Corporate Governance Mutual Fund

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e invite readers to participate in designing the "ideal" mutual fund from the standpoint of incorporating corporate governance principles which have been shown to have increased shareholder value. Instead of "build it and they will come," our mantra here might be "design it and they will build it." The theory here is that we can improve on the performance of index funds (which are based on "efficient market" theory) by focusing on the concept of prudent corporate governance.

One possibility would be to copy pension funds and "relational" investors who have successfully incorporated corporate governance factors into their investment and ownership strategies. Two models might be the California Public Employees Retirement System (CalPERS) and the LENS Fund. Both use a wide variety of shareholder initiatives to encourage managers and/or directors to make changes which increase shareholder value. LENS appears to more actively pursue investments in companies that have unrealized value; CalPERS and the Council of Institutional Investors appear to focus on such underperforming companies already in their portfolios. The LENS Fund can threaten a hostile takeover, whereas this tactic is not as easily available to CalPERS.

Although, as a public employees pension fund, CalPERS is exempt from ERISA (the Employee Retirement Income Security Act of 1974), their policy has generally been to follow the diversification and other requirements of ERISA. Pension fund managers who take seats on the board of portfolio firms are likely to be judged not on the business judgement rule but on the basis of a higher, more conservative standard, the prudent man rule. This more difficult standard, the fact that CalPERS is an indexed fund which would also own part of the competition, and political concerns, substantially limit CalPERS' ability to threaten a hostile takeover. However, this limitation appears to have had little negative impact on their ability to influence corporate governance as evidenced by their record (see Nesbitt).

Just as a pension fund has certain legal and political limitations with regard to the corporate governance strategies it can pursue, so would our theoretical "corporate governance mutual fund." Diversified mutual funds are prohibited from owning more than 10% of the stock in any of their portfolio companies. For 50% of their investments, they are prohibited from having more than 5% of their funds in any one company. For the other 50% there is a 25% limit on the fund's total assets going into a single company and the two companies could not be in the same or related industries. To avoid liquidity problems the fund should be a closed-end fund. These factors, and others, limit the ability of mutual funds to pursue the sometimes hostile strategies of the LENS Fund. However, even with these limitations, a fund the size of Calvert's Social Investment Fund could invest up to $140 million to acquire up to 10% of the stock in a single company. In addition, the fund could build alliances with others to increase its effectiveness. Therefore, active "relationship" investing, of the type carried out by the LENS Fund, Japonica Partners, Relational Investors, and other such funds could represent a sizeable portion of our mutual fund's overall strategy.

The other major strategy available to our model of a diversified corporate governance mutual fund would be to make long-term investments in companies passing certain "corporate governance screens" for adaptive efficiency. The screens developed could be applied in much the same way as "socially responsible investment funds" use them. However, instead of being based on ethical arguments about human/animal rights, the environment, etc., the screens applied would be in the area of corporate governance. That is, the fund would invest more heavily in companies which have adopted corporate governance policies and practices which have been shown to be correlated with adding shareholder value.

One task to be addressed here by discussion participants would be to list the corporate governance strategies which have been found, through scientific study, to be correlated with increased shareholder value. We could start our search for such policies and practices with the fine compilation recently put together by the Council of Institutional Investors, "Does Ownership Add Value?: A Collection of 100 Empirical Studies." A quick glance at that booklet finds the following factors worth investigating for their likely correlation with stock performance:

1. Significant stock ownership among directors, management and employees.

2. Significant opportunities for employees to participate in meaningful decision-making.

3. Institutional block owning by "relationship" investors.

4. A predominance of "independent" directors on the board.

Another factor to be considered is the type of industries the fund would invest in. Certain "good" corporate governance practices may not be as important in industries where, for example, specialized equipment and long production runs are the norm. Employee involvement, for example, is of less concern if employees are not required to develop firm specific skills. However, these skills and investments become more critical in niche markets demanding flexible manufacturing or service. Efficient corporate governance systems minimize the cost of coordination. (see Blair and Gilson)

We also need to look at theoretical issues for which evidence may not be readily available. For example, there should probably a limit on the percent of employee ownership in the firms the fund invests in. If it is too high, those governing the firm are less likely to pass residual profits to outside investors. In addition, restructuring that requires reconceptualizing the corporation is less likely to be initiated internally. The pressure of outside investors provides what Gilson has termed "an important means of adoptive efficiency."

