The Influence of Large Investment Funds

Introduction

Of all the mechanisms of traditional capitalism, few are blamed as harshly for the collapse in values, or seen as exploiting workers to benefit a self-serving elite than large investment funds. Divorcing the investor from any contact with, or even knowledge of, where her money is being invested, they have a legal obligation—a fiduciary duty—to make the best possible profits on their investors’ capital. For decades, this has been interpreted as a licence to buy and sell shares as rapidly as profit maximizing will allow. Investment was regulated to benefit one stakeholder only in the investment: the one with the capital.

Profit maximization does not mean just that the investor wants to make a good return. It means that the fund has to try to return more than all the others, or, usually, the investor can move her money. Competition between funds forced all of them into ever more rapid turnover of share ownership as quarterly or even monthly figures were compared. Where share ownership is measured in days, or fractions of days, any sense of the investor having any responsibility to the company—to help it grow, to improve, using the money invested in it—is lost. The only stakeholder in the transaction whose profit matters is the investor. As events have shown, short-term profit maximization drives businesses into serving their shareholders at the cost of their employees, and even of their customers or clients. In this chapter, we look at the ways some investment funds have started to try to rebalance transactions so that the benefit is not limited to one side—so that not only those providing the capital, but the investee companies, and those affected by their behaviour also start to benefit. Clearly the Economics of Mutuality cannot operate unless large investment funds are willing and able to become responsible partners to responsible businesses. This chapter shows that promoting the Economics of Mutuality need not damage profitability, but indeed can help funds to grow over the long term.

Why the Ownership of the Fund Is Important

This chapter looks at examples of very large funds—private equity funds, pension funds, and sovereign wealth funds (SWFs)1—which have thousands, or even millions of investors as their owners. Sovereign wealth funds do not have a single agreed definition, but share several characteristics. The OECD describes them as, ‘a fund set up to diversify and improve the return on foreign exchange reserves or commodity (typically oil) revenue, and sometimes to shield the domestic economy from (cycle inducing) fluctuations in commodity prices. As such most invest in foreign assets’ (Blundell-Wignall et al. 2008). For countries such as Norway, setting up a SWF is a way to manage an influx of wealth from a commodity—in Norway’s case, oil—so that it is less vulnerable to a drop in the price of that asset, and to avoid a sudden glut of cash destabilizing the economy. Many SWFs are designed to provide an income for the country after the original source of the income—oil, diamonds, copper, or any finite commodity—has run out. The Sovereign Wealth Fund Institute (SWFI) describes these as ‘future generation funds’.2 Typically, they aim for a very diverse portfolio, spreading the risk amongst different sectors and regions. Some SWFs buy controlling stakes in companies, but many, including Norway’s, buy smaller stakes in large numbers of companies. The SWFs in this chapter are protected from too much political influence, including the temptation to spend windfalls from non-renewable resources, by the government of the day being kept at arm’s length through independent managers. Some, including Singapore’s GIC, only invest overseas, avoiding domestic investments and their potential for political influence. Any estimate of the total size of SWF assets under management is subject to rapid changes, but for up-to-date information, the Sovereign Wealth Fund Institute’s Wealth Fund Rankings webpage3 gives the current size, and date of origin. At time of writing, the SWFI listed over USD 8109 billion held by various countries, over half derived from oil and gas.

Public pension reserve funds finance pensions, usually by pay-as-you-go schemes, where the employees, and often the employers, contribute over long periods. Pension funds are usually thought of as being owned by the contributors, but they may be set up as part of a social security system, possibly managed in the public sector, such as the Japanese Government Pension Investment Fund, or the Danish Social Security Fund. Others are managed by the government separately from any social security system, such as New Zealand’s Superannuation Fund. While SWFs typically invest overseas, public pension reserve funds (PPRFs) often come under pressure to invest domestically: the Japanese GPIF and Korean National Pension Fund are invested entirely in government securities (Blundell-Wignell et al. 2008). They have one clearly defined aim, paying pensions, where SWFs may be attempting to avoid ‘resource curses’, shield against inflation, plan for resources diminishing, and export national values through ‘soft power’. Since many pension funds were established over a century ago, whereas most SWFs were established within the last fifteen years, it is unsurprising that the structures that had been developed in pension funds to ensure independence from political influence and the security of the fund have influenced similar structures in SWFs. Pension funds have had independent boards with strict criteria for the eligibility of trustees, including professional qualifications and experience of managing investment funds, for decades. Many SWFs have adopted similar strategies. Their sources of income are different, they have different liabilities, and they invest in different regions, but the aspect they have in common is the need for independence from raids by short-term, often politically motivated governments.

