Here is an article by Colin V. Habberton, posted by his permission:
Executive Summary
Investment decisions made by asset managers are driven by the mandates they receive from their clients that are, by and large, institutional asset owners. These decisions are underpinned by the principle of maximising the financial returns of each investment, with performance measures for asset managers directly linked to those returns. This article asks the question whether this conventional view adequately takes into account the interests and opinions of the individual investor who is ultimately the source of the ongoing flow of capital into investment markets. It presents the argument through the lens of governance of how stakeholder engagement might offer fresh insight to investor engagement and an opportunity for the investment industry to communicate with the broader base of the investment market.
Introduction
In a recent Business Day article , the Government Employees Pension Fund’s exposure (GEPF) was put at R437bn, some R100bn higher than the contingent liabilities quoted by the government in the last budget review that interestingly did not account for any liability for the GEPF itself. With R500bn out of pocket of its defined benefit scheme of an increasingly well-paid community of beneficiaries, the taxpayer ultimately becomes the GEPF’s funder of last resort, a worrying proposition. The rational response to this, echoed by the article’s author, is for the Public Investment Corporation (PIC), the GEPF’s principal asset manager, should focus on maximising returns alone for its client. But is it as simple as that?
The ‘Rational’ View
This rational view certainly stands up to the conventional logic that the purpose of investing is the maximisation of returns – you put your money in, you want the maximum amount of money you can possibly get out. The maximisation of returns becomes the key performance metric and analysts decide on the buy/sell/hold positions according to that baseline assumption.
There are alternative views to the conventional approach. The rise of ‘Responsible Investing’ (RI) provides an umbrella category of investment approaches and practices that do not hold the maximisation of financial return as the only metric for investment analysis and decision-making. There is a litany of sub-categories that arguably fall under ‘RI’. ‘Ethical’ investing involves the screening relating to certain ethical filters incl. faith based packaging i.e. Shariah compliant funds. ‘Sustainable’ Investing takes into account the social and/or environmental sustainability (‘E’ and ‘S’) factors as metrics for making the investment decision but are not the core purpose of the business or investment. ‘Socially Responsible’ Investing is similar to Sustainable Investing but specifically includes governance criteria (commonly grouped together to as ‘ESG’ factors) as components of business’ responsibilities and reporting but profit remains its core purpose. ‘Green’ Investing is predictably focused on assets that have a specific alignment or impact towards environmental outcomes. Target Investing purpose is usually specific for the upliftment of a community, area or interest group. With ’Impact’ investing, social and environmental impact indicators are held core to the business and/or the investment decision.
Although there is much noise around these alternative views in the media and from niche product providers in the industry, on aggregate they still amount to a small fraction of the total volume of capital invested on global markets, and particularly so in South Africa. As to be expected, their attractiveness to investors is still by and large judged by the risk-adjusted financial returns they deliver for their investors. Even the alternative views are measured in the terms set by the rational view. One specific critique that could be leveled on the rational view is whether it adequately takes into account the non-financial interests of asset owners, the trustees of underlying pension funds, right down to the individual pension or provident fund contributor. In illustration, consider the case of an asset owner who through their appointed asset manager invests pension fund contributors money into a particular listed entity whose downsizing programme lifts earnings, dividend income and its stock price – an attractive financial proposition - but results in the redundancy of a number of employees that could in fact be, the indirect investors in the loss of their own employment.
The common assumption is that all investors believe in the mantra of return maximisation, and from that foundation, intermediaries author mandates to pursue that mantra, without necessarily providing their clients and beneficiaries with the opportunity to participate in the decisions that are being made and the motivations behind them. Raising the awareness of how and why investment decisions are made to the broader base of an asset owners’ contributors and improving the education of those stakeholders is currently largely ignored. Decisions are made by the very few with the funds provided by the many.
The Governance Perspective
One lens that provides a different perspective on this challenge is the consideration of good governance and how this impacts the investment decision-making processes for asset owners and asset managers. South Africa currently has one of the most recognised and robust corporate governance frameworks in the world, underpinned by King I, II and III, that has shaped business decision-making for more than a decade. One notable paradigm shift with King III was the recognition and revision of the governance principles to go beyond an assessment of the interests of shareholders, to now include and consider the interest of stakeholders affected by the operations and decisions by a business. More recently, the new Companies Act, turned a number of the key tenets of King III into law, notably that all legal entities – public as well as for profit and not for profit structures are urged to implement and maintain a standard model of good governance.
