Universal Owners, Fiduciary Capitalism and Responsible Investment: Challenges and Opportunities

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Universal Owners, Fiduciary Capitalism and
Responsible Investment Challenges and
Opportunities

• A module for Netspar-UMBS Academy
• May 2008
• Jim Hawley
• Professor, School of Economic and Business
• Co-Director, Elfenworks Center for the Study of
  Fiduciary Capitalism
• Saint Marys College of California

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Organization of Module

• Introduction and Lecture 1.5 hours
• Break 10 minutes
• Norway-WalMart Case Groups 40 minutes
• Case Groups Report Back 25 minutes
• Reading Discussion 35 minutes
• Wrap Up and Conclusions 10 minutes

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Lecture Roadmap

• Background/managerial capitalism
• Fiduciary capitalism and universal owners (UO)
• Corporate governance stages/phases
• UO analytics and examples
• Universal monitoring
• 5 Challenges and opportunities

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Roots and Perspective An Approximate Chronology

• Ethical Investing to Influence Corporate
  Behavior--SRI (socially responsible investment)
• Corporate Governance
• Responsible Investment
• Fiduciary Capitalism
• Universal Owners

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Background

• Fiduciary Capitalism
• Universal Owners
• The Modern Corporation..
• And Adam Smith

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Adam Smith, the Corporation, Nature of Private
Property, and the Agency Problem

• The directors of such companies joint stock
  companies however, being the managers rather of
  other people's money than of their own, it cannot
  well be expected that they should watch over it
  with the same anxious vigilance with which the
  partners in a private copartnery partnership
  frequently watch over their own. Like the
  stewards of a rich man, they are apt to consider
  attention to small matters as not for their
  master's honor, and very easily give themselves a
  dispensation from having it. Negligence and
  profusion, therefore, must always prevail, more
  or less, in the management of the affairs of such
  a company. (Emphasis added.)

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Managerial Capitalism

• Berle/Means, Marshall, Chandler and others
• private property has changed with the rise of
  the modern firm.
• Ownership and control are separated in the modern
  corporate form
• Private property in a new form not your basic
  Adam Smiths (or Karl Marxs) capitalism
• Markets are typically not laissez faire large
  firms have traditionally internalize markets
  (vertical integration and/or tight
  subcontracting alliances, R and D sharing, etc)

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The Modern Managerial Corporation

• Logic of public equity markets and
  professionalization of management leads to
  separation of ownership and control
• Separation leads to the agency problem
• how to constrain managerial opportunism
• Growth of institutional ownership and the
  concomitant decline of individual ownership
  presents challenges and opportunities.
• The rise of fiduciary capitalism--

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What is Fiduciary Capitalism?

• Institutional ownership dominates
• Also called Pension Fund Capitalism (Clark)
• Financially Intermediated Society (Bogle)
• La République des actionnaires (Gomez)
• The New Capitalists-Citizen Investors
  (Davis,Lukomnik,Pitt-Watson)

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Fiduciary CapitalismWhy the Adjective
Fiduciary?

• Describes and recognizes a changed ownership
  structure and
• Nature of institutional ownership in many
  countries-fiduciary or fiduciary-like
• An ownership revolution and its implications
• U.S. as an example.

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Main Types of Institutional Ownership

• Local/regional pension funds
• Sovereign Wealth Funds
• Sovereign Pension Funds
• Mutual/Unit Funds
• Universal Banks
• Insurance firms

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Fiduciary Obligations and Law

• Common law countries (vs. civil law)
• Equity market financing (vs. bank)
• Diversified ownership (vs. bloc)
• Post 1970 institutional ownership vs. individual
  (and controlling blocs main banks, etc.)

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Sea Change in Ownership Underlying UOs

• Common law countries UOs are fiduciaries for a
  large proportion of employees and investors
• 60 or more of the adult population--U.S.,
  Canada, UK, Netherlands (civil law)
• Examples countries where UOs are emerging
• Some are sovereign wealth or pension funds
  others not
• France
• Ireland
• China
• Japan
• Norway is a special case
• Most other countries UOs are few, ownership
  dominated by families, managers and/or
  governments

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Whats unique about UOs?

• Long-term return depends on overall economic
  performance--not simply aggregated return on
  individual shares and other assets
• Internalization of negative and positive
  externalities in portfolio, to some degree
• Closest to a proxy for the general, public
  interest in whole economy

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UOs

• Due to internalizing externalities, the
  performance of the whole is great than the sum of
  its parts.
• Calculate performance holistically, not only on a
  firm by firm (smoke stack) basisCHALLENGE/OPPORTU
  NITY 1
• Have a quasi-public policy interest given
  investment-return horizon and investment
  diversityCHALLENGE/OPPORTUNITY 2

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Logic of Universal Ownership

• Most universal owners cannot or do not sell they
  are indexed or shadowed indexed.
• Most universal owners portfolios mirror each
  other
• Thus, they cannot sell without fear of market
  disruption (and therefore loss)
• Consequently, the importance of non-market means
  of influencing firmscorporate governance
  activism--Engagement

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Logic continued

• Since they cannot sell they must care
• Care
• not only focusing on individual firm performance
  and behavior,
• BUT on the interactive externality effects within
  a universal owners portfolio.
• Secondarily link Risk
• related to norm shifts and the various types of
  contingent liabilities norm shifts often create.