Raids by governments, on capital or profits, are not the only temptation towards short-term aims. However they are managed, pensions are ‘owned’ by everyone who contributes to them, often for decades, and SWFs are owned by all the citizens of the country that holds the fund. With so many owners, organizations are set up to manage the day-to-day transactions of buying and selling the shares. These managers have a fiduciary duty to maximize the profit they make on behalf of those who own or contribute to the fund, and this is where the temptation to short-term profiteering comes in. Under current legislation, investors who buy shares in companies have no responsibility to grow the company, to add to its value, let alone develop the employees’ capacity or consider the relationship between the business and communities around the sites where it operates. Investment managers may consider the business’s use of natural resources if they are concerned that exploitation constitutes a risk, and they may be wary of negative publicity about unfair treatment of workers, but a quick turnaround on buying and selling is one way to reduce these risks. It takes a more imaginative, as well as a more responsible approach to make an investment mutually profitable to investor and company.

The funds we examine here could behave like typical, profit-maximization funds, since few of the pension contributors or citizens who contribute to them or ‘own’ them have any knowledge of the investments made for their benefit. They could buy and sell with no sense of ownership of the companies they invest in. What makes the funds discussed here different—and important—is that they are innovating to make the investment relationship mutually beneficial both to those providing the capital, and the company—and therefore the employees, customers, and communities where they operate. To be clear, these funds are not ‘social impact’ funds, designed to benefit a struggling community, nor are they philanthropic funds demanding only social benefit in return, nor are they running non-profit corporate social responsibility projects in parallel to making a profit on their main investments. Like other funds, they have a fiduciary duty to make a profit for their contributors. The critical difference is that these funds have realized that they can maximize their profit not through ever faster turnover, but through investing in the long term, building mutual relationships with the companies they invest in. By behaving like owners who want to see their return continue past the next monthly report, they aim to develop the companies to be profitable—but sustainably.

Why Long-Term Investment Is Critical

The change of mindset from short-term shareholder profit maximization, to a mutually beneficial investment in which the profit derives from the sustainable growth of the company, depends critically on the investment being long term. The shareholding fund becomes a steward, or ‘guardian’, of the companies it invests in. It requires a mindset where the portfolio is not a set of speculations, to be ditched if they are not working, but a search for companies which can survive short-term difficulties and grow sustainably. Sustainability becomes not a fashionable buzzword, but a crucial feature of a company which can manage resources over decades, or generations.

Building a relationship between investor and investee needs a set of skills missing from short-term ownership. The necessity of building long-term partnerships affects every aspect of the funds’ structure, culture, and governance.4 Learning to be the stewards of their investments has required innovations which go much deeper than holding shares for a minimum length of time. Many funds around the world are innovating in ways which refocus on the long term, meaning that there are currently many models being tried out, and a whole new vocabulary to go with them. One example is Australia’s Future Fund, where managers are known as Guardians of the Fund, intended to benefit future generations of Australians. As the director of Oxford University’s Smith School of Enterprise and the Environment, Professor Gordon L. Clark notes, ‘being appointed a “Guardian” is to stand guard against short-term political interests, a mandate for behaviour that . . . goes well beyond the requirements of simply being a professional.’5 Managers who regard themselves as stewards, or guardians, of the investments they make, need to think strategically over the long term about how to build the value of the company. Many different strategies have been tried in recent decades, and models for business responsibility are still rapidly evolving, giving rise to a variety of terms—ethical, sustainable, long-term, triple-bottom-line—to capture what makes them responsible.

