Two emerging trends are likely to have a dramatic influence on investor and market behavior. One is the unbridled advance in technology. The other is the will of a majority of commissioners at the Securities and Exchange Commission and of lawmakers in Congress to give more power to investors.
At first glance, these trends would suggest positive and welcomed developments resulting in an improved investing environment for securities markets and investor involvement in corporate governance. To test this thesis, let’s analyze what is really going on.
Take the advances in technology that are removing the human element from trading. The major decline of specialist firm members at the New York Stock Exchange was partly a result of advances in the speed of electronic trading. Yet it ended up limiting the ability of specialists to provide capital and maintain a more liquid market.
Split-second programmed trading is a major suspect in the May 6th “flash crash.” While the theory that a “fat finger” (that is, human error) caused a major erroneous trade has largely been debunked, the real reasons behind the 20-minute crash that ultimately drove millions of individual investors out of the market (believing it was no longer a safe place to be) are still largely speculation. And when regulators couldn’t explain why the event happened, many investors were left with the decision of where to move their money. The SEC’s subsequent implementation of more refined circuit breakers did little to quell individual investors’ decisions to move their money out of the equities markets.
The Investment Company Institute, the mutual fund trade group, recently announced that “small” investors withdrew an astounding $33.12 billion from U.S. mutual funds in the first seven months of 2010. The ICI estimates that if this pace continues for the remainder of the year, more money will be pulled out of mutual funds than any year since the 1980s, except for 2008 when the global financial crisis caused many investors to take their money and head for the sidelines. Meanwhile, retail investors pulled billions out of their investments in equities.
As more and more Americans became responsible for their own retirement savings, about half of the country’s households were invested in mutual funds. And investors saw that corporate profits were rising, despite a sagging economy, reinforcing the belief that the equities market was the place to be should the economy rebound. Now that faith has been shaken, and they are looking for safety and stability in bond funds.
Another technology-related factor influencing individual investor behavior is the mysterious role of quantitative or “quant” funds—a form of investment most investors don’t understand but sense is causing a significant increase in market volatility. The funds use superfast computer-driven algorithmic programs designed to outwit more traditional Wall Street investors.
Young wizards with PhDs in math have created these funds using sophisticated statistical analysis that sense historical changes in market price behavior and make their profits on anticipating market changes. This kind of trading leaves many investors feeling powerless to compete against some of the best and brightest minds creating trading models that bet against the market and use super-fast computers for trading with no human intervention. Perhaps the good news for those who blame quantitative funds for contributing to market volatility is that the combined assets of these funds have dropped 61 percent from $1.2 trillion in 2007 to $467 billion today. According to Lipper Tass, quant hedge funds have lost about $50 billion in assets; one in four funds have gone out of business.
Quant funds are just beginning to come under the scrutiny of securities regulators both here and abroad. The International Organization of Securities Commissions (IOSCO) issued a warning Aug. 13 that computer-driven trading could overwhelm traditional trading platforms. The SEC and the Commodity Futures Trading Commission are members of IOSCO, and the two regulators recently held a hearing into the causes of the May flash crash. But as of now, computer-driven trading is largely unregulated.
Trend 2: Empowering Investors
Turning now to the SEC’s efforts to give more power to investors to participate in corporate governance, on Aug. 26, the commissioners in a 3-2 partisan vote adopted changes to federal proxy rules to “facilitate the rights of shareholders to nominate directors to a company’s board.” This capped a seven-year effort by shareholder activists to gain access to the proxy to nominate board candidates for shareholder vote.
The SEC must turn its attention to addressing the underlying issues that are causing investor flight from the equities markets.
Publicly held corporations and their Washington-based lobbying organizations strongly opposed proxy access, and those groups were successful until the Dodd-Frank Act gave the SEC the legal backing to proceed with a proposed rule. There is a 60-day comment period before the rule is finalized, but companies should be prepared for this proposed rule to become a reality for the 2011 proxy season.
In my September column “Governance and IR to Combine in 2011?” I recommended some steps companies should consider in an environment of competitive director elections. As SEC Chairman Mary Schapiro said in announcing the proposed rule change, just because a director is nominated doesn’t mean that person will be elected, so companies need to consider “campaigning” their current board members and nominees for shareholder approval—perhaps an out-of-the box concept, but a necessary one. The activist investors will surely do so for their nominees.
The threshold for nominating a director will limit participation by most investors and funds. The proposed rule does, however, allow funds that hold their shares a minimum of three years and hold them through the annual meeting so they can aggregate their holdings to reach the 3 percent total holdings of the company’s voting power to nominate a director. The ability for funds to aggregate their holdings is something companies should monitor closely through their proxy advisers and solicitors.
In another effort to use technology to facilitate proxy voting, the SEC gave companies the opportunity to provide online proxy materials using “notice and access” to determine which investors were willing to accept materials on-line. This initiative backfired resulting in a significant decline in individual investor proxy voting to a new low of 5 percent for the 2010 proxy season.
Still, based on provisions in the Dodd-Frank Act, all investors will have an opportunity to cast a non-binding vote on a company’s executive compensation plan, giving individual investors some added clout in the governance process. Perhaps this might give them an added incentive to vote their proxies for or against the executive compensation plans. As of June 5, the 647 companies that voluntarily gave their shareholders a say-on-pay vote, only three experienced a majority vote against their plans. The volunteer companies may or may not be representative of the universe of public companies that will be required to offer say-on-pay in 2011, but either way, it does suggest that all companies should make a sincere effort to explain their plans in a way investors can understand so they know what they are voting on. Otherwise a failure to do so could result in votes against the plan.
Certain provisions of the Dodd-Frank Act and the SEC’s more recent efforts to bring about greater shareholder involvement in the governance process may sound like positive developments for investors. However, if they believe the playing field is stacked against them and they can no longer stomach the hour-by-hour market volatility, the ability for companies to raise needed capital could further delay any hope of an economic recovery. Therefore, the SEC must turn its attention to addressing the underlying issues that are causing investor flight from the equities markets.
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