You probably wouldn’t do this without a safety net or a rope. An old rope is not reassuring.
Enacting systems change requires breaking the cycle of positive reinforcement of the current system. Easier said than done.
The current requirements that asset owners and their representatives (gatekeepers, OCIOs, investment consultants) stipulate before entrusting their assets to their investment managers are outdated and hypocritical. No investment consultant was probably ever fired for following existing protocol or for choosing a large, renowned asset manager, but for those that can influence that selection process, it might be time for a rethink of what you’re really trying to achieve other than cover your behind.
I will go through some of the most common requirements that asset owners set for investment managers and suggest why most of these are misguided and will fall short of the challenges required to enable investment and capital allocation to combat the adverse effects of climate change.
Assets under Management or Advisory AuMs
Most commonly, asset owners require investment managers or investment advisors to have a certain amount of assets under management (AuMs) or to have been advising a certain level of assets before they will even be considered as alternative contenders. The idea behind this requirement is that nobody wants to be an experiment for the management of — or advice on — their precious assets. Makes sense. But the vast majority of established asset managers and advisors are performing below their newbie competitors according to numerous studies. This means that asset owners are limiting themselves to getting the performance of a group of mean-reversion, middle of the bell-curve, usual suspects. Why trade middle-of-the-road for unmeasured risk? Doing the same thing over and over is not likely to generate materially different results. But a different result is precisely the objective of system change and needed to overcome the challenges of global warming.
Paradigm Change is Needed
System change is necessary to avoid the effects of global warming on our environment that threatens our very survival. The delicate biodiversity that supports our existence is unequivocally being destroyed and the calls for action are ramping up. Investors, asset owners, and their investment managers and advisors are being held increasingly accountable for where they direct capital. If they are unwittingly directing their capital to the same system that landed us in the current quagmire, accompanied by colorful reports of carbon footprints and secondary impact, we will not provide the necessary impetus for a reversal of global warming. Perhaps if the signatories of the various programs of Net-Zero or Carbon Neutral actually enacted significant systems change, thereby walking the walk, investors could rely on ESG scores and metrics for the assurance that their dollars are working towards the right goals. For reasons similar to those encountered in the asset management industry, most listed companies are designed to maximize profit in their own industries and therefore not likely to move the needle significantly beyond the cosmetic.
By focusing on the experience of the individuals of new investment managers, who are usually not on their first rodeo when they set up a new advisor or management firm, asset owners could envisage that they’re getting quality advice from someone with experience that might offer a new perspective. In these fast-changing times, this might be a rational approach to sourcing new approaches without assuming risks of pure experimentation. Ideally, there should even be a willingness to take on newbies outside of the financial services industry who will not have been formatted, thereby giving scientists, sociologists, anthropologists, and agronomists (to mention only a few), a voice. It is their expertise that will provide rational bases for innovation and improvement on the abstraction of the real world that investment management has become.
Disruptions Rarely Come from Within
Established asset managers are working hard to evolve and change with the increased interest in ESG investing. This is positive because by broadening the indicators of asset valuations to the non-financial factors, risks that were previously ignored or inadequately subsumed under other financial criteria are finally getting noticed. The impact of such practices is observational at best since systems change is necessary to overcome the imperatives of global warming and social injustices, not cosmetic changes to a system that generates unbridled consumption and inequalities. We need to measure it to manage it and therefore ESG integration is a most welcome addition to our management of assets and creation of goods and services. Transformational, not so much.
Recognizing the real consequences of measurement vs. impact is already an uphill battle due to decades of narrative that have far too many people, both in the financial sector and beyond, reinforcing the dogma of invisible hands, market forces, level playing fields, absence of systemic racism, fair competition between conglomerates and mom-and-pop shops, etc. — rationalizing practices that have undesirable outcomes for the many, while idolizing the few winners as deserving and entitled.
