Fundamentally Rewiring Finance
In his book, Finance and the Good Society, Nobel Prize winner Professor Robert Shiller says at its broadest level, finance is the science of goal architecture – of the structuring of the economic arrangements necessary to achieve a set of goals and of the stewardship of the assets needed for that achievement.
“The goals served by finance originate within us. They reflect our interests in careers, hopes for our families, ambitions for our businesses, aspirations for our culture, and ideals for our society; finance in and of itself does not tell us what the goals should be. Finance does not embody a goal. Finance is not about “making money” per se. It is a “functional” science in that it exists to support other goals – those of the society. The better aligned a society’s financial institutions are with its goals and ideals, the stronger and more successful the society will be. If its mechanisms fail, finance has the power to subvert such goals, as it did in the subprime mortgage market of the past decade. But if it is functioning properly it has a unique potential to promote great levels of prosperity,” he says.
Put more simply, finance is good for society. The problem is finance has been waylaid, it has become about making money, and has lost its purpose.
This is an age of financial capitalism, and that will not change, and Shiller argues finance should be embraced. But it should be expanded, corrected and realigned.
In their new book What they do with your money: How the financial system fails us and how to fix it, Stephen Davis, Jon Lukomnik and David Pitt-Watson lists four main roles for the finance industry: providing safe custody for assets, a payments system, intermediation between savers and borrowers, and risk reduction (insurance).
Lukomnik, who is the executive director of the Investor Responsibility Center Institute, says the book postulates the purpose of the financial sector, which he says, like Shiller, is not to make money.
“The purpose is a service business, to serve the real economy,” he says, and its success should be judged on that.
Intermediation the same price for 130 years
However in recent times finance has been failing the real economy. One simple point of failure is the fact the price of intermediation hasn’t changed, and in the past 130 years has hovered between 1.3 and 2.3 per cent.
Thomas Philippon from New York University measures the cost of financial intermediation and shows that the cost has been trending upwards since 1970 and is significantly higher than in the past.
“In other words, the finance industry of 1900 was just as able as the finance industry of 2010 to produce loans, bonds and stocks, and it was certainly doing it more cheaply,” he says in his paper, Finance versus Wal-Mart: Why are financial services so expensive?
One reason is that the total compensation of financial intermediaries (profits, wages, salary and bonuses) as a fraction of GDP is at an all-time high, around 9 per cent of GDP in the US.
Another reason is that while some layers of intermediation may have contracted, others have been added, and money saved in one area has been offset by new charges in other areas.
What is clear is the end user is no better off.
“Despite its fast computers and credit derivatives, the current financial system does not seem better at transferring funds from savers to borrowers than the financial system of 1910,” he says.
So while the finance industry has increased output it has become inefficient in its production, and much of that is due to more trading, Philippon says.
“Trading activities are many times larger than at any time in previous history,” he says.
Lukomnik says it is a failing that the industry is paid by activity or assets and not outcome.
“We’ve moved to a trade-oriented investment management industry,” he says. “The steps between agents is improving, but the A to B of touching the real economy is not becoming efficient.”
“There are 79,669 mutual funds or trusts in the world, this decreases the economies of scale and adds to the costs of investments.”
Lukomnik and his co-authors say in an ideal world, banks should hold more capital to ensure the safety of deposits; stock exchanges should be prevented from giving high-frequency traders faster access to market prices; and executives should be paid bonuses linked to the long-term growth of the business rather than the share price.
But above all, they argue, the interests of the underlying clients of the finance industry – the depositors, the workers and the pensioners – should come first.
So what needs to be done to expand, correct and realign finance? And what role do institutional investors play?
Overcoming short- termism has been touted as one of the cornerstones to recalibrating large institutions and their beneficiaries.
Focusing Capital on the Long Term (FCLT), which was started in 2013 by Mark Wiseman of CPPIB and Dominic Barton from McKinsey & Company, is focused on developing practical structures, and approaches for longer-term behaviours in the investment and business worlds.
Its stated goal is to break the short-termism cycle that rotates from a perceived need by investors for short-term performance, to a perceived need for continuous positive quarterly earnings guidance by corporate boards and senior management. The result is a systemic underinvestment in the kind of longer-term value creation that retirement savers need to generate adequate income streams after they have finished working.
FCLT.org says that “fundamentally rewiring the ways we invest, govern, manage and lead to better focus on the long-term outcome will require taking concrete, pragmatic steps.”
In its long-term portfolio guide it says that “long term investing is a frame of mind rather than a holding period, and a culture rather than a directive.”
Importantly it is also not driven by rankings or benchmarks, but focuses on long term expectations and outcomes.
It outlines five core action areas for institutional investors:
Investment beliefs – Clearly articulate investment beliefs, with a focus on portfolio consequences, to provide a foundation for a sustained long-term investment strategy
Risk appetite statement – Develop a comprehensive statement of key risks, risk appetite, and risk measures, appropriate to the organisation and oriented to the long term
Benchmarking process – Select and construct benchmarks focused on long-term value creation; distinguish between assessing the strategy itself and evaluating the asset managers’ execution of it.
Evaluations and incentives – Evaluate internal and external asset managers with an emphasis on process, behaviours and consistency with long-term expectations. Formulate incentive compensation with a greater weight on long-term performance
Investment mandates – Use investment-strategy mandates not simply as a legal contract but as a mutual mechanism to align the asset managers’ behaviours with the objectives of the asset owner.
