Institutional investors, sometimes referred to as first-tier buy-side institutions, are significant agents in mature capital markets.

Global Assets Under Management

© October 2007, IFSL

Their role and place has dramatically increased over the past 40 years with the advent of the mutual fund investment model, the rise in self-funded pension liabilities globally and, more recently, the strong growth in passive investment models: ie Beta-tracker funds (also known as Exchange Traded Funds). This radical growth of institutional ownership in capital markets has significantly affected one of the traditional tenets of the equity investment: the ownership role.

Equities, unlike debentures, are not designed merely as a financial investment, they are also a form of property that goes beyond the cost of its issuance or their intrinsic cashflow value. Shares offer their buyers the right, and as a recent McKinsey article denoted, the duties associated with ownership.

Global Funds Under ETF Management

Source: © ISLF, 2009

So how is an ‘ownership’ culture maintained and supported in an era of quantitative relative performance metrics and diversification-dominated investment mandates?

The answer to this question is critical given that ownership decisions directly impact asset valuations. As the McKinsey article notes, confronting these issues is fast becoming the new litmus test, both for markets and their regulators, in ensuring continued long-term responsible investment management over the coming century.

The Conflicts Of The Institution: The Issue With Diversification

This post can not detail, in a short space, the full depth and complexities associated with a large investment managers asset allocation decisions. However, one particular example comes to mind: the actual downsides of excess diversification. Diversification is interesting as it is a core tenet of investment philosophy. The anecdotal rule of not putting all your eggs in the same basket is often used to support its soundness.

The Markowitz Efficient Frontier

At a more quantitative level, the Markowitz diversification model demonstrates that an efficient barrier can be constructed across a portfolio’s ressource allocation to ensure that the combination of multiple sources of volatility can actually decrease aggregate volatility and, by extension, provide increased risk-adjusted returns for the portfolio. But is there a downside to diversification when ownership is taken into account? I would like to present the following examples to illustrate this question. These examples are purposely set at two extremes of the investment horizon:

    1. Asset manager Perma-Beta has a broad diversification mandate.
    The fund is engineered and marketed as offering strong risk-adjusted returns through a theory of excess diversification. Essentially, it takes a ‘market-view’, without any qualitative insights into its investment process, and therefore restricts its investment managers to quantitative metrics that are proven and transparent to all market participants.
    Following from this logic, the fund invests across a wide range of equities often linked to currency specific benchmarks as well global cross currency-hedged portfolios: eg FTSE 100, MSCI GLOBAL, ASX200, RUSSELL2000, etc.
    The investment portfolios therefore regularly contain in excess of 100 stocks within its different variants occasionally going as far as reaching a few thousands securities. The weight of each stock is either set out against its benchmark or directly weighted out against the stock’s own volatility and historical one-year yield.
    2. Asset manager Alpha-Alpha-Alpha employs a star fund manager.
    The fund manager is renowned through out the market as being a ‘gun’, the ‘alpha genius’ who knows things before anyone else knows for reasons nobody else know – in other words, the investment method is highly opaque, there’s little else known quantitatively-speaking apart for the outstanding historical performance metrics.
    He/she ‘is’ the fund and the investment mandate, the brand that everyone recognises and his/her decisions are what move the fund. The fund invests into a subset of the market that the manager tracks and decides upon.
    Investors like him/her because he/she is constantly in the news but corporate boards find him annoying because he/she is always at shareholder briefings with annoying question and, occasionally, even takes a seat on one of those boards.
    The media occasionally rever him with titles such as the “new masters of the universe” and at times question him/her through fictional characters with names like “Gordon Gecko” and the like. The fund invests in as many stock as the ‘star’ can manage to keep track of effectively or, in other words, it has a highly concentrated mandate ranging from 10 to 30 companies.

I think the past two examples represent the two extremes I am trying to review here. In reality, the investment universe is substantially more complex than just the models presented above with many fund managers straddling a position somewhere between the two archetypes.

Fund of Funds Assets Under Management 1997 to 2010-Q2

Axis in $bn - Data from

Just as a side illustration of this growing complexity: the past twenty years have seen the rise of a new type of fund: the fund-of-fund model. These feeder funds apply the quantitative knowledge and proven academic credentials of Perma-Beta funds over a diversified set of Alpha-Alpha-Alpha like sub-funds. Even though the fund aggregation model has taken a recent step-back, in part due to the Madoff scandal, they nonetheless remain the single fastest asset inflow growth source for alternative fund managers.

