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Could the investment system contribute to sustainable prosperity?

by CHARLES SEAFORD

While some investors [1] put pressure on some companies to act in a more sustainable or socially just way [2], as yet this is at the margin. In this post, Charles Seaford suggests that this pressure could move centre stage, and that changes to, and clarifications of, fiduciary duty could play a part in this. He is drawing on an industry roundtable CUSP convened in October 2017 and on one to one discussions with investment professionals over the last 18 months.

CC-BY-SA 2.0 :: Chris Brown / flickr.com

There are two distinct reasons why investors could play a larger role in advancing sustainable prosperity: 1) It is often in the financial interest of investors with a long-term horizon for companies that they invest in to target sustainability and social objectives. This is partly, but not entirely, because it reduces regulatory risk. 2) Investors are also citizens and workers. Their agents could attempt to advance their interests as citizens and workers as well as their interests as investors.

Why doesn’t this result in more mainstream pressure? There are some unavoidable and some avoidable limitations on each of these reasons’ impact.

1 | The financial interest of investors

There are three unavoidable limitations on the extent to which the financial interest of investors can contribute to sustainable prosperity: first, targeting sustainability and social objectives has an impact in the long term but only some investors have a long-term horizon; second it is only often not always in these investors’ financial interest for the companies they invest in to target these objectives; and third, the long term is inherently more uncertain than the short term, reducing the relative weighting rational profit maximising investors give to long term outcomes.

This does not mean that there isn’t room for improvement, however. There is inefficiency in the capital market which exacerbates these limitations. This can summed up as follows:-

  1. Corporate managers’ incentives are linked to share prices and so they take decisions designed to maximise these.
  2. Share prices reflect expectations about ‘market’ reactions to limited information – exaggerating the relative importance of easily understood short term outcomes beyond levels justified by the inherent uncertainty of the long term.
  3. Corporate managers are therefore inadequately incentivised to target outcomes with financial impacts mainly in the long term.
  4. Targeting sustainability and social justice objectives has a financial impact mainly in the long term.
  5. Corporate managers are therefore inadequately incentivised to target sustainability and social justice objectives.

In theory there are two ways investors can address this – by changing corporate managers’ incentives (number 1 on the list), or by using better information when buying and selling shares so that the share price better reflects this information and thus likely long term outcomes (number 2 on the list).

Changing corporate managers’ incentives

In some ways the first of these is simpler. Equity investors have the right to set managers’ incentives and they could do this, linking rewards to results over the long term and to leading indicators of that performance. They could also ensure that men and women minded to take a long term approach are appointed to lead these companies, and they could maintain support, and where necessary pressure, to make it more likely that such an approach is followed.

This happens a bit – a few asset managers (who act on behalf of pension funds and their beneficiaries or directly on behalf of investors) do engage with investee companies on strategy and do monitor leading indicators of performance over the long term. However they do not generally effect change, drive appointments or set incentive schemes in the way described, and as a result for many companies shorter term considerations tend to trump longer term ones when there is a conflict.

This is partly a cultural problem – most asset managers (and the pension fund trustees who employ them) are simply not used to this kind of engagement and therefore don’t see it as part of their job. However underlying this are three economic problems:

  1. The free rider problem: the resources required to do even what is done already are significant and the optimal strategy is often to rely on others providing these resources.
  2. The critical mass problem: effective engagement – particularly to determine who gets appointed and how they are incentivised – requires enough votes and most asset managers, and even more so the pension funds that employ them, are too small.
  3. The exit problem: it may be in the investor’s interest for a company to adopt market pleasing short term strategies, since he or she can benefit from the price rise associated with this, and then sell and invest elsewhere before the price comes to reflect the long term damage these strategies create.

The free rider problem, could be solved if there was a stronger duty on asset managers to engage and take into account the objectives of their clients, but this would not address the other two problems.

The critical mass problem could be solved if asset managers collaborated. This happens sporadically but the standing institutions facilitating it are widely regarded as a waste of time: the fact is collaboration does not create competitive advantage for the firms involved, so the incentives are weak. In theory pension funds could collaborate and mandate their asset managers to collaborate in a much more active and strategic way. The difficulties faced by the Association of Member Nominated Trustees Red Line initiative – an attempt to do this in a very limited way –  demonstrate how difficult this is given existing law and organisational structures. These fail to create an imperative on either asset managers or their pension fund clients in this area.