Classifying Responsibility: Ethical, Sustainable, or ‘Green’ Investing and ESG

Because the whole field of responsible investment is in flux, many overlapping terms are used to describe practices which have similar aims in making investment sustainable and mutually beneficial to the investor and company—but slightly different strategies for achieving them. Terms are still evolving; most funds have moved on from ‘corporate responsibility’ (which aimed at little more than not breaking the law), and even from ‘ethical investing’, since many of the funds aim for more than ethical compliance. ‘Green’ investment obviously focuses on environmental sustainability, and ‘triple-bottom-line’ investing includes ways of measuring profit beyond purely financial measures, sometimes including measurements of environmental or human capital. ‘Sustainability’ was defined as long ago as 1972 by the United Nations’ Brundtland Commission6 as ‘development that meets the needs of the current generation without compromising the ability of future generations to meet their own needs’. It’s a useful definition, as it demonstrates the link between current responsibility and future sustainability.

The investment strategies which are most often seen as responsible are the ways they consider ESG (environmental, social, and governance) factors. This term recognizes the connection between the ways in which a company is governed and its impact on the environment and society. At first sight, putting the internal governance of a company together with its external impact on the environment and society to assess risk in investing might seem to be counter-intuitive, conflating different metrics. However, the point of ESG measures is that they recognize that the internal governance determines the external impact. A company run on short-term horizons with no long-term plan for growth is high risk, and likely to impact negatively on society and environment. As with so many aspects of research into long-term investment by large funds, the measures for ESG are undecided, and several systems are used to assess companies. Amongst practitioners, the SWFI uses the Linaburg–Maduell transparency index, and the Financial Times developed its own ESG ratings; the Global Reporting Index offers sustainability reporting standards to analyse impact for climate change, gender equality, supply chains, and transparency; and taking an academic approach, Clark and Urwin (2008) analysed best practices globally to publish their governance scoring system diagnostic tool, and a proposed framework for governance in the Journal of Asset Management; while Cambridge University’s Judge Business School produced the S&P Long Term Value Creation Global Index. At present, this means that no one standard measure for ESG factors has been universally adopted, and funds are able to use the metric that displays them to advantage.

Without a universally recognized standard, it is difficult to compare levels of responsibility and their success in building mutually advantageous relationships with businesses round the globe. However, there are some initial research findings by the GSIA showing areas of strength which could be expanded to other areas of the world through sharing best practices across networks which share codes of conduct or guidelines. GSIA showed that community-level investing and sustainability reporting are practiced by investors in Asia and Australia; Europe and Canada are strong in screening for compliance with international human rights law. There are several organizations working to develop and disseminate strategies for responsible investing, including the United Nations Principles of Responsible Investment’s Academy, UNEP offering training for businesses, and (of the funds analysed for this chapter) Generation Investment’s seed funding and advocacy for responsible investors.

Of course, governance is vitally important not only in the companies that funds invest in, but in the funds themselves—it’s difficult to imagine a fund where staff are recruited and promoted with short-term incentives somehow growing long-term value in the companies in their portfolio. Here, we examine firstly, the ways in which funds are screening for companies with sustainable growth potential; and secondly, how the funds themselves are developing governance structures allied to long-term investing.

Investment Strategies

Funds have always had strategies for selecting their portfolios, but with responsible investment these have evolved from short-term profit to seeking companies in which they can grow value. Ownership Capital are unusual in actively managing 100 per cent of their shareholdings; their declaration ‘Being an owner means knowing what you own’ requires a highly skilled specialist investment team ‘dedicated to understanding every facet of each portfolio company’s business through an in-depth, hands-on research process . . . we actively engage with all portfolio companies on a continuous basis’.7 It would be hard to imagine a mindset more different from the short-term turnover of traditional funds. However, different funds have different capacities to develop such relationships with all their investees. Norway’s SWF actively manages around 6 per cent of its shares, prioritizing those in the highest risk areas; the Ontario Teachers’ Pension Fund actively manages around 80 per cent. Many large funds are seeking to increase their in-house management capacity through employing more skilled staff, or (in some cases, including GIC) building longer-term relationships with external managers.

