The business column - Patrick Hosking says it's better to be underweight than overexposed

You hear "We've only got a small holding" every day in the City. It's code for: we're not going to m

Chewing the fat with one of the City's top fund managers, I heard an expression that goes to the heart of why capitalism works so maddeningly imperfectly. We were discussing the proposed £7bn merger between Boots and a rival chemist chain, Alliance UniChem. Much is at stake. If the deal works, tens of thousands of jobs will be secured. The high street will have a new, beefed-up force to fight its perennial war with the edge-of-town supermarkets. And Britain will perhaps boast a new home-grown champion capable of taking on the Continent.

But this investor, who is ultimately responsible for billions of pounds of small savers' money, didn't think much of the marriage. He foresaw fireworks because of a fudge in the way boardroom responsibilities have been divvied up. "It ain't gonna work," he told me, then said happily, "But we've only got a small holding."

You hear "We've only got a small holding" every day in the City. It is code for: we're not going to make a fuss and we'll vote our shares in favour of the deal despite our reservations. Its close relations are "We're underweight in that one" and "We've got minimal exposure there". Being underweight in a stock or having minimal exposure does not mean the institution hasn't a serious volume of shares. The small holding can amount to hundreds of millions of pounds' worth of a company's shares. My sceptical friend, for example, still had millions of pounds' worth of Boots shares.

The problem boils down to a performance measurement technique known as benchmarking. Most managers of pension-fund money and pooled investment funds such as unit trusts are not usually measured and rewarded according to how they do in absolute terms, but relative to their benchmark. If they invest in UK shares, the benchmark is usually the FTSE All-Share Index. If their normal domain is the US, it might be the S&P 500. So long as they beat their respective index, they are happy, even if their fund is shrinking in absolute terms.

Every index gives a weighting to each constituent share according to the size of the company. Boots, for example, currently accounts for 0.27 per cent of the All-Share. Anyone whose Boots holding accounts for less than 0.27 per cent of their British shares portfolio will therefore consider themselves underweight. This produces a paradox - those who are underweight in a share will appear to do better, the worse that share performs. So, in the case of Boots, the more the merger turns out to be a disaster, the more my friend will outperform his benchmark, the smarter he will appear and, probably, the bigger his annual bonus. There is no incentive for him to vote according to his genuine view of the merger.

There is a serious disconnection between institutional investors and our blue-chip companies. And the bigger our blue chips get, the greater the number of their shareholders who are underweight. The gargantuan BP, for example, accounts for 7.9 per cent of the All-Share. Most UK institutional investors will have a holding in BP, but almost all of them will be underweight: it would not be considered prudent to have as much as 7.9 per cent of a portfolio in a single stock, even one as respected as BP.

A suspicion is growing that the chief City regulator, the Financial Services Authority, while starting to nail some company wrongdoers, somehow loses its nerve when it comes to big fish. The recent decision to close the case against Sir Philip Watts, former chairman of Shell, can only reinforce that view.

The case appeared strong. The FSA had already fined Shell £17m for misleading shareholders over its reserves of oil and gas. It had some strong evidence of a conspiracy at the top. Exhibit one - the infamous e-mail from Walter van de Vijver, a former exploration chief, saying: "I am becoming sick and tired about lying about the extent of our reserves issues." It had the wind at its back, having won an important preliminary skirmish against Watts in the Financial Services and Markets Tribunal. And it had public and City opinion on its side: someone should surely be held to account for an abuse that lasted years and cost shareholders billions.

However, the FSA's regulatory decisions committee - the semi-judicial body made up of sundry City great and good - was apparently unconvinced by the case presented by the FSA's enforcement arm. Regulators continue to assure us that they will hold senior people to account when there has been wrongdoing. Yet time and again, the pursuit of the biggest cheeses by civil means, never mind criminal, seems beyond them.

In the US a string of high-profile businessmen and women continues to be pursued and punished. Here, there haven't been any senior scalps for 20 years. Either our business leaders are going through an unprecedented period of ethical purity, or something isn't working properly.

Patrick Hosking is investment editor of the Times

This article first appeared in the 21 November 2005 issue of the New Statesman, Inside Guantanamo