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• UOs are fiduciaries or have fiduciary like
  qualities
• Duty of loyalty and care (U.S.)
• They are managed by professionals
• They use the services of investment advisers,
  investment managers, consultants, etc. creating
  an investment agency chain--
• a new and complex agency problem
• Smith, Marx, Berle/Means agency problem seems
  simple

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• Thus, major agency-governance concerns
• Internal (vis à vis to whom they are loyal and
  their internal investment managers)
• External (vis à vis their investment
  chain/external managers/consultants)CHALLENGE/OP
  PORTUNITY 3

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Whats Unique 2

• Large funds
• Increasingly concentrated
• Largest 100 U.S. fiduciary institutions hold 52
  of all publicly traded equity
• Indexed (actual or shadow)
• Too big to sell- Must care (Hirschmans voice)
• Not a stock picker

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Whats Unique 3

• A long term investor
• Do they act like them?
• Corporate governance/engagement--is key.
• Long-term economic performance is governance goal
• Is a governance activist of necessity--Or
  fiduciary duty should obligate it to be

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Whats Unique 4

• Ownership Becomes Professionalized
• Investment Agency Chains
• Problems and conflicts of interest
• Interest in Efficient Capital Markets
• No Assumption of Efficient Market Hypothesis Due
  to Externalities Internalized by Universal Owners

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• In SumThe concept fiduciary capitalism captures
  these trends
• Ownership sea change
• Broadly diversified across most asset classes
• Large scale, long-term focus (or should be)
• highly diversified, therefore internalizing many
  externalities
• The agency problem is manifest in the investment
  chain, and perhaps internally
• A corporate governance activist because
  large-scale exit blocked
• Voice (governance) the alternative
• Corporate governance goal Long-Term Performance

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Corporate Governance Stages I and II

• CG I focus on accountability, with some
  improvements in transparency
• On-going, far from complete (e.g. CEO pay for
  performance realistic performance measures
  board independence separation of chair from CEO)
• Significant globalization
• CGII Includes accountability but increased focus
  on transparency
• Significant globalization
• Incorporation of ESG and principles of
  responsible (sustainable) investment

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UO Examples and Some UO Type Activities

• CalPERS/Calstrs/NYcers -US
• Environmental Initiatives Investor Climate
  Change Network Carbon Disclosure project
  (represents/tracks assets of lt35 trillon)
• Hermes-UK
• Dont rob Peter to Pay Paul (Principle 10)
• Pharmaceutical Shareholders Group Enhanced
  Analytics Initiative
• Fonds de Réserve pour les Retraites -France
• Searching for extra-financial factors which
  influence value
• Caisse de Dépôt et Placement du Quebec-Canada
• Norwegian Government Pension Fund an SRI fund?
  2008-2010 focus on
• child labor in developing countries
• Political lobbying by firms they
  own/environmental issues

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A UO Investment Implication

• Searching for Alpha but perhaps long-term finding
  Beta?
• Raising absolute returns means increasing beta
• That is, increasing economic welfare, market
  efficiencies.
• Must find a way to incentivize increased beta
• Implies new benchmarks for the internal and
  external investment chainCHALLENGE/OPPORTUNITY
  4

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Transparency Focus

• In three areas ESG
• Environmental (new)
• Social (new)
• Governance --established in principle
• Some in practice
• Macro failure (e.g. Enron, current financial
  crises)
• E deals with externalities
• S deals with risk (market, reputational,
  regulatory, political, etc.

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Materiality Focus

• ESG brings elements of socially responsible
  investment (ethical investment) to mainstream
  institutions
• Viewed in terms of risk and opportunity
• Not ethical per se, nor political nor moral
• Significant evidence for correlation between E
  and G and performance (S more difficult to study)

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Institutional Example U.S. TIAA-CREF

• Environmental and Social issues begin to look
  like governance did 10 years ago
• TIAA-CREF boards should track and disclose S and
  E issues
• Engagement on
• environment
• human rights
• Labor conditions (e.g. ILO standards)
• product responsibility and society
  (minimize/eliminate negative impacts on
  communities)

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Analytical Example Trucost and
CalPERS/STRS-Utillities and Carbon

• Carbon adjusted rate of return
• TruEVA weighted ave. cost of capital including
  cost of carbon externalized on firm-by-firm basis
• Of largest 25, only 6 had positive TruEVA (scope
  1 basis)
• A measure of firm/sector risk but also of costs
  externalities.
• Next step measure how externalized costs are
  internalized, by firms/sectors.
• What is nature and size of value destruction?
• Specifically on whom?

