Individually Rational and Collectively Crazy

Investment returns are not infinite; like any other resource, they are scarce.


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 decision.

The result was unsurprising — and extremely problematic.

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, it’s problematic because condoning self-interest as the purest form of capitalism forces the broader market to shoulder innumerable externalities, degrading society’s trust in our industry. Let me give you a flavor of the kind of individually rational, collectively crazy decisions I’m referring to:

• 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 rise.

• 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 we’re all prudent people, where will the breakout innovations in our industry come from?

• 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 aren’t 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 that’s exactly what’s 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 don’t understand. They hide the performance fees they’re 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 they’re 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. What’s 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 institutional investors?

In short, a trust-based code of conduct mixed with greater communication is vital to avoid individually rational, collectively crazy decisions.