Novus Soap Box Episode 3: Also Sprach ESG (2020: A Fiduciary Odyssey)
The purpose of this series is to discuss top issues in the alternative investment industry. Here, we delve into the modern odyssey of ESG & fiduciary duty.
This is the third episode of a series on what’s wrong with the investment industry today.
Last time, we discussed the benefits asset managers can reap when they deploy data and analytics throughout their organization. In this segment, we’ll focus on a special set of data which is becoming crucial for institutional investors: Socially Responsible Investing (SRI) and Environmental, Social, and Governance (ESG) metrics. In 2020, both allocators and managers need to expand their notion of fiduciary duty to encompass the notion of knowing where your money is going. This data is the only way to find out.
Ancient Rome and Modern Fides
The word fiduciary stems from the Latin word fides, meaning ‘good faith.' Fides was a core pillar in trade, politics, and public affairs in Ancient Rome, and had to do with reliance on someone’s word—betrayal of which meant severe legal consequences.
While sadly fides is no longer a given during all human exchanges, I’m happy that fides remains associated with that which matters most in the age of capitalism: the act of giving money to an agent in a way that the agent handles it prudently and in accordance with an investment management mandate.
Asset managers of all types must comply with these ever-evolving rules, or face severe consequences. In the 2000s, the focus was on Anti-Money Laundering as a means of fighting terrorism. In the 2010s, it was Know-Your-Client in the aftermath of the financial crisis, the crisis of the offshore wealth management system, and the Madoff scandal. In the 2020s, we expect that fiduciary duty will focus on Socially Responsible Investing.
The difference this time is that demand for ESG is not coming from regulators (at least in the United States), because regulators are flummoxed by how to mandate this new frontier of fiduciary duty. Instead, the demand is coming from asset owners, who are increasingly aligning their dollars with the interests of their underlying fiduciaries.
Growth of AUM Committed to Principles for Responsible Investments
In an otherwise challenging environment for active asset management, ESG and SRI investing are among the few pockets where we see growth. Consider the steady rise of signatories to the Principles of Responsible Investments in the US, shown in Figure 1. Additionally, SRI assets accounted for 1 in 4 dollars of total assets under professional management in the United State as of 2018, at an expected growth rate of around 30%.
Cynically speaking, whether you’re rooting for Greta Thunberg (like I am) or not, you have to at least pay attention to this growing trend, as there is money to be made.
While I am optimistic about our community's willingness to respond, expanding fiduciary duty to encompass complex issues like the environment, and even the very social fabric of communities does present new challenges.
Challenging The (D)evil
Some of these challenges are logistical, and the logistical complexity centers upon transparency. Just as the proliferation of complex investment strategies necessitated some form of scientific risk management, the proliferation of fiduciary duty associated with SRI will necessitate a form of scientific ESG management. The fiduciary duty in the 2020s for asset owners will be to ensure they know where the money's going, not simply how risky the investment is. This will be an absolute must and will require an evolved attitude towards transparency into asset ownership. A VaR statistic cannot tell you how socially responsible your investment is, and that is keeping institutions up at night.
Let’s be clear on what’s needed to excel at this game. Best-in-class practice is where as an allocator, you have instantaneous access, on a look-through basis, to all securities (private and public) held by the investment managers you’ve allocated capital to. And I dare say at a daily frequency. Furthermore, you can attach ESG scores to those securities, and have the analytical power to slice-and-dice your portfolio up and down those dimensions to answer questions like “what’s the carbon footprint of my portfolio?” or “what’s the gender parity score across all the businesses I am invested into?”. For specific approaches on how to solve this, see here and here.
Your mind may now whisper, subtly in your ear, that it’s hard to get transparency into highly sophisticated strategies expressed with highly sophisticated instruments. I invite you to consider that whisper as if it came from the devil himself. As we described here, “sophistication” is too often used as an excuse for intellectual laziness rather than technological possibilities.
If humankind put a man on the moon and discovered the Higgs Boson, it certainly can make sense of discretionary global macro expressed with interest rate swaptions in a way that grandma would understand. As Einstein was quoted saying, “if you can’t explain it simply, you don’t understand it well enough.”
