October 07, 2005

The Tipping Point - How Good Companies Go Bad and Executives Become Rogues

A new book by Sayles and Smith looking at governance from the angle of Corporate Executives being the bad guys is worth a look. It may do a good job of documenting the problems occuring in US business at the moment and the first chapter is online here:

To find their prescriptions one would presumably have to buy the book. I'm not sure I will as they are very keen to blame the executive, which isn't really going to help. Agency theory suggests that your employees do what you incentivise them to do, and executives are no different. Look instead at the incentives that have been created would be my prescription.

By way of example, on the mutual funds scandal (one that I'm at least passingly familiar with from the US Senate hearings) they write:

What Could Management Have Been Thinking? Here is an example of executives "shooting themselves in the foot," deception and cheating that comes back to whack the originator:

Numerous mutual funds destroyed their reputation by allowing a small number of investors to misuse the funds (by overnight trading and buying and selling at "stale" prices). Funds earned very modest extra management fees by granting these special privileges to hedge funds and a few "select" clients. Their corrupt trading and wrongful pricing cost the other 99% of the funds’ investors dearly. When the corrupt practices were revealed, some funds lost half of the investors’ money. In one case, the value of a fund family to its owners dropped half a billion dollars in a matter of weeks.

Yet as has been pointed out by the founder of Vanguard, John Bogle, in his testimony before the same Senate hearings the problems started when greedy investors forced mutual funds from percentage reward scales over to fixed reward scales. Bogle led Vanguard to be a dominating force in mutual funds and is to some extent viewed as the father of the post-war Mutual Funds industry; his words are worth reading:

March 21, 2004, less than two months from today, will mark the 80th anniversary of America’s first mutual fund. Organized in Boston, Massachusetts Investors Trust (MIT) was a Massachusetts trust managed by its own trustees, who held the power “in their absolute and uncontrolled discretion” to invest its assets. The trustees were to be compensated at “the current bank rate for trustees,” 6% of the investment income earned by the trust.

Our industry began, then, with the formation of a truly mutual mutual fund, one organized, operated and managed, not by a separate management company with its own commercial interests, but by its own trustees; compensated not on the basis of the trust’s principal, but, under traditional fiduciary standards, its income.

Has there been any suggestion that the funds industry go back to percentage rewards and thus encourage the managers to think of the investor?

Nope. Expect more problems then. And the emboldened question above is easily answered: Management was thinking of what you told them to think.

Posted by iang at October 7, 2005 11:31 AM | TrackBack
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