This paper examines how investment tools, beliefs and industry conventions impact the interpretation of fiduciary duty in the investment industry.

In particular, it focuses on the broadening interpretation of fiduciary duty to include environmental, social and corporate governance (ESG) issues. Though the interpretation of fiduciary duty is subjective, a combination of new analytical methods, evolving investment beliefs and changing industry conventions are leading to a wider interpretation than has been the norm in the past. The author concludes that recent economic crises provided a catalyst for investors to question the assumptions and conventions underpinning the investment industry, with new tools and changing beliefs laying the foundation for a longer-term investment approach that integrates ESG criteria into investment decisions.

James P. Hawley, Andreas G. F. Hoepner, Keith L. Johnson, Joakim Sandberg, Edward J. Waitzer (Available from March 2014) Cambridge Handbook of Institutional Investment and Fiduciary Duty

Pension fund trustees are generally not required to have specialist investment knowledge, so in practice this means they often rely on external advisors. This can create a conflict of interest if the advisors are incentivised to maximise their own profit. A set of norms has evolved to promote prudent behaviour, including a duty to monitor investments and delegated managers and to adhere to the principle of diversification. However, these processes are often backward looking and may actually impede the forward looking analysis that would be in the beneficiaries’ best interests.

Over-reliance on historical relationships

Guyatt focuses on Markowitz’s meanvariance optimisation framework (Modern Portfolio Theory) to illustrate this. The model relies on expectations of future performance that tend to be based on historical data without sufficient attention to forward looking expectations, leading to construction of an ‘optimal’ portfolio that is anything but. The recent financial crisis showed that a mean-variance approach to portfolio diversification fails to provide downside protection during periods of extreme market stress, which can result in the breakdown of the effectiveness of portfolio diversification following tail risk events.

Improving understanding of risk

A potential solution to this problem is to improve analytical methods by including more rigorous forward-looking analysis and a broader definition of risk, including consideration of ESG issues. A factor approach to risk analysis would consider portfolio risk in terms of the source of potential risk, such as macroeconomic variables, market risk, demographic profile and technological changes, with the aim of achieving diversification across risk factors within the portfolio. Trustees would be encouraged to discuss a broad range of potential risk factors in a qualitative and meaningful way, spending more time formulating the quantitative outputs than is generally the case with traditional mean-variance analysis. Such qualitative discussions better facilitate consideration of the impact of tail risk events, as well as less tangible factors such as ESG issues particularly where there is no (or limited) historical data available such as with climate change risk. Guyatt argues that mean-variance analysis still has a place, but within a more holistic approach recognising its limitations.

Investment beliefs are also an important part of the decision making framework. Typically they are agreed upon by the trustees and guide future investment decisions and policies, and can include reference to ESG issues, (particularly if the fund is a signatory to an organisation such as the Principles for Responsible Investment). However, it can be difficult to translate these beliefs into investment related action. While some funds clearly set out specific actions and targets, ESG issues can become overshadowed by other investment issues.

Guyatt refers to her previous research looking at how trustees and their advisors prioritise ESG issues relative to other investment issues, and whether ESG issues feature in their definition of fiduciary duty. While the majority of trustees felt that ESG issues as a whole are important, when asked which factors are most important to consider when reviewing performance, ESG issues were pushed far down the list of priorities and relative returns versus the benchmark were seen as the most important factor. Guyatt posits that despite their apparent individual views, trustees tend to revert to the predominant conventional thinking when it comes to implementation, perhaps for fear of appearing too different from peers or of contradicting advice from consultants.

Forward-looking and holistic thinking required

Guyatt concludes that investment belief statements need to be supported by changing industry conventions for ESG issues to become embedded within the concept of fiduciary duty. Yet for new conventions to be accepted the old ones must be challenged and, despite the financial crisis, the investment industry still predominantly relies on outdated theories of asset valuation and portfolio construction. Changing conventions, incentivisation structures, attitudes and behaviours is difficult as people tend to resist change, so the finance industry needs new leaders, with more diversity of values, skills and perspectives. This will allow the status quo to be challenged and promote long-term decision-making.

“Despite their apparent individual views, trustees tend to revert to the predominant conventional thinking when it comes to implementation.”

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    RI Quarterly Vol. 2: Fiduciary duty

    January 2014