Does the involvement of institutional investors lead to higher financial performance?
This research focuses on the stock market performance and impacts of institutional investors which precipitates reactions on the financial performance. To begin with, this research seeks to identify generally the institutional investors and outline broadly their modus operandi of investment in the market. It is argued that the frequent trading and short term focus of institutional investors encourages managers to engage in shortsighted investment behavior, conversely it is felt that the large stock holdings, research and net worth of institutions allow managers to focus on long term values rather than on short term earnings, thereby giving a fillip to the financial performance. However the research touches upon optimal trading strategies of major institutional investors and dwells particularly on Pension Funds and their investment strategies, to understand if their involvement in the market leads to changes in financial performance.
Institutional investors have been the focus of constant debate and generated various investigations over the years. Research has established that the institutional investors are the dominant holder of assets in companies. However, the mere fact that they are the dominant holders does not necessarily mean that their involvement would lead to higher financial performance by companies. This research paper focuses on the effect of the involvement of institutional investors on the financial performance of the companies. Financial Performance in this research paper is used as a means to decide how a company can organize and govern itself and make appropriate use of its assets in order to improve or deteriorate the financial condition of itself. Higher financial performance of a firm would lead to better investment returns, which is, the major interest of institutional investors. The research paper will attempt to point out both the positive and negative aspects of the influence of institutional investors on firms in order to affect the financial performance, thereby, trying to maximize investment returns.
Jill Solomon aptly suggests that institutional investors are intermediaries between lenders and borrowers. They have a critical importance in the stability and functioning of the financial markets. Economic theory suggests that institutional investors are opposed to individual actors on the financial markets. UK specific, she points out that institutional investors are organizations with millions of pounds invested in the shares of listed UK and foreign companies, as well as in other form of financial asset, thereby implying that they are major stake holders.
The most important type of institutional investors are Pension funds. The international institutional investors by investing money in companies help in the global movement of money.
Institutional investors differ among each other in their risk taking appetites as well as positioning themselves for maximum planned returns. They manage large quantities of shares and have tremendous influence on the movements of stock markets . This paper will mainly focus on pension funds as they have been the most prominent among the institutional investors.. In the past thirty years, shareholding has been highly concentrated in the hands of institutional investors and not individual investors. The most vital among the institutional investors are the private and public pension funds.Solomon also asserts that the Institutional Shareholders Committee helped in the growth of the institutional investors in the United Kingdom
Institutional investors are more powerful than individual investors and have better resources. They relate mostly to firm level performance. They affect corporate performance by analyzing portfolio holdings of various institutions in companies. Firm level governance is positively associated with international institutional investment.
The first part of the research paper describes the of the increasing influence of the institutional investors over the years. It then discusses the investment patterns of certain types of investors and then goes on to the second part where it tries to prove corporate governance, as the link, between institutional investors and financial performance. This paper shows corporate governance to be the link between institutional investors and financial performance. Over the years this link has become stronger but not necessarily beneficial. The third part deals with the merits and demerits of institutional investors and the various hindrances in their path. Finally, the paper will analyze the various ways in which there can be effective leverage of power on the institutional investors.
It has been observed that the recent trend is towards increasing shareholding by institutional investors as opposed to individual shareholders. In the UK, the top 25 institutional investors are in control of more than 40% of the value of shares held by all institutional investors. Section 5 of the Hampel Report stated that: “60% of shares in listed UK companies are held by UK institutions- pension funds, insurance companies, unit and investment trusts. Of the remaining 40%, about half are owned by individuals and half by overseas owners, mainly institutions. It is clear from this that a discussion of the role of shareholders in corporate governance will mainly concern the institutions, particularly UK institutions.” (ss.5.1). Hampel report ss.5.2 , amplifies the change in the nature of activities of institutional investors , moving away from drawing board policies to active participation in corporate firms .
The total volume of assets of institutional investors in the US almost tripled since 1991 reaching $ 19279 billion in 1999. Although the most significant increase was recorded for investment companies whose assets rose $1376 billion in 1991 to $6289 billion in 1999, pension funds occupy the first place amongst institutional investors in the United States. As from 1997 share holdings have been the most important asset class reaching $15.7 trillion in 1999, followed by bonds which stood at $12.8 trillion. The value of equity investment which partly reflects strong equity prices, grew on average 18 per cent in the period 1991-99 followed by bonds and loans which grew by 9 per cent and 3 per cent respectively. Equity holdings of pension funds increased 15 per cent annually in the period 1991-1999, showing a clear shift in the asset composition as the increase in bonds and loans was relatively modest.
