Investors take LTRI initiative
The last five years have seen a sea change in investment beliefs and practices. Previously those who might have raised concerns about market short-termism would have been dismissed as ideologically motivated critics, and those who favoured SRI, as having other agendas.
While passionate defenders of the status quo have not gone away, many initiatives are now under way which have already changed the reality on the ground. These projects, known collectively as long-term responsible investing (LTRI) are slowly but surely changing investment practices and, arguably more important, investment policies and beliefs. This article seeks to describe some of the underlying dynamics, explain the drivers of change, consider future developments and outline how asset owners and their service partners can best respond.
Underpinning these and related projects are three significant developments in world views or investment beliefs, and which constitute good news for ordinary pension fund members and other end beneficiaries.
Firstly, there is growing acceptance that the mission of the institutional investor should be to optimise the long-term value of the fund and that this should be actively translated into how the business is run (ie, not left as a good intention). While long-term value optimisation is far from being a new concept, what is new is that acting as if the long term is simply a collection of short terms is no longer considered a good enough approach. Similarly, doing what everyone else is doing in order to maximise returns is no longer a good enough solution to optimising risk-adjusted returns.
Secondly, investment professionals in most regions increasingly accept that good standards of corporate governance and corporate responsibility - all else being equal - will improve enterprise risk management. As a direct effect, engagement or active ownership is increasingly seen as good for shareholder value and so has fast become accepted as a tool for safeguarding, if not improving, investment returns over the longer term. It is also close to being accepted as an obligation that goes hand in hand with the rights that come from being a share owner. Few institutional investors, in the UK at least, would now admit to not doing it and none would say, in public at least, that it was a bad idea – arguing in favour of absentee ownership does little to build client confidence!
Thirdly, there is a growing acceptance that asset owners should be much more interested in management of absolute risks and those relating to whole portfolio than has hitherto been the case. In part, an effect of this has been a major evolution in beliefs about the investment relevance of extra-financial issues (EFIs). These are fundamentals that have the potential to impact companies’ financial performance or reputation in a material way, yet are generally not part of traditional fundamental analysis. Examples include future political or regulatory risks, alignment of management and board incentives with durable long-term company value, quality of human capital management, risks associated with governance structure, related party transaction conflicts between management and shareholders, environmental liabilities, public relations risks, fraud/ethical culture exposure, product obsolescence and similar concerns. Some EFIs are material to stock pickers, particularly those who have a longer time frame. Some EFIs, however, relate to the sector or economy as a whole and are of more importance to asset owners who have primary responsibility for wealth preservation and inter-generation equity issues.
What is driving these changes in investment world view? This is an important question and could affect whether the changes are temporary or here to stay. The corporate governance scandals that have affected all markets and all savers are the most obvious reason for change.
One layer down is a growing doubt about the overly fundamentalist interpretation of shareholder value that has dominated business, investor and political thinking in the last two or three decades and the resulting debate about corporate responsibility. One layer deeper are concerns about globalisation, questions over whether the market no longer exists to serve society (ie, whether that relationship has been inverted), and related, corporate influence over issues ranging from executive pay unlinked to performance through to climate change.
For all these reasons, it is highly likely that progress will be maintained. Of course, the defenders (the main beneficiaries) of the status quo will push back.
This is most obvious in the US where concerted and aggressive lobbying by business interests has delayed expensing of stock options, sought to reverse core aspects of Sarbanes Oxley and undermined efforts to allow investors to nominate directors. Much has been made of the damage to corporate America as a result of alleged over-reaction to a few ‘bad apples’. It is ironic that in his letter to shareholders in the company’s 2003 annual report, the former CEO and chairman of AIG, Maurice Greenberg, wrote: “The whole country is paying a price for the gross misdeeds of relatively few executives who shirked their responsibility to create value for all of their corporate constituencies - shareholders, customers and employees - and abused the system to create wealth for themselves and their close associates. It is unfortunate that the misbehaviour of a few companies and their executives could have a negative impact on so many.”
