Can Shareholders Save Capitalism?

One of Tom Toro’s most famous cartoons depicts a father, clothes torn, speaking to his children around a camp fire while civilisation lies in ruins in the background. His words are captured in the caption: “Yes, the planet got destroyed. But for a beautiful moment in time we created a lot of value for shareholders.”

The belief that untrammelled Friedmanite pursuit of shareholder value has led to environmental destruction, climate change, inequality, and all manner of other ills is widely held. Stakeholder capitalism alternatives are frequently based on the idea that shareholder interests need to be deprioritised in favour of other goals. This idea has been reflected in pronouncements of the Business Round Table in the US, the growth of the B-CORPS movement, the British Academy’s Future of the Corporation Project, and in the EU is gradually making its way into law via the Corporate Sustainability Directive.

If shareholders are so much the root of the problem, it seems counterintuitive to look to them for the solution. But increasingly that is the case. Whether you call it impact investing, sustainable investing, or Environmental Social and Governance (ESG) investing, the idea that pursuit of financial returns can, at the very least, be not in conflict with social and environmental goals is gaining traction. And some hold out hope for the industry to play an even more positive role in solving the world’s major problems.

As one example, not even a year ago, GFANZ (Glasgow Financial Alliance for Net Zero) was announced with great fanfare at COP26 in Glasgow, and now boasts 450 members with $130 Trillion in assets under management. The launch press release boldly claimed that the “amount of finance committed to achieving 1.5°C [is] now at [the] scale needed to deliver the transition”.

Unfortunately, it’s not proven so straightforward. The awkward truth is that asset managers don’t invest their own money, they invest on behalf of their beneficiaries. And those beneficiaries may not want, or see it in their interests, to pursue the social and environmental goals that their asset managers sign up to. Recent tension within GFANZ highlights the core problem: pursuing environmental goals that not everyone agrees on can create conflict with the fiduciary duty asset managers and asset owners owe to their clients.

One way to get around this is to create clearer mechanisms for investors to express their opinions on the environmental and social goals they want to pursue, so that their asset managers have the mandate to act. This is the basis of The New Corporate Governance proposed by Oliver Hart and Luigi Zingales. In short, shareholders have non-financial as well as financial preferences. Therefore, we should the move asset manager’s objective function from shareholder value maximisation to shareholder welfare maximisation – reviving an idea that goes back at least to Jensen and Meckling’s famous 1976 paper on the theory of the firm. It is much cheaper to prevent firms from polluting in the first place than to allow them to pollute and then bear the costs of cleaning up. So, beneficiaries that care about this issue will have an interest in asset managers pushing companies to control pollution, even if it costs them money, up to some point which reflects the beneficiaries' preferred trade-off between money and the environment.

But don’t asset managers do this already? They have voting policies and ESG priorities. Surely, they make sure that they reflect their clients’ views? Well, apparently not. New research by Jonathon Zytnick asks the question: Do mutual funds represent individual investors? His answer: “the voting practices of mutual funds appear entirely uncorrelated with the ideological preferences of their individual investors.” Individual investors have clearly identifiable ideological preferences when it comes to social and environmental matters. So do mutual funds, as reflected in their voting practices. But the two do not tally up. There is not a functioning “market for ideology” that allows sorting of investors to mutual funds, other than through the very primitive device of “ESG funds”.

This calls into question the legitimacy of investor interventions in companies on environmental and social matters. If asset managers are asking companies to do things in pursuit of such matters that are costly and that might even damage the returns of their beneficiaries, on whose authority can they so do, other than that of those same beneficiaries? Yet if the ideological preferences expressed in asset manager action are uncorrelated with the preference of their individual investors, then we have a problem.

 A few ideas have been put forward for how we might give ultimate beneficiaries greater voice:

• We could require fund managers and asset owners to do more research on their clients and beneficiaries’ non-financial preferences, as the EU is now requiring.
• Hart and Zingales suggested developing large numbers of mutual funds with different objectives (say a “no-guns” fund, a “made in America fund” a “climate crisis fund”) that would enable investors to sort on their ideological preferences.
• Zytnick himself suggests that we might expect different fund managers to adopt different ideological positions to pursue different market segments so let the market deal with it that way, with, in US terms, “Democrat” and “Republican” fund managers advertising themselves as that. Recent fund launches suggest this may be starting to happen.
• Asset managers could enable clients that do not wish to rely on the manager’s own voting and engagement to vote directly on all or some proposals or to choose from a suite of voting and engagement policies. This approach underpins BlackRock’s Voting Choice offering.
• New engagement and voting aggregators could emerge, like political parties, who would agree to engage with companies and provide voting recommendations in line with certain ideological preferences.

There are obvious problems with several of these approaches. Multiple fund choices will quickly reach limits of manageable complexity for all but the most committed individual or even institutional investors. Separating voting from engagement will significantly reduce the efficacy of both. Specialist engagement and voting aggregators would overcome this problem but would suffer the weakness of lacking the context, influence, and knowledge of the company that being a portfolio manager brings.

Perhaps the most satisfactory solution is the one that Zytnick finds surprisingly absent: a market for ideology that allows matching between fund managers and individual investors of similar persuasion. But other approaches will be tried also. Large incumbent asset managers have ideologically diverse clients (as they are now discovering) and so have an interest in taking themselves out of the firing line.

Will shareholder action on environmental and social goals make a major contribution to rescuing capitalism? It remains to be seen, and there are reasons to be doubtful. But clients certainly want the industry to play a role. Asset owners and individual investors will likely demand more say in how stewardship is exercised. And to retain legitimacy, the asset management industry will need to respond with ways to make that a reality.

If you would like to hear Oliver Hart and Jonathan Zytnick describe their research and hear its implications debated by a panel of leading business people, facilitated by Dr Gosling, then please join us at the European Corporate Governance Institute Inaugural Responsible Capitalism Summit in Brussels on Friday 21^st October. You can register here to attend in person or online.

Dr Tom Gosling is an Executive Fellow at London Business School and the European Corporate Governance Institute (ECGI).

The ECGI does not, consistent with its constitutional purpose, have a view or opinion. If you wish to respond to this article, you can submit a blog article or 'letter to the editor' by clicking here.