Relative Return Investing and Corporate Governance
DealBook ran a column by Simon C.Y. Wong titled “The Problem of ‘Underweight’ Shareholders.” Mr. Wong contends that investors who take positions that are less than the weight in their benchmark have a disincentive to care about matters of corporate governance. Since a portfolio manager holds a position that is smaller than the comparable index, he’s betting that the stock will underperform the index. As a result, Mr. Wong contends, these managers have a disincentive to care about governance issues, which might drive the stock’s price upward. He calls for new regulatory filings so we know a manager’s position relative to the benchmark.
I think Mr. Wong’s argument misconstrues the motivations of investors who are underweight their benchmarks in terms of their interest in corporate governance. Conversely, he relies too heavily on the effect of being overweight the benchmark in regard to taking an active interest in governance matters.
First, most institutional investors aren’t long-term investors, whether they own a large or small position in the company. They buy and sell far too frequently to take the time and effort to delve deeply into matters of corporate governance. They tend to focus on governance when there’s some short-term event such as a merger.
Second, being underweight is fundamentally different from being short. When you are short, there’s only one way to make money. The stock price has to go down. By being underweight, the investor isn’t just managing his return. He’s also managing risk (both in the portfolio and his business). While he’d like to beat his benchmark, he’s trying to make sure he’s not far away from the benchmark, especially if he trails it. If the manager misses the benchmark by too much, he’s more likely to be fired. In technical terms, the underweights and overweights are as much about “tracking error” as returns. The manager’s governance motivations aren’t necessarily weakened or strengthened by the size of his position relative to the benchmark, because he’s managing his business.
Third, even if a holding is over or underweight the benchmark, a particular position may be particularly large or small in the manager’s overall portfolio. The size of a position in a portfolio may have more to do with how much the portfolio manager pays attention to the stock and its governance.
Fourth, governance is only one factor driving stock prices up and down. Many other factors are far more important. Economic conditions, interest rates, industry issues, and a long list of other factors also drive stock prices. It’s hard to imagine that being relatively underweight or overweight would significantly affect a manager’s view on governance.
When it comes to governance, we have bigger issues to deal with than underweight positions. We need to address the speculative and short-term nature of the stock market. Most managers just don’t hold stocks long enough to act like owners. When we’ve solved that problem, we might want to explore Mr. Wong’s thesis. However, I doubt it will get us very far.