The 3-D Fiduciary – Part II
June 29, 2022
By Ravi Venkataraman, CFA
Active Managers Council Chair
MFS Global Head of Investment Solutions
In my introductory “The 3-D Fiduciary” blog, I explored the evolution of fiduciary expectations, historical measurement of financial outcomes, and broader ways to gauge investment and asset management success. In this blog, I build on those concepts and delve into what they mean for asset owners/end investors and whether they are consistent with fiduciary norms.
What Is the 3-D Framework?
Fiduciary duty has historically been translated into a two-dimensional framework of financial outcome (return) and risk. Conveniently, this fits into traditional capital market theory framework considering risk and return tradeoffs — the bedrock of investing.
However, we know that there are significant limitations with this simplistic risk/return framework. As a result, a collection of “other” considerations was always incorporated into investment decisions. Examples of these important “other” considerations include both quantitative factors (shortfall risk, funded status, retirement adequacy) and non-financial factors (social objectives, risk aversion, time horizon).
While it’s impractical to incorporate every possible factor into the decision-making process, we believe adding a third axis that is relevant to multiple stakeholders in the investment chain (owner, manager, adviser) makes sense. This new 3-D framework formally captures a broader set of financially material considerations that are derived from sustainable businesses, models, and objectives. Let’s look more at this third axis — responsibility.
Source: Citi Business Advisory Services
What Does Responsibility Mean?
Responsibility is a reflection of a commitment to the allocation of capital by the asset owner and the asset manager on behalf of the asset owner. It encapsulates environmental, social and governance (ESG) factors that are material but not always easy to capture in the valuation of investment opportunities. It also captures objectives that may directly or indirectly affect the financial valuation of securities, potentially over a long period of time and in less obvious ways. Diversity in the workplace is a good example of this. The immediate impact of a diverse workplace may not be obvious but there is plenty of research that shows that diverse teams and organizations result in better performance and that lack of diversity increases the risk of group think and less optimal outcomes.
Another way to translate responsibility into investment terms is to contrast “exposure” with “ownership.” Exposure can be thought of as the market overall or beta and can be achieved quickly and cheaply with passive management. It is simply a risk/reward proposition. In contrast, ownership is discerning between investment opportunities. It is more complex and requires more of a commitment to work well and comes at a higher cost. Hence, exposure is squarely 2-D, but active management adds that pivotal third dimension going beyond risk and return. Below are some investment implications of the two different approaches.
|Allocate to short-term opportunities||Participate in long-term value creation|
|Focus on performance||Focus on progress toward objectives|
|No public and/or broader societal responsibility||Aligned with public and societal goals|
|Move capital||Commit capital|
|Emphasis on financial opportunity exclusively||Understand business sustainability|
|Transactional relationships||Engagement and partnerships|
|Profit focus||Purpose focus|
|Responds to regulation||Leads regulation|
|Disconnected from sponsoring entity’s purpose and mission||Aligned with sponsoring entity’s purpose and mission|
|Culture is irrelevant||Culture is critical|
|Diversity, equity and inclusion “check the boxes”||Diversity, equity and inclusion are critical to process|
|Pro-cyclical asset allocation||Counter-cyclical allocation|
Does This Conflict With Fiduciary Responsibility?
Long-standing U.S. Department of Labor guidelines state that plan fiduciaries must make investment decisions in accordance with ERISA’s fiduciary duties of loyalty and prudence. ESG factors may be considered when they are expected to have material financial impact. A recent proposed ruling, if adopted, would make this more explicit and supportive by calling out climate change, governance, and workforce practices. Regardless of an explicit ruling, it is well established that ESG factors can have a material financial impact and therefore are clearly relevant to fiduciaries (for more, see the first blog post).
In the words of a Dutch pension fund: “The returns we need can only come from a system that works; the benefits we pay are worth more in a world worth living in.” 1
The UN’s sustainable development goals (SDGs) that has gained the support of 193 member states detail a broad range of the most pressing social, economic and environment challenges the world faces and is an excellent blueprint for policy, strategy, and active ownership decisions. This can be a very viable guide to incorporate ESG factors into the investment decision making process for fiduciaries consistent with the standard of loyalty to beneficiaries/end savers.
How Can Asset Owners/Plan Sponsors Undertake This Journey?
Here are a few steps that fiduciaries can take to develop cohesive principles, implement policies and due diligence in their asset portfolios:
- Educate investment committees and boards on ESG, why it matters, and how to think about it in the context of their responsibilities.
- Develop an ESG philosophy: explore participant attitudes/employee surveys, assess alignment with mission/corporate values, implementation methods, and engage with asset managers to understand alternative implementation methods.
- Establish governance and policies: reflect ESG factors in investment policy, develop context for relevance in investment portfolios, and establish criteria for monitoring and evaluation.
- Work with managers/consultants/trustees: incorporate sustainability into due diligence process/RFPs, request asset managers to describe ESG evaluation process, and develop reporting guidelines, case studies, and stakeholder reports.
- Educate other stakeholders: communicate sustainability philosophy, hold stakeholder seminars, participate in industry initiatives, and showcase ESG in action in the investment process.
Source: MFS presentation: Making the ESG Connection
We cannot do justice to the points above, but it is time for fiduciaries to take ownership of the dimension of Responsibility and administer, monitor, and evaluate it with the same rigor that has historically been applied to the traditional dimensions of return and risk. Even if details are delegated to agents such as consultants and asset managers, fiduciaries must enhance their understanding of these issues in order to discharge their responsibilities expertly, as is required by law.
Asset owners/end investors generally outsource the day-to-day investment responsibilities. The ownership chain therefore extends to Trustees/Boards, Investment Consultants/Advisors, and Investment Managers. It is critical that we as an industry rally around a set of common guiding principles, consistent with the law but with a greater common purpose and a higher order commitment to deliver on our commitment to end savers/asset owners. In the next and final blog of this series, I will explore the role of the investment manager — a critical role in the investment chain.
1 Thinking Ahead Institute White Paper on value creation