In 2015, fifteen Dutch CIOs of asset owners and asset managers wrote an article with the title: ‘Short-term profit or long-term value creation?’ A growing group of pension funds, asset managers, consultants and companies worldwide try to answer this question.
Making an impact by defining the right mix of ESG strategies
Whilst supranational institutions and NGOs have for too long been alone on the front lines of the battle against poverty, corruption, and resource depletion, both companies and the finance sector are now fully aware of the role they have to play in the transition to a more sustainable economy. So-called “megatrends” – demographics, globalisation, the environment, societal evolution – act as disruptive forces and offer growth potential for investors. The motivations of asset owners have evolved; they have become more elaborate, more complex and more meaningful, and now include topics that go beyond the unique consideration of achieving financial performance. Even if performance remains the primary objective, investors now want their portfolios to have an impact on both the environment and society, and want to measure the efficiency of this choice.
Economics has developed as a science, conveniently forgetting its roots in political philosophy. Unfortunately that ‘science’ is severely dated, and the functioning of the global capital markets has become separated from the real world. A simple thought experiment throws light on the theoretically correct strategies for a rational saver, but leaves us with unsatisfactory answers. Neglecting the societal context of our saving activity only serves to further isolate the capital markets. Instead, a self-perpetuating system requires investors to evolve from simple allocators of capital to its steward, with far broader responsibilities. Maximising holistic returns represents practical action of the responsibility by investors, and stretches far beyond creating wealth simply for its own sake.
Using wealth, not returns, to set objectives and measure success
For asset owners that have liabilities to meet, whether they be pension or endowment funds, or a saver planning for retirement, one of the key questions they must answer is how much wealth they need to generate in order to at least meet those cash-flow requirements. Traditionally, investment objectives and our success in achieving those objectives has been predominantly measured by looking at total returns – the general level of return averaged across the life of the fund in question. For example, a pension fund would need to achieve X% return over its expected life to have sufficient assets to meet its expected liabilities. For an individual saver, what level of assets is enough to ensure they have sufficient funds to live on once they retire? It is becoming increasingly clear, however, that focussing on total returns is not sufficient. These questions may be better answered by looking in greater depth at the level of absolute wealth as a target consistent with a desired objective, and the impact of different paths of return on the likely level of that wealth during the accumulation and spending phases of a fund.
DC investors are making a costly trade-off that many are completely unaware of. The focus on daily liquidity in DC pension products might provide members with the ultimate flexibility governments want them to have, but the vast majority of members neither use that flexibility nor realise the hidden cost at which it comes. Research points to a potential gain of five percent or more if DC pension pots were allowed to invest in illiquid assets. As the pensions environment and demographic changes place ever more pressure on individuals’ retirement savings, governments can no longer afford to ignore this issue and must launch consultations on the sense behind both daily liquidity and charge caps. Savers deserve to know about the compromises they are being forced to make. It is time for a serious rethink.
Conventional wisdom focuses on two structures for accumulating wealth to provide income for retirement: defined benefit and defined contribution pension schemes. In each case, ownership of both upside and downside risk sits firmly on one side of the table. There is little talk of alternative structures.
A few years ago, when the 300 Club was first established, the financial community still held onto a belief that the economic and financial tools traditionally used for decision making would be more than adequate to navigate the global economy’s return to safe harbour and rebuild the financial system. Professional investors and central bankers alike still looked to modern economic theory, including, Keynesianism and the Chicago School among other strands, and the ‘scientific’ modality of the financial theory it generated, from Markowitz and Sharpe onwards, to chart the map to the future.
Peter Drucker famously said: “Culture eats strategy for breakfast.” In the investment world, while investment strategy delivers performance it is the people and the culture that shape the investment strategy. It follows that culture is integral to the quality of investment performance and sustainability of investment organisations. Yet this little-understood ‘secret sauce’ of investment organisations is all too often under emphasised to the detriment of the organisation itself and those who trust it to manage their money. The following analysis, derived from extensive discussions with investment leaders in the recent past and over time, suggests a much greater focus is needed on this critical element of successful investment management.
Einstein reputedly said: “We should always make things as simple as we can, but no simpler.” Looking back over the last 40 years, it is clear the investment community has repeatedly been guilty of oversimplification to the detriment of investors. The lessons of the past convince me that, going forward, successful asset owners and asset managers will be those that stop making things too simple. They will instead acknowledge that: tail events occur more frequently than a ‘normally’ distributed world implies; volatility serves little purpose as a risk measure; acknowledging behavioural biases is the most important step to overcoming them; and there are risks and opportunities that no backward-looking statistical measure will ever capture, but it would be extremely foolish not to account for those that should be expected.
The best risk control lies in being able to see an entire portfolio easily and being able to spot deviations from the expected without difficulty. Transparency should therefore be the primary method of risk control in most portfolios.
It is increasingly widely recognised that the industry’s best practice model of the last three decades has not served us well and is arguably not fit for purpose. But while it has been easy to pick holes in the current model, many, if not most funds, carry on regardless because no new model has emerged to take its place.
‘We have changed from a profession with aspects of a business, to a business with aspects of a profession,’ according to John Bogle, founder and former partner of Vanguard. In the past thirty years, asset management has evolved from a profession to a distribution-driven industry, and shifted from a client-driven approach to a product-driven approach. In fact, a growing body of opinion suggests that asset management in its current form does not add value. By far the lion’s share of global savings is controlled by financial conglomerates. These are respectable institutions, of course, but many of them have a short-term focus within an activity they do not even consider their core business. Of the investment funds that are actively managed by the conglomerates, the long-term performance of the majority1 lags behind the index. Apparently, they fail to convert our savings into profitable production capacity.
The 300 Club believes that modern portfolio theory and practice are failing institutional investors at a time when their depressed funding levels and high covenant risks require smarter ways of investing.