The End of Investment?
I recently attended a school function and was chatting with a friend (“Pam” for the sake of this post) who is a buy-side analyst at a major asset management firm, the kind that manages hundreds of billions of pension fund assets, and 401Ks. Pam’s firm, like many mainstream asset management companies, is a signatory of the Principles for Responsible Investment (PRI). The first two Principles state: 1. We will incorporate ESG (Environmental, Social, and Governance) issues into investment analysis and decision-making processes. 2. We will be active owners and incorporate ESG issues into our ownership policies and practices.
In response to a simple “how’s work going” type of question, Pam proceeded to tell me how much the business has changed in recent years, suggesting this was in response to the financial meltdown. She told me she no longer writes in-depth research reports. “Everything is about short-term trading.” Remarkably to me, she told me all the analysts now run their own portfolios and their bonus is 100% driven by performance.
Short-termism on Wall Street has frustrated corporate executives for years. CEOs have rightly complained about all the 29-year-old equity analysts who write on (and move prices on) their stock from the sell side based on what often amounts to quarterly noise in their results. The “sell-side” analysts get paid to make trading calls and to generate trading volume for their firms, the brokerage houses and investment banks. What is so remarkable about my friend’s comments is that she is at a very old school conservative buy-side firm, theoretically supporting long-term investment decisions of term portfolio managers with long-term fiduciary duty to clients. Her comment suggests that the new institutional “buy side” including the analysts whose job is research, are in fact just trading, no different than fast-trading hedge funds. She said the new mantra is to “capture the volatility.”
We’re all traders now.
Think about the system we have created, unwittingly for the most part. Wall Street develops new products in the pursuit of efficiency. For over a decade beginning in the 1980s when I started in the business, products such as derivatives and securitization truly did enhance efficiency of global capital markets. Efficiency begets greater efficiency, enabled by ever-faster communications technology and computing power. Some bad guys (they are usually guys) cause severe disruption along the way, given the high-performance capital markets we have created. But these were just the inevitable bad apples, while efficiency was understood as progress. But as any systems scientist will tell you, efficiency comes at the cost of system resiliency. This is true with or without an ideology of deregulation (although such an ideology compounds the loss of system resiliency).
Greater efficiency, faster flow of capital in search of shorter-term pricing anomalies, and greater concentrations of power in larger and larger pools of capital translate into greater volatility. Which triggers the logical reaction of the asset management firm my friend works for. Analysts begin to trade their own accounts for their bonuses. Meanwhile, those back in the real world, including the corporate executives that were frustrated about the short-term focus of Wall Street a decade ago, have figured out that we face some profoundly serious challenges ranging from natural resource limits to obesity to structural unemployment, to a looming water crisis and of course climate change. Enlightened investors understand the link between investment and the quality of the economy of tomorrow and its ability to deliver well-being without fouling the nest (see PRI principle #1 above). They understand the influence investors should have over corporations in a capitalist system (see PRI principle number 2). Such insight drove the creation of the PRI in the first place.
One data point is not conclusive, but I’m confident my friend’s story is not an anomaly. When major blue chip signatories of the PRI allow, much less demand, their research analysts to trade their own portfolios, and determine their bonus based entirely on annual performance, just like hedge funds, we know we need a new approach.
In a recent post on The Bell, which we reposted on the Capital Institute’s Future of Finance blog, Peter Kinder noted that two ERISA interpretative bulletins, which have received little press and were erected during the Bush administration, will probably also make it difficult for many institutional investors, even those who take their role as PRI signatories seriously, to meaningfully incorporate ESG principals into their decision-making. “In the waning days of the Bush II Administration in October 2008,” he reports, the Department of Labor’s Employee Benefits Security Administration(EBSA) issued an ERISA interpretive bulletin that "adopted a ‘rigid rule’: ERISA barred virtually any type of what it called ‘economically targeted investment’ (ETI) – which includes applying ESG-type criteria in investment decisions.” EBSA also issued an equally chilling bulletin on proxy voting. Kinder notes that this bulletin requires an ERISA fiduciary to “establish the economic benefits of voting proxies.” He goes on to say, “There’s no wiggle room here. If the ERISA fiduciary can’t show a dollars and cents justification for a vote, it must refrain. And EBSA has backed that up by advising fiduciaries to keep records on voting, including the cost-benefit analyses.”
It’s time for the many leading global corporations that are taking sustainability very seriously (which they are) to push investors much harder and to push back on Labor Department rulings like those cited above that make it difficult for fiduciaries to reflect a longer-term view in their investment practices. More important, be serious and engage directly with the world’s leading asset owners, skipping over the middle men on Wall Street who have proven to add so little value. GE, Ford, Unilever, and Duke Power, to name just a few, should not feel constrained by a bunch of 29-year-old, sell-side analysts, nor forty-year-old, buy-side analysts who now trade their own portfolios with other people’s money. Pension funds and sovereign wealth funds who understand real, long-term sustainable value make perfect partners with plenty of political throw weight for the multi-trillion-dollar real investment challenge ahead, beginning with replacing our energy infrastructure. It can be done in separately capitalized ventures if need be. These real investment flows, already happening in private “impact investments” by leading enlightened private investors, will fuel the transition to a sustainable economy, and save capitalism from itself. The end of real investment (in contrast to speculation) spells the end of capitalism. It’s time for real investors to lead.