These fund-of-funds aim to associate modern portfolio theories of asset diversification with the strong positive alpha-bias offered by manager-led investment mandates and are becoming increasingly popular at both an institutional and retail level for access into alternative funds.

However, returning to our simplified two-fund model, how do these funds react and decide when it comes to the ownership value attached to their investments?

Detailed below is an overly simplified example illustrating some of these ownership concerns. This is not a ‘real’ picture of the institutional framework, instead it represents the ‘real’ consequences associated with the institutional equity ownership premia:

    1. For Perma-Beta, the problem is quite complex.
    They are limited in their decision scope purely at the ‘voting-layer’ of their investments. The fund is restricted in its ability to rebalance in and out of the company based on its quantitatively dictated requirements for asset-allocations.
    Furthermore, the funds core operating model is aimed at maintaining its quantitative edge: it therefore allocates the majority of its revenue fees towards up-to-the-second data feeds (to track its market pricing), freshly minted statistical and quantitative geniuses to analyse these data feeds, and brokerage/trading fees to maintain its dynamically-market-priced-determined weighting strategies. However, the fund does not have a broad depth of market analysts and lawyers at its disposal beyond those already assigned to prepare its own legal documents and market its own fund securities.
    When the fund is confronted by a complex or layered corporate action: eg. board replacement, take-over, mergers, or change in corporate governance policies; it is left with little other choice than assign its voting power over to a proxy-vote. This proxy vote body is often represented by an independent shareholder’s association or directly by the company’s board who are both, in theory, equipped with the legal eagles and market analysis depth required to make a good decision.
    In theory, the decision is transparent and open to a diversified shareholder base. However, the Perma-Beta is a ‘dominant’ institutional investor and already represents anywhere between 5 and 15% of the current shareholder vote with the remainder of the holder base similarly occupied by rival Perma-Betas. The diversified holding base therefore leaves only 20 to 30% left to independent shareholders. And that’s unless an Alpha-Alpha-Alpha fund has decided to invest as well…
    In this last case then, the Perma-Betas all end up voting in line with the minority-shareholders, represented by a shareholder association or a board recommendation, and, potentially, in line with an Alpha-Alpha-Alpha voice, who has become the loudest voice within the shareholder body or even occupies a seat on the board.
    The Perma-Beta can’t really do much about this situation as he is restricted by his investment mandate to follow a transparent and openly accountable decision process, even if such a decision flow ends up being determinedly opaque or one ultimately decided by one person, the Alpha-Alpha-Alpha fund manager.
    2. Alpha-Alpha-Alpha seems to have the upper hand
    Alpha-Alpha-Alpha fund manager knows the company like the back of his/her hand, indeed, he might actually be sitting on its board.
    He understands the complexities and details behind the company’s shareholder voting process better than anyone while also having direct contact with its leading decision makers too. In addition, he is not restricted by any investment mandate asset allocation framework, he knows that beyond the amount of his vote: he can also exit, overnight, from his position and cause a dramatic price shift as a result. Though he might not occupy a ‘substantive-holding’ share (usually defined as above 5%), he does occupy a proportion of the company in excess of the share’s mean daily or weekly turnover. In other words, his exit still causes a shift in the share’s aggregate quantitative metrics, which might therefore cause some of the Perma-Betas to follow with their own rebalancing mechanisms as well.
    In other words, he has price capacity and he can use it in addition to his vote. Finally, he also knows that his votes and popular media presence will assist other smaller investors to side by him and potentially sway over the shareholder association’s position in his favour, therefore adding the Perma-Betas to his position as well.

This situation therefore poses a real problem. Institutional quantitative models are heavily reliant on an efficient price discovery mechanism relying on high liquidity to be in place. However, as the example details, the very existence of an ‘ownership’ premia can greatly damage the institutional ‘equity’ portfolio modelling by adding dramatic uncertainties related to significant price moves in the face of a corporate action.

Furthermore, the alpha-alpha-alpha is not automatically in a winning position either. His investment performance is also quite closely attached to overall corporate performance facets: such as how well the company can maintain its operations within the market. More often than not, an Alpha-Alpha-Alpha seeks to buy-in to that performance instead of actually becoming one of its prime actors. Indeed, in an extreme example, the Alpha-Alpha-Alpha fund may come to re-define the very existence and role of the corporation. Good if all goes well, but there’s little space to hide if things go awry.

So how can the market face the impact of the ‘ownership’ premia in an efficient manner? The McKinsey article highlights a number of facets that can improve institutional investors approach to their duties: both as quantitatively sound investment strategies and as responsible asset owners.

