April 2018 • Topic: Making a better case for capital markets • by William Wright
The asset management industry is a huge, important and growing industry, that plays a vital economic and societal role in managing risk and return for its customers and in allocating capital. But it can often be distracted from its underlying purpose of serving is customers by the structure of the industry, misaligned incentives, and its reliance on modern portfolio theory. In an important recent paper, Jon Lukomnik and Jim Hawley explore the underlying purpose of asset management, and how to reconnect the industry with that purpose.
To most people working in the asset management industry, the purpose of what they do is self-evident. But ask a thousaand asset managers what that purpose is and you’ll almost as many different answers. New Financial collaborated with Jon Lukomnik, the former head of the New York City pension scheme and corporate governance pioneer, and Jim Hawley, an expert in corporate governance and sustainable investing, on a recent paper exploring ‘The purpose of asset management’.
Their core argument is that the industry has a mixed record on the two main aspects of its underlying purpose:
1. Risk mitigation and return generation: to pool and manage risk, and to generate a relevant and reasonable return for its customers according to their needs.
2. Intermediation and capital allocation: to move money from where it is to where it is needed and can be most productively put to work in supporting investment, growth and jobs for the wider benefit of society.
This is because it has been distracted by the size, complexity, structure and incentives of the industry itself; and by its over-reliance on modern portfolio theory. While diversification has brought huge benefits to investors, it has encouraged the obsession with relative performance and benchmarks. They argue that the industry should build on this and adopt a wider approach that incorporates wider systemic factors – and that seeks to improve that market-level risk.
You can read the full paper here and see the infographic accompanying it here. The paper is part of the Purpose of Finance initiative on which New Financial is collaborating with David Pitt-Watson, executive fellow in finance at the London Business School, and Pension Insurance Corporation.
And here is a contribution that New Financial made to the paper on the question of purpose:
When you mention ‘purpose’ to many people working in banking and finance they tend to default to one of two positions. First, that the purpose of the industry can be defined in terms of its size (eg. there are roughly £8 trillion of assets under management in the UK), the large number of people it employs (about 1 million in financial services in the UK), its contribution to GDP (about 7%) and the amount of tax it pays (about 11% of total UK tax receipts). Or second, that environmental and sustainable finance, corporate and social responsibility, or philanthropic activity can be used as a proxy for purpose.
The problem in both cases is that while they are undoubtedly important, they distract from the fundamental question of underlying purpose. In most other industries, firms talk about their purpose in terms of what they do, what products they make or what services they provide, and the benefits these deliver to their customers. IAG, the owner of British Airways, Aer Lingus, and Iberia, is a large world class airline but people would describe its ‘purpose’ in terms of delivering passengers from A to B at a reasonable price and in reasonable comfort without crashing or losing their luggage, not in terms of its revenues (£23 billion, roughly the same as the UK asset management industry), the amount of tax it pays, or the number of people it employs (more than 60,000 – or more than the entire UK asset management industry).
Too much focus on narrowly defined good behaviour, such as ESG, CSR or philanthropy, runs the risk of being seen as a distraction from a more fundamental debate, or as the equivalent of CO2 emissions offsetting (‘we do bad stuff over here, so we do this good over here to make up for it’).
Instead, the ultimate corporate and social responsibility of any business is its day job: does it behave in a socially-responsible way and act in the interests of its customers and wider stakeholders day in, day out?
The value of this paper is that it takes the economic importance of the asset management industry as a given, and helps frame ESG and CSR activities in their wider context. This enables the debate to focus on the more fundamental questions: what is the underlying purpose of the asset management industry? How does it live up to that purpose? And how could it do a better job?