Among the earliest strategies for building knowledge of companies into the portfolio was ‘negative screening’, initially rejecting companies profiting from such products as gambling, alcohol, tobacco, weapons, or pornography. Funds which own shares in companies conducting a lot of different activities may also disinvest if they move into such areas. Other funds screen for very specific practices: for example, Australians can opt for an ‘ethical investment’ pension fund8 which screens for ‘the dignity and well-being of non-human animals’. Others screen out businesses involved in fracking, or laying pipelines across indigenous-owned land (see, for example, ING’s statement on their divestment from the Dakota Access Pipeline in March 2017).9 These show how some large investors can respond to local cultures and their concerns.

Negative screening, however, provides only a minimum of responsibility, by avoiding the worst investments. (It is also ineffective where shares are simply bought by a different investor.) Critically, for a long-term partnership between investment fund and company, the risks inherent in commodities or products subject to regulation are often too great. Ownership Capital’s CIO, Alex van der Velden,10 emphasizes that their negative screening for fossil fuels is not for ethical reasons, but because over a long-term investment horizon, they will become a high financial risk. For van der Velden, initial negative screening is not an ethical precaution, but a necessity for long-term profit.

‘Norms-based’ screening is a short step up from negative screening and divestment, seeking companies compliant with minimum standards set by agencies such as UNHRC (United Nations Human Rights Convention), the ILO (International Labour Organization) or agencies with more specialized remits, such as the ICMM11 (International Council on Mining and Metals). Again, mere compliance could be seen as unambitious for reforming the sector.

‘Positive’ or ‘best-in-class’ investing seeks companies with good ESG factors—not just avoiding exploitation of people and damage to the environment, but seeking innovative ways to prevent these practices. The Forum for Sustainable and Responsible Investment12 describes positive screening as ‘investment in sectors, companies or projects selected for positive ESG performance relative to industry peers. This also includes avoiding companies that do not meet certain ESG performance thresholds.’ Investors are constantly developing new metrics enabling them to identify companies’ best ESG performance. The Canadian Coalition for Good Governance (CCGG) represents institutional investors by ‘promot[ing] good governance practices in Canadian public companies and the improvement of the regulatory environment to best align the interests of boards and management with those of their shareholders.’13 An obvious difference between negative screening, divestment, and norms-based screening versus seeking the best-in-class is that organizations such as CCGG aim actively to influence not only the companies they invest in, fostering good practice, but even the wider regulatory environment.

‘Active’ share ownership is increasingly seen as essential to developing good ESG practices. Funds leading innovation to make investment more responsible aim to engage with companies, either directly through attending shareholder meetings, or by employing external agents chosen to align with the fund’s values. The Ontario Teachers’ Pension Fund actively manages 100 per cent of its infrastructure investment fund; Ownership Capital actively manages 100 per cent of its shares through visits to investee businesses. For the very largest funds, developing the capacity to manage all their shares actively is difficult, but they employ external managers selected for their shared values. Norway’s SWF holds shares in 9,000 companies; with so many, it prioritizes directly managing the 6 per cent of its shares in the highest risk areas, and its largest investments.14 CPPIB emphasizes that its external managers are partners, and that they use feedback from their partners to develop their own capabilities. Because active management (directly or indirectly) by shareowners takes time and significant expertise from the fund’s employees, it only makes sense in a long-term relationship—in other words, learning requires a partnership.

While voting on all their shares is assumed to be an essential part of active management (by instructing external agents how to vote where necessary), some funds have evolved more advanced ways of using voting. Norway’s SWF holds a minority share in all its companies, but publishes its voting intentions in advance and files shareholder proposals, aiming to influence other shareholders. Generation Investment Management regards proxy voting as ‘an opportunity for analysts to gain additional insight into companies’, and report to their clients on how their proxies voted.15 Several funds make it clear that their voting is to a consistent set of values, including OTPP, who publish their corporate governance principles, seeing them as in shareholders’ best long-term interests,16 and NBIM, who invite collaboration with their ‘predictable’, ‘transparent’ strategy.17

Voting contributes to the maintenance of relationships between investor and company through regular reading of proposals, contact at meetings, and the use of voting to establish guidelines embodying the values determining how investors vote. In addition, funds have developed further strategies for direct management. Ownership Capital proposes changes in compensation or even to replace the compensation committee. NBIM is one of the funds which use ‘flags of warning’, which lead to divestment if ignored. Litigation is rare, because funds find sustaining partnerships through communication more effective. Funds building longer-term relationships are finding that having a transparent set of values and frequent communication are more effective than threats or divestment.