Greenberg’s fall from grace will not stop efforts to roll back the changes but investors have already begun to find ways past the obstacles raised. This is not to say the shift to LTRI is anywhere near as widespread and as deep-rooted as it could or should be. Standing in the way of LTRI penetrating into the core of investment processes and organisational cultures are some critical ‘resistors’ which explain why the situation today is of one of a work in progress.
So how can progress be enhanced? Adopting the new investment beliefs outlined at the start of this article is one of the four pillars on which the LTRI approach rests. The other pillars are: actively managing the investment supply chain to support this approach; working collaboratively with other investors to deliver change and enhancing fund governance to oppose decisions when required.
Each of these pillars warrants detailed consideration in its own right, but the inevitability of fundamental culture change is shared. There will be strong vested interests and agency issues which get in the way. There is a need for strong and principled leadership that puts the real needs of ordinary pension fund members first. Firstly, they want an absolute - not relative - pension. Secondly, members assume that their pension will give them predictable quality of retirement life: pension funds address the economic inflation-related aspects of this assumption but retirement well-being is also a function of social and environmental capital. Investors currently contribute to the strong market incentive that corporations have to externalise costs and this has significant intergenerational equity implications. This is one reason why investors need to have an active interest in the responsibility agenda in and of itself.
Investing as if the long term really did matter is not rocket science. Actually much of what is needed is common sense and a willingness to learn from good practice and the wider corporate world. The investment community has the resources to do it. What it needs to show is that it has the will.
Raj Thamotheram is senior adviser responsible investment, Universities Superannuation Scheme in London. The views are those of the author and not necessarily of the USS
Drivers to long-term responsible investing
q ABI disclosure guidelines and the Institutional Shareholder Committee principles;
q Carbon Disclosure Project, Institutional Investor Group on Climate & Change Investor Network on Climate Risk;
q Company Law Review (‘enlightened shareholder value’) and the Operating & Financial Review (and equivalent reporting projects in other countries);
q Enhanced Analytics Initiative & UN Global Compact/UNEPFI activities focused on how analysts address extra-financial issues;
q Eurosif Transparency Guidelines;
q Extractive Industry Transparency Initiative;
q Investment consultants evaluating fund manager capacity on RI;
q Just Pensions / UKSIF trustee toolkit;
q Managing pension funds as if the long-term really did matter and Marathon Club;
q Myners review and follow-up reviews;
q Pharma Shareowners Group & Pharma Futures;
q 21st Century Investment Inquiry (Restoring Trust), the UN Principles of Responsible Investment and the WEF/Accountability report (Mainstreaming Responsible Investment);
q Universal investor concept and new thinking on portfolio-wide risk.
Resistors to long-term responsible investing
q Career prospects and remuneration incentives are generally designed to reward relative outperformance over the short term – ie, there is little link with absolute risk, let alone the knock-on impact on corporate ethics/responsibility of the signals investors send to investee companies;
q Availability of quality EFI data is weak (because corporate reporting is generally weak) and what data that does exist is not used well by analysts who are not trained or rewarded to consider these issues. This lack of mainstream analyst interest re-inforces weak corporate reporting;
q Analysts/portfolio managers have a skill set which is fit for purpose but this is the ‘old’ purpose. The same is true for investment world views and here, regional differences are marked. In a recent study, the US stood out by being the only region where the majority of investment professionals believe that EFIs will ‘never’ become material. Somewhat depressingly, young analysts seem even more wedded to outdated investment beliefs than their more experienced colleagues;
q Mandates and monitoring processes still tend to focus on simplistic measures of risk (ie, volatility) and relative returns over short time horizons. This is the fundamental driver of much of the above. Even those who are thinking about this issue tend to focus only on the long-termism agenda on the assumption that this will inevitably improve the responsibility agenda.