Small US investor an anachronism

by Anna Bernasek

While the Dow and the S&P indices were stealing all the headlines over the last decade, a quiet revolution was occurring in the market that’s gained little attention.

Call it the institutionalisation of the stockmarket. In the past decade the number of retail investors in the stockmarket has dropped steeply.

Company filings show the individual investor has been gradually replaced by ever larger index funds, pensions and quant funds. That has caused a fundamental shift in the balance of power in the stockmarket. And it’s something public companies are only beginning to grapple with.

For years, public companies thought they knew who their shareholders were.

Not any more. High-speed, computer-driven trading by quant funds in particular makes it harder than ever for companies to know who owns them. Often it’s merely a computer program, not a person, picking a stock to buy.

Moreover, the extensive use of derivatives blurs the boundaries of ownership. The owner listed in a share registry may have traded away any economic interest in a particular stock.

Retail investors used to be a pillar of the market, demanding and receiving attention from companies and their advisers. In recent years, though, retail investors have been disappearing from the stockmarket.

Partly that’s because there’s been a shift to mutual funds and index funds and away from individual stock ownership.

In the 1980s one-quarter of US households owned a mutual fund. By the end of the 1990s almost half of all households invested in mutual funds, according to the Investment Company Institute.

The reverse is true about direct stock ownership. In 1999, 25.5 per cent of households owned individual stocks directly. By 2011 that dropped to 20 per cent, according to ICI.

At the same time as more investors have shifted into mutual funds, there’s been a decline in the overall number of Americans who actually hold any stock at all.

Today about 46 per cent of US households have any exposure to stocks, either directly or indirectly, while in 2001 almost 60 per cent of households held stocks.

While individuals have been disappearing, institutions have emerged as the dominant owners of the stockmarket.

Institutions include active investment managers, index funds, quant funds, public pension funds, hedge funds and exchange-traded funds. According to one analysis by Goldman Sachs, in 1998 institutional investors owned 57.1 per cent of the stockmarket. By 2009 that had grown to almost three-quarters.

The composition of institutional investors has also been changing. More institutional shareholders are typically passive investors such as index or quant funds, rather than active fund managers.

There are a number of interesting implications. For starters, households these days have considerably less power to influence public companies than they did in the past.

Holding stock through a mutual fund means there’s an intermediary between the investor and the company. Will the index fund manager have the same concerns about executive compensation, for instance, or any other corporate governance issue as the investor?

As long as the stock meets the index manager’s performance requirement, mightn’t he or she be satisfied with that? But then who’s looking out to make company management better?

Then there are issues for public companies. How do companies talk to and communicate with shareholders when some of them might actually not even be human?

What’s more, the rise of derivatives and other complex securities means companies might not even know who their shareholders are. Two years ago the management of US retailer JC Penny was shocked to learn that two activist investors, Pershing Square Capital Management and Vornado Realty Trust, suddenly owned almost 27 per cent of the company after exercising derivatives positions.

The shift in the balance of power in the market puts more influence in the hands of traditionally passive shareholders.

The big question is what they will do with that increased power. Could Vanguard, for instance, the pioneer of index funds, become a more active shareholder?

The CEO of Vanguard hinted earlier this year about a growing focus on corporate governance.

“We continue to be generally optimistic in our assessment of governance practices broadly," F. William McNabb said.

“Nonetheless, the tension among the roles of regulators, shareholders, company directors and executives in corporate governance matters remains a subject of much debate and we believe there is still substantial room for improvement on a number of fronts."

How all this plays out remains to be seen as institutions adjust to their new, more powerful positions and companies adjust to their new shareholders.

One thing is clear, though. The US stockmarket is now a game of big players. The era of the little investor is long gone.

The Australian Financial Review