Thursday, February 11, 2010

John Bogle to institutional investors: Stop being part of the problem

In a recent op-ed in The Wall Street Journal, investing legend John C. Bogle argues that institutional investors need to change the way they do business and begin to assert their fiduciary responsibilities as dominant shareholders. The ability for institutional investors to exert activist pressure on corporations to ensure the creation and preservation of value for investors is among the remedies Bogle seeks.

Bogle indicts institutional investors, who control 70% of shares of U.S. corporations, on several levels and writes, the "failure of money managers to observe the principles of fiduciary duty played a major role in allowing our corporate managers to place their own interests ahead of the interests of their shareholders."

He says that the apathy of instituional investors is partly to blame for a range of ills including the rise of speculation over long-term value investing, the ready acceptance of financial engineering and "innovation," and excessive corporate compensation systems.

At the same time, Bogle sees institutional investors as having the potential to be agents for positive change and as having the potential to act as important corrective forces in better functioning financial markets. This blog calls that kind of dynamic the new financial world order. The role of institutional investors, including, ostensibly, hedge funds is important, Bogle says, because government is ill-equiped to effectively police the markets. "There are few regulations that smart, motivated, targets cannot evade," he writes.

A recent example of an institutional investor trying to use its weight to enforce fair play is AllianceBernstein's opposition to the terms of Novartis' takeover of Alcon. The deal would pay Nestle, the majority shareholder in Alcon $180 per share, while minority shareholders in Alcon will receive $147.

The New York Times piece linked above notes that it is rare for AllianceBernstein to take such a public stand that challenges corporate interests. That's because the bar is too low for mutual- and pension- fund managers. They don't have enough incentive to put the time and effort into correcting corporate abuses and they simply shift their assets elsewhere. Bogle believes that has to change.

Clearly, though, hedge funds are incentivized to take on corporate boards and constructively use activist strategies to enhance the value of their investment. In the Alcon situation, getting $180 per share for the minority holders represents at 22% increase in value. What hedge fund wouldn't pursue that?

Hedge funds need to take the lead in ensuring corporations deliver value and need to, when appropriate, get other money managers to support activist campaigns. There is no lack of targets. Morgan Stanley reported that compensation at the firm last year represented 62% of net revenue. TIAA-Cref, Oppenheimer, and Calvert Asset Management are among the institutions publicly decrying the situation.

With massive failures of leadership at America's largest (and at one time most respected) companies, like GM, Citigroup, AIG, TimeWarner, etc, it has become easier to effectively criticise boards and the media is more receptive than ever to views that challenge management. Hedge funds and other asset managers can capitalize on that to exert pressure on boards and corporations.

UPDATE: Calpers' portfolio of funds that challenge underperforming companies exceeded the return of the S&P 500 by 8.2% since 1999. "The long-run returns for experienced activists should again beat the broader market. Slumbering boards beware," writes a column by BreakingViews on the market prospects for activist hedge funds.

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