Thursday, October 13, 2011

The Powers and Responsibilities of Ownership

The public release of the GMI Risk List on October 12, 2011 raises the most critical question of fiduciary responsibility.  There has been extensive discussion of the propriety of trustees’ investing in index funds due to the probability that some of the holdings in the index would not be considered appropriate fiduciary investments if they were acquired as separate investments.

This issue was extensively debated in the years following the enactment of the Employees: Retirement Income Security Act of 1974 (“ERISA”). The statute basically adopts the “prudent person” standard for fiduciary investment, but it specifically mandates that trustees should invest in as widely diversified a mode as possible.  This accorded with the then prevailing economic theory of “efficient markets” and inclined trustees toward investing in indices. The history of indexing suggests special problems in monitoring.

The U.S. Department of Labor (DOL), entrusted with oversight of the Employee Retirement Income and Security Act of 1974 (ERISA) has warned private pension fiduciaries that they may be held accountable for screening the performance of indexed holdings. An early DOL guideline, never rescinded, assumed that pension funds are screening their indexed holdings as an aspect of prudence. 

When it came time a dozen years later (1986) to proscribe an investment standard for the Federal Employees’ Retirement System (“FERSA”) the statute expressly limited the trustees’ discretion in creating an equity investment alternative to recognized index funds. As was predicted at the time of its formation, FERSA through its Thrift Investment Board, trustee, has become one of the largest holders of equity securities in the country.

Legislators were concerned that government not be associated with the purchase and sale of individual securities, so the statute limits the trustees’ authority to choosing an equity index. There is, therefore, no discretionary determination by the trustee that a particular company is promising and, therefore, its securities should be acquired for the trust.

Involvement by owners with companies is purely mechanistic; the fiduciary institution would not normally have personnel familiar with particular companies, it would be prohibitively expensive to follow all of the companies in an index, and because investment is made pursuant to formula, such skills are superfluous.

We have thus arrived at a point where beneficial ownership is so fractionated and intermediated that there is no clearly logical person or institution appropriate to undertake the responsibilities and exercise the powers of ownership. Indexed funds provide no discretion for asset managers with regard to trading. Index fund managers do not have the option of selling the stock if they do not agree with management's proposals; they have to wait until it sinks far enough to fall off of the index. They need not, indeed, should not wait for that to happen.

GMI has generated a disciplined, experienced-based, methodology for evaluating unacceptable risks in the governance and forensic accounting posture of individual companies. The problem for trustees for existing index funds is very severe; the problem for those creating new funds is even more threatening. The question cannot be ignored that a trustee in holding or acquiring one of the GMI Risk List securities (and others receiving the lowest rating of “F”) will have been put on notice by a responsible respected service that the company is more likely than its alternatives to decline in value.
Originally published on the GMI blog
October 13, 2011  |  0 comments  | 

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