It’s an odd phenomenon that, although capitalism as a philosophy is built around the meritocracy of free markets, in the area of corporate governance the power of profit maximization has often failed to dump ineffective boards of directors and/or management in favor of more competent people.

Boards are usually made up of invited friends, and sometimes their supervision of senior management resembles that of golf partners where it’s good manners to ignore others’ poor shots while offering congratulations on the good ones. The pressure to avoid rocking the boat is felt by everyone.

Hence the Economist this weekend noted an innovative solution to the issue of weak, sometimes unqualified board members. Why not outsource the function to companies whose business it is to provide such services? This currently happens with audit and legal work. Board members are hardly engaged full-time by any one corporation. Why not develop specialists who are truly independent and full-time?

It struck me as quite a clever suggestion. It ought not to be necessary, but the many failings we see week after week highlight that capitalism is often coming up woefully short in this important area of corporate governance, or how the very stewards of capital are managed and evaluated. Even Warren Buffett punted when a few months ago he was asked about the egregious compensation plan recommended by Coke’s (KO) management.

Although Berkshire (BRK) is KO’s biggest shareholder and Buffett about as vocal on investor rights as anybody, the great man meekly abstained rather than vote against a plan he freely admitted was needlessly generous.  “If you keep belching at the dinner table, you’ll be eating in the kitchen,” was his typically folksy and non-combative explanation. He understands as well as anybody the duty of board members to be only occasionally critical and then in the nicest possible way.

Other examples include ADT, which as I’ve written before is busy demonstrating the ham sandwich test (invest in a company that could be run by a ham sandwich, because one day it will), as shown by their buyback of Corvex’s position in ADT stock last year at $44 just before disappointing earnings took its price eventually below $30. Activists are often a force for good as they seek to expose management failings, but Keith Meister’s Corvex is a negative since he’ll readily throw other investors under the bus for a quick profit. We own ADT in spite of its leadership since we think anybody could run it as badly as current management and many could do better. It’s an option on executive suite change.

Currently the role of using capital to improve management is taken by activists such as Carl Icahn. He just provided a stark reminder of how shareholders often need activists to correct some of their self-seeking behavior. Family Dollar (FDO) just the other day agreed to sell itself to Dollar Tree (DLTR), an unlikely partnership since they operate different business models and would continue to do so afterwards.

FDO CEO Howard Levine noted that no discussions had taken place with the more obvious and bigger merger partner Dollar General (DG), to whose steadily improving operating metrics FDO eternally aspired but never reached. DG’s CEO Rick Dreiling flatly contradicted this by noting that DG had expressed interest in a combination multiple times in recent years. Carl Icahn backed this up, recounting a dinner with Levine at which the subject of a combination with DG was discussed. With DG, Howard Levine will lose his job to the superior operator, whereas with DLTR he’d keep it. As Icahn memorably noted, Levine thinks that because his father founded the company the son owns it. But he doesn’t. FDO’s stock has consistently underperformed DG’s in recent years as has its business. As close competitors it’s been helpful for investors as well as the companies themselves to compare their relative operating performance which has invariably favored the larger, better run DG (we are currently invested in DG, and were until very recently invested in FDO).

DLTR was a better merger partner for a CEO putting his own job ahead of his fiduciary obligation to his shareholders, and the FDO board passively acquiesced. Levine even agreed to a $300 million break-up fee in the DLTR transaction, a final slap in the face to those stockholders who thought he had their interests at heart.

Investors though should be far more assertive. If well-run boards with good corporate governance were more highly valued, they’d arrive more quickly. The more a poorly run company’s stock is shunned the quicker activists or competitors can buy a stake and fix it. The best solution to poor corporate governance is to invest with competent management and avoid the poorly run, at least until they’re cheap enough to draw in an activist. FDO had at least met this test in the last couple of years. Even institutional investors don’t have to own every publicly listed large cap company. Until investors become even more discriminating in their allocation of capital, activists will continue to correct perhaps the biggest weakness in contemporary capitalism – the management of the executive suite.

If you didn’t have the data, you might reasonably assume that any fund manager worth his salt was heavily invested in his own fund. This ought to apply to an overwhelming percentage of all the actively managed funds out there. In fact, as a recent article in Barron’s points out, it’s the exception rather than the rule. Using data from Morningstar, they find that almost half the funds tracked were led by a manager with no money invested at all. This sorry bunch may think they’re good, and their marketing materials presumably make the case, but by investing their own money elsewhere they tell you what they really think.

And of the 7,700 funds tracked by Morningstar, only 910 had a personal investment by the manager of at least $1 million. This isn’t a high hurdle; less than this threshold either means the manager doesn’t have $1 million to invest, a paucity of personal resources that should give any potential client pause, or chooses not to.

It’s not just that it feels right to know your manager is invested alongside you. For the client, this is the only way to ensure alignment of interests and protect themselves from the principal-agent problem so prevalent in finance. If you’re a fund manager only managing OPM (Other People’s Money), your compensation is fully linked to the size of the fund you manage. The most reliable way to grow your fund is to outperform your competition. A seductively simple way to outperform is to take more risk than the others. Because if you take more risk in a rising market, you will assuredly do better than most and money, which chases performance, will follow. If the market goes down and you underperform, you haven’t lost much because it’s only your clients that suffer the returns. And if performance is really bad, you can always start a different fund.

