The following guest editorial was written by John Rogers, CFA, president and chief executive officer of CFA Institute. It was published in the May/June 2014 issue of the Financial Analysts Journal.
Five years after the global financial crisis washed over us all, the future of finance is unclear. The debate continues over how to rebuild a financial system that is vibrant and dynamic, that serves society, and that won’t blow up and drag the whole world down every few years. From my perspective, a new era of capitalism is emerging out of the fog. What I define as fiduciary capitalism is gathering strength and needs to become the future of finance. An era of fiduciary capitalism would be one in which long-term-oriented institutional investors shape behavior in the financial markets and the broader economy. In fiduciary capitalism, the dominant players in capital formation are institutional asset owners; these investors are legally bound to a duty of care and loyalty and must place the needs of their beneficiaries above all other considerations. The main players in this group are pension funds, endowments, foundations, and sovereign wealth funds. Fiduciary capitalism has several attractive traits. It encourages long-term thinking. As “universal owners,” fiduciaries foster a deeper engagement with companies’ management teams and public policymakers on governance and strategy. In textbook terms, they seek to minimize negative externalities and reward positive ones. Because reducing costs is easier than generating alpha, we can expect continued pressure on financial intermediaries to reduce costs. To be sure, there are considerable gaps to bridge between today’s landscape and fiduciary capitalism. Transparency and disclosure, governance of fiduciaries, agency issues, and accountability are all areas that need more work.
Capital Market Eras
To provide a sense of how I demarcate capital market eras, let’s consider the nearly 70 years since the end of World War II. There is ample evidence of a distinct period from 1945 to 1980 that is often termed industrial or managerial capitalism. In the United States, Japan, and Germany, the corporate issuer of debt and equity was the dominant force. A great deal of capital formation occurred through bank loans, and corporate governance problems were minimized through either dispersed ownership (the United States) or cross-holdings (Japan and Germany). Many remember this era for the rise of conglomerates and “national champions,” which were nurtured with export-oriented market-share strategies.
In the early 1980s, a 30-year fall in interest rates began, as did financial market deregulation, financial engineering, and the ascendancy of what is often termed finance capitalism, or financialization. Finance capitalism was characterized by financial intermediaries — banks, asset managers, and brokerage firms — that made the most of deregulation, technology, globalization, and leverage to achieve tremendous (and likely unsustainable) growth in revenues, earnings, and market capitalization. Employment in the sector boomed, and the prospect of riches attracted legions of bright young people to the industry. In popular culture, bond traders became “masters of the universe.” The results of a search for the term financial engineering in the Google Ngram Viewer, graphed in Figure 1, are indicative of the era. As a share of GDP, financial services grew from 4.9% in 1980 to 8.3% in 2006. Finance became viewed as an end unto itself rather than as an enabling function. This era was a supercycle for financial services that ended badly in 2008. Although the causes of the global financial crisis were many and complex, the finance industry — seemingly unmoored from its original socioeconomic purpose — received much of the blame.
Researchers at the Federal Reserve Bank of Dallas have estimated that the global financial crisis cost the world between $50 trillion and $90 trillion. Today, despite the many benefits of the age of finance capitalism, the public mistrusts financial institutions; it is unrealistic to expect this cycle to be repeated anytime soon.
What makes me think fiduciary capitalism has a chance to take the leadership role? At least three major forces: size, technology, and the agendas of large fiduciaries.
- Size. Institutional investors are the sumo wrestlers of the financial markets. Powerful but a little slow, the top 1,000 such fiduciaries worldwide account for $25 trillion of global equity market value — more than half. When these institutions act together, as they increasingly do in matters of corporate governance and market structure, they can shape the financial markets into the form they desire.
- Technology. Technology has leveled the playing field in finance. For decades, brokers and investment bankers enjoyed an asymmetric information advantage over the institutional asset owners they did business with. That information gap is mostly gone now. The digital age has put as much computing power and market access into the hands of large fiduciaries as in the hands of brokers and bankers. Sophisticated asset owners are moving their business away from traditional capital marketplaces. Institutions are doing business directly with one another on multiple private trading platforms, away from rapid-trading robots and transient liquidity. We read of increasing numbers of direct placements in private market opportunities. The plethora of low-cost index strategies and the rise of “smart beta” have put most of the capital markets in the category of commodity products. Accordingly, we have witnessed the unstoppable rise of in-house management of all but the most esoteric asset classes. This massive shift has changed the money management industry and will continue to drive down margins for asset managers for years to come. In my opinion, today’s most interesting jobs in finance are with endowments, foundations, and other institutional asset owners. Talent is responding, and the smartest people in financial markets are no longer only on the sell side or working only for asset managers. In Singapore, the $300 billion Government Investment Corporation employs more than 500 investment professionals, rivaling any asset management firm or sell-side research department in sophistication. Institutional investors are powerfully redefining how markets operate.
