Whose risk counts?
Paul Woolley – a successful academic economist, regulator and fund manager – gave sustainability investors a direct challenge at the recent Responsible Investor conference.
“When will large funds stop using their beneficiaries’ capital to fuel a dysfunctional asset management industry?” he asked.
So what should investors do differently? Some things are beyond any reasonable doubt. One example: stop using cap-weighted benchmarks (which are distorted by momentum) and shift to fundamental indices (eg, global GDP plus local inflation). Other examples: do more stewardship activity, no more new coal IPOs. Underweight what the ESG research firm, GMI, has called ‘drone’ corporations.
Finding things that need to change is easy. It’s changing that’s very difficult. Just two examples. JP Morgan Chase is an archetypal drone corporation, and given its size, creates risks for the whole global economy. Yet investors blinked at the resignation threat from Dimon. And at the 2012 IPE Awards seminar, a clear majority of attendees agreed that pension funds were not making using of their long-term potential but also voted, just as strongly, for quality reporting.
What’s the fundamental reason for this disconnect between what we know needs to happen and what is happening? The answer is simple: agency issues. The risk ordinary members face is very different from the risk investment professionals face, and it’s clear whose risk counts most.
The dysfunctionality of the supply chain gets worse as the chain gets longer, and sell side/credit-rating agency research and investment consultancy are particularly problematic. But agency issues are also to be found within pension funds themselves since the technical experts who direct these funds often have the same mental models as Wall Street and often incentivised over periods that are much shorter than the interests of end beneficiaries would suggest.
Of course, there are exceptions. Also speaking at the event was Sally Bridgeland. She co-developed with one of us the 2002 competition Managing Pensions Funds as if the Long Term Matters. Bridgeland highlighted the good news – 450 registered for this conference, and the greater sophistication in thinking has developed over the last decade. While this is important and true, it is also evident that progress is far more incremental than it needs to be.
What will accelerate the pace?
• Another crisis: it is coming and probably soon but will we learn given that we haven’t learned from last ones? If the next crisis is bigger than the last one and results in a real change in government, the ‘Iceland effect’ could be seen in other countries too;
• Campaigners forcing through asset owner disclosures: this has already started on climate change and many NGOs are starting to understand the role of funds;
• Litigation: could those who adopt herd mentality face charges of fiduciary irresponsibility in court? The lesson of the last crash is that litigation is slow to get going but can itself become a herd activity – look at LIBOR;
• New leadership in trade bodies using best practice to drive up standards: the UK Investment Management Association, for example, looks to be a work in progress, changing the definition of good performance;
• Unions deciding to do something about their trustees who have been ‘brainwashed’ (to quote the general secretary of the ITUC): this is where the ‘whose risk counts?’ question might get played out most powerfully as soon as union leadership really understands the costs of this brainwashing for their members.
Probably many, if not all, of these actions will be needed and each will reinforce the other. Yet we should not underestimate the immunity to change, and the current rush to shale gas shows just how short-term and non-systemic our thinking is.
Readers may wonder whether these change drivers will be enough and whether it will be in time. This is understandable but they are the wrong questions because we simply cannot know. By far the most useful question is which of these drivers can you best contribute to. And then just do it.
Raj Thamotheram is an independent strategic adviser, co-founder of PreventableSurprises.com and president of the Network for Sustainable Financial Markets, while Aidan Ward is director of Antelope Projects, a UK-based consultancy