Building Values into the Structure of the Organization

Moving from short-term to long-term investment relationships doesn’t just take a change of mind-set: funds have to change their own governance and practices. Instead of bonuses for maximizing profit by whatever means, they must provide incentives to invest responsibly. The challenge for funds aiming to be more responsible is finding ways to innovate towards long-term horizons while operating within the existing law.

Funds have found ways to encourage longer-term horizons in their boards of directors, and across their employees more widely. Singapore’s SWF, GIC, sets an ethics quiz for employees annually, and provides a confidential platform to enable whistle-blowers to raise concerns.18 Other funds have pensioner or employee representation at board level; the Netherlands’ pension fund, PGGM, has a Members’ Council, in which fifteen current employees and fifteen pensioners are represented, enabling them to influence board decisions. PGGM treats pay as a vital aspect of governance; rewarding responsible investing affects every aspect of managing the organization, from recruiting staff with the right motivation, to the stability of a management aiming for a horizon of up to ten years.

Ensuring that managers and the board are incentivized to invest responsibly is vital. Ownership Capital consider non-financial as well as financial measures in setting bonuses, and pays them only when the investments outperform the market—pay by long-term performance. Norway’s SWF bases bonuses on performance, limits them to a percentage of salary, and instead of paying them at once, pays half immediately and the rest over three years. The Ontario Teachers’ Pension Fund lists several measures to ensure that pay is based on performance, combined with full disclosure on pay and benefits. It has introduced say-on-pay voting, banned ‘one-off discretionary awards’, and states its intention of paying senior and middle managers linked to the long- and short-term objectives of the company. Employees must keep equity awards for a minimum of a year after retirement, preventing their immediate sale and motivating employees to consider the value of the award even after their retirement. Increases in salary must be approved by an independent assessor, based on performance. Finally, it uses clawback provisions, ‘allowing the company to recoup compensation already paid in the event of financial restatements or misconduct’.19

As well as adopting such measures themselves, responsible funds ask the companies they invest in to adopt them too. CPPIB explains how it cooperates with other organizations in order to extend its influence on both governance practices and legislation. Alongside active management of their shareholdings, funds need to be actively involved in making sure their innovations are more widely adopted. Making them mainstream will need changes in the regulatory environment before short-term investors are likely to change.

Conclusion

It is always difficult to draw conclusions from a field in which innovation is at the experimental stage, and practices are still evolving before being widely accepted. However, these funds provide several crucial lessons. Firstly, far from innovation being stifled by complying with more ethical or responsible standards, this is driving the development of research within the funds into balancing pay and bonuses, experimenting with employee representation, and finding new ways of leveraging their influence as shareholders. Having learned from their experiments, funds are actively seeking ways to encourage others to share this knowledge across regulatory networks.

Secondly, the time factor required to build partnerships with investee companies is crucial. Developing knowledge of a company’s current operations, the structures it has in place to manage future risks, the ways it is ensuring effective governance through planning successions: all of these new kinds of knowledge are essential to a stewardship role. In order to tolerate regular questioning about its plans, a company must focus on its own long-term horizons, but must also want a long-term relationship with the investor.

The skill set needed to build and maintain such partnerships is profoundly changing the ways in which funds recruit, compensate, and retain staff aligned with their values. Balancing the need to be transparent and responsible about pay at every level with the need to retain knowledgeable staff who are building relationships with companies which could last decades is also driving innovation. Only those funds whose governance structures enable them to innovate in areas such as employee representation, partnering businesses, and sharing the knowledge from their innovations will be able to influence other funds, the businesses they invest in, and the regulatory environment.

___

Notes

1. For this chapter, around thirty funds were screened for innovative practices allowing for more mutual relationships with the businesses they invest in. The funds included as a focus of best practices are three Sovereign Wealth Funds, Singapore’s GIC, Norway’s NBIM, and Australia’s Futures Fund; three pension funds, the Ontario Teachers’ Pension Fund, the Canadian Pension Plan Investment Board, and the Netherlands’ PGGM; and two private investors’ funds, Ownership Capital and Generation Investment Management. They therefore represent different classes of owners: sovereign states, pension contributors, and private investors, but all are large funds seeking responsible ways to invest.

