Initial research indicates that better-governed companies do better.
Fiduciary Analytics of Sewickley, Pa., and
Morningstar of Chicago recently began rating mutual funds based on
fiduciary issues. Later this year, Standard and Poor's is expected to
enter the fray.
However, there are few empirical studies on
fiduciary quality and performance at the corporate and pension-fund
levels. The jury still is out with mutual funds. "There hasn't been
much empirical evidence because it is difficult to compare qualitative
data on fiduciary performance and quantitative performance data," says
Hany A. Shawky, finance professor and director of University of
Albany's Center for Institutional Investment Management. "But casual
observations show that corporate boards (and pension and mutual funds)
that have strong governance usually perform better."
Although it is difficult to quantify fiduciary
ability, recent studies show a strong relationship between fiduciary
responsibility and performance. Negative corporate governance policies
result in lower stock valuations and stock returns, according to one
working-paper study by Harvard Law School professors Lucian Bebchuk and
Allen Ferrell and Alma Cohen of the National Bureau of Economic
Research.
The study examined 24 governance provisions of the
Investor Responsibility Research Center (IRRC), New York, and their
correlation to a company's stock value and shareholder returns. The
IRRC monitors the 24 provisions, which appear beneficial to management,
for institutional investors and corporate governance researchers.
In the study, "What Matters in Corporate
Governance," published last November by the John M. Olin Center for Law
Economics and Business, the researchers designed an entrenchment index
of six IRRC provisions that benefit management but not shareholders.
Four are constitutional provisions that limit shareholder powers and
two are takeover provisions that benefit management.
The constitutional provisions are staggered boards
of directors, limits to shareholder bylaw amendments, supermajority
requirements for mergers and supermajority requirements for charter
amendments. The takeover readiness provisions, poison pills and
golden parachutes are put in place by boards to prepare for hostile
takeover bids.
The researchers analyzed IRRC reports on governance
arrangements of companies that represented more than 90% of the total
U.S. stock market capitalization from September 1990 to February 2002.
They rated the companies based on entrenchment index scores, the lowest
being zero and the highest five.
A measure of performance, "Tobin's Q," was used to
analyze a company's stock valuation. Tobin's Q is equal to the market
value of assets divided by the book value of assets. The market value
of assets is computed as the book value of assets plus the market value
of common stock, less the sum of the book value of common stock and
balance sheet deferred taxes.
The researchers used some complex calculations to
analyze stock returns, based on Fama-French benchmarks. They looked at
actual stock returns less the predicted normal returns.
The study revealed that the majority-18 of the 24
IRRC provisions-did not negatively impact stock valuations or
performance. They were not negatively correlated with either a
company's stock value or stock returns from 1990 to 2003.
However, six provisions of the entrenchment index
had a -0.044 correlation to a firm's valuation, as measured by Tobin Q,
indicating a negative impact on stock valuations and performance. The
researchers found that if investors had gone long on stocks with low
entrenchment indexes and simultaneously shorted stocks with high
entrenchment indexes, they could have earned a return as high as 1% per
month on the transactions.
On the pension fund side, a study by three
consulting advisory firms indicated that improving a pension fund's
organizational structure enhanced fund performance.
That study, by Keith Ambachtsheer, Ronald Capelle
and Tom Scheibelhut, quantified pension funds' fiduciary and related
guidelines to performance. The report, published in the
November/December 1998 issue of the Financial Analysts Journal,
analyzed the returns on 50 pension funds from 1993 through 1996.
In the study, Improving Pension Fund Performance,
the researchers asked pension funds to complete a questionnaire. A
metric scale from 0 to 100 was created, based on the degree of clarity
in the organization's structure.
The pension funds underperformed their passive
policy benchmark by 60 basis points annually. However by improving a
pension fund's organizational structure, which includes the
decision-making process, resources and clarity of goals, fund
performance improved.
More precise and clear fiduciary guidelines had a
statistically significant effect on returns, based on the risk-adjusted
net value added return (RANVA). RANVA is a standardized pension fund
calculation that adjusts the gross asset return for operating costs and
risks.
