Can Fiduciary Values Lead Mainstream Finance Back to Responsible Behavior?

by Jay Youngdahl

John D. Rogers, the former head of the CFA Institute believes so. And he has a plan.

The financial community today is properly reviled by many. The financialization of the economy, with its “too big to fail” banks and investments undecipherable even by those who traded them, brought the world to its knees in the 2008 financial crash. Researchers at the Federal Reserve have estimated that this catastrophic event cost the world between $50 trillion and $90 trillion.

Thoughtful men and women who work in the financial arena realize they must work to restore trust in their profession for their own sake and for the sake of the global economy. To regain this trust they must acknowledge the mistakes of the past and chart an efficacious and ethical path forward. Finance must return to the primary reason for its existence, the support and building of sustainable economies and healthy families, instead of playing the parasitic role it has played in recent decades.

On October 2, at his lecture at the Edmund J. Safra Center, John D. Rogers, formerly the head of the CFA Institute, took on the crucially important task of considering a new kind of financial system. Employing the lessons learned from “ESG” investing—the process of paying attention to the financial risks present when environmental, social, and corporate governance factors are ignored—Rogers charted a way forward. Framed by classic principles of fiduciary duty, the ethical and legal obligations that one commits to when investing the assets of others, Rogers argued for a transition from Financial Capitalism to Fiduciary Capitalism. 

In his lecture and in the discussion, Rogers admitted the spectacular failures of the financial system over the last decade. Rogers, as might befit the former head of the most respected financial accreditation organization in the world, did not call out his brethren in the financial service industry for their personal roles in the failures, but instead made the bold pronouncement that it was the system, Fiduciary Capitalism, that was to blame.

To bolster his argument, Rogers, an industry veteran with deep experience in Asian financial markets, provided a historical overview of finance since the end of World War II. During the period of industrial or managerial capitalism, from 1945 to 1980, corporate issues of debt and equity were the dominant force in finance in the U.S., Germany and Japan. Things changed in the early 1980s, however. A 30-year fall in interest rates began, followed by financial market deregulation, financial engineering, and the ascendancy of the financialization of the global economy. This finance capitalism was dominated by financial intermediaries—banks, asset managers, and brokerage firms—that made the most of deregulation, technology, globalization, and leverage to achieve Midas-like growth in revenues, earnings, and market capitalization. Employment in the sector boomed, attracting the “best and the brightest,” who worked to become “masters of the universe.” As a share of GDP, financial services grew from 4.9% in 1980 to 8.3% in 2006; its share of profits was even higher. Finance became an end unto itself rather than as an enabling function.

But due to its failures and to the concomitant growth in inequality, this financialization is coming to an end, Rogers argues. Fortunately a replacement is present: Fiduciary Capitalism. The leaders of this transformation can be asset owners, especially the mammoth investors who invest large pools of the world’s financial capital, such as pension funds and sovereign wealth funds. The leaders of these asset owning bodies are guided by a duty of care and loyalty and an obligation to place the needs of their beneficiaries above all other considerations. These fiduciary duties, Rogers argues, can be applied to the system as a whole, so that the financial system can lessen its predatory urge and replace it with a set of ethical principles that can guide capitalism itself.

Fiduciary capitalism has several attractive traits. It encourages long-term thinking and a deeper engagement with companies’ management teams and public policymakers on governance and strategy. Investors can more clearly seek to avoid negative externalities and reward positive ones. A recognition that reducing investment costs is easier than “beating the market” can grow, allowing a bloated financial sector to shrink.

Having come to this conclusion, Rogers follows the path set by Responsible Investment, a global movement of investors who seek social responsibility and stable financial returns. Spurred by concerns over climate change and issues such as the effect of investment on corporate governance and upon civil society as a whole, responsible investment is led by global groups like the UNPRI. It has now gone mainstream as trillions of dollars are invested according to an ESG mandate.

To have an industry insider such as Rogers—a leader of an organization of men and women who were at the heart of all the good, bad, and horrid that has happened in finance over the last thirty years—embrace this position and use this language, is truly a remarkable thing.

It is not just ethics or morals that will lead this transformation, nor are they the sum of Rogers’ inspiration. Rogers finds three structural factors that will aid the development of Fiduciary Capitalism. The first is the size of these institutional investors. The top 1,000 such investors worldwide account for $25 trillion of global equity market value—more than half. When these institutions act together, as they increasingly do in matters of corporate governance and market structure, they can shape the financial markets.

Second, technology has leveled the playing field. For decades, an asymmetric information disadvantage confronted institutional asset owners doing business with financial intermediaries. That information gap, though, is quickly shrinking as the digital age is putting more computing power and market access into the hands of large fiduciaries relative to that possessed by brokers and bankers. The result is a lessening of the dependence of large investors on third parties. Certainly conflicts still exist between the two groups, but transparency is helping investors manage these important concerns.

The third driver of this new era is the agenda of these institutional investors. To these large fiduciaries, issues like market outperformance or ultra “sophisticated” strategies matter far less than delivering the stable sustainable returns required by their ultimate beneficiaries. Further, trillions of dollars are now managed by sovereign wealth funds and others who have social outcomes as drivers of their behavior. Large investors are now “universal investors” who increasingly understand that the overall success of the global economy, not savvy asset picking by hired masters of the universe, is the most important factor in their financial returns and thus their ability to fulfill their organizational missions. Many asset owners have come to realize that their beneficiaries 50 or 100 years from now will inherit not only the profits or losses but also the negative externalities of the investments made todaysuch as climate change and global inequality. These mammoth funds understand that because they will essentially have to own large companies’ stocks “forever,” they are destined to become involved with the companies’ long-term problems as well.

Rogers finds many positive outcomes in this transition. Reasonable fiduciaries should be able to improve investment returns by reducing the cost drag of transactions, the over packaging of financial instruments, and other forms of rent-seeking behavior by agents and intermediaries. Understanding their status as universal owners, the recognition that they are owners for the long term should suit businesses looking for more stability and consistency from their shareholders. Short-termism, a headache for issuers and patient investors alike, will be disfavored. Under fiduciary capitalism, corporate management teams will have longer-term owners of their shares, who increasingly will hold them accountable for long-term performance and for the true environmental and social costs of their activities.

The future of finance, Rogers believes, should be less about leverage and financial engineering, and more about efficiently connecting capital with ideas, about long-term investing for the good of our world, and about the globe we pass to future generations.

For Rogers, a true financial insider, to acknowledge the necessity of responsible investment, and even more, to speak the vocabulary of its proponents, is a recognition that a tipping point is at hand. Investors can no longer focus solely on short term returns without regard to the external effects of their investments on societies and its citizens. For large long-term investors, responsibility to beneficiaries means that attention to environmental, social, and governance factors in their investments and to the kind of markets that their powers allow them to craft can move the global economy from Finance Capitalism to Fiduciary Capitalism. For a planet struggling with myriad problems, Rogers’ economic prescription represents a hopeful and logical step.