In the United Kingdom, the role of the institutional investors came to the limelight in 1973. The most dominant class of institutional investors in the UK is the pension fund. 1994 figures for UK reveled that almost 66 billion pounds of all occupational pension fund assets was managed by mainly five pension funds. Ever since the pension fund assets have grown in leaps and bounds.
The work of institutional investors has been appraised for leading to higher financial performance of firms by their making use of modes such as voting and engagement also dialogue but at the same time has also been criticized for emphasis on short –termism. As has been explained in the myopic institutions theory (Hansen and Hill, 1991) that institutional investors in the long run become more short sighted than the individual shareholders. The reason for this is the competition for accounts and their assessment on the basis of their performance.[
This part of the research paper makes the influence of the institutional investors (mainly the pension funds) on the firms clear. This clearly proves that they are more powerful than the individual shareholders in terms of their resources and the ways in which they could influence the firms. These resources if used in the right way would definitely mould the company in the right direction, thereby leading to better governance.
Investment Patterns of Institutional Investors.
Mutual Funds comprise of cross section of investors who contribute to create a common pool of funds investing in securities e.g. stocks, bonds, money market instruments and similar assets. These funds are managed professionally by qualified fund managers, who strictly follow the norms of investment objectives of its prospectus. The fund managers deploy the fund’s capital after due diligence with an aim to create capital gains for the investors. On the other hand Unit Investment Trust is a registered investment company which purchases a fixed, unmanaged portfolio of income producing securities and then sell shares in the trust to investors. The major difference between a Unit Investment Trust and a Mutual fund is that a mutual fund is actively managed, while a unit investment trusts self governing. Capital gains, interest and dividend payments from the trust are passed on to shareholders at regular periods. If the trust is one that invests only in tax free securities, then the income from the trust is also tax free. A unit investment trust is generally considered a low-risk, low-return investment. Some investors prefer UITs to mutual funds because UITs typically incur lower annual operating expenses (since they are not buying and selling shares), however, UTIs often have sales charges and entrance / exit fees.Then, there are those firms which are created to hold securities of other firms who raise their capital from public issue of shares which are traded on the stock exchanges; these are known as Investment Trusts. These institutional investors issue a fixed number of shares (traded at a discount on their net present value) which are bought by new investors from the existing share holders. These are closed ended funds. In this a unit holder is not a share holder of the unit trust and these units are not shares but qualify the interest of the investor in the unit trust’s investment portfolio.
Another high value institutional investor which have deep pockets for investment in the markets are Hedge Funds. These funds are highly flexible and opportunistic. These funds can take both long and short positions, use arbitrage, buy and sell undervalued securities, trade in options or bonds and after discounting risks Hedge Funds look to maximize returns. The main strategy of Hedge Funds is to preserve their capital and ensure positive returns in both uptrend and downtrend in markets. The very fact that these funds have a very large flow of capital and can deploy large chunks of capital in the markets, they are very informed investors.
Hedge funds have distinctive strategies in their investment appetite; each such strategy has different degrees of risk and return. For example a macro hedge fund is volatile but has a higher return potential, they dabble in stock and bond markets, currencies, hoping to profit from global shifts in interest rates and various countries economic policies. Then there are distressed – securities hedge funds that buy the equity or debt of companies entering or exiting financial distress, these are conservative funds. Equity hedge funds on the other hand are global or country specific, their strategy generally amounts to identifying overvalued stocks or stock indexes and shorting them to play against downturn in equity markets. (is it from the same site?)
As per Davies, pension funds collect and invest pooled funds contributed by sponsors and beneficiaries to provide for the future pension entitlements of the beneficiaries. They provide means for individuals to accumulate savings over their working life so as to finance their consumption needs in retirement. The sponsors are mainly big companies, public corporations, or industry or trade groups, in spite of this pension funds still continue to be favoured mode of investment. (Davies 1995a, 2000a, Davis, E. Philip; Steil, Benn, Published Cambridge Mass. ; London : MIT Press 2001)
Life insurance companies are long-term investors. They have a large share of tradable assets in their portfolios. Their main purpose is to provide insurance for dependants against the risk of death at a given time in the future. They now progressively provide long term saving vehicle for pensions, to repay loans for house purchase and the like.
