Fiduciary Duty: Dealing with Market Failure, 2014

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Fiducary duty is set to become an increasingly prominent issue, not least because it bears on the ‘big convergence’ of maximising long term investment returns, the interests of investors, investees and society at large, sustainability, financial value, True Value, and the importance of innovation in supporting all of these. Below we start with fiduciary duty as traditionally understood, and then work forward to changes and implications.

The General Implications of Fiduciary Duty

As described in the UN backed Principles of Responsible Investing, fiduciary duty is the legal requirement for an agent, such as a fund manager, to act in the interests of their client, where the client — not having the skills, information and/or time to second guess their agent — places their trust in them. Think of it as the financial equivalent of the duties of a guardian, although it applies to the fund managers responsibilities to individual and institutional investors alike.

There has been growing concern that the fiduciary duty of the financial sector to their clients was not being respected. The UK financial industry has global importance, so it was significant that in 2012 the UK Department of Business, Innovation and Skills commissioned and then accepted the findings of the Kay Review of UK Equity Markets and Long-Term Decision Making [NB equity = shares; other assets in investment portfolios typically include items like government bonds].

Among other points, John Kay’s review found ignorance of the obligations of fiduciary duty amongst fund managers and their institutions. Some believed that this was whatever was in the contract that the investor had signed, and that caveat emptor (buyer beware) applied. But, as Kay confirms, fiduciary duty is a legal requirement of fund manager where the situation involves“ ‘discretion, power to act, and vulnerability’. Vulnerability typically arises when the agent receiving the funds has (or should have) greater knowledge or expertise than the person or agent placing the funds. Vulnerability is therefore closely associated with information asymmetry.” of which the fund manager must not take advantage of the loyalty placed in them. Kay continues “Common law defines several facets of the duty of loyalty: ‘A fiduciary must act in good faith; he must not profit out of his trust; he must not place himself in a position where his duty and his interest may conflict; he may not act for his benefit or the benefit of a third party without the informed consent of his principal’ ”.

What isn’t spelt out in the Kay report, but is common knowledge, probably well before Fred Schwed’s 1940 classic Where are the Customer’s Yachts?; and quantified in the academic financial literature since at least 1968, is that funds that are actively managed by fund managers, whether for individual investors, institutional investors such as pension funds, or for High Net Worth Individuals, significantly and consistently under-perform as a class compared to low cost passive tracker funds (that simply include and update all the companies in, for instance, the S&P 500, and into which investors could readily deposit funds at low cost). The basis of trust between investor and fund manager, as reviewed and modelled in 2014 by academics Nicola Gennaioli, Andrei Shleifer and Robert Vishny in the Journal of Finance and in the Quarterly Journal of Finance may be of surprise. “Critically, we do not think of trust as deriving from past performance. Rather, trust describes confidence in the manager that is based on personal relationships, familiarity, persuasive advertising, connections to friends and colleagues, communication, and schmoozing.” Moreover (as explored in the earlier link ) institutional investors may also not act in the best interest of the ultimate investors on whose behalf they collectively invest. Perhaps even more remarkable, high risk/high return of the sort that might be sought by High Net Worth Individuals attract higher fees, yet generally produced poorer proportional returns, than standard investments according to Gennaioli and colleges, and the research they cite.

Fund mangers generally charge a fee of which a substantial part is a percentage of total value of the assets managed, and clients may not be aware of the implications of the fee structure. An annual fee of 2% of total asset value for a worse performance than a tracker fund is a very different matter from 2% taken off annual gains in excess of the tracker. Gennaioli and colleagues put it in the best possible light, suggesting that the service for which investors pay a premium is peace of mind, believing their money to be in better hands than their own.

This cannot be squared with fiduciary duty. Apart from directly shifting to passive tracker funds, investors have the option of requiring proposals from fund mangers that would guarantee rates of return above passive trackers, and for customer-owned financial institutions where customer governance is still functioning, they can insist upon it. They have the ultimate sanction of either taking the institution to law and/or transferring their assets to newly created customer-owned funds, which would take them full circle to the causes and creation of mutuals (in the European sense) and the Raiffeisen Banks of the nineteenth century.

