Top 400: Time for compulsory stewardship
It is a sign of the times that the push for compulsory stewardship, at least among passive managers, is also supported by the CEO of Hermes. Industry commentators are rattled. ‘He’s just talking up his own book’, has been one response. But knee-jerk defensiveness simply exposes the industry’s difficulty with being customer-centric, acknowledging its aggregate economic impact and seeing the writing on the wall. However, there is a clamour for a more substantial debate about the goals of economic policy in the context of stewardship and responsible investing.
We have experienced decades of economic complacency. At first, growth was assumed to be both guaranteed and good for society. Then came the financial crisis. The underlying message has been, ‘give the economy what it needs (first financial market deregulation, then austerity) and it will give us back what we need’.
But as we move into comparative economic stability, we also face low growth combined with intractable social and environmental problems. The question is, what kind of economy and growth model will best serve human welfare in the short and long term?
The arguments in favour of tighter regulation of systemically important investment managers are powerful. First, the problem of investor short-termism has worsened, while talking about long-termism has increased. Investors refuse to publicly acknowledge the scale of the change needed.
Second, with every corporate crisis investors say they are doing things differently. But what we know from the few firms that have been investigated is that investors are ineffectual when it comes to stewardship in relation to failing corporate business models.
• Investment professionals are reluctant to challenge management as long as business models are delivering shareholder value;
• Corporate governance/ESG professionals lack experience in business-model issues and have less influence than their traditional investment peers;
• Large corporations are powerful actual or potential clients for investment firms, not to mention board-level personal connections. These conflicts of interests result in profound self-censorship.
Third, the stewardship agenda is set by insiders. The agenda may have little connection with the real world, despite strong evidence for ‘materiality’. This explains why little progress has been made on human capital management. It also explains why, despite many investors asking for disclosure of greenhouse gases, emissions have not fallen at anywhere near the pace needed to avert big climate risk. And why wealth-destroying M&As are approved so often.
The best way to assess the seriousness of stewardship intent is to look downstream of the investment ‘supply chain’ to see what sell-side and credit-rating analysts know their (immediate) clients consume. For a short while after BP’s Macondo crisis, some oil and gas analysts covered health and safety. But that has largely stopped, despite the fact that drilling (for instance in Arctic or ultra-deep water) is even more risky than it was in the Gulf of Mexico.
Fourth, these voluntary initiatives are just that – voluntary. Investors decide what they will report and how. Comparability is low and detail is weak. The new principles from the UK’s Investment Association are a case in point. Yes, in theory, one principle (the eighth) goes further than the UK Stewardship Code by asking for a narrative about what investors do. But there is no mention of what happens if managers do not report, or report badly. Other sectors, like aviation, mining and nuclear, have found ways to police laggards, but this is still a long way from investors’ thinking.
On the other hand, we also know some concerned insiders who are not knee-jerk anti-regulatory ideologists and who do acknowledge the scale of the problem but also see the weaknesses of the regulatory option.
First, they highlight that if investors really do not want something, they will do everything in their power to actively block it. And investors have considerable political influence, as was shown in the debate about the financial transaction tax.
Second, if investors are eventually cajoled to act, they may take a tick-box approach with very little positive impact. Many investors simply do not think high corporate pay is a problem. Having ticked the box, investors are then off the hook on what arguably is even more important – pay packages that reward executives for taking on dangerous levels of risk.
The Dodd-Frank reforms in the US illustrate how relying on prescriptive regulation becomes part of the problem. As regulation gets more detailed, a well-resourced industry runs rings around the regulator, helped by high levels of corporate political capture. So, seven years after the global financial crisis, the legislation is still being fought over.
Synthesising the good arguments from both sides, the answer is to focus on much higher levels of transparency and to make this mandatory. Investors should be made to disclose, for example, how they vote their shares and their portfolio turnover. And this should include asset owners, not just investment managers.
What will make this happen? The answer is as simple as it seems unlikely – public pressure on a scale that causes governments and regulators to be assertive to protect the public’s best interests. But it is clear that the investment system alone is incapable of delivering the necessary change.
The current meaning of fiduciary duty is taken by many asset owners to mean maximum nominal return at lowest cost. One investment manager, speaking anonymously, confirms that doing stewardship loses clients because of very slightly higher costs. So it should come as no surprise that investment managers and consultants make a parallel error by interpreting fiduciary duty to mean delivering the return they promise within the volatility parameter they predict.
All these interpretations are as supremely short sighted as they are commonplace. What can we do? Either we can wait for another Icelandic banking crisis or ‘Luxleaks’ to get sudden regulatory change. Or we can proactively create the context that insider reform initiatives need to deliver meaningful change. That means two things.
First, societal pressure forces an expansion in how fiduciary duty is interpreted, so encompassing the views of key stakeholders and over a much longer time period than is normal. Record investor support for resolutions at BP and Shell on disclosure of climate risk, which even management supported, is one example. What is noteworthy about these resolutions is that they were triggered by religious investors and local authority pension funds, both of which have a bias towards stakeholder engagement – and this investor coalition also had the support of civil society NGOs.
Second, regulators must make full use of the law, especially ensuring that current law is interpreted correctly to remove the benefits of free-riding. In fact, much can be achieved simply by engaging purposefully, as the Bank of England has shown in regard to insurance companies and climate risk. With a focus on execution, change could happen very quickly. Interestingly, the UK’s Financial Reporting Council has appointed a senior Hermes staff member as its first director of investor engagement.
If regulators wanted to they could easily make adhering to the Stewardship Code much more than the box ticking ‘nice to have’ that it is today. If climate risk disclosure is good for BP and Shell, might regulators ask all major institutional investors (including pension funds) whether they are asking the same from other fossil-fuel companies?
The good news is that leadership of the investment industry has finally woken up. The CEO led project, Focusing Capital on the Long-Term, co-ordinated by McKinsey & Co, is one example.
But progress remains incremental and is not fit for purpose in terms of meeting real-world challenges. We favour radical transparency. Perhaps we are dreaming, but miracles do sometimes come (partially) true and the investment industry (or at least its clients) could really use such a miracle.
Raj Thamotheram is CEO at Preventable Surprises and Matthew Taylor is CEO of the Royal Society for the Encouragement of Arts, Manufactures and Commerce (RSA)