As compared to banks and individual investors, the institutional investors have an edge in case of equity and corporate bond financing. The complete framework within which the institutional investors work is more organised and has an edge over individual shareholders. They help in overcoming various problems such as information asymmetry and are also useful in countries where individual shareholders are not given considerable legal protection. This shows the basis on which the investments by the institutional investors are based. Pooling is an essential aspect for institutional investment. People would be ready to pool in if they are satisfied that they would ultimately get good results. This factor motivates the institutional investors to seek higher returns; hence they are encouraged to monitor the company judiciously. Better monitoring would lead to better governance and time is witness of the fact that companies which have good corporate governance produce higher financial returns, as opposed to companies with poor financial performance because of bad governance mechanisms.
The growing corporate governance role of institutional investors manifest itself in three ways:
First, institutional investors have enhanced their corporate governance role in the form of an increase in market control via equity and debt. Institutional investors are major shareholders so that their role in take-overs is a central one. Regular performance checks on fund managers against “the market” may induce heightened willingness of institutional investors to sell shares in take-over battles to maintain or improve performance.
Second, an increase of de facto direct control via equity in the form of an increase in share-holder activism by institutional investors has been an important characteristic of the change in corporate governance in 1980s. The institutional investors as shareholders are in a potentially strong position to exert pressure on the management of enterprises. Although institutional ownership of entities has increased sharply, institutional investors are for the most part, passive investors. Moreover, regulation may prohibit some categories of institutional investors to acquire direct control or dominant influence over the management of a company. E.g. European insurance companies are not allowed to acquire dominant influence in any business other than their own. Thus, institutional ownership per se has no clear implications for corporate governance.
Third, direct control via debt is an important mechanism of corporate control in continental Europe and Japan. Pension funds’ role via the mechanism is a passive one in Germany and Japan; most of the loans by pension funds are to the banks or arranged by the banks, leaving banks in a controlling position to provide monitoring of management on the part of all external financiers.
The investment pattern and strategies being followed by institutional investors remain highly differentiated, ranging from strong risk aversion to fairly aggressive strategies using sophisticated techniques in making asset allocation decisions. Some funds are actively managed while others use passive investment strategies based on indexation techniques. Funds may be managed in-house or externally. There appears to be a tendency among institutional investors to increasingly delegate the management of their portfolios to professional fund managers. The role of fund management professional is therefore a key factor in analyzing the relationship between institutional investors and financial markets.
CORPORATE GOVERNANCE- THE LINK BETWEEN INSTITUTIONAL INVESTORS AND HIGHER FINANCIAL PERFORMANCE.
Poor corporate governance bears witness to major historic examples of corporate failures, be it Maxwell, Parmalat or Enron. The financial sheets of Enron were always doctored. It was like a bubble built on off- balance sheets that finally burst. Such creative accounting leads to misleading financial information, resulting in information asymmetry. Risks in the financial markets are often increased due to poor corporate governance. Shareholder activism is definitely an effective mode of checking this problem. Specially when it comes to a powerful group like institutional investors, who have much more power and resources. The system of checks and balances definitely becomes more proficient. (Noteworthy attention was given to the responsibility of institutional investors in the Cadbury Report (1992). The Cadbury Report stated: “Given the weight of their votes, the way in which institutional shareholders use their power to influence the standards of corporate governance is of fundamental importance. Their readiness to do this turns on the degree to which they see it as their responsibility as owners and in the interest of those whose money they are investing, to bring about changes in companies when necessary, rather than selling their shares.”
Primarily the activist shareholders try to emphasize on poor performing firms and try to compel the management of such firms to improve the corporate performance, thus improving shareholder value. Institutional investors have as equity holders gained great importance in the U.S. markets. As per research, equity ownership of large institutions increased fairly from 24.2% in 1980 and almost touching 50% by the end of 1994. It is important to note that most of this increase has been attributed to the growth of pension assets.
The impact of institutional investors has always been a debatable topic. The positive impacts of activism are the flag bearer for the proponents of activism. They argue that the methods used to target the firms is to enhance monitoring of the management, thereby implying that better monitoring would produce results that would be valuable to investors as well as help the company to be financially solvent. Investors with sizable stakes in a reputed company have stronger incentives to take on monitoring activities, as they would try to cover the costs incurred for monitoring by the larger investment returns obtained by astute monitoring. The proponents also assert the fact that the activists focus on the long term performance of firms thereby helping the management to perk up long-term performance. Conversely the opponents to the positive view argue that the pension funds do not have sufficient expertise to advise corporate management. Authors like Murphy and Van Nuys (1994) raise their contention on the incentive structure on the pension funds and express their surprise to the fact that these funds are even engaged in this activity. Their research has also proved that the data on shareholder activism consisted of 2042 proxy proposals made by shareholders on the governance of corporations which were submitted at 452 companies from 1987 to 1994.