In other practical steps, the paper says that investors wanting to focus on the long term should align stakeholders and minimise agency costs; focus on intrinsic value of assets and long term real value creation, invest rather than speculate; develop and execute robust, sustainable investment processes and positively influence the management of investee companies.
Similarly the PRI’s mission calls for it to promote a sustainable global financial system that supports long-term value creation and benefits the environment and society as a whole.
This mission was borne from a belief that the financial system must contribute to sustainable economic development if it is to effectively serve society.
But Martin Skancke, chair of the PRI board, says: “The reality, however, is that the financial system does not function as effectively as it should. It does not exhibit the characteristics that market participants would typically associate with being sustainable, such as being fair; resilient; transparent; efficient; inclusive; well-governed and aligned with society’s needs.
It is susceptible to risks and sustainability challenges that can manifest themselves in various ways.
“We believe that because the operation of the financial system influences the performance of institutional investors, investors should consider the operation of the financial system as a whole, including its purpose, its design, its effectiveness and its resilience to risks and sustainability challenges.
“We are already supporting signatories to respond to financial system risks, including: integrating externalities such as climate change; providing guidance to asset owners on how to embed environmental, social and governance (ESG) considerations into mandates; improving corporate sustainability disclosure via the Sustainable Stock Exchanges initiative; and re-stating the case for action on ESG issues as part of investors’ fiduciary duty.”
This year the PRI conducted a consultation process with signatories to identify the key areas for the PRI to influence, the underlying causes of risk and sustainability challenges in the system; and the drivers that may shape these over the next decade.
According to the PRI, the issues affecting a sustainable financial system fall into four main areas of risk and opportunity:
The relationship between investors and companies
The relationship between managers, owners beneficiaries and advisers in the investment chain
The operation of the markets
Asset Owner Power
Many commentators agree that an effective way to really enact change is to focus on building strong buy-side organisations.
Stephen Davis, associate director of the Harvard Law School Programs on Corporate Governance and Institutional Investors, says in the past two decades there has been considerable effort reforming the governance of corporates, and great improvements have been made in management and on corporate boards.
“But we have made those companies more accountable to large institutional investors, and little time has been spent on the governance of those investors,” Davis says.
“We need to shift the focus to the issues of accountability and transparency of institutional investors, then the agents will be more aligned with the grassroots – us, the people. If asset owners are more aligned to the beneficiary then there will be a knock on to asset managers.”
Building strong buy-side organisations is something Keith Ambachtsheer has been advocating for many years.
This means asset owners need to take stock of their internal organisations, pay attention to governance and decision making, hire good internal teams, invest directly, reduce the number of external providers and be conscious of costs.
“It is costing the Norwegian Sovereign Wealth Fund around 1 per cent a year not to have an arm’s length organisation with internal management, like the Canadian Pension Plan Investment Board,” he says.
“The Norway model produces 15 basis points of excess return per year but Ontario Teachers Pension Plan produces excess return of 2 per cent per year.
“Applying the Drucker principles to pension organisations – you’re effective or not, and this comes down to vision clarity,” he says.
“Removing the number of agents is key. There are too many agents and we need more clarity so the agents truly represent the principals.”
And, he says, the most direct way to deal with that is to produce strong buy-side organisations.
Harvard’s Davis says that beneficiaries should know who’s in charge of their money, who the governing body is and how to reach them.
“And if the governing body is not performing they should be able to get rid of them,” he says. “There should be more transparency so beneficiaries know how their money is used. You can look up how a manager is investing in what companies, and the last transaction, but you can’t find out exactly what you’re paying in fees or how on a regular basis your money is voted. Beneficiaries should know how their voice is expressed on certain issues, for example CEO pay, or climate change risk.”
“Mostly as an ordinary beneficiary you don’t know how your money is managed. We need to refocus and look at where the beneficiaries’ interests lie.”
“If we can get the governance of the fund sorted out they can make choices to, for example, invest directly. Are decisions made in best long term interest of the beneficiaries? We can’t have confidence in that if the governance is not there.”
Davis, who was involved with the PRI since the beginning, says it has been transformative in influencing the capital markets, but it is still feeling its way.
“That’s right that it is still feeling its way, there’s a new adventure.”
“It’s all about stepping back, and looking at how do you make institutional investors, these large bureaucracies, into long term owners?”
Geoff Warren, research director at the Centre for International Finance and Regulation agrees that addressing agency issues associated with multi-layered investment organisations is central to organising an investment firm to be focused on the long term.
The aim is to ensure alignment,” he says. “All involved should remain focused on long-term outcomes; and success should be appraised in these terms. It is critical that the organisation is designed to foster this alignment, which in turn is reinforced in the processes by which outcomes are evaluated and rewarded.”
In his paper, Designing an investment organisation for long-term investing, he highlights the need to avoid making judgments based on the flow of short-term results, and how an element of trust is required to give fund managers the encouragement and confidence to be long-term investors.
Another key theme, he says, is the requirement for an investment approach that focuses on the long term. The investment philosophy, process and information used should all look beyond near-term market prospects, and address what will maximise long-term outcomes.
In sum, long-term investing is about perspective and horizon: the sights should be squarely directed towards the long run.