In practice the ultimate owners of shares often do not exercise the power they collectively hold (e.g. because the owners are many and diverse each with small holdings), and the financial institutions (as agents) may or may not choose to do so. There is a general belief that shareholders, by which is often meant the institutions acting as agents, could and should exercise more active influence over the companies they hold shares in (e.g. to hold managements to account and to ensure that Boards function effectively). This would mean that there would be another effective pressure group (additional to the regulators and the Board) overseeing management.
Some institutions have been more vocal and more active in pursuing such matters than others. Some institutions have believed that there were investment advantages to building up substantial minority shareholdings (e.g. 10% or more) and then bringing pressure on managements to change the way firms were run. Another widespread tactic is for institutions to effectively collude to force management change. Perhaps more widespread is the sustained pressure that large institutions can bring to bear by talk and persuasion as they liaise with managements over time.
The national context in which shareholder representation considerations are set is variable and important. The USA is a litigious society and shareholders use the law as a lever to pressure managements. In Japan it is traditional for shareholders to be low in the 'pecking order' and for managements and work forces to some extent to operate as mini-clubs able to ignore the rights of the ultimate owners. In Japan we may say that there is more of a stakeholder mentality where it is felt appropriate to seek consensus amongst all interested parties against the background of strong unions and labour legislation.
The skill of the successful fund manager consists in constructing the asset allocation, and separately the individual holdings, so as to outperform the peer group of competing fund management organisations, and the bond and stock indices (appropriate to the client's objectives and preferred style).
In a typical case (let us say an equity fund), then the calculation would be made (as far as the client is concerned) every quarter and would show a percentage change compared with the prior quarter (e.g. +4.6% total return in US dollars). This figure would be compared with other similar funds managed within the institution (for purposes of monitoring internal controls), with performance data for peer group funds, and with relevant indices (where available) or tailor-made performance benchmarks where appropriate. The specialist performance measurement firms calculate quartile and decile data and close attention would be paid to the (percentile) ranking of any fund.
Generally speaking it is probably appropriate that an institution should persuade it's clients that performance be assessed over a longer period e.g 3 or 5 years to smooth out very short term fluctuations in performance and the influence of the business cycle. This can be dificult however and, industrywide, there is a serious pre-occupation with short-term numbers and the effect on the relationship with clients (and resultant business risks for the institutions).The Businesses
The activity of institutional fund management has several facets e.g. employment of professional fund managers, research (e.g. of individual assets and asset classes), dealing, settlement, marketing, internal audit, the preparation of reports for clients. The largest financial fund managers, or institutions, are complex financial firms with all the complexity that their size demands. Apart from the people who bring in the money (marketing) and the people who invest it (the fund managers), there are compliance staff (to ensure that no laws or financial market regulations are broken), internal auditors of various kinds (to examine internal systems and controls), financial controllers (to control the institutions own money and costs),computer experts, and the "back office" (the people who track and record transactions and fund valuations for sometimes literally hundreds or thousands of clients per institution).Key Problems of Running such Businesses
Key problems include:
The most successful investment firms in the world have probably been those that have been separated physically and psychologically from banks and insurance companies. That is, the best performance and also the most dynamic business strategies (in this field) have generally come from independent investment management firms.Representing the Owners of Shares
Institutions control huge shareholdings. In most cases they are acting as agents (intermediaries between owners of the shares and the companies owned) rather than principals (direct owners). The owners of shares theoretically have great power to alter the companies they own...via the voting rights the shares carry and the consequent ability to pressure managements, and if necessary outvote them at annual and other meetings. Philosophy, Process and People
If a client is to have confidence in an investment manager, then there have to be reasons why the manager is going to produce above average results. These reasons tend be found in the 3-P's of philosophy, process and people.
Fund Managers and Portfolio Structures
At the heart of institutional fund management however are the fund managers whose job it is to invest and divest client monies. Typically, if we take the example of a segregated account run for a single client (as opposed to a pooled account run for several or many clients), then the fund structure has to be determined and implemented. Briefly, for any given type of client there should be an agreed concept of the type of structure that the client thinks will make sense (given the institutions advice) and e.g the fund might be invested in several asset classes including bonds and equities. A great deal of thought then needs to go into the asset allocation and changes to the allocation over time, not least because a great deal of research and experience shows that the asset allocation is the prime determinant of long term returns. Long term returns and asset allocation
A good deal of importance tends to attach to the evidence about long term returns to different assets, and to holding period returns (that is the returns that accrue on average over holding periods of different length). For example, over very long holding periods (say over 10 years) in most countries and in most time periods equities have generated higher returns than bonds, and bonds have generated higher returns than cash. According to financial theory, this is because equities are higher risk (more volatile) than bonds which are themselves more risky than cash. Diversification
Against the background of the asset allocation, fund managers consider the degree of diversification that makes sense for a given client (given its risk preferences)and construct a list of planned holdings accordingly. The list will indicate what percentage of the fund should be invested in each particular stock or bond. The theory of portfolio diversification was originated e.g. by Markowitz (see below) and effective diversification requires consideration inter alia of the correlation between the asset returns and the liability returns (relevant e.g. if the assets are held against some long-term final salary pension obligation), as well as issues internal to the portfolio such as the volatility of the returns of individual holdings and cross-correlations between the returns. Investment Styles
There are a range of different styles of fund management that the institution can implement. For example, growth, value, market neutral, small capitalisation, indexed, etc. Each of these approaches has its distinctive features, adherents and, in any particular financial environment, distinctive risk characteristics. For example, there is evidence that growth styles (buying rapidly growing earnings) are especially effective when the companies able to generate such growth are scarce; conversely, when such growth is plentiful, then there is evidence that value styles tend to outperform the indices particularly successfully.Performance Measurement
Fund performance is the acid test of fund management, and in the institutional context accurate measurement a sine qua non. For that purpose, institutions measure the performance of each fund (and usually for internal purposes components of each fund) under their management, and performance is also measured by external firms that specialise in performance measurement. The leading performance measurement firms (e.g. Frank Russell in the USA) compile aggregate industry data e.g showing how funds in general performed against given indices and peer groups over various time periods.