Hope, experience and business models (Con Keating)



This summer, the steady stream of surveys of the attitudes and actions of asset managers and asset-owners on ESG and climate change has exhibited a common and disappointing finding: the integration of these concerns into investment processes and decision-making seems to still be a minority sport. There is some good news; these findings can only result from honest survey responses. The ‘greenwashing’ and misrepresentation of earlier times seems largely to have passed into history. There is no gain to these denials and negative responses.

Academic findings on climate change are overwhelming; COP21 demonstrates the views and commitment of governments; NGOs and think-tanks abound; even the vultures and ambulance-chasers of the legal profession are gathering in the wings. There are several highly visible role models, who have been managing their investments in an engaged and responsible manner, but the rate of spread is glacial. A cynic might even wonder which may occur first; the complete disappearance of all glaciers or the integration by the majority of these concerns into investment processes.

Climate change deniers are clearly now a very rare breed, an endangered species; so much so that, for the few remaining, a preservation programme may be warranted, on grounds of biodiversity. It is clear that the majority of the stated reasons for inaction are ex-post rationalisations rather than true ex ante motivations. Concerns centred on fiduciary duty are an obvious example of this. Driven, perhaps, by feelings of shame and guilt, self-exculpation frames these explanations.

In one regard, the advocates’ expectations of change, positioned as they are in a culture of shareholder primacy, were poorly founded. Shareholders do not own the firm, and their property rights and degree of influence over the company, through voting and the board, are quite limited. Maintaining balance among and for the benefit of other stakeholders is an important ingredient in successful capitalism.

The open question remains: why so slow a rate of progress of adoption?

Both ESG and climate change issues are widely presented as matters of risk. Effectively, the approach to investment management being advocated by these campaigners is management by risk, rather than the risk management where we are both familiar and experienced. It is a profoundly different business model for asset manager and indeed asset-owner.

The traditional investment management model is management by expected return, supplemented by risk management, with diversification entering only as a distant lower order consideration. Analysis of the sensitivities of the return, volatility and diversity parameters of standard models of asset allocation, such as Markowitz, provide academic support for this approach. In asset allocations, the expected return is an order of magnitude more important than the volatility, and that is itself around five times as important as the diversification.

Asset managers are facing many immediate concerns, notably pressure on transparency and their costs and fees, alongside substantial concerns over the uncertainties of current economic and financial evolution – the new normal.

The risks of climate change and poor governance are long-term in nature; and the problems with short-termism have been debated for decades. There is still not even widespread acceptance that chasing the immediately optimal outcome, even if successfully repeated, may not, and usually will not lead to the long-term optimal. Such short-term iterative processes tend to get stuck in local optima, never finding the global heights. Such strategies fail to admit indirect approaches, John Kay’s obliqueness; think of taking one step back to leap three forward.

The risks now faced are qualitatively different from the risks of traditional financial risk management. Here we are facing uncertainty, ambiguity and even indeterminacy; the very nature of these processes makes causal chains difficult and often impossible to identify, even ex post. The implicitly proposed change to management by risk is questionable and may not even be feasible. Moreover, as one of the few things that we know about risk is that it means that more things may occur than will, the possibility of redundant and costly mitigation interventions and actions is real. In this regard, reticence, repeated discussion and slow development on the part of investment managers and asset owners are attractive features, not undesirable traits.

Portfolio management is intrinsically and traditionally a business in which conservatism makes sound commercial sense. The prospect of regret similarly biases asset-owners, and their agents, notably trustees, operate in a culture of prudent behaviour, and reckless prudence is more than a good soundbite.

The howls of protest from a fright of ghostly fund managers are ringing loud in my ears: we have innovated this and that. It is true that we have seen much innovation in financial services over the past few decades. However, these new products and innovations have been overwhelmingly concerned with the rearrangement of claims on existing assets; new divisions of the fixed sum game of market performance. Some have merely been resurrections of past practices. The business model shift proposed later is qualitatively different; it is about increasing the total pay-offs to the game.

The increasing importance of indexed portfolios is clear evidence of the threat to active fund management. In order to deliver value in their client services and warrant their income, it is growing increasingly clear that fund managers need to change their business model. Among many possible, the most likely to succeed to be one in which they co-operate and collaborate with their investee companies in order to improve the long-term performance of those companies and with that their own value and investment performance; a model of direct involvement.

Some fund managers see governance fulfilling this role, but that is a triumph of hope over experience. While good governance may help to avoid disaster and usually lead to better positive performance, it is far too limited in scope and range of effect and outcome to compete with the co-operative approach. Indeed, it is contained within that co-operative, collaborative model; governance alone will not suffice.

In many regards, this was what we expected of the private equity sector, only to be acutely disappointed. One real obstacle to the new direct approach is that asset managers currently lack staff with relevant competence, the detailed knowledge and experience of the day-to-day operational challenges faced by industrial and commercial enterprises; financial analysts being rather more concerned with the animal spirits of markets than the fundamental performance of the firms they cover analytically. But that is easily resolved, and may carry the incidental benefit of grounding asset managers and their compensation in the real world.

This collaborative model has been adopted in recent times by a few; notably the Canadian CPPIB and Australian Super. It is notable that they have succeeded in integrating both ESG and climate change concerns into their return expectation formation, but more importantly in their co-operation and collaboration with investee companies.

The evidence so far is that this new model involves fewer and larger investment exposures, across the entire financial structure of the investee company. The resultant lower diversification should not be a central concern. In any event, it can be mitigated by secured forms of collaboration, such as equipment leasing.

For the first time ever, intangible investment, in patents and intellectual property, by UK companies has exceeded investment in tangibles, such as fixed assets. Traditionally this has been an area where the financial services industry has not served or performed well. The new direct model could well rectify that failing.

Under this new approach, these funds may be disintermediating investment bankers, but provided they possess the required competences, that need be no bad thing. The holistic nature of the collaborative model, with these funds being represented in numerous stakeholder groups also serves to resolve or lower some of the limitations and conflicts inherent to shareholder primacy.

It seems unlikely that we will see significant real progress on ESG and climate change until this new model has been widely adopted by asset managers. Though many have advocated the use of behavioural techniques to accelerate the rate of progress, there are philosophic and cultural concerns with that. Simple commercial self-interest should prove sufficient, but it will take time. We must hope that climate change affords us that time.

About henry tapper

Founder of the Pension PlayPen, Director of First Actuarial, partner of Stella, father of Olly . I am the Pension Plowman
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2 Responses to Hope, experience and business models (Con Keating)

  1. George Kirrin says:

    If I may play back one of Con’s comments with a very few [bracketed] additions of my own:

    “One real obstacle to the new direct approach is that [many, but not all] asset managers currently lack staff with relevant competence, the detailed knowledge and experience of the day-to-day operational challenges faced by industrial and commercial enterprises; [many] financial analysts being rather more concerned with the animal spirits of markets than the fundamental performance of the firms they cover analytically. But that is [not so] easily resolved, and may carry the incidental benefit of grounding asset managers and their compensation in the real world …. [but I wouldn’t bet or bank on it anytime soon].

    Liked by 1 person

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