And, of course, another large task will be to locate available sources of information concerning what companies meet the various criteria examined.

1. Significant stock ownership among directors, management and employees.

The March/April 1996 edition of The Corporate Board: The Journal of Corporate Governance contains an interesting article "Paying in Stock: The Rank and File" by John McMillian and Robert Swalwen. McMillian and Swalen briefly dismiss market purchase plans as providing minimal value to employees. They go on to describe Section 423 stock and option purchase plans more favorably, noting the tax advantages and the allowance for a 15% discount (taken at the lower of either the beginning of year or end of year price. "If the stock doubles during the year, employees buy the stock at less than half the year end price. If the stock drops by half, employees still buy the stock at a 15 percent discount from the year end price."

However, most of the article focuses on stock option plans, which also come under the provisions of Section 423 stock and option purchase plans. The authors note that option plans have been widely used for senior executives but such plans are now being adopted by PepsiCo, Lyondell Petrochemical, DuPont, Merck, NationsBank and Toys R Us to grant stock options to all employees. Broad stock plans were used by half of the fastest-growing companies in the U.S., according to a cited Business Week article. McMillian and Sawlwen point out that under Section 423, shares can be optioned at a guaranteed discount and they "let the employer pay competitive compensation without spending cash, often critical for high-tech, startup, and companies with high capital costs. Since stock options do not usually vest for several years, this creates "golden handcuffs."

In summary, option plans cost the company nothing when they are granted, receive favorable accounting treatment, and allow the employee to acquire an immediate equity interest in the firm. When tied to a culture of participative management, firms with broad based stock option plans can be expected to demonstrate significantly more growth.

One of the best sources of information for data in this area is National Center for Employee Ownership. We would appreciate learning of other sources.

2. Significant opportunities for employees to participate in meaningful decision-making.

In Margaret Blair's recent book Wealth Creation and Wealth Sharing Jonathan Low, then with the Department of Labor, reported they had been approached by five different groups looking to set up screens or create funds to invest based on the principles of high-performance workplaces. I suspect that collecting data on such firms would be one of the fund's more difficult tasks. One problem is in defining "high-performance workplaces" or those which allow significant opportunities for employees to participate in meaningful decision-making. Another is in locating firms where such practices are firm-wide, not just isolated experiments.

Upadate 11/28/96. In the few months since I wrote this short piece I have come across a few interesting mutual funds. Please let us know of others.

Equus II trades as a closed-end business development company on the American Stock Exchange, under the symbol "EQS." It invests in a small number of privately-owned companies (current portfolio is 22) which intend to expand by acquisition. Criteria being used to determine whether to make an investment include "willingness of the company to permit the fund and its co-investors, if any, to take a substantial position in the company and have representation on its board of directors, so as to enable the Fund to influence the selection of management and basic policies of the company."

General Securities is a diversified open-end no-load fund which invests in companies which have commitment to Total Quality Management (TQM). For more information contact them at 800-927-6799.

Oakmark Select is a nondiversified no-load fund. For more information contact them at 800-927-6799 or harjs@aol.com. Bill Nygren manages the Select Fund. He can be reached at 312-621-0619. In general, they will use the same philosophy they use in The Oakmark Fund. We are told they "probably will not be inteventionist with corporate affairs; the biggest problem we see--in addition to time--is that it might take away a lot of our flexibility."

Parnasus takes a longer term approach than most. We sent them a personal letter asking for information on the corporate governance policies. However, their response merely indicated they still expect to have a low turnover rate and that their new policy "does not mean we can't pay attention to corporate governance issues." That's not exactly the kind of commitment we were seeking.

Lexington Corporate Leaders (800-526-0056) is another possibility, started in 1935 on the premise that they would buy an equal number of shares in 30 great companies and hold them forever. They would sell only if the company is managed out of existence, delisted or stops paying dividends. The fund has finished in the top quarter of its investment category for each of te past 3, 5 and 15 year periods, accordingto Morningstar. If you had put in $10,000 on 1/87 you would have had $50,000 by 7/31/97 compared to $42,000 in the average fund of its category.

with the Corporate Governance NETwork!

Contact: corpgov@usa.net

All material on the Corporate Governance site is copyright © 1995-1997 by Corporate Governance and James McRitchie except where otherwise indicated. All rights reserved.