It is widely accepted that good governance within a business is a key requirement in any due diligence process. It is a clear indicator of a well-managed organisation confirming that decision-making processes are transparent and the separate levels of authority within the business are evident and accountable to each other. Good governance is a tangible indicator of a good investment opportunity. But is good governance applied and practiced in the same way by the institutions and their appointees taking responsibility for investment decisions on behalf of significant stakeholder communities, such as the contributors to pension funds?
Pension fund contributors do not have the skills and experience for the complexity of analysing investment opportunities and assessing what the right investment decision would be, or so the argument goes. And so trustees are usually appointed, not necessarily through transparent or widely publicised process but, usually based on their willingness, political influence, financial skill set or combination of all three, to represent the interests of the members of the pension or providence scheme. Governance, tick. However, are trustees the best representatives for the interests of the members, especially when those interests may go beyond the pale of pure financial return? It could be argued that, in the terms of King III, asset owners and asset managers, as entities falling under the requirements of the Companies Act bear a wider responsibility of remaining accountable towards all their respective stakeholders, not just their shareholders. A possible response to this challenge is for asset owners, asset managers and trustees to ensure they critically assess their disclosure, education and awareness policies and practice.
Towards Institutional Investor Accountability
Teaching on governance is slowly but surely bleeding into financial textbooks, it is promoted as a key requirement in the assessment and management of investment assets, but the true experience is largely practiced in the boardroom and the benefit of governance understood by those privileged few who have access to those books and boardroom discussions. In 2011, the publisher of the King III report, the IODSA, in association with ASISA penned the Code for Responsible Investing in South Africa (CRISA) in response and alignment to the UNPFI’s Principles for Responsible Investment, which applies to asset owners, asset managers, and consultants. CRISA calls for the integration of ESG factors into the investment decision-making and management process.
In 2013, ASISA partnered with the Principal Officers Association (POA) and the International Finance Corporation (IFC) to spearhead the Sustainable Returns for Pension and Society Project. This initiative provides industry players with a framework and tools to assist with the implementation of CRISA and compliance to Regulation 28 of Pension Funds Act. A relevant requirement of Regulation 28 is that all trustees of asset owner funds understand what responsible investing is and ensure that their fund’s assets are managed in line with ESG principles. ASISA has taken a lead on this by providing training to trustees through their Academy from 2014 onwards.
Industry bodies, regulators and government are recognising the importance of taking the wider view regarding investment decision-making. Despite these clear, unified steps, only a selection of asset owners and asset managers have committed themselves as signatories to the PRI and CRISA. To date, there are few, if any examples of asset owners and asset managers proactively communicating the reasons and outcomes of their investment decisions to their broad base of stakeholders.
Maximising Value
The opportunity exists for asset owners and asset managers to take the lead in this area and investing time and resources in educating their respective clients on the variety of investment choices that exist and why certain decisions are ultimately taken. This should include awareness of the practice of alternative investment approaches like responsible investing. By actively communicating the reasons for a commitment to ESG (or not) to their stakeholders, asset owners could take a proactive role in making their decision-making more transparent, offering their members the opportunity to engage with trustees proactively, allowing for collaborative decision-making processes. Informing individual investors would equip them to take a personal interest in their investment decisions holding asset owners responsible for the fiduciary role they play in advising third parties such as asset managers and the details of the specific mandate they carry from their members. On the converse, individual investors could become increasingly informed of the state of their investments and connected to performance of their funds. This knowledge could be a powerful tool for collective understanding for the broad base of stakeholders to maximise value when markets or investments face distress and resultant impact that there might be on returns in the short term.
In South Africa, deep socio-economic challenges continue to exist. The collective interests of all investors present a powerful force to shape the flows of capital that not only challenge the assumptions of conventional investor decision-making but also offer exciting potential for new approaches to how and particularly where their money is invested.
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