An acceptable fact is that, if the boards are not effectively supervised by managers then the boards might start working for the management instead of working in the interest of shareholders and become passive in their approach. All this can be avoided by effective corporate governance which includes in it institutional investors. These institutional investors have the power to compel managers to allocate profits to the external financers. It is easier for institutional investors to get their rights enforced in courts. However, there is sometimes a possibility of the larger investors superseding the interests of the minority investors for their private motives. In agreement with the above view, it has been found that profitability for those firms would be higher where shareholders have upto 5% of the stake. Institutional investors are usually limited by regulation or by a desire to maintain liquidity, to hold upto 5% of a firm’s equity. This particular condition is to generate better returns.
The large holdings by institutional investors have now made them more conscious and their activities and role as monitors of firms are closely monitored. The theory and empirical work on corporate governance shows that the limit on stakes of being up to 5% is exactly that which needs to motivate corporate performance. By improving corporate governance, the institutional investors help in boosting an overall corporate sector performance.
Pack of stocks in the New York Stock Exchange ,studied over a period of an yearly time frame , which receives maximum increase in institutional ownership is seen to show higher returns by over 28% than the pack of those stocks that register a decrease in institutional ownership. This high percentage of returns lends credence to the theory that institutional ownership and returns are directly proportional to each other. Similarly mutual funds too show the same connection when analyzed quarterly. However numerous studies have been unable to establish the link between this positive sway between changes in institutional ownership and returns. So as to QED that this positive sway is consistent with three hypotheses: (1) Institutional buying of stocks create price pressure which in turn pushes up the prices; (2) Institutional investors invest on the prevalent trends thereby taking advantage of the momentum;and (3) Institutions are better informed allowing them to successfully forecast inter period returns.
The price pressure hypothesis is basically governed by the demand and supply of shares which forms a basis for this hypothesis to take effect. Given that the supply of shares are matched and institutions as a group add to their holdings of a certain stock, as per price pressure hypothesis it is expected that their buying activity will push up the price of the stock. The price increase as a result of buying by large institutions cannot be countermanded by selling by individuals and smaller institutions. The liquidity hypothesis deduces that institutional trading may impact prices. Large institutions initiate trades to displace small investors or individuals , these high net worth institutional investors receive price concessions as compensation. (The “liquidity hypothesis”). This explanation is consistent with models developed by Grossman and Miller (1988) and Stoll (1978) as well as empirical studies that examine price changes around liquidity. Besides this the volume of shares and the trading experience make the institutional investors better informed (the “informed trading hypothesis”). The microstructure models give credence to the pattern. Looking into the informed trading it has been found that higher institutional ownership leads to lower post earning. This is further strengthened by research which amply clears firms with high institutional ownership have lesser price volatility. Nofsinger and Sias (1999) and Chakravarty (2000) have deduced that daily changes in security prices are dependent on daily changes in institutional ownership when analyzed over a three month period.
The informed trading hypothesis qualifies that the institutional investors are better informed and hence forecast intra-period returns successfully justifying the positive relation between changes in institutional ownership and returns. Hence their purchase should give higher returns than those they sell. Link has been established between institutional demand and returns, giving substance to the fact that institutional investors can forecast returns.
As per Long,Shleifer, Summers, and Waldmann, 1990; Cutler, Poterba, and Summers, 1990; Hong and Stein, 1999, smart investors indulge in trading strategies which are derived from positive feedback. Also as suggested institutional investors purchase or sell stocks performance based.stocks.(e.g.,Grinblatt, Titman, and Wermers, 1995; Wermers, 1999, 2000; Nofsinger and Sias, 1999; Cai, Kaul, and Zheng, 2000). As daily data on institutional holdings in not available and institutional ownership data is only available on a quarterly basis, an intelligent guess can only estimate proportions between changes in institutional ownership and returns over shorter intervals.It has also been stated by Agrawal and Knoeber, concentrated shareholding by institutions, can increase managerial monitoring and thereby improving the firms performance.
The effect of shareholder activism on corporate governance structures has been shown with regard to CalPERS which is one of the largest pesion funds. It shows that initially when CalPERS started targeting firms with regard to their governance structures, hardly 7% i.e. 1 of 15 either adopted the resolution made or made changes in order to come to a settlement. But these resolutions were related to takeovers, hence, because of the poor performance, CalPERS switched over to performance related resolutions. It was seen in the period from 1989 to 1993, that the resolution was either adopted or settlement of the first year target was made by 72% of the firms.
