Shareholder activism puzzles me, since it goes against free-market principles by allowing people who are far from a business (and therefore less well-informed) to influence the running of it. In the long term, I think this will do little to improve the corporate governance and shareholder returns of individual companies. Instead, I think that shareholder activism is a symptom of the fact that most investment managers are not good at what they do. Some introspection on behalf of the industry might be in order.
Now, I am only a free-markets advocate to the extent that my default is to revert back to ‘leaving well-enough alone’ and to agitate for a more long-term and ecosystem-centric view of markets and the regulations that govern them. Because of the non-linear dynamics at play in your typical market, any changes or new regulations are liable to have unpredictable and long-term effects. As a result, intervening into dynamic systems will require significant thought to predict and correct for any unforeseen consequences that might result. Even then, the intended effects are often far from the changes that ultimately do result. As a result, my opposition to intervention is not absolute, but I reserve my approval to policies that have considered the long-term and long-range impacts and take these into account.
In brief, my main issue with shareholder activism is that it takes power away from the people who are the closest to a business, who—one supposes—have the most relevant and accurate information to hand. This increases the distance between decisions and decision-makers, which dilutes the efficacy of the decision-making and introduces the potential for unintended, off-target effects. Indeed, a lot of this boils down to the perennial argument between centralised and decentralised decision-making.
My preference—which informs the argument below—is to be in favour of decentralised decision-making, since this maximises the autonomy of individual agents in the system. Such dynamics also apply across systems, and across industries we see an increasing push for technologies operating ‘at the edge’, whether this be in the form of an ‘Internet of Things’ or local processing on decentralised devices to reduce lag time (the comparison between Android and iOS voice-to-text springs to mind, see below). The rationale for such initiatives in that the most robust systems are also often the most dynamic and flexible, and this is enabled by decentralisation. (Octopodes are an example of this in the natural world, where each arm is capable of making decisions independently of the brain. But I digress.)
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Shareholder activism has a long history, but regulatory changes have seen increasing interest in shareholder activism over the last 20 years. Previously, shareholder activism often took the form of divestment. As a result, well-run companies would see their popularity among investors grow, resulting in win-win scenarios as share prices go up because of higher investor demand. Conversely, less-well-run companies would see reduced investor demand and lower market-capitalisations. In other words, these dynamics (where investors vote with their feet to support well-run companies over their less-well-run brethren) would exert a selective pressure on companies; selecting for well-run companies and penalising the less-well-run. The quality of the average company would therefore be expected to increase over time, as well-run companies persist, and poorly-run companies fade away into irrelevance due to an inability to raise capital.
Shareholder activism however turns this dynamic on its head. Aggressive shareholder activism often sees the activist take a meaningful holding in a company. The targeted companies have often suffered poor operating performance, which the activist seeks to improve over the short term to pump the share price enough to justify exiting the position. The long-term health of the company (poorly run or not) often suffers as a result. Less aggressive shareholder activism is however more common, and it is often practised by mutual fund managers in the form of ‘engagement’. Under this form of activism, fund managers engage with company management teams to advise them on matters like capital allocation and corporate governance and the like. Not only does this allow the fund managers to feel as if they’re ‘doing something’, but it also allows them to justify their fees (and existence) in the face of the rise of passive investing. Furthermore, the assumption (on behalf of the fund managers) is that they know better than their corporate kin.
By gently encouraging (or forcing) poorly-run companies to improve, activism however only artificially increases the quality of a company. External change will always be incremental and therefore less effective than the change that comes from within. Shareholder activism would therefore be expected to reduce the overall quality of companies in the long run, by allowing non-competitive companies to persist and retain access to capital markets. In this way, activism is almost like a type of corporate social welfare, ultimately leaving poorly-run companies increasingly dependent on their activist investor base in order to thrive. This is not sustainable in the long run as these dynamics could easily erode managerial accountability. (Hypothetically, management teams could blame their poor performance on poor advice given to them by activist investors.)
