Keith Ambactsheer will be speaking about long horizon investing at RI Americas on December 10.
“….‘Responsible Investing’ presents a Zen-like paradox. It will only become truly successful when it ceases to exist altogether….”
Dr. Matthew Kiernan, Author, Investing in a Sustainable World, McGraw-Hill, 2009
The Kiernan quote above, which goes back further than 2009, actually used the term ‘socially responsible investment’ or SRI for short. Since those early days, the ‘S’ has been dropped, so now we speak of the ‘responsible investing’ movement, or RI for short. Interestingly, Kiernan repeated his ‘zen-like paradox’ observation in a 2009 article in a UNEP publication, but there used the term ‘sustainable investment’ or SI for short. While the descriptor evolution of the movement from SRI to RI to SI over the last ten years (with ESG occasionally thrown in) is interesting, that is not what this article (which is extracted from a recent Ambactsheer Letter) is about. Instead, it is about Kiernan’s intriguing observation that the true measure of success of the SRI-to-RI-to-SI movement is its disappearance altogether. We agreed with Kiernan’s success measure ten years ago, and continue to agree today. So has the movement ceased to exist yet? If not, why not? What are the prospects for its disappearance? These are the questions we address below.
Addressing the Achilles Heel of the SRI-to-RI-to-SI Movement
We observed ten years ago in a similar Letter that the biggest risk facing the (at that time) SRI movement was marginalization. If it was to be populated only by a well-meaning, dreamy-eyed band of ‘do-gooders’ who made careers of going to conferences attended by people just like them, nothing much would come of it. Only by going mainstream would the movementeventually have ‘real world’ impact. Fortunately, that Letter noted there was a clear, potentially persuasive path to mainstreaming the essential SRI tenets. And that was to change the conversation from SRI investing to long horizon wealth-creating investing. We argued that this was one of three mainstream investment styles, with the other two being short horizon active management (what Keynes called ‘beauty contest’ investing), and liability-hedging management (where the objective is to achieve payment-certainty).
The essential difference between the short- and long-horizon return-seeking investment styles is that the former attempts to generate capital gains through adversarial short horizon trading strategies. In contrast, the focus of long horizon wealth-creating investing is the acquisition and nurturing of healthy cash-flows over multiple years and even decades. So successful investing in this latter case is to acquire these cash-flows (e.g., interest, dividends, rents, tolls) at a reasonable price (i.e., to achieve or exceed pre-established IRR hurdle rates), to understand the risks attached to those cash-flows as well as is humanly possible, and to monitor the organizational effectiveness of the entities (e.g., public or private corporations) actually generating those cash-flows through the execution of their business models and plans. Much has happened over the course of the last ten years to move the narrative away from single-focus SRI, or ESG, or RI investing discussions, and towards broader, more integrated conversations about long horizon, wealth-creating investing. However, stating the obvious, not yet to the degree that these terms have completely disappeared from the investment lexicon. Before we move on to assessing where the ‘mainstreaming’ process goes from here, we make an important digression.
An Important Digression
Advocates of the long horizon, cash-flow oriented style of investing often suggest that this style offers a good
‘fit’ for institutions with long liabilities. Examples could be DB pension plans, foundations, endowments, and life insurance companies. This good ‘fit’ is not necessarily the case if those long liabilities come with hard payment guarantees. What has been overlooked in many of these cases is that, presumably, with hard payment guarantees come hard payment guarantors. Who are these guarantors? Do they know there is an enforceable pension, endowment, foundation, or insurance contract that requires them to make up any future negative difference between assets and liabilities? Or alternatively, is there enough of a capital buffer to absorb measured mismatch risk? If not, are these types of arrangements really sustainable? Why is it important to raise these questions here? What do they have to do with long horizon investing? A lot, actually….for the simple reason that successful long horizon investment programs must not be short-circuited by faulty pension plan, endowment, foundation, or insurance company contract designs. Sustainable designs allow long horizon investment programs to stay long horizon even during financial crisis periods such as 2008-2009. As a sustainable design example, we have frequently pointed to the ‘2 goals–2 instruments’ pension model exemplified by TIAA–CREF. TIAA provides payment certainty (or close to it) by converting contributions into deferred annuities. CREF buys and nurtures long horizon dividend streams. TIAA–CREF participants have exposure to both.
An Important ‘Mainstreaming’ Contribution
Former US Vice President Al Gore, his partner David Blood, and their colleagues at Generation Investment Management made an important ‘mainstreaming’ contribution last year through their “Sustainable Capitalism” White Paper. The Paper was widely distributed, and received considerable media attention. Its essential message was that there is too much short horizon, trading-oriented, active management in the world, and not enough of the longer horizon, wealth-creating kind. Five specific steps were proposed in thePaper to facilitate this transition to wealth-creation mindsets from ones with a short horizon trading focus:
1. Address stranded asset risks: the potential impact of climate change on asset pricing is highly material. For example, CO2 emissions will eventually be priced. The longer we wait, the higher the price point required to control global warming and the higher the risk of catastrophic outcomes. These events will eventually have material negative stock price consequences in such industries as utilities, mining, transportation, chemicals, and fossil fuels.
2. Embrace integrated reporting: investors and other interested parties need a more holistic picture of how their investments are (or are not) creating value. This implies combining financial and non- financial information in a single document. It should connect the organization’s capital resources (i.e., physical, natural, financial, intellectual, human, and social) to the organization’s outcomes (i.e., products/services, financial returns, externalities).
3. Stop the provision of quarterly earnings guidance: this practice creates incentives to manage and trade for the short-term, rather than focus on long term value creation.
