A friend of mine sits on the board of a small foundation that decided to add an impact investment mandate to its portfolio mix. She described to me a scene in which the board was reviewing some “impact asset managers” and one stood out as offering remarkable performance. During the board interview the manager was asked to explain how his firm’s high financial returns aligned with the desired social impacts. The manager indicated that over 30 percent of its portfolio was invested in African communities. The investments were, the board was told, creating jobs in profitable African businesses. Nodding heads. What industries?, the board asked. Agriculture, they were told. Smiles all around. Perfect, thought the board members. That is, perfect until another member thought to ask: What type of agriculture specifically? The response: Tobacco. The fund’s biggest holding was in African tobacco companies.
In the investment business, it is commonplace to see managers attempt these sorts of moves to take advantage of asset owners’ suboptimal routines and behaviors. A lack of innovation, herd behaviors and employees’ focus on career risk all render asset owners extremely vulnerable to such manipulations. As perverse as the above scenario is, I have a grudging respect for the manager’s attempt at manipulation here. His firm has rightly noted momentum in impact investing and is seeking to blend its offering into the language and interests of the owner to achieve an objective that’s desirable for the asset manager. This is the investment management version of aikido.
Aikido is a Japanese martial art that seeks to redirect an opponent by leveraging his momentum with minimal effort. An aikido master blends with an attacker’s movements for the purpose of controlling them, ideally toward an outcome that’s in the interest of the aikido master. The most common investment aikido move is the use of basis points of assets under management to define fees. Managers that use basis points are harnessing momentum to achieve an outcome that’s in their own best interest. How? An asset-based fee treats dollars the same as dirt, but one is much easier to move than the other. If assets go up (which long-term momentum suggests they will), fees automatically go up too — without a proportional increase in the work required on the part of the manager.
In the tobacco case, the momentum behind the asset owner was to do something good for the world, and the manager’s aikido move was to define “impact” in a way that suited the manager but almost certainly not the asset owner. But asset owners can also use these sorts of redirections and manipulations to drive the change they want and need.
Take as an example the taxation of carried interest. Most general partners complain that the taxation of their carry would dramatically alter their businesses’ performance, as a fee change would affect the incentives in their business. Okay, that’s fine. But if you think a change to this fee is so important for incentives and success, surely you won’t mind delivering 100 percent transparency on all the fees and costs you receive, even those from portfolio companies? After all, these are all incentives.
Let’s consider climate change as another example. As crazy as it may seem, some investors remain skeptical that humans are contributing to climate change and as a result do not take climate-related actions when constructing their portfolios. But let’s break this down. To be a climate skeptic means you doubt that humans are responsible for climate change. That’s fine. But doubting that people contribute to climate change is not the same as being positive that people are not driving climate change. Are you 100 percent sure we aren’t causing this? If the answer is no, then you should be investing more thoughtfully. The only people who can justify taking zero climate action in their portfolio are those with 100 percent conviction that climate change is not real. Everybody else should be managing the risk of climate change.
Another example could be when a board asks staff to consider ESG investments. Staff often view these policies as a distraction from their one-dimensional pursuit of returns. The aikido move here would be to accept this distraction and use it as an opportunity to develop new internal resources that can be deployed throughout the organization. I believe sovereign development funds have performed so well over the past few decades precisely because their extra-financial objectives were a license from the sponsor to try innovative things. And it was the innovation that drove returns.
A final example: Pension boards often reject staff compensation increases because the increases don’t align with those of other government employees. If I were staff, I’d welcome the board’s focus on the cost of the investment process and suggest expanding it to both internal and external teams. Why? Because the board opened the door of costs, and once the true picture of fees and costs is shown for both internal and external providers, the board will almost always deliver higher salaries and resources to the internal team in a bid to improve internal capabilities and lower external fees.
The deeper I get into the world of institutional investment, the more jaded I seem to become about the entire financial services industry. In this case, I find myself using the tricks of the asset management industry against itself. What’s more aikido than that?