The necessary impact through the trillions of dollars needed for a systemic shift that will ensure environmental and social justice will not likely come from the current beneficiaries of such a system. Their business model thrives on the barriers that have been created in favor of themselves and their risk/return ratio is optimized with minimal effort. Conducting due diligence on emerging or recently constituted asset managers is costly and not without risk.
Why increase costs and risks when the system is profitable and safe? Because there will come a time when the inadequacies of the incumbents and their inability to move beyond their short-term benefits will be costly both to the investor and to the environment. The cost-benefit analysis is skewed by the fact that the barriers to entry have been set in such a way as to essentially ensure that the incumbents will remain without threat until the demonstrated advantages of new asset managers are clear. New asset managers that will never be given a chance.
Since new asset managers will almost never get the opportunity to demonstrate their ability to outperform, we are at an impasse, where asset owners are condemned to continue to entrust their assets to the usual suspects; asset managers whose evolution is limited by factors that are structurally impossible to change from within.
Such factors would include— inclusive and collaborative culture, humility, curiosity, and the ability to question perspectives that are built on outdated theories. These aspects of the required evolution to achieve systems-change are not likely to come quickly enough if indeed they ever come at all. The focus on profitability and the inexperience of creating value by other paradigms requires a vision and a skill-set that are not part of current asset managers’ design or systems in which they operate. Curiosity and humility are not associated with profitability unless a longer-term horizon is considered, which is incompatible with the short-term interest of maximizing financial returns — the defining heuristic within the current system.
There exist alternative options for investments that generate exceptional absolute returns (not linked to a benchmark) that could fulfill the requirements of investors to make financial gains for retirement, education, savings, etc. Such ideas are struggling to gain mainstream acceptance even though they should be center stage in our current predicament. The size and inertia of the current financial industry have muted these voices. Not surprisingly as they threaten the business model of the incumbents.
Past performance is the most hypocritical of the requirements often presented by asset owners. In most financial centers around the world, the regulator stipulates and makes the financial services providers stipulate in their marketing materials that “past performance is not an indicator of future performance”. Indeed, that would require that the manager or advisor have a crystal ball to see into the future, thereby ensuring continued positive performance. Behind this is the idea that security selection is a skill that, once demonstrated by out-performance, can be applied to continually beat markets. The non-financial factors in asset valuation can influence more than the traditional financial factors. Non-financials are often qualitative rather than quantitative and therefore unpredictable. Since we all know that there is no crystal ball, why would you continue to base future performance on the past? Once again, there is a good reason for using this requirement and it rhymes with the AuM argument. If we can’t evaluate the performance of the past, how do we know that the manager or advisor will perform in the future? The short answer — we don’t, we can’t and we shouldn’t.
New managers should be evaluated on criteria that is relevant to the task at hand. Outperformance in a fossil-fuel-based economy, where the name of the game is risk/return optimization according to (historical) securities prices (Modern Portfolio Theory — Markowitz 1952) has been the guiding principle of our securities markets for over half a century. Thanks to the excellent work by Jon Lukomnik and James P. Hawley in their work “Moving Beyond Modern Portfolio Theory: Investing that Matters” (Routledge; April 2021) we now have a rigorous and comprehensive examination of the limitations of MPT and suggestions for overcoming them. William Burckhart and Steven Lydenberg’s equally significant book, “21st Century Investing: Redirecting Financial Strategies to Drive Systems Change” (Berrett-Koehler Publishers; April 2021) provides further concrete evidence of practical solutions.
These works do not deal with the manager selection process specifically, but one of the conclusions of their wisdom is that the same investment management techniques that are prevalent will not overcome the challenges that we currently face. By extension, the same managers, unless completely transformed, will not be equipped to push the new paradigms forward. I’m very skeptical about their ability to transform.
Bricks and Mortar Address
In another throwback to the past, many asset owners require a stable and lengthy occupation of bricks and mortar premises, with the requisite personnel to staff and justify such premises. The idea behind this appears to be that there must be someone answerable to the asset owner at all times. After all, there is no telling whether the firm that one hires to take care of one’s assets might not just disappear, ghosting the asset owner and leaving a befuddled mess.
