“The Agency Problems of Institutional Investors” Bebchuk, Lucian A., Alma Cohen, and Scott Hirst

Question 1

What is the main idea?

Answer 1

How the rise of institutional investors over the past several decades has transformed the corporate landscape & the governance problems of the modern corporation

Question 2

How have institutional investors evolved?

Answer 2

Widely held corporations with dispersed ownership among small shareholders has been common in the history, managers have control, because ownership dispersion has led to a free-rider problem.

Times are changing: more institutional investors than before (from 6% to 60%). By pooling the assets of investors, institutional investors hold substantial stakes in corporations to have an effect when voting.

Question 3

What are the 3 types of institutional investors?

Answer 3

Active funds
Passive (Index) funds
Hedge funds

Question 4

What is stewardship?

Answer 4

Engagement with public companies (voting in shareholder meetings, monitoring corp. managers, engaging with the management), stewardship activities mean more costs

Question 5

Why is index funds’ popularity growing?

Answer 5

Low costs
Tax advantages
Evidence that they actually outperform actively managed funds

Question 6

What are the agency problems of index funds?

Answer 6

1. Compensation is based in fixed % of assets under management, no incentive fees on the change of portfolio value, manager not incentivised to make portfolio grow more
2. The performance is relative to the index (value of a portfolio increases the value of the index) and relative to the rivals

Question 7

What does “closet indexers” mean?

Answer 7

Active funds that follow a benchmark index, only under- and overweighing some stocks

Question 8

What are the agency problems of active funds and what are the sources of these problems?

Answer 8

*Private costs
*Investment managers might be bearing additional private costs

Sources:
1. Small monetary benefit from stewardship
2. Investing in stewardship activities can reduce relative performance of the fund
3. Institutional investors want to keep good relationships with the managers, because managers can in return provide more business

Question 9

What are hedge funds?

Answer 9

Active funds, that offer services to sophisticated investors, thus their regulations are more tolerable. More risky positions, more leverage. Hold significant stakes, capturing more value from stewardship activities than active or index funds.

More incentives to increase value: hedge funds take 2% of value of assets, 20% of increase of value in portfolio

Question 10

What are the limitations of hedge funds?

Answer 10

Opportunities giving small returns are ignored.
Managers spend on stewardship only when the value increase is high enough to offer a reasonable return to investors after the fees are subtracted.
To win proxy fights (for the control over an organisation), hedge funds need support from other institutional investors

Question 11

What do the agency problems of institutional investors prevent?

Answer 11

Agency problems of institutional investors prevent the full realization of the potential benefits of the increased concentration of shareholders

Question 12

What are possible systematic improvements for the agency problems?

Answer 12

Adopting disclosure regulations (how voting takes place) that would enable beneficial investors identify and assess agency problems themselves

Adopting incentive-based compensation for mutual fund managers