Like capitalism, but worse.
In 1993, the oft-quoted Russian Prime Minister Viktor Chernomyrdin provided one of his better one-liners when he said, “We wanted to make things better, but they turned out like usual.” This quote can often be applied to financial regulation and innovation.
In early 2014, past-President and Chief Executive Officer of CFA Institute John Rogers published a blog in Enterprising Investor outlining his vision for the future of finance in the wake of the 2008 financial crisis — fiduciary capitalism. According to Rogers, fiduciary capitalism “would be one in which long-term-oriented institutional investors shape behavior in the financial markets and the broader economy.”
These institutional investors were to be pension funds, endowments, foundations, and sovereign wealth funds. Describing these institutions as “universal owners,” Rogers argued that because of their large size, these institutions were destined to be invested in the entirety of the market. Furthermore, their fiduciary obligations and long-term (if not perpetual) mandates would mean that they would have no viable “exit” out of this market portfolio. Thus, these institutions would be forced to engage more closely with management and policy makers to maximize long-term sustainable value.
In other words, by being permanent universal owners, they would — by definition — internalize the externalities that typically are ignored by short-term investors. The correct pricing of externalities (e.g., pollution), in theory, would serve to improve welfare outcomes in an economic sense.
A year later, in 2015, Benjamin Braun started research on an article that ultimately would be released only in June 2020 and that would yield a fascinating update on this “new capitalism.” Labeling his description of the new reality as “American Asset Manager Capitalism” the article deserves several comprehensive rereadings, but the sense of it being like a splash of cold water on the face of fiduciary capitalism will stay with the reader throughout.
I’m an institutional investor, and I’m here to help.
The central motivating observation of the article is that the asset managers BlackRock, Vanguard, and State Street Global Advisors (SSGA) collectively own more than 20% of the shares of the average S&P 500 company. At face value, this observation is entirely consistent with the description of fiduciary capitalism just outlined: stock ownership is concentrated among large institutional investors that are universal owners of the diversified market portfolio and, as a result, have great scope to “shape behavior in the financial markets and the broader economy.” Some detailed observations, however, end up making a significant difference.
The question Braun poses himself is this: how does index fund dominance change the political economy of corporate governance?
Rogers and Braun summarize the historical development of corporate governance in an overlapping way despite some apparent contradictions. The essence, however, is as follows:
- Monopoly capitalism in the late-nineteenth and early twentieth centuries saw the infamous “robber barons” exert high levels of control over their firms as owner–managers while being personally undiversified across the market portfolio and thus having a lot of “skin in the game” when it came to the success of their corporations.
- Post-war managerial capitalism saw a professional class of managers take over on behalf of a dispersed set of owner–shareholders. This period gave rise to the corporate governance theory we are most familiar with today — Jensen and Meckling’s agency theory of the firm.
- Both Braun and Rogers agree that something changed in the 1980s and that the driver for this was financial deregulation and innovation. Financialization or shareholder primacy are terms both authors likely would agree on to describe this period, which saw stock ownership reconcentrate into a layer of institutional intermediaries, driven in large part by global tax and pension reforms that encouraged equity investments for retirement portfolios.
Rogers, writing in 2014, extrapolated this reconcentration of stock ownership as leading to a future of fiduciary capitalism, but Braun, with the benefit of extra time, is able to show the way in which this reconcentration has actually manifested.
Three is a crowd.
A key element to understanding what happened (or went wrong) at this point is Braun’s observation that the investment chain, which could at this point be loosely described as savers > pension fund > underlying firm, lengthened once more as the institutional investors increasingly turned to asset managers to deploy their (or more accurately their beneficiaries’) assets productively.
This narrative is intimately related to the well-documented rise of passive index products, supercharged by the arrival of low-cost exchange-traded funds (ETFs). These products attracted asset inflows at the expense of actively managed funds that have failed for decades to deliver convincing and unambiguous value net of fees.
The low-fee economics of passive asset management only reward scale, and since 2000, Braun has noted that the dominant dynamic in stock ownership is consolidation within the asset management sector, leading to the rise of the aforementioned Big Three — BlackRock, Vanguard, and SSGA — that have a collective ETF market share of 80%.
So, why is this inconsistent with the fiduciary capitalism that promised market dominance by benevolent large institutional investors, as described by Rogers in 2014?
Braun argues that the key difference is that, unlike pension funds (or sovereign wealth funds) that face economic incentives that are aligned — by mandate — with returns to plan beneficiaries, asset managers selling passive-indexed or ETF products operate a business model that is incentivized to maximize fees from assets under management (AUM), with scale and network effects similar to those found among digital platforms.
While asset managers can be convincingly described as “universal owners,” as per fiduciary capitalism, they are in an economic sense — disinterested owners — because any returns are passed through to the ultimate beneficiary. The asset manager sees fees on AUMs as the ultimate economic incentive.
Reading between the lines, it seems Braun is not yet clear whether this market structure will yield the hoped-for externality-internalizing promise of universal ownership, or the more mundane and damaging competition-reducing downsides of common ownership.
Whatever market structure we try to create, it always ends up looking like BlackRock.
Braun spends the final section of the article discussing the political economy implications of this market structure. While recent headlines regarding public asset manager commitments to environmental, social, and governance (ESG) issues and a cooperative effort to develop a Covid-19 vaccine are presented, it is clear the author remains skeptical that these headlines are sufficient to conclude that asset manager capitalism is, in net terms, a good outcome for market structure.
The most convincing argument Braun presents against asset manager universal ownership fully internalising negative externalities is the under-appreciated fact that stock ownership itself is extremely concentrated among the top 10% of the wealth distribution, which owns 86% of corporate equity either directly or indirectly through funds (further, the top 1% own 50% of corporate equity). The bottom 50% of the wealth distribution own no shares. That is, today’s universal-owner asset managers are fully diversified and internalising externalities across a market in which Braun notes, at best, only 50% of the population participates.
As a result, Braun argues, negative externalities that affect those who own no shares (the author cites low-skilled workers as an example) may still be ignored, whereas negative externalities that affect shareholders, indeed, are internalized. Perhaps uncomfortably for the author, this section of the paper, in some sense, formalizes the argument posited by ESG sceptics who decry the ESG trend as corporate virtue-signaling for the already wealthy.
The final interesting part of the paper is Braun’s analysis of the macroprudential implications of this market structure. He argues that the AUM-maximizing incentive facing universal-owner asset managers gives them a strong vested interest in monetary policy, specifically those policies that support asset prices. In the post-Covid-19 era of QE-infinity and BlackRock-managed Federal Reserve asset purchase programs, the author’s implications are clear without further elaboration.
The conclusion of the paper notes that many detailed characteristics of this modern incarnation of capitalism are without historical precedent. The optimistic interpretation of this conclusion is that the outcomes of this structure may not be doomed to repeat the usual historical excesses, either.
Mr Chernomyrdin, however,
would probably disagree.
 It is difficult to translate this quote accurately and concisely while keeping the full impact in the original Russian. This translation is the authors’ own.
 John Rogers, “A New Era of Fiduciary Capitalism? Let’s Hope So,” Enterprising Investor, 28 April 2014, https://blogs.cfainstitute.org/investor/2014/04/28/a-new-era-of-fiduciary-capitalism-lets-hope-so/.
Image credit @ Getty images/Nora Carol Photography