December 09, 2003
Watchdog Fund Established to Take a Bite Out of Corporate Governance Malfeasance
by William Baue
The new investment vehicle is part mutual fund, part shareowner advocate, and part hedge fund.
While many socially responsible investment (SRI) mutual funds use shareowner action to promote
better corporate governance practices, corporate governance is not their exclusive focus. Last
month saw the launch of the Watchdog Fund, which intends to enhance
shareowner value exclusively through corporate governance reform. The fund seeks to achieve this
goal not only through shareowner advocacy, but also by establishing long positions in corporate
governance best performers while shorting companies deemed to have corporate governance practices
that are hopelessly beyond reform.
“The need for effective oversight by
shareholders has never been clearer," said Nell Minow, editor of the Corporate Library (TCL), an independent investment
research firm specializing in corporate governance and board effectiveness. "The Watchdog Fund's
arrival is well timed and I look forward to seeing them constructively engaged in protecting and
enhancing management accountability and shareholder value."
The fund’s primary
objective is the same as all other funds’: to earn money for its investors. Corporate
governance reform is a secondary objective, a means of achieving the primary objective. Portfolio
manager Howard Horowitz, chair and CEO the fund’s investment adviser H Team Capital, explains
how these dual objectives will affect stock picking.
“We have two filters: we start
with the first filter, valuation, and then move to the second filter, what I’ll call
situation,” said Mr. Horowitz. “By valuation, I mean traditional financial analysis,
and by situation, I mean the whole spectrum of corporate governance issues, from conflicts of
interest to excessive compensation plans.”
The fund will invest primarily in small-
and mid-cap US companies with corporate governance problems that can be addressed through
shareowner action. Reforming poor corporate governance practices may also unveil hidden value at
“There’s a very strong business case to be made for
corporate governance reform,” Mr. Horowitz told SocialFunds.com. “There are a number
of hard, quantitative studies that look at real stock performance over many years with many data
points and many different corporate governance criteria.”
“What these studies
repeatedly find is that companies with better governance outperform companies with worse
governance,” Mr. Horowitz explained. “The other thing they find is that companies with
active shareholders can outperform, and can also avoid disasters.”
Governance and Equity Prices" by Paul Gompers of Harvard and Andrew Metrick of the University
of Pennsylvania’s Wharton School and "Governance Mechanisms
and Equity Prices" by Martijn Cremers of Yale and Vinay B. Nair of New York University, as well
as research by GovernanceMetrics International (GMI), a global
corporate governance rating agency.
“This is not an untested strategy,” said
Mr. Horowitz. “I might like to take credit for inventing this strategy, but I did not invent
the idea of being an activist shareholder or that corporate governance adds value.”
Mr. Horowitz points to his predecessors for establishing the model for strong financial
performance through shareowner advocacy on corporate governance. For example, Robert Monks’
Lens Fund outperformed the S&P 500 throughout the 1990s.
Other examples include funds managed by Relational
Investors and the California Public Employees’ Retirement System (CalPERS).
The Watchdog Fund will use other
strategies besides shareowner advocacy. The fund will establish long positions in larger companies
with strong corporate governance to capitalize on the value created through such best practice.
Mr. Horowitz also intends to use the hedge fund tactic of short-selling companies whose
corporate governance practices he deems cannot be repaired. Short selling involves borrowing
shares of a stock and selling them to a new buyer, then later buying back the shares at a lower
price at a profit when the price has lowered and returning the shares to the original owner.
Social investors typically notify senior management of their intention to short the company as a
means of communicating their disapproval of the company’s practices, in this instance over
corporate governance issues.
The decision whether to notify senior management is subject
to mutual fund regulations and will be made on a case-by-case basis, Mr. Horowitz told
The Watchdog Fund has been criticized for its relatively high expense
ratio of 1.95 percent and the fact that the chair of the fund’s board is not an independent
board member but Mr. Horowitz himself. Mr. Horowitz responds that relatively high fees are
necessary for startup funds and will drop after the fund fills its coffers enough. He also said
that he plans to relinquish the board chairman title after the fund has increased in size.
“When the fund becomes viable and stable, with a sufficient asset base, we’ll put
in an independent chairman,” Mr. Horowitz stated.