The revolution in equity ownership

In an important opinion article in the Wall Street Journal, the founder of the Vanguard Group John C. Bogle documents the impressive transformation in the US public capital markets that took place in the last half of the 20th century - no less than a ‘revolution in equity ownership’.

In the mid-1950s, institutional investors held less than 10% of all U.S. stocks. This number increased to 35% in 1975, 53% a decade ago and now institutional investors own and control almost 70% of the shares of US corporations.

With the rise in equity ownership by institutional investors, the US financial system widened the range of investment opportunities available to the nation’s pool of savings. This steady rise not only improved the ability of the economy as a whole to allocate capital to its most productive uses, but also made the higher returns of equity markets available to the wider public.

At a corporate level, the availability of public capital markets to fund the growth of companies increased the transparency of the corporate system, increasing the attractiveness of US markets to investment. Also, the increased liquidity compressed bid-ask spreads and allowed capital and risk to be more efficiently priced.

No doubt such advances in its financial system contributed to the growth and general success that overall the US economy enjoyed in the last part of the 20th century.

Still, the shortcomings of the system that John Bogle describes speak to the some of the reasons of why economic growth in Western economies has been persistently punctuated by periods of drastic contractions and recessions.

Annual stock turnover was barely 21% 30 years ago. It increased to 78% a decade ago and appears to have been 250% in 2009. As Bogle argues, economic fundamentals and company prospects alone cannot justify ownership stakes in corporations to change hands two and a half times on average in one year.

Only short-term expectations of generating returns unrelated to fundamentals and fees generated from trading activity can justify such high turnovers.

Focus on short term gains has increased the volatility of prices and with it the intensity of business cycles – with period of overvaluation of equities being followed by drastic and sudden divestments originating significant financial losses as well as contractions in economic output.

Increases in financial intermediation costs has siphon part of the increased returns on the nation savings to the financial industry at the expense of investors – while fundamentally changing the GDP composition of cities and nations of such services were located, making them increasingly dependent on the industry’s revenues.

The separation of ownership from management that the access to public capital markets entailed also seems to have weakened corporate control systems. The focus on share price as the preferred measure of performance and board of directors agency fundamentally misaligned the interests of shareholders and management. Accounting and reporting tricks became common and senior management compensation relative to the average worker rose drastically (from 42 times in 1980 to close to 400 times in 2009).

John Bogle proposes tax devices to incentivize long-term holding of public equities – granting long term extra voting rights and/ or higher dividends; and a tax on short-term realized capital gains.

Such strategies would seem to address some of the shortcomings described – by incentivizing investors to focus on long term strategies, equity prices would tend to better reflect underlying fundamentals as well as increasing the accountability of senior management to boards of directors by realigning its economic interests in the company’s performance.

Given the vast vested interests dependent on the profitability of the industry, such proposals seem to have little chances of successfully being enacted. Nevertheless they are certainly worth of being included in the financial stability plan being elaborated by the current administration.