2. http://www.swfinstitute.org/sovereign-wealth-fund/.

3. https://www.swfinstitute.org/sovereign-wealth-fund-rankings/.

4. For a more detailed outline of the ‘Guiding Principles’ and investment strategies

   over the long term, the ‘Long-Term Portfolio Guide’ (FCLT March 2015) is a useful resource, developed by the Canadian Pension Plan Investment Board and McKinsey and Company.

5. Clark and Knight (2010).

6. The Brundtland Commission’s report for the United Nations, Our Common

   Future, defines a sustainable company as ‘one whose current earnings do not borrow from its future earnings; whose sustainability practices . . . drive profitability and competitive positioning, and . . . provide goods and services consistent with a low-carbon, prosperous, equitable, healthy and safe society’ (http:// www.un-documents.net/our-common-future.pdf).

7. https://www.ownershipcapital.com/investment-philosophy.

8. https://www.australianethical.com.au/pensions/.

9. https://www.ing.com/Sustainability/ING-and-the-Dakota-Access-pipeline.htm.

10. Johnson (2015).

11. https://www.icmm.com/en-gb/about-us/member-commitments/icmm-10-principles.

12. http://www.ussif.org/esg.

13. https://www.ccgg.ca/.

14. https://WWW.NBIM.no/en/responsibility/ownership/.

15. https://www.generationim.com/media/1141/generation-im-stewardship-code-october-2016.pdf.

16. http://www.cppib.com/en/public-media/headlines/2016/long-term-portfolio-guide/.

17. https://www.nbim.no/en/transparency/news-list/2016/clear-expectations-towards-companies/.

18. http://www.gic.com.sg/about-gic/code-of-ethics.

19. https://www.otpp.com/investments/responsible-investing/governance-and-voting.

Helen Campbell Pickford researches learning in organizations, the development of best practice codes, relationships between investment funds, MNCs, and local communities in developing countries, and the impact of business-led social interventions. Her work is based on an ethnographic understanding of the ways people and organizations construct and distribute knowledge and meanings, particularly in policymaking. Helen comes from a background in development and education which has taken her to Sri Lanka, Kenya, Malaysia, the Democratic Republic of the Congo, and Oman. She has worked in engaging communities in schooling post-conflict, analysing the roles of businesses, NGOs, community stakeholders, and governments in education.

Published by Oxford University Press. Great Clarendon Street, Oxford, OX2 6DP, United Kingdom.

Oxford University Press is a department of the University of Oxford. It furthers the University’s objective of excellence in research, scholarship, and education by publishing worldwide. Oxford is a registered trade mark ofOxford University Press in the UK and in certain other countries

© Oxford University Press 2021. The moral rights of the author have been asserted. First Edition published in 2021. Impression: 1.

Some rights reserved. No part of this publication may be reproduced, stored in a retrieval system, or transmitted, in any form or by any means, for commercial purposes, without the prior permission in writing of Oxford University Press, or as expressly permitted by law, by licence or under terms agreed with the appropriate reprographics rights organization.

This is an open access publication, available online and distributed under the terms of a Creative Commons Attribution–Non Commercial–No Derivatives 4.0 International licence (CC BY-NC-ND 4.0), a copy of which is available at http://creativecommons.org/licenses/by-nc-nd/4.0/.

Enquiries concerning reproduction outside the scope of this licence should be sent to the Rights Department, Oxford University Press, at the address above.

Published in the United States of America by Oxford University Press198 Madison Avenue, New York, NY 10016, United States of America.

British Library Cataloguing in Publication. DataData available. Library of Congress Control Number: 0000000000. ISBN 978–0–19–887070–8. DOI:10.1093/oso/9780198870708.001.0001.

Printed and bound in Great Britain by Clays Ltd, Elcograf S.p.A.

Links to third party websites are provided by Oxford in good faith and for information only. Oxford disclaims any responsibility for the materials contained in any third party website referenced in this work.