Issue: July/Sept 2010


Greed was good

For some, on Wall Street and its acolytes, while it lasted. The mantra, popularised by movie character Gordon Gekko, led the world into financial crisis. It’s thoroughly discredited but doesn’t die. Now needed is a climate change, spearheaded by institutional investors.

Sustainability this and sustainability that. From protection of the planet to promotion of corporate citizenship, it’s come to mean almost anything that smacks of do-goodism. We must have sustainable industry and infrastructure, clean water and energy, companies that denude neither natural resources nor their bottom lines, and anything else that will earn brownie points for “responsible investment” that enhances “sustainability”.

Gradually, with a proliferation of governance codes and stumbles toward environmental regulation, the sustainability concept is seeping into boardrooms against the remorseless tide of pressure for quarterly earnings growth. Therein lies the paradox; not quite as impossible to overcome as squaring the circle but, on embedded practice, not too easy to bridge either. Leave it be and sustainability will be relegated to another fad in box-ticking compliance, another twist in marketing spin.

The conflict is between long termism and short termism. In the marketplace cut and thrust, they mix as oil and water. Instant performance maximisation trumps noble investment policies any day. Doesn’t it? Sustainability, essentially a long-term concept, relies for execution on a whole industry focused essentially on the short term.

To the one side are pension funds, by their nature long-term investors. To the other side are asset managers, by their structures incentivised for short-term performance. In between are companies, significantly owned by pensions funds but whose share prices are determined by asset managers.

Because pension funds are long term, they must necessarily look to the sustainability of their investments. They have an inherent obligation to ensure, for the benefit of retirees in present and future generations, that the environments where they invest are socially and economically stable.

Their motivation is, or should be, to target investments in companies and projects that contribute to development rather than depletion of these environments. This implies a hand-in-glove responsibility: to help build the society and to engage with companies – either directly or via their agents, the asset managers -- in the process of complying with best-practice environmental, social and governance (ESG) standards.

Pollution of air and sea...threats to life

Here comes a blockage. It’s in the restrictive provisions of Financial Services Board circular PF 130, on the good governance of pension funds, underpinned by Regulation 28 of the Pension Funds Act which guides their asset allocations (TT April-June ’10).

PF 130 says that funds must formulate an investment policy statement that includes “whether the fund has a socially-responsible investment (SRI) policy and its definition of such investment type”. It views SRI as an asset class, an afterthought to be considered amongst “other” in a fraction of the portfolio’s make-up only once the fund has met its “primary obligation to provide optimum returns”.

This presupposes, against a mass of evidence, that SRI returns are necessarily suboptimal. It flies in the face of the UN Principles for Responsible Investment.

These principles insist that ESG criteria pervade all asset classes. Some two dozen of SA’s top asset managers have followed the Government Employees Pension Fund in signing the principles. They’re monitored for compliance and committed, under pain of expulsion, to having ESG policies that they apply and disclose in proxy voting.

As agents of pension funds, with which of the two are SA asset managers to comply? With PF 130, which is regulation, or the UN principles, to which they’ve voluntarily committed themselves? It can’t be both.

Then comes another problem. It’s to stimulate long-term ESG objectives when the weight of the investment industry rests on short-term premises. The industry includes pension funds whose trustees jump from one asset manager to another, depending on who comes out best in rankings surveys.

To retain existing clients, and attract new ones, pity the manager who isn’t in the upper quartile for three years or often less. So he has to be right up there, assessed against peers on the basis of returns over relatively brief time horizons. More than this, managers’ performance bonuses are awarded in tranches measured annually or less. That’s not much incentive to look down the line.

Mervyn King

King...powerful initiative


The draft ‘Code for Responsible Shareholders Investing in SA’ contains six principles, all comprehensively amplified for detailed application. They’re that the governing body of an institutional shareholder should:

  • Ensure the sustainability of its investment strategy;
  • Ensure that there are clear standards in place for the governance of investee companies;
  • Oversee service providers and safeguard the alignment of the principles of responsibility, transparency and accountability in the investment process and exercising of rights;
  • With its agents, recognise the potential for conflicts of interest and proactively manage them;
  • With its agents, be able to demonstrate responsible ownership;
  • Be responsible for a policy on voting disclosure.

The term “institutional shareholder” includes pension funds, insurance companies, investment trusts and other collective-investment vehicles. It applies to the governing bodies and their agents, such as asset managers, appointed by the governing bodies to act on their behalf.

Service providers to institutional investors may include asset or fund managers, actuaries and other consultants. There is often an agency relationship, the draft points out, between these service providers (agents) and the institutional investor (principal or client), and between a service provider that is agent to a service provider which acts as principal.

The same applies to companies. Let earnings slip, in any reporting period, and woe betide the share price. The best to be said is that “the market”, which rushes like a headless chicken (it’s called “volatility”) in different responses to each titbit of ever-flowing news, prices in not only historic but also future earnings as it perceives them. This would reflect continuously-changing risk assessments.

Take institutional favourite BP where a disaster for the share price flowed from the oil spillage off the American coast. There was a patent failure, by the company and analysts, to identify potential risk in new techniques for deep-sea extraction. The market didn’t foresee a calamity waiting to happen, considered with hindsight to have been inevitable at some future point as the oil majors become more venturesome, just as it didn’t foresee the sub-prime crisis or the knock-on to the sovereign-debt crisis.

This is because of myopic obsession with the labyrinth of here-and-now numbers, for all their lack of intelligibility to mortals unskilled in such accountancy nuances as total shareholder return, economic value added, normalised headline earnings per share, diluted eps before interest, tax, depreciation and amortisation etc. It defies what’s supposed to pass for stakeholder communication because numbers by themselves can be intimidating, obscuring and misleading. They exclude the narrative of where the company’s come from, where it’s headed and the risks it faces.

