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.

The 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.