The exit problem is becoming less severe as investors switch into passive funds (where the funds are invested in an index, eliminating asset managers’ discretion to buy and sell individual shares). For active funds it might be mitigated by a duty to engage, however if exit is an option it cannot be dealt with fully while prices fail to reflect expected long term outcomes.

Share prices that reflect expected long term outcomes

So can investment strategies result in prices better reflecting expected long term outcomes?  In theory there are considerable incentives for these strategies: investors can buy shares in companies with good long term prospects that are not fully reflected in the share price and then see the prices rise as the market wakes up to these good prospects. The more investors adopt this strategy, the less time they will have to wait for the market to wake up, reducing the average under-weighting of long term outcomes in share prices and thus the bias in corporate managers’ incentives.

It appears, however, that long term investors do not adopt this strategy as much as they might, thereby increasing the average under-weighting of long term outcomes in the share price and thus the bias in corporate managers’ incentives. This is largely because of failures of communication within the investment supply chain, most obvious in the case of pension funds. The ultimate beneficiaries are represented by trustees, who in turn sub-contract to asset managers. Trustees do not know how to assess the performance of the asset managers they employ and so rely on quarterly portfolio valuations, even though they are universally regarded as useless indicators of future performance. This incentivises the asset managers to focus on short term movements in the share price, in other words on market reactions to limited information, in practice information about easily understood short term outcomes. It is not that they don’t also look for undervalued shares and buy these for the long term – they do – but they probably do this less than they would do were they more fully incentivised in this direction. The under-weighting of long term outcomes in share prices is thus greater than it need be, although it is difficult to quantify this effect.

Asset managers’ incentives also increase the market for reports by brokers’ analysts (the asset managers are their clients) who tend to be even more short term focussed since their job has traditionally been to stimulate trading.[3] This is significant because corporate managers tend to have more regular contact with these analysts than with asset managers, and this can lead to their getting a distorted impression of what their shareholders want.

Having said all this, some trustees do assess their asset managers in a more sophisticated way, and metrics and more informal assessment approaches exist and are being developed. In other words the existing situation is not inevitable. However this has largely been because of individual leadership or institutional tradition. In general trustees are under no pressure to adopt a more sophisticated approach, either from their beneficiaries or from the regulatory regime. Given this there is little incentive for the investment consultants who advise them on asset management assessment to invest in developing and selling optimal products.

In the retail market, in which asset manager behaviour is more directly driven by consumer choice, a parallel problem exists. Most personal investors and their advisors are even less equipped to assess asset management performance than pension fund trustees, although it is possible that the power of inertia reduces the tendency to switch and thus the pressure for quarter on quarter performance.

2 | Advancing investors’ interests as citizens and workers

Investors’ interests as citizens and as workers as opposed to as investors can be affected by investee company behaviour, for example through its policies on carbon emissions, tax avoidance, and employee relations. Note that even if the direct impact of a company’s behaviour is small, it can contribute to norms in the business community and government policy and thus have an indirect impact.

Saker Nusseibeh, CEO of Hermes Investment Managers, uses the example of aggressive tax avoidance to illustrate this. If I am a small investor, it may be that the gains I enjoy as a shareholder as a result of aggressive tax avoidance by an investee company are less than the losses I suffer as a citizen and taxpayer.

Again, though, there are some unavoidable limitations to the effects of this approach. For a very large investor, the relative importance of his or her interests as a citizen or worker may be negligible when compared with the straightforward investment interest. Leaving aside material interests of this type, there may also be strong ethical disagreements between different shareholders as to what a company should or should not do.

These differences between investors’ interests and ethical preferences do not, however, mean that their interests other than as investors cannot be advanced or that their ethical preferences cannot be taken into account. It simply means that they need to be consulted, and to the extent that there are conflicts of interest or different preferences the interests and preferences of the majority can be advanced. If there are strong conflicts of interest, then perhaps some companies will end up being owned by large investors and some by small.

Investors from different countries may appear to have different interests. Returning to the tax avoidance example, it may appear to be in my interests for the company to engage in aggressive tax avoidance overseas, even if not in my own country. However this is only true in the absence of some kind of informal pact, which makes it in my interest to stop avoiding tax in your country to the extent that you adopt a similar stance towards avoiding tax in mine.

Nonetheless, despite all this pension fund trustees do not mandate asset managers to consider these wider interests, except in the case of specialised ethical funds, which, as their name suggests are not driven by beneficiaries’ material interests but by their ethical preferences. They do not do this because they are not allowed to, unless beneficiaries specifically instruct them to do so, and in any case beneficiaries are only asked about their ethical preferences, not about their wider material interests. As a result, there is no framework to guide asset manager investment decisions or engagement practices with a view to advancing beneficiaries’ wider interests.