4. Rethink executive compensation structures: many current structures have a short term focus and have heavy stock price- based components. There is no obvious, direct connection between such structures and incentives to create organizational value over the longer term.
5. Promote constructive investor behavior: the White Paper originally proposed some form of ‘loyalty’ reward for long-term shareholders (e.g., extra voting rights, extra dividends). Subsequent research is re-orienting this proposal towards measures to assure thoughtful capital stewardship through the investment supply chain (i.e.,
from fund participants to fund fiduciaries to fund managers to the companies they invest in).
In June this year, the feasibility and potential impact of these five proposals were discussed in a workshop organized by the Rotman International Centre for Pension Management (ICPM) in collaboration with the Generation Foundation. It brought together board members, senior executives and investment professionals from the 40 ICPM-sponsoring pension organizations, as well representatives from organizations such as the PRI, ICGN, the Aspen Institute, Harvard Business School, and the Rotman School of Management at the University of Toronto. In all some 100 people from 12 countries participated in the workshop.
Workshop Design and Outcomes
The workshop was designed to discuss and debate the five White Paper action steps for a full day. Most of the group reassembled the following morning to see if agreement could be reached on how to turn them into a series of concrete, specific action recommendations. This ‘see if agreement could be reached’ test was especially telling, as the 100 participants included some pretty hard-nosed investors with little patience for soft-hearted ‘do-goodism’. Participants were divided into working groups for the ‘concrete action recommendations’ part. The groups were asked to come up with a micro (inside your own organization) and a macro (multi- organization collaboration) recommendation for each White Paper action step.
The groups did indeed arrive at five micro and five macro recommendations. The five micro ones were:
1. Stranded asset risks recommendation: Undertake an in-house project aimed to raising the understanding of the stranded asset risks issue at both the Board and management levels.2. Integrated reporting recommendation: Commence and advocate the adoption of the framework both for reporting our own organization’s results and for assessing the long horizon prospects of our investments.
3. Quarterly earnings guidance recommendation: Focus discussions on yearly results in one-on-one meetings between investors and corporate managements.
4. Compensation structure recommendation: Think carefully about how to best exercise our shareholder rights in order to foster effective compensation practices.
5. Investor behaviour recommendation: Design and implement concentrated long horizon investment mandates, and ensure that we have the necessary resources to successfully implement them.
The five-macro recommendations were:
1. Stranded asset risks recommendation: Seek out effective collaborations with like-minded organizations to best manage the climate change issue and its potential investment-related impacts.
2. Integrated reporting recommendation: Ensure that we are fully informed about the evolution of the initiative, and that our own organization is in line to become an early adopter.
3. Quarterly earning guidance recommendation: Call for a joint declaration by professional investment associations (e.g., the CFA Institute) that analysts should not pressure corporations to provide quarterly earnings guidance.
4. Compensation structure recommendation: Collaborate to achieve consistent regulations on executive compensation that have enforceable consequences for corporate boards.
5. Investor behavior recommendation: Develop a ‘model investment mandate’ through an organization like ICPM that can be widely shared and reported on by investors.
Note that some of the working group recommendations are quite concrete, others less so. One likely factor here was the considerable time pressure the groups were under to arrive at some consensus. Another factor is that some of the White Paper action step subjects are inherently more complex (e.g., stranded asset risk) than others (e.g., quarterly earnings guidance).
Two Lessons from the Workshop
A unique workshop feature was to ask participants to assess both the potential impact of each of the recommendations they constructed, as well as its ease of implementation. Not surprisingly, the micro recommendations generally received higher ‘ease of implementation’ rankings, while the macro recommendations generally received higher ‘impact’ rankings. Two important implications strike us:
1. Look inside first: pension funds that want to lengthen their investment horizons and want their investments to be consciously wealth creating, should look inside their own organization first. It is important to practice what you preach. Equally important, organizations learn by doing. In the ‘stranded asset risk’ and ‘integrated reporting’ recommendations for example, the wisdom in the room was to really understand the issues internally before joining any multi-organization collaborative initiatives.
2. Collaborations must be effective: achieving the kind of impact that can only be achieved through multi-organization collaborative initiatives is not easy. Collaborations must be both strategic and well-organized if they are to be effective, and that cannot happen without careful planning and allocating the necessary resources required for success.
Both of these implications should be pursued to their logical conclusions. All pension organizations should conduct internal ‘walking the talk’ surveys: are there gaps between what we preach and what we practice? If there are, what are we going to do about it?Similarly, on the collective action front, pension funds should list the collaborations they currently participate in, or are contemplating participation in. How ‘strategic’ are these collaborations? Are they being effectively managed? If they are not strategic enough, or are poorly managed, what are we going to do about it?
Not Done Yet
So are we done now? Have we managed to merge the SRI-to-RI-to-SI movement into mainstream investing over the course of the last ten years? You know that the answer is ‘no’. Having said that, there is no doubt that there has been steady progress towards mainstreaming the key ideas embedded in the SRI-to-RI-to-SI movement over the course of the last ten years. In our view, this success has not come about because of the triumph of ‘do-goodism’. Instead, it is because of a growing recognition that long horizon wealth-creating investing benefits beneficiaries. The five micro and five macro recommendations hammered out in the ICPM-Generation Foundation workshop constitute an important new step in that journey.
Keith Ambactsheer will be speaking about long horizon investing at RI Americas on December 10.
This article was first published as an Ambactsheer letter.
“Sustainable Capitalism” White Paper (February 2012): Link
“Ten Strategies for Pension Funds to Better Serve their Beneficiaries” a Rotman ICPM report from the ICPM-Generation Foundation workshop (June 2013)