A firm’s performance is directly proportional to the managements’ governance skills. The expertise and skills of the management are multidimensional which are honed through experience, professionalism in keeping the interests of the firm first and foremost. Proper governance, even if does not lead to value creation, can definitely avoid value destruction. Mc Kinsey and Company which had been working with institutional investors for years with the idea of pegging a precise number for the value credited by them to governance finally produced results in July 2000 which indicated a range from 20 to 40% of value.
MERITS AND DEMERITS OF INSTITUTIONAL INVESTORS
As the saying goes “every coin has two sides”, institutional investors have an edge over individual investors and banks in numerous ways but there are demerits of institutional investment as well. This part of the paper would discuss both the pros and cons of institutional investment. As has been very aptly stated by Prof. Clarke: “ As the power of the institutions expands further they could either become an irresistible force for further economic instability induced by short-termism, or they could impress upon markets and companies longer-term horizons, and the pursuit of sustainability.”
A point in case of influences exerted is, when a CEO made a phone call to a large institutional investor that had voted against her proposed merger reminding them that her company did significant business with the institutional investors parent company. Deutsche Asset Management changed their vote.(Corporate Governance, Robert A.G. Monks and Nell Minow, published by John, Willey and Sons Ltd. 1995,2001,2004,2008)
Institutional investors are definitely considered to be a strong corporate governance mechanism to keep a check on company management, as they have considerable amount of power which can be used to influence the company management and can align management interests with those of the shareholder groups. However, such concentration comes with its negative effects. The institutional investors end up having more access to privileged information, and this creates one of the most dreaded problems of information asymmetry between the investors and the shareholders. But some writers have believed in the positive influence of institutional investors, e.g. as has been stated by Agrawal and Knoeber (1996) that the effect of the participation of investors can be positive on the financial performance of the firm.
In certain quarters, it is perceived that agency problems arising are the creation of Institutional investors, while it is debatable, it must be realized that these institutional investors are the one that can end the same. These institutional investors control large blocks of shares which often results in gap between ownership and control. The advantages outweigh the disadvantages as concentrated ownership block enforces better monitoring of companies which in turn helps to come over the agency issue. However accountability is another issue reported from time to time. Fund managers and foreign investors in UK companies will have to become publicly accountable for how they monitor the boards and performance of groups they invest in, according to a new City code published .The Stewardship Code, produced by the Financial Reporting Council (FRC), will set out the extent of investors’ responsibilities for the first time. Institutional investors are encouraged to put up a public statement on their websites by September explaining how they are meeting their responsibilities under the Code. The Financial Services Authority will now decide whether to make this mandatory for authorized asset mangers on a “comply or explain” basis.
Under the Code, fund managers will have to ensure “company boards and committee structures are effective, that independent directors provide adequate oversight, including by meeting the chairman, and where appropriate other board members,” and by attending general meetings. They will have to keep a “clear audit trail” of private meetings with companies and records of how they vote on shareholder issues to ensure that problems are identified early and that shareholder loss is minimized. Foreign and overseas investors are also encouraged to comply – as are UK-based asset managers in relation to their overseas holdings. Alan MacDougall, managing director of shareholder action group PIRC, said the “Code represented a significant step forward and that all institutional investors should seek to apply it.”
Institutional investors like Pension funds are faced with the dilemma that they are not the actual beneficiaries of the envisaged higher returns. The actual shareholders are the clients of the institutional investor organizations. There is immense pressure on the pension fund manager to ensure that the investee companies pursue shareholder wealth maximization, as failing to do so would mean that the pension funds would not be maximized and subsequent maximized benefits to pensioners would not be forthcoming. Hence the shareholders have to be concerned about not only the interests of the management of the investee company being diverged but also have to keep a check on the actions of the pension fund managers. This adds on to the agency problem. Specially, when it comes to pension fund management, there is an extra layer of complexity, i.e., the presence of pension fund trustees. The pension fund trustee has the fiduciary duty to make sure that the pension is ultimately maximized.
Such intermediaries can cause obstruction in the corporate governance functions, as they mainly emphasize on short- termism. The reason attributed is in their projections they need to make the returns look as healthy as possible. To achieve this they resort to pressurizing the company management, which ultimately becomes detrimental to the long-term survival of the company(Graves and Waddock,1990, 76-77).However, in a recent publication, ‘Tomorrow’s Owners-Stewardship of Tomorrow’s Company’, institutional investors are shown to be naturally interested in maintaining their sustainability, as this would have two effects, either it would be beneficial to them if they monitor the companies effectively or they should be ready to bear the negative impact if they do not do their job properly. There is another school of thought, wherein a group of academicians argue that the large stocks held by the institutional investors is used by them as a tool to monitor and discipline managers, thereby ensuring the fact that there is maximization of the long run value.
