Are ETFs and activist investors redefining the agency theory?

I wrote a few weeks ago that the rise of ETF might, in the end, make markets less efficient. While I still believe this to be a likely effect, The Economist just gave me a reason for hope. In two articles (here and here), the newspaper observes the parallel rise of activist investors.

GordonGekkoThe Economist adds another reason to my list of potentially negative effects of ETFs on financial markets: corporate governance. Indeed, not only buying indices raises the share price of all firms (good and bad) across a given portfolio, reducing the information contained in prices, but also ETFs are the most informal investors ever. They passively replicate the market and do not intervene in firms’ management. Underperforming managers consequently benefit from: 1. the value of their firm evolving in line with better-performing peers, and 2. not being questioned by demanding shareholders.

Thankfully, this remains an imaginary world (at least for now), as some investors (mostly hedge funds) have decided to take a more active stance. Those activists take a small stake in the company and lobby other, more passive, investors to join them in their quest for sometimes radical changes in the firm’s structure. As I pointed out when hedge funds took over the UK-based Cooperative Bank, conventional wisdom depicts them as corporate vultures seeking short-term gains at the expense of the long-term health of the firms they invest in. But I also mentioned this study, which couldn’t be clearer in dispelling those common myths:

Starting with operating performance, we find that operating performance improves following activist interventions and there is no evidence that the improved performance comes at the expense of performance later on. During the third, fourth, and fifth year following the start of an activist intervention, operating performance tends to be better, not worse, than during the pre-intervention period. Thus, during the long, five-year time window that we examine, the declines in operating performance asserted by supporters of the myopic activism claim are not found in the data. We also find that activists tend to target companies that are underperforming relative to industry peers at the time of the intervention, not well-performing ones.

For sure, not all activists are beneficial. But to maximise the value of their stake, activists need to convince other potential investors that the longer-term operating performance of the firm has indeed been improved (which should reflect in the investment’s expected future cash flows). As we say, “you can fool all the people some of the time, and some of the people all the time, but you cannot fool all the people all the time.” While Gordon Gekko’s ‘Greed is Good’ speech might enrage some, it does contain a fundamental corporate governance truth. If activists on aggregate damaged companies’ prospects, the value of their stake would plummet and they would run out of business. As The Economist reports:

Activists point out that if they were to propose changes that clearly damaged a firm’s prospects the stock price would fall. “Unless you have one eye on the long term—how customers and products are affected—you will not succeed,” says Mr Loeb.

In short, financial markets are becoming increasingly polarised between two trends situated at almost the opposite side of the investing spectrum: on the one hand, conventional investors pile into cheaper but ‘dumb’ and passive index funds; on the other hand, very active shareholders get their hands dirty fighting to improve the operations of underperforming firms. This is welcome and reassuring, and provides further evidence that markets can spontaneously correct themselves when required and when there is the opportunity to do so.

This also represents a corporate governance paradigm change. Conventional agency theory states that, due to asymmetric information, managers may not always act in the best interest of shareholders. The theory also implies that shareholders aren’t actively involved in operational decisions. But activist investors turn the theory on its head. As a result, the new agency theory relies on a small number of activist investors (agents) taking the right strategy decisions for hundreds or thousands of other passive investors/ETFs (principals). I would argue that, while imperfect, this new version of the agency theory is more likely to work as agents’ and principals’ interests are naturally more aligned.

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4 responses to “Are ETFs and activist investors redefining the agency theory?”

  1. Ed Bugos says :

    >> “Indeed, not only buying indices raises the share price of all firms (good and bad) across a given portfolio, reducing the information contained in prices.”

    I agree the etf is a bad product and creates this incentive but isn’t it the function of traders and active investors (in the real sense) in a free market to find out those situations and treat them as arbitrage opportunities?

    As a trader, i welcome any and all such misguided concepts for the errors they create because those errors just become opportunities if they are one off. The true and biggest source of the destruction of the price mechanism as mentioned in the quote comes not from flawed products per se but from the central bank’s persistent interventions. If it weren’t for them the ETF concept might not exist.

    The incentives would be far different.

    But because the central bank policy (i.e., interest rate suppression) imposes a boom-bust cycle and generally inflates the sea level over time the incentives favor trading macro (top down) planning while the art of stock picking might as well be forgotten. That’s because in these cycles all the babies are thrown out with the bathwater during the downturn – even the best looking ones – and in an upturn pigs fly and every story sticks no matter how slippery.

    In the end the etf structure is an ad hoc market innovation (an imperfect product) – a reply to the centralization of industry and interventions of the central bank.

    It would not imo exhibit the tendency described in the quote in a free market where market error presented an opportunity for profit seeking traders to correct.

    • Julien Noizet says :

      Ed,
      I think you should take a look at my previous post on ETF and market efficiency, in which my point is clearer.
      I am talking about the still hypothetical world in which ETFs have grown to become the main investment channel, replacing most other sorts of mutual/hedge funds. If almost all investors just buy and sell basket of securities instead of each security separately, this causes aggregation problems by not differentiating between good and bad security.
      And this makes it very hard for arbitrageur to arbitrage anything as the whole market moves one way or another through ETFs anyway.
      The only arbitrage that becomes available is cross-market, rather than intra-market.
      Take a look at my previous post.

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