step further, in claiming that institutional owners not only nudge CEOs into tearing down their companies rather than building them, but that they also wink at corporate collusion. Neither Bogle nor I are convinced.)

Not everybody regards these developments as bad things. CEOs certainly do not, nor, I suspect, do many people who have invested substantially in the U.S. stock market in the past 35 years. From the perspective of share prices, we appear to live in the best of all possible worlds.

However, there are legitimate opposing views. One could argue that CEOs should oversee more than share prices (and their own pay packages). Writes Bogle, "The enterprises that will endure are those that generate growing profits for their owners, something they do best only when they take into account the interests of their customers, their employees, their communities, and indeed the interests of our society. Please don't think of these ideas merely as foolish idealism. They are the ideals that capitalism has depended upon from the very outset."

(Bogle then quotes Adam Smith--because, after all, who can accuse Adam Smith of misunderstanding capitalism? I know how these rhetorical tricks work, Jack.)

Bogle offers a solution to the problem that he perceives. The board of directors should be reworked, so that it is almost completely independent. Only the CEO would come from corporate management, and would not be given a board vote. The company's public accountants would report directly to the board. Bogle proposes opening up the proxy process so that smaller shareholders might have a larger voice. He also suggests, cheekily, that perhaps "renters" who have owned a company's stock for less than two years should be denied full voting rights.

In addition, Bogle prods institutional investors to take a broader view of their fiduciary duty. He notes (as do Morningstar's researchers, in a white paper published last week) that in recent years the giant institutions have paid more attention to proxy voting. The effort is increasing. But there remains much work to be done, including reaching a shared understanding of what constitutes the best corporate-governance principles.

That's all very well and good. But there is one more item to be addressed. There is more to the tale of U.S. stock ownership than the institutional replacement of individuals. There is also the consolidation of those institutions. A handful of the leading index fund providers have gobbled up the fund industry's market share, which means in turn that they are becoming ever-larger owners of Corporate America. These firms are not yet at the stage where they possess a controlling interest in the U.S. stock market. But that day may come.

Who Governs the Governors?
I do not think that will occur without political intervention. If a group of institutional investors own so much of the U.S. stock market that they can as a group determine the direction of U.S. corporations, Washington will want its say. Which it should. There is a term for a handful of businesses that share a common interest, and which can exert enormous power: a cartel. There would not, I think, be a need to break up the giant institutional investment firms, but they certainly would require oversight. The corporate governors would need to be governed.

This strikes me as a probability more than a possibility. I think it likely that the indexing revolution will continue, for decades; that the top fund providers will gain even greater market share; and that at some point, they will indeed hold enough of the U.S. stock market to exert their collective will. Whether Bogle finds that an appealing prospect, I do not know. But I suspect that Vanguard does.


John Rekenthaler has been researching the fund industry since 1988. He is now a columnist for and a member of Morningstar's investment research department. John is quick to point out that while Morningstar typically agrees with the views of the Rekenthaler Report, his views are his own.