Institutional Investors Need to Stop Abdicating Their Responsibilities
Some (or even many) of the ills embedded in our system of capitalism are driven by the fact that our pensions, sovereigns, and other long-term investors aren’t highly sophisticated investors.
Allow me to channel Winston Churchill by saying that capitalism is the single worst economic coordination system in the world ... except for all the other models that have been tried. In short, capitalism’s got its problems but it’s still better than any of the alternatives. And that means it’s worth our while to spend some time thinking about how to improve it (rather than replacing it with something silly).
I’m clearly not alone in thinking this, as a growing army of finance and business people look to render capitalism more “inclusive” and “conscientious.” As evidence of this enlightened perspective, witness sustainable development initiatives, impact investing, community based investing, SRI, ESG, CSR, SEE, PRI, OMG, LOL, WTF, and all the other random combinations of letters that will transform icy-veined capitalists into... this guy.
I think all those initiatives are great. Expanding the number of risks that investors price in their investment decision-making can only create value in the long run, if done with rigor and routine. But it hasn’t seemed to be enough to meaningfully change the system because these strategies operate at the margin. To really transform capitalism for the better, there’s a more basic approach that could be very significant: empowering the ultimate sources of capital to be better stewards of their capital. Let me explain (and reiterate something I’ve argued for a long time now).
As I see it, the biggest problem with our economic system is that the economic actors that amass large capital holdings -- pension funds, endowments, sovereign funds and other big savers -- are not adequately resourced to fully execute their entrusted mandate. Most of these organizations don’t have the capabilities to be good stewards of their capital. And, as a result, the ultimate “principal” in the long series of principal-agent relationships that make up our economic system is not capable of disciplining or incentivizing its agents in ways that will maximize its interests.
And that’s tragic, because these long-term investors should really be in the driver’s seat in their quest for value over the long term. Instead, the true owners of capital too often abdicate their responsibilities to a series of outside agents, resulting in a multitude of (potentially compounded) distortions in the owners’ objectives. It’s sort of like a long game of telephone, and at every new conversation, more economic rents are extracted. As a result, long-term investors end up being pulled into short-term investment strategies. In turn, companies – who sense this pressure from shareholders wanting short-term gains – prioritize quarter-to-quarter performance instead of sustainable growth and de-risking cash flows. Everybody starts to think of finance as a zero sum game rather complementing and adding value to industry.
In other words, I’d argue that some (or even many) of the ills embedded in our system of capitalism are driven by the fact that our pensions, sovereigns, and other long-term investors aren’t highly sophisticated investors. Truth be told, these are the capital allocators in our economy, and they should be staffed by the best and brightest individuals we have in our society. I sincerely believe that the CIOs of these pension funds and sovereign funds should be some of our most brilliant minds. Unfortunately, due to poor governance and compensation systems, the best and brightest often (though not always) wind up as agents selling financial services to the pension funds and taking capital in return. As a result, the capital is deployed in sub-optimal ways and, worse yet, the incentives that come with that capital (that should drive capitalism towards long-term value creation) are derailed in favor of what the agents tend to want: short-term profit maximization (even if it’s at the expense of long-term profit).
And so let’s now talk about whose fault this is, as it may not be whom you think. Honestly, as much as it would be fun to blame the billionaires on Wall Street... I can’t. These finance professionals are simply taking advantage of one of the longest standing asymmetries of information and power in the global economy. The blame, then, should lie with the creators of these asymmetries.
So I blame the politicians who sponsor these funds and, in particular, the funds’ boards of directors. Need an example of a villain in this world? How about Massachusetts Treasurer Steve Grossman and MassPRIM Chair. The fundamental problem with Mr. Grossman and others like him is that they ensure that the pension funds for which they are responsible are insufficiently resourced. For example, he thinks paying the employees of MassPRIM a couple hundred thousand dollars a year is egregious. Although these employees do make a very good living on an absolute scale, their pay is woefully low in relative terms, as they are making about 10 percent of what they’d make in similar jobs in the private sector. The real kicker is that while MassPRIM underpays its staff (and then, one could argue, gets under-qualified hires or suffers poor retention of talented staff), the fund actually overpays the millionaires and billionaires on Wall Street.
Not convinced? Let’s break this down a bit farther. The total cost of running MassPRIM in 2012 was $8 million (which includes things like rent payments for the office space). Over the same period, Grossman paid fees to private sector asset managers worth... wait for it... $230 million. Get my point? Grossman is out to lunch on this one. He panders to voters by voting against paying his staff higher salaries, while reinforcing the power and hegemony of Wall Street.
And what’s most frustrating is that he could spend $50 million on in-house talent and cut his total expenses from $238 million to $125 million and generate the same or better returns. But will he do it? No. Why? He’s a politician; and, in my mind, that makes him ‘The Problem’. He’s chosen to support the super elite on Wall Street because he’s unwilling to defend paying pension employees high salaries. Pretty weak.
And so let’s get back to capitalism. It’s the sort of insane ‘Grossman-Like Logic’ that has neutered the influence of long-term investors on the actual economy.
What’s most ironic about all of this is that most of the free market capitalists I know would undoubtedly say that they’d prefer public pension funds and sovereign wealth funds to simply hand over their capital to private managers avoid the intrusion of these public actors in private markets. But, as you go deeper into this space, you realize that doing this creates an acute principal-agent problem with enduring, negative outcomes for the global economy and the capitalist system as a whole.
(Phew. I apologize for sounding like a broken record on this topic. I just hope I’m starting to convince some people out there that we can do this better. Every time I see politicians arguing against raising pay at pension funds, I start to lose it...)