Why we risk a cartoon version of capitalism

An oil platform off Norway. The country’s oil fund, created to hold profits from Norwegian fossil-fuel reserves, is stepping up its involvement with companies. (PHOTO: LARS LINDQVIST/ALAMY)
An oil platform off Norway. The country’s oil fund, created to hold profits from Norwegian fossil-fuel reserves, is stepping up its involvement with companies. (PHOTO: LARS LINDQVIST/ALAMY)

Summary

Private-sector investors are so ineffective at overseeing companies that state-run funds feel the need to step in..

It sometimes feels as if we are living in a cartoon version of market capitalism, where shareholders have given up trying to control companies.

Money floods into shares based on memes, is shifted around by algorithms based on past patterns, or goes into vast passive index trackers sold on the basis of being virtually free. None have an incentive to devote resources to keeping the corporate bureaucracy in check, since day traders and hedge funds will be gone before the next CEO meeting, while passive funds can’t sell even if the CEO is thrown in prison.

Reality isn’t as bad as the cartoon. There are still stock pickers out there who buy and hold, so really care who runs the business. But the situation is bad enough to make the biggest equity investor in the world worry that the passive approach that dominates its own strategy risks damaging markets. It’s getting more active as a result.

“Not everybody can just be passive," said Nicolai Tangen, who runs Norway’s $1.5 trillion oil fund, the Government Pension Fund Global. “You can’t basically free ride on a well-functioning market. Somebody needs to vote."

Norway’s oil fund, created to hold the profits from the country’s vast fossil-fuel reserves, is stepping up its involvement with companies and has asked the Norwegian parliament for permission to start buying companies outright.

The fund became the lead plaintiff, along with a large Swedish pension fund, in a class-action case against the defunct Silicon Valley Bank, its management and advisers, the first time it has led such a case. This brings Norway in alongside a handful of American state pension funds that frequently take the lead in class actions against companies—the ultimate way shareholders enforce control of big business in the litigious U.S.

It is one of the great ironies of 21st-century capitalism that because private-sector investors are so ineffective at corporate governance, state-run funds have stepped in instead.

A market dominated by passive management means little oversight of what executives spend shareholder cash on, and could lead to share prices disconnected from corporate profitability, as index trackers blindly buy no matter what.

True, hard-core activist hedge funds lead proxy fights against incompetent boards, and underperforming companies make themselves targets for private-equity takeovers.

But capitalism’s theoretical goal of harnessing the wisdom of crowds to ensure the best allocation of capital is at risk. That’s because there’s insufficient oversight of executives at companies that haven’t yet run into enough trouble to attract the attention of activists or buyout shops.

The system has ended up with a handful of overworked stewardship specialists at passive funds trying to vote on thousands of resolutions a year. Voting decisions even from active funds tend to be outsourced to just two dominant proxy advisers—perhaps wise, but hardly a crowd.

Passive funds, dominated by Vanguard, BlackRock and State Street, care a bit about governance, since they own pretty much everything (and attract public criticism if they fail to vote).

But they don’t have a strong incentive to put resources behind monitoring companies. They compete fiercely on price, so don’t want to spend much. And they run client money, not their own money, so even if better monitoring made a stock outperform, they would only reap a small benefit.

Large, long-term investors care a lot more, because they will still be around to suffer the consequences if a CEO wastes their cash on gold-plated toilet seats in the executive bathroom or on ego-driven takeovers.

Most of the biggest long-term pools of cash are state-run in some form, but university and charity endowments share similar incentives, without government control. Unlike passive funds, they have the ability to sell their stock in firms that won’t listen.

Nick Moakes, chief investment officer of Britain’s Wellcome Trust, one of the world’s largest charity endowments, pushes companies to be what he calls “sustainable in the broadest sense," and has no passive holdings.

“If you’re going to own things for the long term you want to be in companies that are going to be around for the long term," he says. That means both selecting stocks, and engaging with management.

Norway’s oil fund is particularly interesting because of its power. Not only does it have on average 1.5% of every listed company, but its transparent approach to how it plans to vote its shares means many others follow its lead. According to a study in December, this almost triples its voting impact. However, unlike Wellcome, it is only about 15% active in its holdings of developed market stocks.

The risk for investors is that political objectives edge out financial ones, as briefly seemed to be happening with some of the passive funds’ adoption of environmental goals, before a backlash forced a retreat.

There’s quite a lot of that. Norway’s oil fund’s rules and its ethics council block investment in oil, tobacco and nuclear-weapons stocks, among others. Since 2022, it has to try to persuade companies to comply with the Paris Agreement’s 2050 net-zero emissions goals.

Tangen insists the fund primarily wants the companies it invests in to make money in the long term. That means focusing on issues such as executive pay, board independence, the split between chairman and chief executive, directors having too many jobs or staying too long.

“We do not consider ourselves a global policeman," he says. “We do not operate as a public-sector entity. We’re hopefully shrewd capitalist investors. Everything we do we do to enhance future long-term returns."

If politicians can resist the urge to meddle, and state funds behave purely from a profit motive, the drawbacks of the cartoon version of capitalism can be overcome. Tangen thinks things are going in the right direction.

But as passive funds grow ever larger, it becomes ever harder to stop corporate executives from adopting a Mickey Mouse version of corporate governance. I worry that ceding too much power over companies to state funds will eventually lead to more political meddling and less focus on ensuring companies are well run. Still, it’s better than the hands-off approach of so many shareholders today.

Write to James Mackintosh at james.mackintosh@wsj.com

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