Note that for these wider interests to drive corporate decisions, asset managers and investors would probably need to engage more actively with investee companies than they do, at least until new norms of behaviour had been established. In other words the freerider and critical mass problems described above would need to have been solved.

3 | Solutions

It is likely that a complex array of measures will be needed to address these problems. The following are probably part of this array, although this section is not intended as a worked up set of recommendations, just a report on work in progress. It is based on a series of one to one discussions with industry professionals over the last 18 months, together with a roundtable on fiduciary duty that CUSP convened this October and that was hosted by Aviva Investors. Recommendations made at this roundtable are asterisked.

Fiduciary and other duties

Fiduciary duty is typically owed by trustees but comparable duties can apply to asset managers, investment consultants and those operating contract-based as opposed to trust-based pension schemes. In principle these duties can be used to address the various incentives issues referred to in section 1, and to change the nature of those trustees obligations that currently prevent consideration of wider interests, as referred to in section 2.

Reliance on duties begs the question of how they are to be enforced. There needs to be a clearer view on enforcement mechanisms and on the role and nature of any sanctions*. The existing pensions industry structure (relatively small entities, often run by amateurs) makes enforcing duties on trustees problematic*, suggesting that there should either be industry consolidation (see below) or a much greater focus on asset managers and investment consultants.*

Improving corporate engagement

I have suggested that a major barrier to effective engagement is lack of effective collaboration in the asset management industry, linked to a lack of responsiveness to client concerns. This could be mitigated by a duty on asset managers to engage, including an obligation to respond to the concerns of their clients (and, indirectly, of final beneficiaries).* However effective engagement of the kind needed probably requires increased market power and determination amongst pension funds, possibly requiring that they too have a duty to engage (albeit through asset managers) and a duty to consult their beneficiaries on this engagement.* Increased market power and determination amongst pension funds may also require some form of consolidation (see below).

Improving the assessment of asset managers

I have suggested that trustees are under no pressure to adopt a sophisticated approach to asset management assessment, either from their beneficiaries or from the regulatory regime. I have also suggested that this means there is little incentive for the investment consultants who advise them to invest in developing and selling optimal products. Fiduciary duty could increase this pressure.

In theory, pension fund trustees already have a duty to take appropriate advice, on asset management assessment as on other aspects of their work. In practice, this has little effect since many trustees do not have an understanding of what is needed, what is ‘appropriate’. This suggests that the nature of this advice should be clarified by the Law Commission or the Pensions Regulator.* At the same time investment consultants should have a duty to provide appropriate advice and the current review of the industry could make recommendations along these lines.* Comparable duties could be extended to personal investment advisors.

The wider interests of beneficiaries

The European Commission’s High Level Expert Group on Sustainable Finance (HLEG) has recommended (draft) that there be a duty to consider the wider material interests of beneficiaries and there was widespread support for this at our roundtable.* This will need to be complemented by a duty to consult beneficiaries on their interests and on the ethical principles they want to see applied.* But: this has to be done in a way that engages beneficiaries effectively (see below).*

Other measures

Any new duty or guideline needs to be accompanied by training and training materials (for example modifications to the Pensions Regulator training tool kit).*

Duties also need to be supported by standards to guide what is and is not good investment. This involves development of metrics for the variables to be considered, for example climate risk, and an analysis of their financial impact.*

The duty to engage with beneficiaries and other investors need to be accompanied by serious work to create easily understood and to the point digital communications designed to facilitate real decisions by beneficiaries and increase their response rate. It also needs to be accompanied by efforts to improve financial literacy more generally.*

It is arguable that there needs to be significant consolidation in the pensions industry – or at any rate the emergence of more formal collaboration between trusts. This is primarily in order to address the barriers to effective corporate engagement, but also to make more sophisticated assessment of asset managers easier, to increase the market power of trustees in their negotiations with asset managers, and to create a class of professionals who have an enforceable fiduciary duty.


[1] I use ‘investors’ to mean end-investors including pension fund beneficiaries, although when describing investors’ actions I may mean the actions of their agents, to the extent that the agents are acting as theoretically perfect agents. When I want describe the real life actions of these agents I refer to their specific role, for example ‘pension fund trustee’ or ‘asset manager’.

[2] This is sometimes expressed as paying attention to Environmental, Social and Governance (ESG) factors.

[3] Traditionally they were paid for out of trading commissions. This is set to change however.

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