The money manager who’s invested elsewhere has a free option at the expense of his clients. He has far more to gain from outperforming than he has to lose from underperforming. For the investors, their risk is linear. Bad returns hurt, and good returns help.

The analysis of the Morningstar data supports other research which shows that active managers in aggregate take more risk than the overall market. They are biased towards stocks with more volatility than average, and as a consequence their actions underpin the Low Beta Anomaly, the tendency of low volatility stocks to outperform over the long run. This is because high volatility stocks draw more demand from active managers which raises their prices, thereby depressing future returns. An active manager owning low volatility stocks is failing to exploit the optionality that his role as agent provides at the expense of the principal (i.e. client). It’s one of the reasons we like low volatility stocks – because although they’re widely owned, they’re not widely owned by active managers. And we think that active managers under-invested in their own funds are likely to continue exploiting their advantage which will cause the low volatility bias to persist.

For the investor, it’s not a bad rule to simply eliminate from consideration any investment manager not personally and significantly invested in his own strategy. It makes intuitive sense but it also provides for an alignment of interests. Don’t let the uninvested take advantage of you.

The ham sandwich test, credit for which goes to Warren Buffett, asks whether a company you’re invested in has such a great business with such high barriers to entry that it could be run by a ham sandwich. I’m increasingly beginning to think that ADT will be subject to this test, and we’ll see how good a business it is in spite of their management.

ADT has a great competitive position. They are by far the biggest home security business with 25% residential market share. Their target market is higher income households who have more to protect and the means to pay for it. They ought to be able to steadily acquire far smaller firms, increasing market share and finding operating synergies.

Instead, they are seeing rising customer attrition, barely growing revenues and declining profits. The big cable companies are looking at home security as an attractive service that they can bundle with cable and internet, making switching costs higher for consumers. And yet, their enthusiasm for home security cannot be driven by the execution of ADT’s business plan.

Last year Keith Meister of Corvex completely outfoxed (or “outbullied”, might be more appropriate) ADT’s CEO Gursahaney by selling stock back to the company as part of a stock buy back program Meister had himself advocated. His access to the company’s books and records had given Meister a far more negative view of ADT than Gursahaney, and as subsequent events have shown these two do not belong at remotely the same poker table.

After ADT announced it had bought back Corvex’s stake at $44.01, the stock collapsed and is currently around $30. Leon Cooperman of Omega asked the best question on today’s earnings call when he noted that ADT’s buybacks represented a far bigger investment than their acquisitions or capex, and asked what type of analysis management had done to assess that $44 a share represented a good return on invested capital.

One would think that such a question demands a quantitative response, something that describes the expected return on invested capital with a number. But since the answer to Cooperman’s question consisted of vague optimistic statements about the business the answer was clearly, “No, we have not done that analysis”.

Of course it’s possible that Gursahaney is smarter than I give him credit for, and that the return on capital decision for buying back Corvex’s stake was less important than getting rid of an investor likely to be vocal in his criticism of the company, even at the cost of poorly allocating shareholder capital. In which case some other adjective is more appropriate, but even so this explanation is no more shareholder friendly.

Which sounds like a company entering the ham sandwich test. For our part, we are modestly invested in ADT, in no small part because we believe there’s some chance another company (Comcast? Google?) will find ADT’s current market cap of $5.5 billion a bite-sized way to obtain a leading position in home security at a time when more and more devices are linked – the “internet of things”. Somebody needs to put current management out of its misery.

Since I read Flash Boys, those ads for discount brokerage now appear differently to me. I used to think that when, say, TD Ameritrade offers commissions of $9.99 a trade it’s because their platform is so efficient, so geared to enjoy economies of scale, that this low rate was sufficient to generate revenue in excess of its costs. But after reading Michael Lewis’s latest book it’s now dawned on me that an important element in the business model of these firms is to sell their order flow on High Frequency Trading (FHT) outfits or “dark pools”. The payment for order flow concept is a market-based recognition that many investors represent a reliable source of profit for the counterparties to their trades over and above the commissions they pay. So the $9.99 commission doesn’t represent the full return to (in this case) TD Ameritrade from their participation in your business.

It’s all naturally legal and therefore held to be beyond reproach. And perhaps the clients on such terms are naive for assuming that their visible cost of execution (i.e. the commission) was the only cost. But wouldn’t most people like to know if their orders were in effect the subject of a bidding war among the HFT crowd? Wouldn’t you think that the broker is getting you best execution not in the literal sense as defined in the regulations, but actually setting about to do that? If a discount broker can sell your orders on to a profit-seeking algorithm, they may still be providing you with a service but are not obviously working in your best interests.

It just seems as if there’s been a colossal error of judgment. The client might well be staggered to comprehend the economics of the online broker. The HFT apologists are no doubt equally shocked that anybody else is shocked. Hasn’t all this been disclosed? Well, technically I guess it has, but you can’t blame the average retail investor for wondering who they can trust. The brokerage model is full of the potential for principal-agent conflict. Dark pools and HFT algorithms are the latest manifestation. At a minimum, this is a PR disaster. The burden of proof is on those who equate volume with liquidity, who find nothing offensive in computer software being implemented to front-run orders. When it’s worth $300 million to build a perfectly straight fiber-optic line from Chicago to NY so as to transmit orders in a fraction of the time it takes us to blink, the casual observer may be forgiven for assessing that something is very wrong.