MacKenzie airs and endorses another area of concern, stating that the fund managers usually delegate their duties to a person who has little or no knowledge and usually no experience in fund management. Thereby, this unfair practice resulting in such a person being forced to take the responsibility for activism with hundreds of companies.
Myners from his own research found that: 62% of trustees had no professional qualifications in finance or investment; 77% of trustees had no in-house professional to assist them; Over half the population of trustees had received less than three day’s training when they assumed their responsibilities; 44% of trustees had not attended any course since their initial 12 months of trusteeship; 49% of trustees spent 3 hours or less preparing for pension investment matters . (Implying that, given 4 meetings a year, trustees spent less than 12 hours a year on investment matters!)This gives vent to the inadequacies of governance issues which may ultimately have a direct bearing on the performance of the company.
In the constantly evolving market and involvement of institutional investors there emerges flexibility potential of institutional investors to protect their investment and maximize returns. Institutional investors to minimize their exposure, dump risky ventures to the household sector wherein policies offered by life insurance companies offer high value return on policies which are only partially guaranteed and the major portion is performance linked(such as variable-life or unit-linked policies).
This necessitated keeping pace with the changing financial environment resulting in fine tuning ways to transfer economic resources over time, across geographic regions, or among industries. The optimal deployment of household funds over their investment period is the basic requirement of an aging population. Over a period of time the confidence has eroded in the promises of social security pension systems. Capital markets provide flexibility, this has led to increased demand for transfer retirement savings held in life insurance companies and mutual funds ( see section 1.5.3 and Husier 1990) so that the funds are optimally allocated to their most efficient use. In OECD countries an there is an increased demand for long- term saving, for security. However investors are not looking for maturity value of the long term savings only and would like to look for higher value of their worth taking the institutional investment route.
Investment through large institutions, by sheer scale of investments reduces the average costs for investors. Whereby the commission charges are reduced as well as the advisory fees of investment managers are shared amongst the investors.
The domestic securities are balanced with both debt and equity where by risky exposures are minimized. Institutional investors are better positioned than individual investors, as their portfolios are professionally managed and can take full advantage of both international investments as well as domestic securities.
Institutional investors minimize risks as the risk is shared amongst the investors thereby reducing the impact. Besides this a manager can choose to hedge , diversify or insure his investments. Also institutional investors may use derivatives and as a means of risk control on their portfolios. Innovations have been developed especially to cater for institutional demand and attract a larger client base. Clients are provided life cover or defined pension benefits.
Institutional investors have an long term liabilities, thereby having a longer holding power to tide over volatility in the markets and can plan their period of investment or disinvestment thereby giving them an edge over banks and individual investors. Most of the institutional investors have their assets and liabilities balanced which allows them flexibility and stability resulting in superior leverage in corporate governance.
Certain constrains which have prevented institutional investors from performing their responsibilities effectively have been brought to the fore by David and Kochhar in their research paper. They mention the business associations shared between the investors and the companies. They cite example of British Gas in which the views of the minority shareholders was suppressed because of the proxy votes by the institutional investors in favour of Cedric Brown, the then Director of the company to run the company. The excessive regulations passed by the government also restrict the activities of these investors to a certain extent. One more reason that restricts their ability to monitor companies effectively , is the fact that they do not have much access to the information that they require to monitor management effectively. However in spite of these restrictions institutional investors have performed their duties reasonably well. There has been fair amount of institutional investor activism specially in the area of director remuneration. The fact that the institutional investors have been trying to monitor the companies well in order to increase shareholder returns and which in turn also supplements in maintaining good financial health of the company.
However, there are certain disincentives which hinder institutional investors from taking actions. It was discussed at the Conference on Pension Reform In Russia that even the active investors might become passive when they have to make actual good use of their rights and make sure that the interest of the management are aligned with that of the investors.One of the major hindrances is the cost. The cost of monitoring the management of the company or of taking any sort of action might ultimately prove to be more than that of the benefits actually received. Nonetheless, if the financial returns are promising and good then there would be some motivation to intervene.