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A UO Perspective Expands the Business Case for
Responsible Investment (RI) Examples

• Emergence of ESG and RI Materiality
• Ways and means to bring the not yet financial
  or emerging financial (extra financial) into
  the bottom line. E.g.
• Market pricing of governance
• Climate risk (and opportunity)
• Principles of Responsible Investment and the
  Freshfields Report
• PRIlt 13 trillion and over 200 signatories
  (March 08)
• Watson Wyatt sustainability as substitute for
  SRI?

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A Closer look at Externalities Pecuniary and Non
Pecuniary

• Externalities affect return on investment by
  imposing costs or returning benefits to firms
  which are neither typically accounted for or
  controlled.
• Pecuniary create costs or benefits measurable in
  monetary terms.
• E.g. dumping effluent by an upstream plant.
• Non Pecuniary create costs or benefits not
  directly and initially measurable in monetary
  terms, but may have important economic
  consequences.
• E.g. lost future productivity of a child who
  labors in a factory rather than going to school.

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A Closer Look at Market and Public Policy
Implications

• Universal owners cannot avoid externality effects
  as they own the economy and do not stock pick.
• Fiduciary duty should mandate identifying and
  accounting for interactive externality effects on
  an investors portfolio.
• Fiduciary duty and due diligence should mandate
  consideration of what actions (if any) would in
  the long-term result in minimizing negative and
  maximizing positive externalities.
• The value of a universal portfolio would increase
  due to the growth of productivity in the economy.

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A Closer Look at Norm Shifts and Risk

• Norm a generally accepted attitude by society of
  a given activity or practice.
• Norm shift an increasingly accepted change in
  that attitude.
• Examples
• Attitude toward child labor in OECD nations in
  the last 100 years.
• Current controversy over child labor in various
  under-developed or developing economies.
• OECD Guidelines for Multinational Corporations
• Risks
• Regulatory
• Political
• Market/reputational
• Liability/contingent liability

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Example Child Labor and Norway Fund-Global

• Long-term perspective
• Relation of schooling to child labor.
• productivity intersects with norm and moral
  issues.
• A non-pecuniary externality.
• Norway Funds analysis

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Norm Shifts and Contingent Legal/Tort Liability
(U.S.)

• Norm shifts over time impact legislative and case
  law, defining the boundaries of what is legally,
  ethically and prudentially possible.
• Fiduciary duty suggests portfolio monitoring for
  norm shifts and related contingent tort liability
  
• A standard form of risk analysis

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An Implication for UOs

• A Holistic Monitoring ModelCHALLENGE/OPPORTUNITY
  5
• Making use of increased data transparency

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Universal Monitoring I Firm Performance (Micro)

• Outlier Performance Monitoring
• Focus 12traditional underperformance
  monitoring
• Suspect 12Hyper-performance monitoring
• Examples Enron, Worldcom, Dot.com
• Examples Sub-prime, CDOs, structured products,
  financial sector in general.
• Firm by Firm or Sector by Sector Screen for
  governance and other factors
• E.g rankings by Governance Metrics Fitch
  Ratings evaluations by Trucost, Innovest based
  on a full(er) accounting for ALL material
  factors. Materality.

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Universal Monitoring II Externality Effects
(Micro)

• Micro source of externality is firm or sector
  specific but seeks interactive macro effects
• Examples Global warming, ground water pollution,
  U.S. steel tariffs, dangerous working conditions.
• Example CalPERS high performance workplace
  study.
• Example Hermes (U.K.) Principle 10 Do not rob
  Peter to pay Paul.
• Enhanced Analytics Initiative (USS and others)
• Trucost input-output environmental data
• UKs OFR (operating and financial review)

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Universal Monitoring IIISystemic Risk (Macro)

• Macro Effects resulting from micro or multiple
  firm level activities
• Examples of important systemic risk factors
• Accounting Standards
• Lack of Transparency (Including of Money Manager
  and their Agents and Sub-agents)
• Governance Structures (E.G. Incentive Systems,
  Board Composition/structure)
• Political Influence of (lobbying by) Firms
• Regulatory and Deregulatory Activities and
  Policies

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Universal Monitoring IV Norm Shifts

• Monitor (environmental scanning) for long-term
  fundamental changes in what are socially
  acceptable market practices. E.g. developing
  markets labor standards environmental practices
• Focus on contingent legal liability (U.S.) and
  political and/or market risk.

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Problems of Costs, Collective Action and Free
Riders

• Universal monitoring may be expensive
• Costs can be shared where appropriate
• Division of labor can be developed to reduce
  collective action problems
• PRI and other coalitions very important
• Cost/benefit --
• the CalPERS effect

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5 Challenges/Opportunities

• 1-Portfolio-wide trucost UO accounting
• 2-Public policy as important
• But slippery slope problem
• 3-Institutional owner agency-chain problem
• 4-Searching for Alpha finding Beta
• How to compensate/reward increased absolute
  return in the long-term?
• 5-Holistic monitoring

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Universal Owners, Fiduciary Capitalism and
Responsible Investment Challenges and
Opportunities

• A module for Netspar-UMBS Academy
• May 2008
• Jim Hawley
• Professor, School of Economic and Business
• Co-Director, Elfenworks Center for the Study of
  Fiduciary Capitalism
• Saint Marys College of California