Remarks at the Ethics in Action Conference
My remarks will focus on the ethical challenges of one particular aspect of the financial system: the investment management industry. Given the increasing size and importance of this industry globally, I believe that it is of utmost importance that we develop an ethical framework for its functioning.
In my remarks today, I would like to argue that there is a quiet, large scale “illicit financial flow” happening under our noses – and that is from everyday savers and pensioners to the employees of the financial sector and the shareholders of these companies. I believe that this “illicit financial flow” is deeply problematic for the end investor, who is trying to save for retirement or important expenses in their lives, and for our broader economic and planetary system, which does not have the appropriate stewards in the financial sector. I believe that without a transformation in how our collective savings are managed, we will not be able to achieve the broader goals of sustainable development.
My comments will focus on three particular aspects of the investment management industry that constitute the key pillars of the ethical challenges of the industry: 1) costs and fees, 2) time horizon mismatch the investment management industry versus the beneficiaries, and 3) lack of active stewardship of investments. I will end with a few comments on innovations in the industry that are trying to tackle some of the challenges I have outlined and will close with some reflections on whether they are moving in the right direction.
Before I begin, let me give you a sense of the size of the global investment management industry:
When I speak about the “investment management industry,” I am referring to the thousands of companies involved in the management of our savings in our pension funds, insurance accounts, additional savings we may have accrued.
The total size of the asset owner community – pension funds, SWFs, Endowments and Foundations, Mutual Funds and Insurance Funds – is approximately $131 trillion. This number has been growing at between 5 and 7% per annum for the past 10 years.
The total size of all professionally managed, third party investments has reached $79.2 trillion at the end of 2017. Roughly half of these assets - $37 trillion - are in the United States, $22 trillion in Europe, and $13 trillion in Asia excluding Japan.
The total direct revenues associated with the management of professional assets has reached approximately $200-$250 billion a year, and is growing as global wealth increases.
The first major ethical challenge of the investment management industry is the extraordinary level of fees that are charged by the various intermediaries involved in the management of money. A recent study by Professor Andrew Clare of the Cass Business School has found that in between you as an end investor placing your money within a pension fund or into an investment account, and that money earning a return in a publicly listed security, there are over 100 fees placed on you by various intermediaries in the financial industry. A recent study by Grant Thornton, a global accounting and audit firm, has found that someone who entrusts a GBP 100,000 with a financial advisor in the UK will end up paying 2.56% annually in the various fees that are levied, which would mean that after ten years, 40% of your return would be eaten up by fees along the way. Given the fact that over 90% of actively managed equity portfolios underperform their low cost benchmark over a ten year period, this is quite troubling. And despite the growth of automation, robo financial advice, the number of financial advisors to manage assets of all kinds is increasing significantly, not decreasing. I could go on and on about the fee structure of the investment management industry, but I will spare you all for the time being.
The second major ethical challenge of the investment management industry is the mismatch of time horizons between financial market participants and the beneficiaries for whom they are managing money. The average, asset-weighted portfolio turn over rate for US mutual funds from 1984-2017 is 57%, which means that the average US mutual fund turns over their entire portfolio less than every two years. What is the benefit of such turnover? It is certainly not for the end investors, who pay a significant cost to the traders, accountants, book keepers, stock exchanges and more for their investors to churn portfolios. In addition, if the average professional investors has less than a 2 year time horizon for holding a stock, do we really think that they will be thinking about long-term, systemic risks in the global economy and financial system – things like climate change, inequality, corruption and so on?
This brings me to the third and final ethical challenge of the investment management industry, which is that of stewardship. Owning a stock of a company, or owning the bond of a company or country, gives you a right to future earnings of these entities, but it also gives you a responsibility as a small owner of the security. It gives you a vote in the election of the company’s board members, it gives you the right to issue resolutions for the company’s board to consider reform their practices on certain issues ranging from environmental impact to pay gaps to gender diversity on corporate boards and more. Over the past forty years, what has happened is that stock ownership has moved from individuals, who in the early 1980s owned 80% of the stock market directly, to institutional investors and asset managers, who now own a large majority of publicly listed companies on behalf of individuals. Although this may have created some efficiencies, it has also delegated an important set of decisions to intermediaries such as pension funds and asset management firms, who I believe, are not putting sufficient resources in being representative stewards of capital on behalf of their beneficiares. To give you one important anecdote, in 2017, there were 63 climate change related resolutions for publicly listed corporations, a small number to begin with compared to the multiple thousands of publicly listed companies. The average vote outcome was only 33% in favor, and only 3 positive outcomes. Do we really think that asset managers and institutional investors are voting in line with the best, long term interests of their clients and customers with a voting record like this? I think not.
Over the past few years, there has been a significant amount of hope that “institutional investors” and “private sector financial institutions” would be leading actors for sustainable development. Every UN and World Bank meeting related sustainable development financing since 2014 has had a significant discussion on “how to get the investment management industry through institutional and retail investors” to contribute to the SDGs? The intuition may be right, given the size and influence of this industry, but the reality is a lot more challenging than what most people expect.
The good news is that innovation is under way to tackle some of the challenges that I have outlined. Low cost index investing has the potential of bringing down the costs of investment management by 1, if not 2, orders of magnitude. Behavioral finance insights are being used to decrease the churn of portfolios. New platforms are being built to give retail investors a mechanism to express their voting preferences to their fund managers so that they vote according to their beneficiaries interests on Environmental and Social issues. But all of this is still at the margin, and a lot more work is needed.