hawley-elfenworks center 1 universal owners, fiduciary capitalism and responsible investment:...

Hawley-Elfenworks Center www.fidcap.org

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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 Mary’s 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 Smith’s (or Karl Marx’s) 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 Capitalism:Why 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 UO’s

•Common law countries UO’s 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 UO’s are emerging•Some are sovereign wealth or pension funds; others not

–France–Ireland–China–Japan

•Norway is a special case•Most other countries UO’s are few, ownership dominated by families, managers and/or governments


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What’s unique about UO’s?• 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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UO’s• 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/OPPORTUNITY #1

• Have a quasi-public policy interest given investment-return horizon and investment diversity

CHALLENGE/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 firms—corporate 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 owner’s portfolio.

• Secondarily link: Risk– related to norm shifts and the various types of contingent

liabilities norm shifts often create.


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• UO’s 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)



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What’s 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 (Hirschman’s voice)

– Not a stock picker


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What’s 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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What’s 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 Sum:The 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 <$35 trillon)• Hermes-UK

– “Don’t 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 chain



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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

• PRI:< $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 investor’s 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 Fund’s 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 UO’s

• 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 12”—traditional underperformance monitoring– “Suspect 12”—Hyper-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– UK’s OFR (operating and financial review)


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Universal Monitoring III:Systemic 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 importantBut slippery slope problem

3-Institutional owner agency-chain problem

4-Searching for Alpha finding BetaHow 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

OpportunitiesA 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 Mary’s College of California

hawley-elfenworks center 1 universal owners, fiduciary capitalism and responsible investment:...

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