The California Public Employees’ Retirement System has taken substantial heat from critics who deride its institutional activism, accusing the pension fund of harboring a special interest agenda. In a blistering op-ed in 2004, for example, the president of the U.S. Chamber of Commerce railed against CalPERS as a self-appointed “arbiter of good corporate governance.”
But institutional activism apparently reaps economic benefits.
A University of California-Davis professor has found that CalPERS’ activism has created short-term wealth of $3.1 billion over 14 years – and that is his conservative estimate. Long-term benefits could be as high as $89.5 billion.
Brad M. Barber, a finance professor and director of the university’s Center for Investor Welfare and Corporate Responsibility, analyzed stock performance of companies named on CalPERS’ Focus List between 1992 and 2005.
The Focus List, which targets companies for reform based on poor financial and corporate governance performance, included 115 companies over this period. This year’s list names Brocade Communications, Cardinal Health, Clear Channel Communications, Mellon Financial, OfficeMax and Sovereign Bancorp.
Although CalPERS embarked on its path of shareholder activism in 1987, it did not announce its first list of targeted companies until 1992. Barber’s study, released this spring, begins with that 1992 Focus List.
While many institutions now consider themselves activist funds, CalPERS arguably has the highest profile and is widely recognized for what has been described as the “CalPERS effect.” Barber set out to review the theory and the empirical evidence underlying the motivation for institutional activism.
According to Barber, the benefits of institutional activism depend on two critical agency costs. The first cost arises from conflicts of interest between shareholders and corporate managers. These managers might pursue projects that benefit themselves – not shareholders. Institutions that properly monitor corporate managers can reduce costs and benefit their own investors and investors overall, he said.
The second cost derives from the conflicts of interest between the fund’s own board and investors. In this scenario, fund directors may pursue investment policies that will benefit their own objectives – not those of their members.
“At the end of the day, one needs to make sure that the activism pursued is in the best interests of the beneficiaries,” Barber told the Monitor. “When it’s squarely focused on corporate governance-related issues, there’s strong research to suggest that it’s a useful thing to do. But when it extends beyond governance, funds need to look at the economics to see if this makes sense.”
To analyze the effectiveness of institutional activism, Barber used two methods: short-run analyses based on immediate market reaction to the Focus List; and long-run analyses of targeted company stock returns.
In the short run, he found that Cal-PERS’ activism resulted in small but “reliably positive” market reactions on the day that the pension fund announced its Focus List. But “small” is a relative term, translating into total wealth creation of $224 million annually – or $3.1 billion over the 14-year period studied.
Barber said the long-run analysis was less conclusive, but nonetheless intriguing. Market vagaries and volatility make it difficult to determine whether a stock’s success can be directly linked to CalPERS’ involvement. So Barber adjusted for a variety of characteristics of each targeted firm – such as large or small cap, value or growth firm. If the stock market returns “are causally linked to the activism of CalPERS, the wealth creation is enormous – as much as 20 times greater than the short-run benefits and as large as $89.5 billion through December 2005,” he writes.
“I think the early results of activism are encouraging,” Barber said in a telephone interview. He noted, however, that further analysis is needed to state conclusively that institutional activism has a long-term, positive effect.
Widespread institutional monitoring can also deter corporate malfeasance, Barber said. Companies may be less likely to engage in practices that reduce shareholder value if they know that institutions “stand ready to publicly excoriate” them, he writes in the study titled “Monitoring the Monitor: Evaluating CalPERS’ Shareholder Activism.”
“The deterrence benefits of activism are exceedingly difficult to measure, but nonetheless provides additional justification for institutional activism,” the study says.
Yet pension funds need to be mindful of their reasons for institutional involvement, particularly when it comes to sensitive moral or political issues, Barber cautioned. Portfolio managers must follow the interests of their investors, rather than their own.
He cites as an example CalPERS’ 2000 vote to divest all of its tobacco firm holdings. This decision, Barber says, was motivated by moral and not investing considerations. “There is no evidence – theoretical or empirical – that tobacco firms should or do earn sub par rates of return,” he writes, noting that past performance is not a reliable indicator of future performance.
Barber argues that institutional activism should be limited to situations where there is strong theoretical and empirical evidence suggesting that proposed reforms will boost shareholder value.
“Institutional activism is a double-edged sword. When prudently applied, activism can provide effective monitoring of publicly traded corporations. When abused, portfolio managers can pursue their personal agendas at the expense of those whose money they manage,” he writes. “Moral issues are challenging and nettlesome. But do not throw the baby out with the bath water. Institutional activism can provide important and effective monitoring of publicly traded firms.”