The increasing competition between the equity managers also discourages them because it would be very demoralizing if the equity manager which incurred cost for monitoring receives lower returns than the other manager who did not take any such efforts for monitoring. But only because of the fear that their competitors may be in a better position, the institutional investors cannot get away with their main job i.e., shareholder wealth maximization which cannot be attained without proper monitoring.
The decision in Prudential Assurance Co. Ltd. V. Newman Industries Ltd.(No.2)  Ch 204 can be well quoted to show the discouragement for institutional activism. In this case, Prudential held 3% of the shares of Newman Industries. Their allegation was against two directors who had committed a fraud of 400,000 pounds against the corporation. Prudential was successful at its first stage, however the court of appeal, in approving of the appeal in part stated: “We were invited to give judicial approval to the public spirit of the plaintiffs who, it was said, are pioneering a method of controlling companies in the public interest without involving regulation by a statutory body. In our view the voluntary regulation of companies is a matter for the city. The compulsory regulation for companies is a matter from parliament. We decline to draw general conclusions from the exceptional circumstances of the present case. But the results of the present action give food for thought.”
Nonetheless, in spite of these discouragements, institutional investors can play a proactive role in monitoring the management of the corporation..Some of the major examples where pension funds have played an active role (with quite but active support from some mutual funds like fidelity) around the period of 1992-93, was their ability to have been able to remove the incumbent CEO’S and some members of the boards of directors of the economically underperforming firms like IBM, Westinghouse, and Sears.
There have been certain other constrains as well which have prevented institutional investors from performing their responsibilities effectively. These include the business associations shared between the investors and the companies wherein invest. A classic example of this is the case of British Gas in which the views of the minority shareholders was suppressed because of the proxy votes by the institutional investors in favour of Cedric Brown, the then Director of the company to run the company. The excessive regulations passed by the government also restrict the activities of these investors to a certain extent. One more reason that adds on to their ability to monitor companies effectively, it is the fact that they do not have much access to the information that they require to monitor management effectively. However, in spite of these restrictions institutional investors have performed their duties reasonably well. There has been fair amount of institutional investor activism specially in the area of director remuneration. The fact that the institutional investors have been trying to monitor the companies well in order to increase shareholder returns and which in turn also supplements in maintaining good financial health of the company.
As is revealed in De Long’s study, that there is no strong evidence as to the positive or negative impact of institutional investor activism on firm performance in the United States. Also there are certain disincentives to institutional investor activism. There is mixed evidence on whether long term “relationship-investing” by institutional investors improves firm performance. However there may be certain institutional investors who might be skilled enough to enhance the performance of their portfolio companies.(See De Long’s 1991study of J.P.Morgan).
This mixed evidence depends on certain factors i.e. political, economic and certain legal factors as well. In the United States, the shareholder activism is mostly influenced by political and economic factors. (e.g. Black., 1990: Roe 1994). Research shows that the restrictions on the American institutions are much more than on the British institutions (Black and Coffee 1994; Roe 1993a). Black and Coffee, 1994 suggest that the regulations on the institutional investors in the United Kingdom are less than the regulations on them in the United States. In Britain the larger shareholders are unenthusiastic about intervention in order to monitor the management because of certain reasons, like not obtaining perfect information, uncertainty about the benefits they would receive from intervention, a limit on the institutional capabilities and a priority for liquidity.
As has been stated above the evidence of the effect of activism on firm performance is mixed. Certain studies have shown that the performance of the firms with a high level of institutional ownership is poorer than the other firms. However, certain recent studies have failed to find this effect.Certain studies also showed that there was no relationship between firm performance and institutional investor activism (Daily, Johnson, Elstrand and Dalton 1996). However Nesbitt 1994 did report of positive long-term stock price returns to firms targeted by CalPERS. In fact Opler and Sokobin 1997 also find noteworthy above-market performance after targeting. Although there is mixed evidence of the effect of institutional investors on firm performance but the fact that they have played a vital role in corporate monitoring is self evident. The rise in shareholder activism in case of director’s remuneration, greater board independence, separation of the role of CEO and Chairman (e.g. Disney, the roles of the CEO and Chairman were split as a result of the institutional investor activism at the annual general meeting on March 2004) increased use of voting and more of engagement and dialogue are all ways of improving corporate performance thereby, leading to better financial performance. Hence, the positive impact of the involvement on the firm’s overall performance is definitely noteworthy.