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		e invite readers to participate in designing the "ideal" mutual fund from the standpoint of incorporating corporate governance principles which have been shown to have increased shareholder value. Instead of "build it and they will come," our mantra here might be "design it and they will build it." The theory here is that we can improve on the performance of index funds (which are based on "efficient market" theory) by focusing on the concept of prudent corporate governance. One possibility would be to copy pension funds and "relational" investors who have successfully incorporated corporate governance factors into their investment and ownership strategies. Two models might be the California Public Employees Retirement System (CalPERS) and the LENS Fund. Both use a wide variety of shareholder initiatives to encourage managers and/or directors to make changes which increase shareholder value. LENS appears to more actively pursue investments in companies that have unrealized value; CalPERS and the Council of Institutional Investors appear to focus on such underperforming companies already in their portfolios. The LENS Fund can threaten a hostile takeover, whereas this tactic is not as easily available to CalPERS. Although, as a public employees pension fund, CalPERS is exempt from ERISA (the Employee Retirement Income Security Act of 1974), their policy has generally been to follow the diversification and other requirements of ERISA. Pension fund managers who take seats on the board of portfolio firms are likely to be judged not on the business judgement rule but on the basis of a higher, more conservative standard, the prudent man rule. This more difficult standard, the fact that CalPERS is an indexed fund which would also own part of the competition, and political concerns, substantially limit CalPERS' ability to threaten a hostile takeover. However, this limitation appears to have had little negative impact on their ability to influence corporate governance as evidenced by their record (see Nesbitt). Just as a pension fund has certain legal and political limitations with regard to the corporate governance strategies it can pursue, so would our theoretical "corporate governance mutual fund." Diversified mutual funds are prohibited from owning more than 10% of the stock in any of their portfolio companies. For 50% of their investments, they are prohibited from having more than 5% of their funds in any one company. For the other 50% there is a 25% limit on the fund's total assets going into a single company and the two companies could not be in the same or related industries. To avoid liquidity problems the fund should be a closed-end fund. These factors, and others, limit the ability of mutual funds to pursue the sometimes hostile strategies of the LENS Fund. However, even with these limitations, a fund the size of Calvert's Social Investment Fund could invest up to $140 million to acquire up to 10% of the stock in a single company. In addition, the fund could build alliances with others to increase its effectiveness. Therefore, active "relationship" investing, of the type carried out by the LENS Fund, Japonica Partners, Relational Investors, and other such funds could represent a sizeable portion of our mutual fund's overall strategy. The other major strategy available to our model of a diversified corporate governance mutual fund would be to make long-term investments in companies passing certain "corporate governance screens" for adaptive efficiency. The screens developed could be applied in much the same way as "socially responsible investment funds" use them. However, instead of being based on ethical arguments about human/animal rights, the environment, etc., the screens applied would be in the area of corporate governance. That is, the fund would invest more heavily in companies which have adopted corporate governance policies and practices which have been shown to be correlated with adding shareholder value. One task to be addressed here by discussion participants would be to list the corporate governance strategies which have been found, through scientific study, to be correlated with increased shareholder value. We could start our search for such policies and practices with the fine compilation recently put together by the Council of Institutional Investors, "Does Ownership Add Value?: A Collection of 100 Empirical Studies." A quick glance at that booklet finds the following factors worth investigating for their likely correlation with stock performance: 1. Significant stock ownership among directors, management and employees. 2. Significant opportunities for employees to participate in meaningful decision-making. 3. Institutional block owning by "relationship" investors. 4. A predominance of "independent" directors on the board. Another factor to be considered is the type of industries the fund would invest in. Certain "good" corporate governance practices may not be as important in industries where, for example, specialized equipment and long production runs are the norm. Employee involvement, for example, is of less concern if employees are not required to develop firm specific skills. However, these skills and investments become more critical in niche markets demanding flexible manufacturing or service. Efficient corporate governance systems minimize the cost of coordination. (see Blair and Gilson) We also need to look at theoretical issues for which evidence may not be readily available. For example, there should probably a limit on the percent of employee ownership in the firms the fund invests in. If it is too high, those governing the firm are less likely to pass residual profits to outside investors. In addition, restructuring that requires reconceptualizing the corporation is less likely to be initiated internally. The pressure of outside investors provides what Gilson has termed "an important means of adoptive efficiency." And, of course, another large task will be to locate available sources of information concerning what companies meet the various criteria examined. 