* The Agency Problems of Institutional Investors Bebchuk, Lucian A., Alma Cohen, and Scott Hirst, 2017

Question 1

CONTEXT

Answer 1

How institutional investors have evolved: widely held corporations with dispersed ownership
among small shareholders has been prevalent in the history, managers have all the control because
ownership dispersion has led to a free-rider problem.
Times are changing: more institutional investors than before (from 6% to 60%). By aggregating the
assets of investors, institutional investors hold substantial stakes in corporations to have nonnegligible effect when voting.
How it works: Investment funds pool together the assets of many individuals and invest them in a
diversified portfolio of securities (this can be both active and passive).
Types of Institutional Investors: Index funds (Passive), Active funds (most of them are “closet
indexers”), Hedge funds (very active).

Question 2

STEWARDSHIP

Answer 2

Stewardship activities: engagement with public companies, promoting corporate governance
practices that encourage long-term value creation for shareholders. They include: voting in
shareholder meetings (and being informed when voting), monitoring corporate managers, and
engaging with the management (using voice and exit- if you don’t like something about the system,
express yourself).
Stewardship activities (expected from the funds) mean more costs. Performance of these duties is
under the discretion of the investment manager. Question: can this person be considered to be
reliable if they come from the management and not from an outside party?

Question 3

INDEX FUNDS

Answer 3

Growing popularity of index funds is driven by their low costs, tax advantages and the evidence that they
actually outperform actively managed funds.
Index fund agency problems:
1. Arising from costs and compensation. Investment managers of index funds bear full costs of
stewardship yet capture only a fraction (as low as 0.12%) of benefits created, because compensation is
based on fixed % of assets under management. No incentive fees on the change of portfolio valuethe manager is not incentivized to make the portfolio grow more.
2. Arising from index tracking. One way to increase the capacity of stewardship is to increase assets
under management. To do it, relative performance matters. The performance is: 1. Relative to the
index (If an index fund spends on stewardship and increases the value of a portfolio this also increases
the value of the tracked index, leaving performance relative to it unchanged) 2. Relative to the
rivals (rivals following the same index experience the same % increase in value).

Question 4

ACTIVE FUNDS

Answer 4

Most of the active funds are “closet indexers” whose holdings highly overlap with the benchmark index, differing
only by under- and over- weighting some stocks.
Active fund agency problems: private costs. Investment managers often run both investment fund and investment
services (e.g., cash management, short- and long-term investments) firms. Retirement plans are a huge part of funds’
portfolios and significant revenue driver for investment managers. Investment managers might be bearing additional
private costs (e.g., losing revenue, having notorious reputation among corporations) from taking positions that
corporate managers disfavor.
Sources of this agency problem:
1) Small monetary benefit from stewardship,
2) Investing in stewardship activities can reduce relative performance of the fund (i.e. the fund would perform worse
than other funds and nobody would want to give money to that fund),
3) Institutional investors want to keep good relationships with the managers because managers can in return provide
more business. (Private costs).

Question 5

HEDGE FUNDS

Answer 5

Hedge funds (very active) offer services to sophisticated investors; thus, their regulations are more
lenient. More risky positions, more leverage, more activism. Typical hedge fund manager fee is
based on the “2 and 20” scheme (a fund charges an annual management fee of 2% of assets under
management and a performance incentive fee of 20% of any profits). Hedge funds hold significant
stakes, capturing much more value from stewardship activities relative to mutual or index.
Hedge fund limitations: managers spend on stewardship only when the resulting value increase are
high enough to still give investors a reasonable return after higher fees is charged. Opportunities
giving smaller returns are ignored. To win proxy fights (unfriendly contest for the control over an
organization, changing corporate governance), hedge funds need to acquire support from other
institutional investors (many are not willing to oppose the management).
=Without mutual fund support, hedge funds are hardly a threat to the corporate management.

Question 6

REMARKS

Answer 6

Agency problems of institutional investors prevent the full realization of the potential benefits of
the increased concentration of shareholders. There are incentives to spend less on stewardship and
side with managers than would be optimal for beneficial investors.
The rise of index funds, while having been seen as a positive development, raise serious costs for
corporate governance. Modern corporations suffer from too little shareholder intervention.
Possible systematic improvements:
1. Adopting disclosure regulations (e.g., on how voting takes place) that would enable beneficial
investors identify and assess agency problems themselves (e.g., business ties)
2. Adopting incentive-based compensation for mutual fund managers.