There are more efficient ways in which to ensure that the manager or advisor to the asset owner’s assets won’t just disappear. First, as a manager, advisor, or fiduciary, they must be registered to perform their duties. Second, their registration, while no indication of competence, is most certainly an indication of identity and requisite knowledge of the industry. Where they chose to operate from — their yacht in the Caribbean or in swank NY mid-town offices is a reflection of their ability to absorb huge overheads, ultimately thanks to the fees of the asset owner.
A New Look at the Risks
From an environmental, social, and governance (ESG) perspective, the challenges facing asset owners in the new economic environment should be more about forward-looking issues defined by the E the S and the G. Add to that the systemic change required to fulfill stakeholder interests and stewardship as opposed to pure profit motives, and the entrusting of assets to managers requires a fundamental rethink. I will present three important challenges, although there are many more.
Here is a way to get that comfort with regards to the stability of the manager without requiring an expensive office or a stellar track record. Has the manager or advisor voted in accordance with the asset owner at shareholder meetings and when and why have they not? The risk that is being mitigated here is one that will come back to bite many an asset owner in a tender place; that entrusting assets to a manager or advisor who doesn’t respect the voting intentions of the asset owner exposes the latter to stakeholder ire and shaming. This can be costly in terms of reputation and track record as failure to exert shareholder rights in the interest of stakeholders will be increasingly recorded and judged.
ESG Approach & Methodology
Getting the manager or advisor to align with the values and convictions of asset owners requires a considerable amount of time and effort. It means translating some fuzzy concepts into clear and unambiguous positions in terms of a variety of material issues that are non-financial and therefore not easily measurable. But they are measurable and they need to be defined to the satisfaction of everyone involved before getting into the market.
Conflicts of Interest
If the manager or advisor is representing the asset owners' values and convictions in the handling of their assets, then the reputation of the asset owner becomes inextricably tied to the manager or advisor. If the manager or advisor funds fossil fuels, unacceptable worker compensation, or any other questionable business practice in their other mandates, then this will not reflect positively on the choice of the asset owner to whom she has entrusted her assets. The fox cannot be both a fox and a babysitter for hens. Perhaps some of the larger asset managers can buy themselves new holiness in terms of the track record of their conflicts of interest. But currently, there are very few established asset managers that can make any claims to directly tackle the nefarious effects of climate change and inequality. The cosmetic stuff using catch-phrases, scoring, and gimmicks might work for a while, but the overall tendency for transparency and consistency will not abate and when we look back at who among the advisors and managers took real concrete action to avoid impending environmental and social catastrophes, there will be voting with dollars.
On a Final, More Positive Note…
The time has come for investors to take their responsibility for the transition to a fairer, renewable, and more equitable economy seriously. Public opinion and various interest groups are gaining more and more ground in their demands for increased transparency and concrete action against the threats that are conveniently covered by the 17 United Nations Sustainable Development Goals (SDGs).
Climate change which is grouped under SDG 13 — Climate Action, but related to multiple other SDGs, has an urgency that the other goals do not — namely that failure to act will not just make the poorer and less privileged members of the global community suffer, but undermine the very basis of our current economic system. All of the SDGs are interdependent. For effective changes to occur, there needs to be an upheaval of the system or system change.
Unlimited consumption, programmed obsolescence, and the increased fossil fuel necessary to feed the GDP, GNP, or another such expired measure of prosperity will have to be replaced by a real commitment to a circular economy, human well-being, and the idea of sustainability in the form of re-new-ability to ensure our grandchildren have a planet to thrive on. This requires a well-thought-out strategy that current managers or advisors are ill-equipped to design and structure. The problem is cultural because the mission and values of their firms are based on an outdated blueprint which ultimately translates into an inappropriate investment strategy.