Black(1992) and Pound(1992), state their views on institutional investors by asserting that initiatives which the institutional investors take in relation to corporate governance are just a way to reduce the costs which would otherwise be much higher in case of takeover bids or proxy proposals.However, Ryan (1998), Gordon (1993), Pozen (1994) unlike Black and Pound state that the recommendations made by institutional investors have a possibility of encouraging the managers to make certain decisions and changes that would enhance the value of the firm. The profit concerns which the institutional investors have, is clearly evident from certain examples in which the institutional investors played a key role in encouraging the company to make a decision for appointing new outside directors and reversing the diversification strategy of the company which did not seem to yield much profits.
In a research conducted by McConnell and Servaes (1990), it has been found the impact of institutional investors on U.S. firms is positive.
It has been argued that the large blocks of shares held by institutional investors act as an incentive to allow them to monitor corporate performance more effectively as they have substantial voting rights which can be used when deemed necessary.
The active monitoring hypothesis has shown that institutional investors would not vote for amendments that have the capacity to bring about a depreciation in shareholder wealth.In fact a positive relation has been shown to exist between institutional ownership and productivity by McConnell and Servaes (1990), as has been measured by Tobin’s q.
Institutional investors are portfolio investors and they have financial expertise, this expertise is indeed very essential to study the financial data produced by the firms. Shareholder activism in the true sense is very important for the management to be accountable. Without accountability, however good the management and governance of a company be, the likelihood of value creation would be scarce.
WAYS TO IMPROVE THE EFFECTIVENESS OF INSTITUTIONAL INVESTORS
As has been observed in this research paper, there are certain hindrances which prevent the institutional investors from being using their powers effectively. In this modern and complex world it is not easy to trace ways as to increase their effectiveness. However, it is suggested that if they are given more protection (in terms of disclosure, accounting, and certain specific information which is required to make the right kind of investment). There should be more transparency in the voting procedure. This might help to improve their effectiveness. Moreover, there is a possibility that if better incentives are given to institutional investors this might help them to take more interest in their effectiveness in the affairs of the company. This was explained by Admati, Pfleiderer and Zechner, where they asserted that the activism as an equilibrium condition takes place where the shareholders are sure that the benfits that they would attain out of the activism would be more than the costs incurred by activism. This also incentivizes them to effectively monitor management in spite of a major hindrance in monitoring i.e., free riding by other shareholders.
Martin and McConell (1991) have shown a negative relationship between the firms with poor stock price performance and the possibility of being the target of activism. However, the same research paper also examines the threat of activism. It suggests that if the firms foresee a probability of being targeted by activism, then the threat itself would be enough to bring in line the interests of managers to that of the shareholders.
Though institutional investors possess numerous tools at their disposal , their nemesis often is the stringent regulations that govern the portfolios. Which has a direct bearing on asset allocation, thereby enforcing a conservative approach such as a prudent man rule ( the rule, that assets should be invested in a manner that would be approved by a prudent investor). This study assesses these varied regulations as ‘governors’ which impact investment patterns.
In a suggestion made by Greco(2001), the focus was on the Government to change the laws to an extent that would be necessary to empower pension funds to curb excessive and uncontrolled corporate power and would also require the fulfillment of their actual fiduciary duty. Institutional investors however are portfolio investors and they have financial expertise at their disposal , this expertise is indeed very essential to read between the lines of the financial data produced by the firms, thereby deciphering the documentary financial haze and take an informed call .
There is no simplistic way of arriving at a view of whether involvement of institutional investors leads to higher financial performance. Some researches show enhanced performances, while others are quick to point out the anomalies.
It can be appreciated that with such divergent views it is not possible to arrive at a firm conclusion. However this research points to the fact that there is a great potential of attaining very high standards of corporate governance in companies / institutions as a result of institutional investor activism. One of the key factors of success would be to oversee that the quality of indicators must be given prominence and taken into account to make a fair assessment of organizations:-
1. Voice and accountability
2. Political stability
3. Government effectiveness
4. Regulatory quality
5. Rule of law
6. Control of corruption
7. Economic freedom
8. Political freedom
However from the research, taking into account the positive and negative preponderances of institutional investment, it can be assumed that international institutional investors, export good corporate governance practices around the world. In addition, in countries where institutional investors actively participate in the corporate governance, their presence possibly reduces the cost of capital for firms and also positively influences stock market capitalization. In the same breadth it is pointed out that fund e.g. like pension funds , if subject to direct or indirect political control , as a result of putting their political agendas ahead of the funds beneficiaries will always post poor financial results. From an academic perspective the inference of “does the involvement of institutional investors lead to higher financial performance” is a matter of perception in a given set of conditions , also may differ from country to country and most certainly post tangential results when analyzed in developed and developing economies.