I recently polled MORE THAN 40 pensions and sovereigns on
whether their fiduciary duty allowed them to consider the
interests of their peers alongside their own in an investment
The result was unsurprising and extremely
Half of the giants said they could not consider peers in
their investment decisions, implying that their only job is to
optimize their own interests, irrespective of the consequences
for peers or for the community they inhabit.
First, this is unsurprising because egocentrism is baked
into the fundamental theories of institutional investment.
Second, its problematic because condoning self-interest
as the purest form of capitalism forces the broader market to
shoulder innumerable externalities, degrading societys
trust in our industry. Let me give you a flavor of the kind of
individually rational, collectively crazy decisions Im
Most institutional investors will not invest in
first-time funds, which seems, at least on the surface, to be
sensible. But if nobody invests in first-time funds, then fewer
new funds will be enter the market and prices will inevitably
Many institutional investors strict definition
of fiduciary duty discourages them from considering climate
change as a legitimate risk. For a long time, climate was
and in some places, still is perceived to be
extra-financial despite the fact that the
individual economic costs of climate change could be high if we
fail to act collectively.
Investors are often bound by a prudent-person rule,
which asks that they do only those things that a prudent person
would deem appropriate. But if were all prudent people,
where will the breakout innovations in our industry come
Some investors hide the fees paid to external
managers. This secrecy prevents boards from understanding the
true cost of producing these returns, which limits their
ability to suitably resource their own organizations. Over
time, secrecy leads to under-resourcing and erosion in
sophistication and competiveness.
At times, outrageous fund terms or side letters are
the price of access to a given fund. This reduces
market pressure on managers and further empowers private
managers to extract higher fees over time.
I could probably fill the rest of this magazine with
examples of things we do as individuals that make our
collective jobs harder. In economic parlance, they are
tragedies of the commons in that individual
optimizations hurt our collective interests. These tragedies
happen when we deplete a scarce resource by overusing it or
overpollute an ecosystem because the assets arent owned
or the governance is weak.
Investment returns are just such a resource. They are not
infinite; they are scarce. When people chase returns in
unsustainable ways, their stock can and will decline from
overuse. An aggressive, short-term approach to generating
returns may lower the returns that are possible in the future.
Asset managers can also pollute returns if fee structures are
misaligned with the long-term interests of asset owners.
And thats exactly whats been happening: Asset
owners, addicted to high returns, engage in secretive and
selfish behaviors that, over time, further deplete and pollute
the stock of these returns. They invest in black boxes they
literally dont understand. They hide the performance fees
theyre paying managers. They happily sign side letters to
get favorable treatment at the expense of others. They beg for
access to managers, often giving up their ability to discipline
their agents. They dive headfirst into an ocean of individually
rational, but collectively crazy, decisions.
We spend so much time thinking about how we can avoid
short-termism take a second and count the number of
organizations focused on long-term investment capital
but the real challenge is figuring out how to get individuals
to acknowledge the social and economic costs of polluting the
global capitalist ecosystem.
One solution to the problem of externalities that economists
suggest is to clarify or assign ownership of the resource at
risk, so that those owners will ensure its maintenance and
sustainability. Another is to turn to regulation. Thorny
questions will need answering: Who has a stronger right to own
the resource that is investment returns? Is it the asset
managers or the owners of capital?
Whatever the case, we must find a way to help all giants
consider each other when theyre deciding how to optimize
their own portfolios. To do that, I propose we consider two
solutions to the prisoners dilemma, a classic game in
which two prisoners, each thinking only of himself, end up
worse off, and likely in jail. First, we need a culture that
sets expectations of conduct. In the case of the prisoners, a
strong and enforced code of conduct not to
rat can result in both men going free. Whats
our equivalent of not ratting in the institutional investment
industry? Second, we need to open the lines of communication.
In the case of the prisoners, communication can clarify and
confirm their intentions, allowing them to coordinate in an
effort to go free. Can we establish stronger links among
In short, a trust-based code of conduct mixed with greater
communication is vital to avoid individually rational,
collectively crazy decisions.