3.4 The Current Limits and Potential Role of Institutional Investment Culture and Fiduciary Responsibility
- (Correctly) understanding fiduciary duty, as well as the complex decision-making chain of institutional investors, is key for mainstreaming impact investing. Conventional interpretations of fiduciary duty can lead to herding, because what looks like a reasonable and therefore fiduciarily sound decision to one investor tends to be the decision that others are also making.
- Reorienting institutional investment culture towards long-term wealth creation will support incorporation of ESG values into the institutional decision-making process. Impact investors need to link long-term performance to social and environmental considerations.
- Education around the long-term implications of ESG analysis is needed across stakeholders in the asset management supply chain (large asset owners, their trustees and investment consultants).
Investment decisions for institutional investors are ultimately made through the interaction of multiple stakeholders – a network including boards of trustees, staff at funds, investment consultants, managers, and end users of capital – and are filtered through a variety of beliefs at every level about how markets work, what sorts of investments are appropriate, and what sorts of incentives are attached to individuals acting within that network.
Unless consideration is given to how impact investing interacts with the culture of mainstream investing, product and policy design to encourage institutional participation in impact investing is likely to fall short of its potential. Moreover, even well-performing impact investments of scale, and with track records, may not receive the attention they deserve.
What types of challenges does the culture of mainstream institutional investment present to the broader adoption of impact investing? Three of them are highlighted here:
Fiduciary Duty and the Incentive to Herd among Pension Funds
The potential role of pension funds in impact investing bears consideration. Pension fund trustees have a fiduciary obligation to their members; fund investment decisions must serve the interests of all their beneficiaries. Fiduciary duty, in theory, is the governance tool that aligns the interests of investors with beneficiaries, and ensures sound decision-making.
These large asset owners have the wherewithal to shape markets, and to carry the scale and credibility for encouraging managers to design products with social impact. As evidenced by the ranks of the world’s largest pension funds that have signed onto the PRI – with tens of trillions of US dollars under management – many institutional investors have an expressed interest in incorporating ESG information into their investment decision-making. According to the World Economic Forum report From the Margins to the Mainstream: Assessment of the Impact Investment Sector and Opportunities to Engage Mainstream Investors, around 6% of US pension funds have made an impact investment, and nearly 64% say they expect to in the future.
Yet, for pension funds to engage in impact investing, products must meet the long-term needs of the fund and must be reliably assessed for their long-term effects on fund portfolios. The recent financial crisis demonstrates how hard this ideal is to achieve in practice, just as it has reinforced the crucial role these funds play in retirement security.
Fiduciary duty is the lens through which these decisions are made; it is the standard of care that, for example, fund trustees must exercise in the interests of their fund’s ultimate beneficiaries. But in practice, conventional interpretations of fiduciary duty can lead to herding, because what looks like a reasonable and therefore fiduciarily sound decision to one investor tends to be the decision that others are also making. Shared portfolio theories that funds adopt in the name of fiduciary duty – which may encourage the evaluation of investments along a limited set of factors related to past returns and volatility, and the benchmarking of performance against those (often short-term) factors – may also contribute to herding.
In turn, herding raises concerns that fiduciary duty in conventional practice can become an excuse for pension funds not adopting the unconventional, because performance measures make it difficult to spot opportunity. While providing the safety of numbers, this behaviour may end up producing investment decisions that are not in investors’ long-term interests.
For impact investing to engage pension funds, advocates must deal directly with the theory and practice of fiduciary duty. This requires both a clear account of how impact investing is congruent with fiduciary duty, and active engagement with asset owners on why impact investments may require funds to reassess their own attitudes towards what constitutes “conventional” investment. Without addressing how pension funds approach impact investment through their governance and portfolio structures, the impact investing field will be less likely to build mainstream support. Prudence, in terms of fiduciary duty, is process. Impact investors need to work with large asset owners to develop systems that evaluate promising new sectors for impact investment, to link long-term performance to social and environmental considerations, and to identify performance measurement systems which do not favour short-term herding.
Integrating Environmental and Social Goals into Investment Practice
There have been a number of efforts to integrate environmental and social information into investment decision-making in recent years, as advocates have (correctly) identified the lack of systems for processing this information as a fundamental barrier to impact investment. These efforts are often explicitly counterposed to conventional, mainstream investment analysis, which has no standard method for integrating environmental and social information.