In addition, activism is also an easy ‘out’ for the fund managers themselves: By forcing companies to take actions designed to increase shareholder returns, investors are effectively pushing their responsibilities onto the corporate management teams. In an activist ecosystem, it is no longer the responsibility of the investors to pick good companies to invest in. Why bother, if you can ‘engage’ with the duds to smooth over your own investment mistakes (and look good in the eyes of your own investors in the process)? From this perspective, rather than allowing investors to ‘earn their fees’ by adding shareholder activism to their toolbox, activism is in fact another argument in favour of passive investing as activist shareholders cannot leave well enough alone.
Arguments in favour of fund managers enabling grassroots shareholder activism—by the individual investors of mutual funds—are also misplaced: Can we really expect people who are not experts on the companies they’re (directly or indirectly) invested in to know what is the best approach for a company to take when it comes to issues such as corporate governance in order to maximise the long-term benefits for all parties involved?
(I don’t want to unnecessarily invoke politics, but it makes for a good parallel, and one need only look to the failures of democracy in societies where the deme is not well-versed in the complications of public policy to see how easily it can go awry even when implemented with the best of intentions. The best-case scenario often leaves the regulator playing whac-a-mole with new, unintended problems arising, when the implemented policies do not even address the underlying problems at hand. The UK’s decision to leave the European Union and the rise of Donald Trump in the US, are examples of short-term, activist solutions with long-range consequences that fail to address the complicated, long-term, underlying problems.)
One of the immediate impacts of shareholder ‘engagement’ on behalf of fund managers is an increasing emphasis on ‘diversity’ on corporate boards. Unfortunately, because of the vague definitions of ‘diversity’, such policies often revert back to specifying superficial proxies of diversity like sex, gender, and ethnicity, which does little to increase more meaningful measures of diversity (the exact nature of which could very well vary from company to company and industry to industry). In addition, shareholder policies around corporate governance often include provisions to limit the tenure of board members, again with the intent of maximising superficial measures of diversity. Objectively talented CEOs like Mark Leonard at Constellation Software have lamented such policies in the past.
For example, in his 2017 letter to shareholders, Leonard commented on how hard it can be to find talented directors to staff a company’s board: They need to be people with relevant experience, who are also good at what they do, and who are willing to commit both time and effort to their new responsibility as directors over a long period of time. Leonard then proceeded by commenting how silly it is of shareholders to make the already-hard task of finding competent and qualified directors even harder for companies: Talented directors are hard enough to find already, without the need for further complications in the form of artificial demands in the name of ‘diversity’. This is just one example of how well-meaning shareholder activist-engagement can have a negative impact on the long-term performance of otherwise well-run companies.
Whenever you introduce new selective pressures on a complex, dynamic, evolutionary system, you need to consider the long-term run-on effects of the selection process, and only implement those policies that have the maximum potential of optimising for the actual goal that you’re trying to optimise for. Financial markets are no different, and shareholder activism is likely to have long-term negative impacts that are yet to be felt. The most robust systems are often the ones that see maximum autonomy and minimum interference, and where interventions have been carefully chosen with the intent of optimising for a specific measure in the long run.
My concerns regarding shareholder activism is that the practise will not optimise for what it claims it will optimise for (improved corporate governance and shareholder returns). Instead, shareholder activism is a short-term solution to a different problem: The fact that financial markets are growing increasingly competitive and that many investors are struggling to stay relevant. Perhaps increasing investor activism directed at fund managers is in order, but that’s still not addressing the underlying problems at hand: That we’ve organised the long-term welfare of many people around the idea that financial markets are wells of prosperity rather than the zero-sum games that they actually are. As a result, we see the impact of problems like many investment managers not being good at what they do (everyone can never be above average). Instead, we should make it easier for under-performing managers to fade into irrelevance (just like their poorly performing corporate counterparts) so something better can grow in their place.