Investment Chain Alignment

From pension fund members and their funds, to the investment advisors, fund managers
and research houses, there is evidence of significant inconsistencies in the basis of remuneration, the holding period of investments, the management of systemic risks. The area of active ownership gives a hint of the changes occurring in the way that asset owners do business. The gradual clawing back of responsibility for the functions that for years many asset owners have outsourced is a one-way trend that is already advanced amongst some of the leading asset owners. Those leaders have recognised that issues such as climate change require a comprehensive review of their investment chain, starting at their own policies and governance and extending through to their investment advisors/asset consultants and their fund managers.

While few asset owners are looking to completely reclaim the core functions of asset allocation and investment, many are considering what new guidance is to be given in these areas. In the case of fund managers, this guidance is extending beyond policy and into data integration techniques, screening, advanced risk management, capability development and incentive alignment.

The reason why this new guidance is required is partly because of the weaknesses of the current framework. Throughout the entire investment chain there is a significant misalignment of objectives and rewards. From pension fund members and their funds, to the investment advisors, fund managers and research houses, there is evidence of significant inconsistencies in the basis of remuneration, the holding period of investments, the management of systemic risks, etc.

Most of these inconsistencies stem from the long-term investment horizon of the pension funds and the typically short-term investment horizon of their investment advisors and fund managers. This is exacerbated in particular in the context of climate change.

Asset owners have many risks to consider. Fears about systemic risks such as banking stability are rife following the sub-prime collapse and resultant global financial crisis, but climate change is perhaps the largest single threat to an asset owner’s long-term performance. Of all the environmental, social and governance (ESG) issues, climate change has the highest material threat to all aspects of an asset owner’s portfolio.

The physical and policy impacts of climate change already affect specific asset classes and jurisdictions but also have the ability in the future to create sudden, widespread repricing of global markets and panic regulation in future which may drive down values.

Asset owners are beginning to recognise that climate change is an investment risk with a unique profile. It is a long-term risk that also has high certainty and high impact. Furthermore, the inherent short termism in capital markets does not enable an accurate assessment of such a risk.

Still today, there are investment banks using long-term pension fund member capital to invest in new fossil fuel exploration listings as a matter of business as usual, without question.

To see hints of the coming change it is advisable to look at arguably the greatest investor of all time – Warren Buffet. The majority of Wall Street is still trying to figure out how to ‘model’ his investment techniques and strategy. The reason they can’t is he is different, thinks differently and acts differently. Quite simply, he is the greatest long termer in the market and Wall Street….is not. Even his most famous quotes allude to his investing principles – “My favourite holding period is forever”, referencing the amount of time he holds a stock before selling it. Whereas most fund managers turn over their entire portfolio many times a year, Buffet treats companies like family businesses, he is there for the long haul. As he again says “You don’t invest in a farm and worry if it rains one year or another – you know in the long term that it is a good investment”. Such messages are key for asset owners wanting to realign their own practices and industry.

Consider capital intensive investments, particularly those in high emissions industries often 25 years in length, that are heavily exposed to rapid changes in carbon prices during the 2020’s. There is no logical reason to ignore the back end of these large projects where these potential liabilities lie but there is enough evidence to promote them from a sensitivity analysis to a base case contingency. Would investors still finance coal fired power stations if they factored in that the International Energy Agency predicts carbon will be priced at $110 a tonne by 2030 or even if there was a 20% chance of such a re-pricing?

Would those projects make their returns if investors said they need a 10-15 year payback rather than a 25-40? Some commentators have said that this optimisim might be convenient for fund managers who are often bonused annually, and thus are often incentivised to calculate the short term before the long term. In the case of climate change this incentivisation might lead them to attempt to maintain the status quo rather than invest in the potentially volatile transition to the low carbon economy, but this factor should not let asset owners dictate their thinking and actions and certainly amongst the current leaders it doesn’t. But just because the Dodd-Frank and other country based legislation failed to address the recommendations of the Financial Stability Board following sub-prime in re-aligning those incentives, doesn’t alter the fact that asset owners still have the power and some might argue duty to take control to ensure the new paradigm is addressed.

Addressing some of these new issues creates new business process, cultural and human resource management demands of asset owners and demands that might have the big four consultancies rubbing their hands with glee. In the old 100% outsourced model where the asset owner were often only a secretariat, (still the case for some asset owners), change management was not a core skill, whereas it has now become a necessity. Also, the understanding of many stakeholders, including members, of how the financial system is built has refocussed people and customers on the very top of the tree.

Some commentators such as Stephen Davis in his book The New Capitalists argue that citizen investors are reshaping the corporate agenda. He argues that soon, members of pension funds will be better educated and begin new levels of pressure to address societal issues such as climate change. Following the sub-prime collapse and its various children, they are starting to follow the money. They are starting to look at a rather large pile of over $70 trillion, in their combined pension fund investments, and how much of it seems to be invested in the high carbon economy.

This disconnect and others may drive new pressures on asset owners as members discover new found influence. Whilst many members currently find little enthusiasm for the subject of their pension, this is changing already and the pace is accelerating. Imagine the influence they might exert when they realise the statement letter they normally place in the bin without even opening contains; power to change the way the world works; the power to influence companies and capital flow towards long term societal and environmental issues such as climate change; the power to ensure bubbles are burst calmly and smoothly without calamitous financial crises and social consequences. This of course is highly relevant to the climate change debate as in each major economy there is a disproportionate number of pension and superannuation members who care about climate change compared to the volume of capital reflecting that desire to manage the long term risk.

In response to these pressures there may be some asset owners arguing the dubious protections of fiduciary duty or sole purpose tests but the leaders are already recognising that change management IS now their job. It will certainly be a painful process for some asset owners but realigning the investment chain towards the long-term will ultimately prove to work in their, and their member’s, favour.

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