The Law Of Diminishing Returns Or How Too Much Diversification Can End Up Losing Focus

Simon Hoyle and John Collett of the Sydney Morning Herald published two articles over the course of 2008 and 2009. Both set forth the case that the “only free lunch in investing is diversification”. Though I can agree that diversification is useful, indeed, critical in an investment strategy, it is nonetheless false to state that it is a “free lunch”. As any good economist would note, there is no such thing as a free lunch.

Diversification is useful, but it also has a cost, and for institutional investors these can become add-up over time. And there lies the problem: cost-cutting the management of the ownership premia can reduce profitability if it impinges on an enterprise’s core competitive advantage.

The McKinsey article also observed this fact, noting that increasing empirical evidence is mounting to limit diversification to up to 50 discrete equity investments. I am wary of attaching too quickly a number to this figure, in large part as it is quite probably strongly related to the size and stated goals of the investment mandate. In addition, certain common sense methods can be established to reduce the impact of increased diversification.

Nonetheless, as Warren Buffet denotes in the quote below, too much of a good thing can distract from the core role of an investment manager, that of investing monies, and money, much as any other asset remains a form of property. The responsibilities of the owners are real and, all the more so, when this owner is a large multi-national investor such as the modern institutional equity investment fund.

a policy of portfolio concentration may well decrease risk if it raises, as it should, both the intensity with which an investor thinks about a business and the comfort level he must feel with its economic characteristics before buying into it.
Warren Buffet

Increasing Institutional Awareness of Custodial Duties

Institutional investors have a custodial duty towards a broad class of savers, investors, and interest groups within capital markets; it is for this reason that their responsibility towards taking a front and center position in the ownership debate is so critical.

However, institutional investors can not expect to deliver this without the support of their clients, there must therefore be an ongoing dialogue between institutions and their clients to explain the added complexities of the ownership premia and to demonstrate that the added costs required to manage it are justified.

This is not to say that costs minimisation for institutional investors does not remain a core prerogative. In order to balance these requirements with the ‘ownership’ mandate many institutions have sought to improve, through benchmarking, their reporting of ‘ownership’ performance.

An example of such a benchmark is the Morningstar stewardship review, that seeks to establish a performance metric beyond the traditional short-term historical relative fund return measures.

This should provide clients, as well as capital-management suppliers, the ability to measure and relate their mandates back with a third-party benchmark.

Whether such measures prove sufficient and not risk the same issues confronted in the past by the ownership agency dilemma remains to be seen. Personally, I am more concerned by the ever increasing pressures exerted on fund manager to align with a market Beta. In the purest sense, fund managers have gone to the extreme of simply engineering basic passive exchange tracking funds in order to gain such relative correlation to a benchmark. But such measures have in turn then diluted their core ownership focus.

Can Technology Assist in the Ownership Debate?

Technology is often touted as a solution to many of our ills. And, indeed, in finance, it has provided us with a number of tools and abilities that were direly needed in our development of capital markets. One notable example surrounded the development of increased trade execution automation and so-called liquidity dark-pools.

This particular technological front dramatically improved market liquidity and efficient price discovery mechanisms that are critical at times of heightened volatility. In part, they have also reduced the impact that can occur between large investment mandates and more marginal activist funds as illustrated in the examples above.

However, there still remains the issue of the ownership focus and how strongly diversified funds and, at the other extreme end of the spectrum, exchange tracking funds can represent the interests of the ultimate beneficial owner.

Potentially, one of the developments over the coming decades will be added information transfer for the ‘ownership’ facets of investment securities. A beneficial owner, whether it be the end investor such as the retiree-in-waiting or the fund-manager who purchased ETFs to add more Beta to his mandate, should be able to decide through his preferred channel towards a predefined set of voting decisions. This ability to properly transfer, efficiently and cleanly, the ownership facet of an investment, should ensure the possibility of increased focus on ownership at a lower cost.

However, whether such technologies will automatically reduce the asymmetric information advantages that occur with ownership decisions still remains to be seen. Indeed, I still thing that the Alpha-Alpha-Alpha fund, whether it be the Warren Buffett’s or Carl Icahnn’s of this world, will continue to have a strong advantage at the pointy-edge of the investment process. This is probably why some corporations work hard to welcome such investors on to their shareholder registers while others, for much the same reason, try hard to keep their shareholder registers protected from such activist investors.

Whichever your point of view on the matter, there is one point that remains pivotal in equity investments: they are not merely fund-allocation decisions but they are always an act of discrete ownership.

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