SHIFT IN STRATEGY
Doing so requires a considerable change in thinking among investors, however, towards creating a sustainable economy and environment for pensioners over the longer-term. For a developed economy such as the UK, the implications of this fly in the face of much of today’s entrenched investment thinking.
Rather than global diversification, it would mean investing more in the growth and well-being of the domestic and even local economy. Rather than indiscriminate passive investment in equities, it requires careful selection and engagement with investee companies to ensure good governance.
Take for example, the pre-crisis banking sector, which was dominated by a handful of very large players with global reach and massive market capitalisations. As the success of the financial sector grew, so passive investors became ever-more exposed to those stocks. Events in 2008 proved how damaging poor governance of domestic companies can be. Between January 1983 and February 2007, shares in Royal Bank of Scotland Group rocketed from 233 to just shy of 6000. By August 2014, it was back to 1986 levels, trading around 340. But the consequences of poor governance within the banking sector were felt far beyond the financial losses from share prices for pensioners. They have been painfully felt in terms of domestic economic growth, lost jobs, the evaporation of banks’ support for small businesses and the diversion of taxpayers’ money to fund government bailouts of poorly-governed banks.
Investors and the institutions representing them have historically been woefully slow to take up their role as stewards of investee companies. Today, environmental, social and governance (ESG) issues are increasingly taken into account and the future looks relatively bright.
Paul Todd, assistant director of investments at the National Employment Savings Trust (NEST) believes: “In future we suspect that the ESG debate will stop being a separate discussion and become just another element of long-term investing, in the same way that market and liquidity risk would not be separated out from the overall investment process.”
In no small part, the growing interest in ESG factors is because the financial impact of poor governance has become increasingly evident. Hermes Investment Management research shows ESG value is predominantly driven by governance factors and companies with a poor standard of corporate governance underperformed in 62% of the months during the last five years. Well-governed companies tended to outperform poorly-governed companies by an average of 30 basis points per month. Capturing this consistent source of value can enhance equity strategy returns, the research concludes. Hermes argues if ESG factors can influence long-term value and if engagement with companies can help to reduce long-term risk and increase value, then trustees have a fiduciary obligation to take ESG factors into account and to expedite engagement with portfolio companies.
BETWEEN A ROCK AND A HARD PLACE
Professor John Kay, in his 2012 review of the UK equity market, noted some trustees took a narrow interpretation of the interests of beneficiaries, focusing on maximising return, that prevented consideration of factors such as environmental or social impact, or sustainability on company performance.
In response to Kay’s review, the UK government asked the Law Commission to investigate how the law of fiduciary duties applies to investment intermediaries and to evaluate whether the law works in the interests of the ultimate beneficiaries. The importance of considering ESG factors in fiduciaries’ investment decision-making process was underlined by the Law Commission’s report, Fiduciary Duties of Investment Intermediaries, published in June 2014.
It concludes: “In pensions, the purpose of the investment power is usually to provide a pension – with contributions invested to provide a return, often several years into the future. The primary aim of an investment strategy is therefore to secure the best realistic return over the long term, given the need to control for risks.”
Comments