- Agendas. The third driver of this new era is the agendas of these fiduciary capitalists. Large and sophisticated institutional investors have needs that are different from what brokers and bankers have been conditioned to expect through decades of dealing with other financial intermediaries. This shift is especially disruptive where markets are oriented to providing services to asset management firms that are paid to deliver alpha relative to a market benchmark. (We have already seen the impact of hedge funds on the sell side’s service model.) To many fiduciaries, things like market outperformance, an information “edge,” trading, flow, and league tables are not particularly important. The only thing that really matters to these investors is delivering the returns that are uniquely required by their ultimate beneficiaries. Trillions of dollars are now managed by sovereign wealth funds whose behavior is driven by social outcomes. Moreover, many asset owners (e.g., endowments) are “permanent” funds that have come to realize that their beneficiaries 50 or 100 years from now will inherit not only the profits but also the negative externalities of the investments made today. These megafunds understand that because they will essentially have to own large companies’ stocks “forever,” they are destined to become involved with the companies’ long-term problems as well. The term universal owner has been coined to describe this genuinely long-term, total cost–oriented approach to equity ownership.
Pros, Cons, and Obstacles
So, what are some of the pros and cons — and obstacles — to an era of fiduciary capitalism? On the plus side, savvy fiduciaries should be able to improve investment returns by reducing the cost drag of transactions, the overpackaging of financial instruments, and other forms of rent-seeking behavior by agents and intermediaries. As universal owners, large fiduciaries recognize that they are owners for the long term, which should suit businesses looking for more stability and consistency from their shareholders. Short-termism, a headache for issuers and patient investors alike, should face a stronger headwind. The average holding period for equities continues to drop to the level of a teenager’s attention span, and publicly owned companies’ boards and managements have become cynical about the intent and commitment of their shareholders. Under fiduciary capitalism, these corporate management teams will have longer-term owners of their shares, who will hold them accountable for long-term performance and for the true environmental and social costs of their activities. Truly patient capital, which considers the total costs and benefits of a strategy over many years, will drive talent and innovation in finance, rather than the “I won’t be here, you won’t be here, so who cares” stereotype that has plagued the industry for years.
The road to fiduciary capitalism is not without some major obstacles. Too many institutional investors are secretive and do not disclose enough about their activities. Their beneficial owners (including voters, in the case of sovereign funds) need more information to make reasonable judgments about their operations. Similarly, far more transparency is needed in the true costs of running these pools of assets. Investment management fees and other expenses often go unreported. Too much time and energy is spent comparing returns with market benchmarks, and not enough is spent defining and comparing the organizations’ performances against their liabilities — or against adequacy ratios. Pension governance itself needs to be improved. As Ranji Nagaswami, former chief investment adviser to New York City’s $140 billion employee pension funds, has observed, public pension trustees are often ill equipped to govern platforms that are effectively complex asset management organizations. Compensation remains a complicated issue. In the public sector, paying for great pension staffers ought to be at least as important as a winning record on the playing field, yet in 27 of the 50 US states, the highest-paid public employee is the head coach of a college football team. The agency risks within fiduciary organizations need to be watched carefully. Another weakness of the current system is that many asset owners are fragmented and relatively unsophisticated. Mark Frazier of the New School has noted that there are more than 2,000 municipal pension funds in China, most of them underfunded and understaffed. The era of finance capitalism saw huge consolidation in the banking and brokerage business. In the same way, pensioners should be able to take advantage of large, sophisticated fiduciary platforms to access low-cost, high-quality services. Let’s also recognize the value of the profit motive. Incentives and the fruits of hard work are an essential part of how capitalism in any form works. Fiduciary capitalism needs to define and demonstrate how “animal spirits” can thrive with its support.
What would an era of fiduciary capitalism mean for financial firms? Certainly, it would mean continued downward pressure on fees. In the past six years, fee compression for traditional equity products has exceeded 15%. It would also mean new opportunities for firms that figure out how to partner with fiduciaries beyond acting in a traditional money manager or consultant role. Alignment of interests is critical, which is why I believe some alternative managers are well positioned for the change. These firms are mostly privately owned, with investment horizons of 5–10 years, and should be prepared to be compensated on the basis of long-term performance, using absolute return as their yardstick. We must not overlook the retail investors in search of low-cost, long-term investment solutions for retirement. There is a tremendous opportunity for financial services firms to behave as true fiduciaries and embrace these customers for the long haul.
Fiduciary capitalism may well supplant 30 years of finance capitalism as a driving force in the global economy. An era of fiduciary capitalism could shape the global economy for many years, as did the era of finance capitalism that preceded it. But if the financial sector triggers another episode of global instability and another round of bailouts, then more regulation — and another step toward utility status for financial services — will almost certainly be the result. The future of finance needs to be less about leverage, financial engineering, and stratospheric bonuses and more about efficiently and cleanly connecting capital with ideas, long-term investing for the good of society, and delivering on promises to future generations. In the public policy arena, governments that promote long-term savings, reduce taxes on long-term ownership, and require transparency and good fiduciary governance can help hasten this welcome change in our financial markets.
The era of finance capitalism wasn’t all bad, and an era of fiduciary capitalism wouldn’t be all good. In a time when leadership in finance is desperately lacking, fiduciaries have the potential to reconnect financial services with the society they serve. Let’s hope it’s not too late.
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