The institutional investment culture likely disfavours incorporating new types of information, as unconventional approaches such as environmental and social analyses can be labelled as dilettantish or motivated by “nonfinancial” considerations. Interviews with mainstream investors about responsible investment reveal language that marginalizes impact or responsible investment strategies, such as “soft” as opposed to “quantitative” or “rigorous” analysis, and this even in a post-financial-crisis period when the supremacy of financialized mathematics and the rigor of conventional analysis has come into question. As a result, mainstream investors often begin with a bias against impact investments.
For impact investing to gain mainstream acceptance, advocates will need to forthrightly challenge the idea that a concern for environmental and social outcomes necessarily means “taking your eye off the ball” with regard to investment returns.
Advocates may need to directly challenge conventions for measuring short-term performance; to advocate for investment analysis that focuses as much on the fundamental value of assets as on their price movements; and to resist a rhetoric of “rigour” used more to police conventional boundaries than to identify sound investment strategies. Merely claiming that using ESG standards makes for a more effective analysis is unlikely to do the trick.
The primacy of short-term performance standards has not served institutional investors well over the past 15 years; many critics feel that those standards have contributed to the financial crises and poor economic performance that have so affected the beneficiaries. Trustees and staff should directly engage consultants and managers on the long-term value propositions of investment strategies. They should ask hard questions on how investment propositions are linked to generating real economic value. Reorienting institutional investment culture towards long-term wealth creation will likely support the integration of environmental and social analysis into investment decision-making.
Agency Issues and the Challenge of Intermediation
Investment decisions by asset owners typically involve input from a series of internal and external stakeholders. Theoretically, members delegate authority to board members, who direct staff and help choose consultants, who in turn select managers; however, this decision chain is not so linear in practice. The agency issues inherent in this network of decision-makers – such as alignment of interests and variance in time horizons for performance assessment and rewards – are often implicated in critiques of market short-termism, bubbles and fraud. More generally, the interaction of agents with different institutional and personal agendas necessarily shapes the availability of investments in the marketplace and how these options are presented to various decision-makers along the chain.
Impact investing faces a particular challenge when considering agency issues, as it takes more multiple sets of decision-makers for impact investing to explore and adopt something new and different. For example, a staff managing a large university endowment decides that an impact investing strategy would benefit long-term portfolio performance and better achieve the university’s mission. The Board of Trustees must sign off on any newly proposed strategy. In turn, its investment consultants must have the ability and willingness to identify investment options that fit into this strategy. Fund managers must meet social goals as well as the consultants’ other criteria for investability. Those managers will need a sufficiently robust pipeline of opportunities with social impact to merit investing at a scale large enough to attract investment not only from this one endowment, but also from enough investors so that the endowment’s position will not be too large for the fund staff’s comfort.
Of course, any investment faces these challenges. But the nature and newness of impact investing means that the field may lack products that fit neatly into existing asset allocation schemes. If impact investing is seen by agents in the chain as a marginal or niche activity, they may dismiss it as unappealing. Further, for the strategy to be successful, agents in the chain must develop their own capacity to manage impact investments, and those without this capacity may resist the perceived (and real) costs of developing it.
How can advocates for the field address this issue? No easy path for navigating agency issues exists. Perhaps it is best to say that impact investors need to regularly review whether they are taking multiple stakeholders into account as they develop their strategies and tactics. They may also seek to concentrate efforts on key actors in the chain – asset owner trustees and investment consultants are frequently mentioned in this regard – who have particular influence on how decisions are made.
One obvious path forward is for large asset owners themselves to signal demand for different kinds of products, and to engage the market through requests for proposals that call for ESG-themed investments. Alternatively, they can engage investment consultants to introduce ESG-related issues into the management selection and evaluation process. But it is too easy to claim that these forms of asset owner interest alone will move the market. More general education across stakeholders in the asset management supply chain on the long-term implications of ESG analysis will be necessary for institutional investors to become players at scale in the impact investment marketplace.
To say that existing institutional investment culture throws up barriers to impact investing is not to say that impact investing cannot grow to scale in the mainstream investment community. We have seen an openness across a variety of channels in the institutional investment community, a history of engagement on environmental and social issues among many investors, and important and recent movements that have expanded interest in the field. These developments suggest that impact investing on a much larger scale than is currently practised is very possible.
The intent here was to highlight some of the well-known ways in which conventional investment-decision-making culture may disfavour impact investment. Efforts to engage the “mainstream” in impact investing will be best served if this culture is taken into account. The challenges of changing how investments are made, and how success is measured, are necessarily part of bringing impact investing to scale – and those challenges are unlikely to be met by financial innovation and incentives alone.