The 3-D Fiduciary
March 22, 2022
By Ravi Venkataraman, CFA
Active Managers Council Chair
MFS Global Head of Investment Solutions
In years past, the process of evaluating fund managers was simple. Beat the market and be hailed as a success, under-perform and get fired. But today, investor objectives, opportunities, markets, risks, and society’s expectations are much more complex, which has investors demanding more than just returns on their investments. This blog is derived from many conversations with clients and industry colleagues from around the world and in this introductory piece I explore how expectations have evolved and set the stage for a new approach to measuring the success of active management, for both investors and managers.
An Evolving Mindset
This change in the investment management industry has been gradually taking place over the past few decades. Historically, investors looked at investing with a two-dimensional mindset made up simply of risk and return; how much money do I put in, what is the appropriate level of risk, how much more do I get out and how does that compare to the market? While that two-dimensional mindset is still largely true, investors have mostly replaced return with “financial outcome.” Instead of seeking only returns, investors are focused on specific goals for those returns such as paying for a child’s college education, saving for retirement, funded status, payouts, etc.
Investment Outperformance: “Quality of Performance” Comes into Focus
In today’s complex world, focusing on delivering outsized returns is not enough. Investors increasingly want a “mosaic of outcomes” that optimize both the “quantity and quality of returns”, adding additional dimensions to investment results. Examples of quality of returns and outcomes are consistency of performance, absolute volatility/ downside risk budgets, liability/ income benchmarks, non-correlated outperformance patterns, idiosyncratic sources of returns, factors and liquidity, and capacity budgets. And that puts the pressure on active managers to step up and deliver the value in line with varied client expectations. Active management is being redefined from a simplistic monetary metric such as “alpha” to one where the impact on broader goals and constraints are considered.
Value of Insight and Advice
As a logical extension of more complex objectives, investors are increasingly relying on investment managers (in addition to consultants) for information, insight, and advice. Part of the active value proposition is to provide, whenever possible, value add via both performance alpha and indirect alpha. Beyond performance and reporting, clients look to managers for research, surveys, and bespoke solutions and projects such as asset allocation, portfolio construction and stress testing, and investment insight and operational training. Active managers in particular can provide insight via their investment teams that include industry analysts, portfolio managers, traders, global market strategists, and other subject matter experts that clients can use to make investment decisions and ultimately be better fiduciaries.
The New Frontier
The days of the two-dimensional investor/manager mindset may be numbered, however. Integration of ESG factors is rapidly become mainstream in that it is increasingly clear that environmental, social, and governance factors have a direct bearing on the financial valuation of companies. The graphic below shows a sampling of “traditional” factors that are considered in financial analysis and newer “ESG factors”.
In reality, most of these factors are not new and were always part of the analyst’s evaluation framework. What is perhaps new is that data is increasingly available via disclosures and reporting prompted by regulation, asset owner and asset manager demand, that allows analysts to bring more rigor to the analysis. There is a lot more that can be said about the quality and inconsistencies in the data, the “aggregate confusion” of ESG ratings etc. that is beyond the scope of this blog, but the fact of the matter is that as an industry we are moving in the right direction in using this information in the investment process. You can also see how the evaluation of ESG issues in the valuation process is dynamic, ongoing, and by definition an active management activity.
The Third Dimension
If this isn’t complex enough, we are now in a transition to where investors are beginning to explicitly consider responsible ownership or stewardship as a third dimension of fiduciary responsibility, in addition to risk and financial outcomes. We expect this dimension to be even more complex, nuanced, and dynamic. To appreciate this complexity, one has to look no further than the tragic war in Ukraine and reflect on the implications of evolving defense policy, energy initiatives, and financial sanctions for regions, countries, industries, and companies. This example not only calls into question our sense of what is ethical and what is not, but also how to interpret this in fiduciary terms, how to factor in asset managers’ responsibilities, factor it into the investment process, and over what time horizon.
Do All Roads Lead to Active?
With these new demands coming to the forefront, both fiduciaries and managers face pressure to deliver. The emerging focus on responsibility, stewardship, and financial materiality of ESG factors entail “active decisions” made by investment managers. While passive management plays a very important role in the investment process and enables cost effective market exposure, only active management inherently has the complete set of tools to evaluate and implement what is necessary to address this dynamic new world of investor expectations.
We are potentially on the cusp of a profound evolution of fiduciary responsibility. Asset managers, in turn, have an enormous responsibility as they are the stewards of capital and responsible for committing it to portfolio companies on behalf of clients. I’ll explore some more ideas about how the 3-D fiduciary could respond to these challenges and how asset managers can help in future blogs.