Quick thought experiment. Imagine for a moment you are CIO of a university endowment. In the backdrop of escalating gun violence throughout the country, your students are organizing protests to ban the sale of semi-automatic firearms. How would they feel if they knew their new stadium was paid for, in part, by companies that release semi-automatic firearms into the public? What happens if your board of trustees, out of support for a nearby mass shooting, demands to know the university's exposure to gun manufacturers?
If at this point, the devil on your shoulder is now whispering “don’t worry about all this, you’re invested in passive instruments,” you’ve got to send that devil back to hell. Note that the Russell 2000 Index (and associated ETFs which you may use to gain exposure to the index) has exposure to American Outdoor Brands (AOBC: NASDAQ).
A standard exposure report would give you no comfort in this situation. A sin stock list is too easily gamed. To be SRI compliant requires a different set of transparency principles and tools to unlock their analysis.
Fiduciary responsibility that encompasses ESG and SRI starts with managers willing to provide position-level transparency into their investments. Some investment managers continue to bristle at this notion. They focus on the operational cost associated with this, the agency risk, and the fear of idea leakage. On their own, each concern has merit. But technology can be a solution here:
- The cost of sharing transparency has come down by orders of magnitude. As data cleaning and transfer is continuously streamlined through intelligent ETL and APIs (Extract, Transform, and Load; and Application Program Interface), the ability to reduce marginal cost to the manager is unlocked.
- Agency risk has fundamentally changed in a period where investment managers must be more attuned to the needs of their LPs to maintain their employment. It is no longer acceptable to simply send an obtuse quarterly letter or to periodically invite the CIO to a power dinner. Investment managers must become true partners with their institutional investors.
- Regarding idea leakage, this is nothing new under the sun. It starts with brokers, is stoked by rumors, and culminates with chummy idea dinners. Investment managers must evolve to this reality and weaponize it for their own benefit. If the dissemination of their ideas holds market-moving power, then they must use it to their benefit, akin to an activist. Too much media attention has historically been focused on this, even giving life to conferences that platform these ideas. This platforming will change, and SRI will be an important part of it. Investment managers must adapt to the new normal and become increasingly active in their mandates, not simply their stock picks.
Most importantly, cultural attitudes are finally starting to change. Granted, I have spoken with a few investors, as recently as last year, whose portfolio secrecy culture is so deeply rooted that most of the investment team still does not know what’s in the portfolio. I respect where they’re coming from and their position. But this is considered old-school thinking now, as next-generation portfolio managers frankly just don’t care as much about disseminating portfolio information, so long as there is trust with their LPs and the dissemination is protected.
Alright. Maybe you think we’re out of our minds when forecasting that position-level transparency (between GPs and LPs) will be ubiquitous to the point of becoming the new norm. Well, think back to the beginning of the millennium. If I told you then that people in this world would be offering their couches to complete strangers over the Internet, you would have said the same thing: you’re out of your mind. And yet, Airbnb is planning to file for IPO this year.
The new normal fundamentally means that managers must go beyond just generating alpha, and become true stewards of their investors’ capital. That is the added wrinkle to fiduciary responsibility, and unlike prior wrinkles, it is not a top-down mandate from regulators, but a key behavior required to maintain the privilege of managing institutional capital. Investment managers would do well to make the most of this opportunity.
The title of this episode is, of course, a nod to Stanley Kubrik’s “2001: A Space Odyssey,” a 1968 science-fiction film which still earns our attention today, despite the less-than-dazzling special effects compared to what we’ve become accustomed to. Its foresight into the deep drivers of human nature and the perils of artificial intelligence remain accurate, even as we pass the movie’s 50th birthday.
Written at a time when condensing action into a few seconds was not the priority, and extending scenes without any dialogue for several minutes was considered an art, the movie features one of the most impressive visual intros and propelled Richard Strauss' “Also Sprach Zarathustra” or "Thus Spoke Zarathustra" into one of the most famous piece of classical music.