The study's results, using a sample size of just
six, show that the coefficient of determination (R squared), which
tells how much one variable contributes to the other variables'
behavior, was 0.60. The R squared translates into a 77% correlation
between performance and the pension funds' organizational
accountability structure.
The study shows that good organizational framework
contributes to performance, says John Ilkiw, director of research and
strategy with the Russell Investment Group in Tacoma, Wash. The reason:
Clearly defined roles, procedures and accountability within the
investment organization are carried out effectively.
However, Ilkiw suspects that the correlation between
performance and fiduciary quality may be lower today. The reasons: The
correlation was performed on a small sample size and the investment
environment is different today compared with the mid-1990s.
"You can't hang your hat on one statistic because
there are other random factors going on," he said. "But the
Ambachtsheer study shows that the clarity of the fiduciary process is
important. Fiduciaries have to have clear investment and risk
guidelines and avoid unwanted consequences."
On the mutual fund side, it is too early to tell if
funds with high fiduciary ratings will be top performers. "Companies
with good governance perform well, so you are almost certain to find a
strong correlation between fiduciary responsibility and mutual fund
performance," says the Center for Institutional Investment Management's
Shawky. "But it could take several years of data before you can say
with a great deal of conviction that funds with high fiduciary ratings
will outperform funds with lower ratings."
He says the big problem with the new mutual fund
rating services: It is hard to quantify fiduciary behavior. And when a
third party evaluates fiduciary activity, an extra layer of judgment is
added to the process.
Shawky believes independent boards of directors are
an important variable in mutual fund stewardship. Analysts need to do
an intensive evaluation of the members of a mutual fund's independent
board of directors before they rate the funds. They need to investigate
the board members' financial education and work experience. They need
to find out how many other boards they work on and their past
relationships with an investment company.
In addition, the mutual fund analyst also should
look into the investment company's trading activities. This activity
has been overlooked in the fiduciary grading process.
"Some of the data is very soft," he says. "Over time, better measures will be developed."
Nevertheless, mutual funds that operate in the best
interest of their shareholders should fare well. A preliminary study in
the January 2005 Financial Advisor found that mutual fund families with
high fiduciary ratings by Fiduciary Analytics also register higher
Morningstar fund family stock fund scores. The Morningstar "Fund Family
Score" is an asset-weighted average of a fund company's Morningstar
performance ratings, also known as "star ratings," within an asset
class.
Morningstar has assigned fiduciary grades, called
"stewardship grades," to 985 funds. More than 2,000 funds will be rated
when the project is complete. Morningstar assigns funds a
stewardship grade from A, the highest, to F, the lowest. The grades are
based on the evaluation using a number of criteria regarding regulatory
issues, board quality, manager incentives, fees and corporate culture.
For more information go to www.morningstar.com. Then click on "mutual
fund" and "stewardship."
A preliminary analysis shows that the relationship
between Morningstar's individual fund fiduciary grade and performance
seems to hold up. But it is too soon for a meaningful statistical
analysis to be performed. Several years of data are needed before the
degree of association between stewardship grades and performance is
valid.
That said, at the time of this writing, there were
51 large-company growth-stock funds that have stewardship ratings by
Morningstar. The relationship between their ratings and their one-year
performance ending December 2004 was favorable. Funds A rated had the
best stewardship scores. Funds rated F were the worst. The performance
results of the growth stock funds with stewardship grades show:
A-rated growth stock funds had a median return of 10.1%.
B-rated growth stock funds had a median return of 9.6%.
C-rated growth stock funds had a median return of 8.1%.
D-rated growth stock funds had a median return of 6.3%.
F-rated growth stock funds had a median return of 7.1%.
Although A- and B-rated funds exhibited the best
returns, funds with lower stewardship ratings also performed well. For
example, the Franklin Capital Appreciation fund, rated C by
Morningstar, grew 16.02% over the year, and the Columbia Growth Fund,
rated F by Morningstar, gained 8.03%. By contrast, the average
large-company growth stock fund gained 7.64% in 2004.
Alan Lavine is author of numerous books and a contributing editor to Financial Advisor.