Numbers are what the market counts, and what it can’t count doesn’t matter. Companies’ earnings performance must be reported at six-monthly intervals, for immediate digestion by analysts and attention by media, to the neglect of all else. Numbers are verified by the audit; the story of what a company’s trying to do is verified by the public relations department. Sustainability, embodied in ESG, is a soft issue for attention of soft-minded greenies and their irksome ilk.

Part of the problem is that pension funds are too lethargic to become active owners in asserting ESG. Another part is that there’s little in it forasset managers, relating effort to reward, or little to make it worthwhile for them to embarrass companies that are fee-paying clients of their parent institution. Yet another part is faceless ownership; passive trackers and unit trusts, for instance, that cannot glean voting mandates and couldn’t give a hoot about individual companies so long as their funds make money at the macro level.

What’s to be done?

On its way is a ‘Code for Responsible Shareholders Investing in SA’ (see box). Drafted by a committee under Mervyn King, and going through the process of consultation with the investment industry before finalisation, it complements existing governance codes including King III which significantly substituted “companies” with “entities”.


Sustainability concerns the quality of life. It recognises that resources are finite, to be cared for and conserved. As resources are depleted, so far as possible they must they be replenished.

Water, for instance, is a scarce resource. It’s availability is essential for human sustenance. Without clean water for drinking, people die; without adequate water for agriculture, food security is endangered.

An acute problem for SA is that the population size is increasing at a rate oblivious to resource limitations. And not only natural resources. On the most optimistic projections for economic growth, there’d still be insufficient job creation for unemployment to reach manageable levels.

Resource limitations are equally apparent in skills and funds for education and healthcare, amongst the gamut of state-provided services, despite the rights that the constitution promises. Limitations exacerbate when resource availability decreases faster than population size increases.

There was a time when family planning was on the national agenda. It isn’t any longer. There are borders and laws to stem illegal immigration. They aren’t effective.

If raising these topics has become politically incorrect, isn’t there an element of unreality in the sustainability debate?

Says King: “It’s a living document. Integrated reporting is universally accepted and affects companies all along their supply chains. If companies want to raise money, they’ll have to raise it from institutions including pension funds that have assessed them on ESG criteria. There’d have to be a lot of upskilling and re-education, using scientists and environmentalists where they weren’t used previously.”

Real pressures are building, he believes. Companies can no longer ignore, for example, the effects of greenhouse gases and the trading of carbon offsets. Neither, as Wal-Mart shows, can they turn a blind eye to sweatshop labour practices in foreign factories from which product is sourced.

Regulations are strengthening, as are lending requirements. SA’s major banks have signed the Equator Principles, an international financial-industry benchmark for determining and managing social and environmental risk in project finance.

Less sanguine is Phil Armstrong, an author of earlier King codes and now head of the Global Corporate Governance Forum at the International Finance Corporation in Washington DC: “Around the world, the money chases short-termism. Until pension-fund trustees are well-informed professionals, competent to apply their minds and impose standards on asset managers rather than amateurs accepting the say-so of their consultants, an inherently powerful body of opinion will remain disenfranchised.” Asset managers are tempted to go for the “big hits” to earn big bonuses. They usually lack capacity to research and monitor compliance with principles for responsible investment amongst the dozens of companies in their portfolios. “You can’t change a mentality by codes and decrees,” reckons Armstrong, “but you can change it by changing the remuneration structures.”

He’s supported by Will Oulton, founder of the FTSE4Good indices and recently appointed head of responsible investment at UK consultancy Mercer. Oulton points to a Mercer survey showing that, as measured by percentage of turnover, 65% of long-only managers have shorter investment horizons than their mandates intended.

The managers reported a range of reasons. One was their short-term incentive schemes; another was mixed signals from clients. Many of the causes were industry-systemic and therefore immune to quick-fix solutions.

But there’s much that pension funds can do, Oulton adds: “These include providing their managers with clear signals and having incentive schemes to invest for the longer term. They must expect managers to integrate ESG factors into their investment processes and be clear in their manager agreements on their investment horizons.”

Interestingly, the research also found that SRI strategies that prioritise ESG in the selection of assets had a lower turnover than non-SRI assets. For the asset owner, responsible investment can provide a basis to address some of the negative consequences – such as higher costs and investment-behavioural biases – which are exacerbated by short-termism.

On the local front, Malcolm Fair of RisCura has three suggestions:

  • Much stronger focus on managing risk e.g. the cost to a platinum mine of polluting water;
  • Mindset switch from beating performance benchmarks to achieving liability-driven results. Though easier in defined-benefit funds, because of their rules, in defined-contribution funds the liabilities are members’ expectations of comfortable retirement. Liability-driven results build in longer-term time horizons;
  • Trustees evaluate their asset managers, multi-managers and consultants on scores that aren’t exclusively quantitative.

Also at the coalface is Zoe Lees of KPMG and a member of the JSE SRI advisory committee. At the company level, she finds, chief executives “either get it or they don’t”.

Once they do get it, she notices a “totaltransformation” in the way they address long-term change: “They begin to understand how the national industrial plan and a whole new spate of environment-related regulation will impact on their companies. They realise the fundamental effects in store for the economy and themselves, and start asking the fundamental questions on how to adapt.”

As investors in these companies, trustees of pension funds had better come to grips with the same issues too. Seriously and soon. Or “fiduciary” might as well be removed from their lexicon, with consequences that fund members won’t want.

"You can't change a mentality by codes and decrees, but you can change it by changing the remuneration structures."

– Phil Armstrong