The death last week of the founder of Vanguard, Mr John Bogle, offers a timely reminder of the upheaval in the asset management industry brought about by the advent of index investing around four decades ago. Index investing had its antecedents in the development of modern portfolio theory. The capital asset pricing model said that subject to various assumptions, investors should hold the same portfolio of risky assets, namely the market portfolio. Differences in investors’ risk aversion would be reflected in a movement along the capital allocation line facilitated by the introduction of a risk free asset.
Investors wanting to take on more risk would borrow at the risk free rate, such that the tangency solution between their indifference curve and the capital allocation line was associated with more portfolio risk. In other words, they would leverage up to lift their exposure to the market portfolio. Investors with a low appetite for risk would reduce their exposure to market risk by lending at the risk free rate.
By recommending that investors hold the market portfolio, modern portfolio theory espoused the benefits of financial diversification. A key implication was that corporations should not engage in diversification themselves; why should companies diversify when investors could do it themselves?
The real world of investing in the 1960s wasn’t yet ready for the implications of modern portfolio theory because the costs of DIY diversification were prohibitive. Trading costs were high and there were few products available offering DIY diversification. Even with the introduction of index funds in the mid-1970s, it was still expensive for investors to achieve reasonable diversification themselves. Thus there was a defensible case for corporate diversification. As it happens, there was a conglomeration of the corporate landscape in the United States of America during this time.
Two developments would eventually tilt the playing field against corporate diversification. First, growth prospects for many conglomerates failed to meet expectations, with the failure stemming from a lack of management focus and the inability of internal capital markets to allocate resources efficiently across often disparate and unrelated business units.
Second, the growing institutionalisation of the stock market made it easier and cheaper for investors to achieve diversification themselves, thanks to the development of low cost index and exchange traded funds that track country and sector benchmarks. The success of index investing marks Mr Bogle as one of the great disruptors of the asset management industry.
The dark side of diversification
The rapid growth of securitised investment vehicles during the credit boom and the subsequent financial crisis offered a glimpse into the dark side of diversification. Well diversified bond investors expended fewer resources on credit risk analysis than not so well diversified banks.
In The Modern Corporation and Private Property (1932), Adolf Berle and Gardiner Means offered some insights into the dark side of diversification. They suggested that diffuse share ownership would reduce monitoring incentives necessary to address the conflict of interest which arises from the separation of ownership and management of corporate assets.
In a similar tradition to Berle and Means, Professor Lucian Bebchuk, Alma Cohen and Scott Hirst from Harvard University suggests that the institutionalisation of stock markets exacerbates the conflict of interest (The agency problems of institutional investors, Journal of Economic Perspectives 2017). In a world of diffuse and dispersed share ownership, institutional investors are reluctant to engage in monitoring in the knowledge that their competitors also benefit from their own time consuming and expensive monitoring activities. Index funds in particular, face weak incentives to engage in stewardship activities that improve governance and value because they bear the full cost of such activities but not the full benefits.
Against this backdrop, we believe that founder companies offer a resolution to these agency problems because most founders are poorly diversified financially and/or emotionally. Their skill set and vision are unique to the company they have founded and are therefore unlikely to be active in the market for managerial talent. This gives them the freedom to focus on maximising shareholder value over the long-term particularly if they have a material ownership stake or derive non-pecuniary benefits such as reputation and legacy.
Of course there is scope for powerful company founders to exploit minority shareholders. But our investment strategies have risk controls designed to invest in founders who have a track record of delivering strong value to shareholders over the long-term.