1. Significant stock ownership among directors, management and employees. The March/April 1996 edition of The Corporate Board: The Journal of Corporate Governance contains an interesting article "Paying in Stock: The Rank and File" by John McMillian and Robert Swalwen. McMillian and Swalen briefly dismiss market purchase plans as providing minimal value to employees. They go on to describe Section 423 stock and option purchase plans more favorably, noting the tax advantages and the allowance for a 15% discount (taken at the lower of either the beginning of year or end of year price. "If the stock doubles during the year, employees buy the stock at less than half the year end price. If the stock drops by half, employees still buy the stock at a 15 percent discount from the year end price." However, most of the article focuses on stock option plans, which also come under the provisions of Section 423 stock and option purchase plans. The authors note that option plans have been widely used for senior executives but such plans are now being adopted by PepsiCo, Lyondell Petrochemical, DuPont, Merck, NationsBank and Toys R Us to grant stock options to all employees. Broad stock plans were used by half of the fastest-growing companies in the U.S., according to a cited Business Week article. McMillian and Sawlwen point out that under Section 423, shares can be optioned at a guaranteed discount and they "let the employer pay competitive compensation without spending cash, often critical for high-tech, startup, and companies with high capital costs. Since stock options do not usually vest for several years, this creates "golden handcuffs." In summary, option plans cost the company nothing when they are granted, receive favorable accounting treatment, and allow the employee to acquire an immediate equity interest in the firm. When tied to a culture of participative management, firms with broad based stock option plans can be expected to demonstrate significantly more growth. One of the best sources of information for data in this area is National Center for Employee Ownership. We would appreciate learning of other sources. 2. Significant opportunities for employees to participate in meaningful decision-making. In Margaret Blair's recent book Wealth Creation and Wealth Sharing Jonathan Low, then with the Department of Labor, reported they had been approached by five different groups looking to set up screens or create funds to invest based on the principles of high-performance workplaces. I suspect that collecting data on such firms would be one of the fund's more difficult tasks. One problem is in defining "high-performance workplaces" or those which allow significant opportunities for employees to participate in meaningful decision-making. Another is in locating firms where such practices are firm-wide, not just isolated experiments. Upadate 11/28/96. In the few months since I wrote this short piece I have come across a few interesting mutual funds. Please let us know of others. Equus II trades as a closed-end business development company on the American Stock Exchange, under the symbol "EQS." It invests in a small number of privately-owned companies (current portfolio is 22) which intend to expand by acquisition. Criteria being used to determine whether to make an investment include "willingness of the company to permit the fund and its co-investors, if any, to take a substantial position in the company and have representation on its board of directors, so as to enable the Fund to influence the selection of management and basic policies of the company." General Securities is a diversified open-end no-load fund which invests in companies which have commitment to Total Quality Management (TQM). For more information contact them at 800-927-6799. Oakmark Select is a nondiversified no-load fund. For more information contact them at 800-927-6799 or harjs@aol.com. Bill Nygren manages the Select Fund. He can be reached at 312-621-0619. In general, they will use the same philosophy they use in The Oakmark Fund. We are told they "probably will not be inteventionist with corporate affairs; the biggest problem we see--in addition to time--is that it might take away a lot of our flexibility." Parnasus takes a longer term approach than most. We sent them a personal letter asking for information on the corporate governance policies. However, their response merely indicated they still expect to have a low turnover rate and that their new policy "does not mean we can't pay attention to corporate governance issues." That's not exactly the kind of commitment we were seeking. Lexington Corporate Leaders (800-526-0056) is another possibility, started in 1935 on the premise that they would buy an equal number of shares in 30 great companies and hold them forever. They would sell only if the company is managed out of existence, delisted or stops paying dividends. The fund has finished in the top quarter of its investment category for each of te past 3, 5 and 15 year periods, accordingto Morningstar. If you had put in $10,000 on 1/87 you would have had $50,000 by 7/31/97 compared to $42,000 in the average fund of its category. with the Corporate Governance NETwork! Contact: corpgov@usa.net All material on the Corporate Governance site is copyright © 1995-1997 by Corporate Governance and James McRitchie except where otherwise indicated. All rights reserved. Back to the top