The implications of fiduciary duty for long-term investment

While passive trackers may out-perform actively managed funds in a market dominated by the white noise of short term share price fluctuations, by definition they are on a random walk regarding portfolio composition, and cannot actively bend towards trends no matter how obvious those may be on longer time scales.

And while fund managers may not achieve additional value, that does not mean it cannot be achieved. First, it is now known that general long term investment for intrinsic value, with reinvestment of dividends, has outperformed short term speculation in recent decades (see The Triumph of the Optimists and From Golden to Grey Age). The argument, sometimes used, that fiduciary duty prevented long-term investment per se (and where environmental and social considerations will increasingly play a larger role in determining value if nine billion are to live well), because the returns were less than the current short term speculative model, turned out not to be true. It is, and will continue to be, interesting to see how funds specialising in securing capital value long term, such as Rothschild, spread their portfolio. Second, the success of the Raiffeisen movement in nineteenth century Germany came from transferring well established innovations from adjacent countries, which is one well established route to capturing value. The third way that value can be identified to outperform trackers is to identify long term trends that are well understood and unlikely to change. There are not many that can be anticipated to emerge over time from short term noise, but those that exist are primarily related to global environmental and social change. So, for example, the German Development Bank KfW has built up funds of €500 bn by, in effect, underwriting long-term economic development, with environmental and social objectives to the fore, which conventional banks would otherwise have been less likely to lend.

Continuing population growth is considered highly likely. Increasing global affluence and consumption is widely assumed to be an additional strong trend. If so, that places investments concerning resources that are in short supply and relatively substitutable, i.e. water, in the front rank of long-term investments. The additional demands on food production either mean investments in innovation for sustainable food production, and/or increasing value of land and/or reductions in excessive consumption as part of innovatory approach to preventative health care. Some decisions (i.e. river extractions of water) have immediate cause and effect. Others do not (groundwater depletion). Similarly the full impacts of greenhouse gases are deferred, even if they are inevitable (just as the heat retained under a duvet takes time to build up — and unfortunately CO2, once in the atmosphere, can’t quickly be thrown off like a duvet when we wake up, which is one reason why it is so concerning). Rational and timely interventions would be sensible but, as Ebola has shown, these can fail to materialise even when the consequences of delay are obvious and near-immediate. It may only be when events combine with major consequences to people that action is taken. So humanity may shrug off the loss of summer ice at the North Pole, but may be stirred into action as a result of a major disruption and economic loss from cities and agriculture competing for scarce water. On the other hand, there is greater optimism that limited known reserves of other minerals will stimulate the discovery of new sources, and/or the innovation of substitutes, just as happened with the USGS mineral reserve projections of the 1990s.

Generating long term value is increasingly recognised as a priority. Kay concludes “equity investment will serve the long-term interests of promoting economic growth in the UK, and the interests of beneficiaries taken as a whole. This can be achieved only if the dominant purpose is the location of the most rewarding source of long-term return, rather than the selection of the intermediaries who are most likely successfully to outwit other intermediaries”.

In other words the financial sector in general has a fiduciary duty to wider society, going beyond that of vulnerable clients. Long term we are all vulnerable to market failures: investors are vulnerable to the decisions underlying other investments. So the wider fulfilment of fiduciary duty to society, via fiduciary duty to the long term returns to investors, and so synonymous with true value, sustainability and trend bending, is the final paradigm shift (the others being changes in economic paradigms and in the balance of power between investors, investees and fund managers). In effect fiduciary duty is the financial dimension to the Vorsorgeprinzip.

The twist in the tail is that environmental and social trend bending requirements have not only become a defining reason for fiduciary duty to be required, but that the previous underlying justification sometimes asserting that fiduciary duty prevented such action (higher short-term returns — much the same argument could have been made about anti-slavery campaigns, and health and safety, from the eighteenth century onwards) turned out not to be true in the past generally (Triumph of the Optimists) and even less so in future because of the trend bending agenda.

Finally, not all investments are in equities (shares): although not usually expressed in such terms, one successful soft approach to discharging both fiduciary duty, and a long-term focus, seems to be investing in your own, whether through family controlled businesses, or through the creation of locally based customer-owned business banks and other such institutions.

Updated from Future Business, Long Finance, 2014, MMG