Regulatory Compass, Financial Purpose report

July 14, 2018 Ben Yeoh

Purpose of Finance: “creating money, channeling money, looking after other people’s money, sharing risk, and maintaining transaction and settlement systems

-Data on the efficiency of the financial system suggests that the ‘overheads’ which the industry extracts from society for fulfilling these functions have not reduced in over a century.

-we need to dig deeper to understand the ultimate purpose of finance: how it creates, deploys and facilitates the movement of money in a way that best enables us to achieve our goals, as individuals, as communities, and as a society

-If we want a financial system that meets its social purpose, we also need to take much more of an interest in the purpose of individual businesses within that system

…In this report, we argue for a new regulatory compass… we need to focus regulatory analysis and action on the social purpose of finance…. a provoking read by charity think tank, Finance Innovation Lab, Christine Berry et al. (2018)

“The experience of social purpose businesses in our community suggests that regulation – which is frequently assumed to be ‘purpose-neutral’ – is often designed around the large incumbent firms that dominate the market and are usually focused on profit maximisation. We explorethree challenges this raises.

The volume and complexity of regulation has proven extremely challenging for smaller, social purpose banks to comply with, since they do not have the same economies of scale or large compliance teams. Capital requirements are a particularly good example of how well-intentioned regulation designed around large incumbent banks can have unintended consequences for others. We argue that the Financial Conduct Authority (FCA) should launch a standalone Diversity Hub to complement its efforts to support innovation; likewise, the Prudential Regulation Authority (PRA) should offer additional support (including a sandbox) for firms that bring diversity to the banking sector, including new community and stakeholder banks.

The regulation of investment advice and product marketing is still relatively poor at recognising social and environmental investment objectives. The shift to automation risks exacerbating these problems – particularly if machine learning techniques use historical data that reproduce historical biases that no longer reflect society’s views.

We argue that the FCA should adopt a human-centred approach to regulation, starting from the perspective of a person who has a range of objectives for their finances, rather than assuming maximum financial return is the sole aim.

Regulatory approaches to innovation tend to focus on technological developments, to the detriment of other forms of innovation, particularly new business models centred on social or environmental purpose. The authorisation process can be especially challenging for these types of firms; often the unique risks of social purpose models are considered, but not the unique benefits. We argue that regulators need a framework for thinking about the societal challenges we want innovation to solve – and thus the kinds of innovation we want to support – rather than focusing solely on increasing competition through technological innovation.

Three regulatory fallacies

We identify three fallacies that permeate current regulatory thinking:

-The fallacy of composition (if every unit in the system works, the whole system works)

-The fallacy of neutrality (current regulatory approaches are values-free and any changes to this would mean taking an unjustified moral stance)

-The fallacy of market efficiency (competition and ‘market integrity’ are effective proxies for the outcomes we want the financial system to serve).

We can either transfer these flawed assumptions to a new regulatory regime, or take this opportunity for a deeper reconsideration of how we regulate financial systems....

Link to paper here.

Comment: Given the incremental and evolutionary nature of regulation, these ideas are in the "thought-provoking" but ultimately not practical at this point in time, Although, to some extenet, that's the point of think-tanks.

Further, the report is very UK focused, while being aligned to the organisations purpose, it somewhat underappreaciates or ignores the global interconnectedness of regulation and particularly with respect to financial regulation. There is regulatory arbitragage which governments are aware of.

The report makes several provoking suggestions to regulators, however I feel many of these recommendations sit somewhat outside of regulators current mandates and if such "purpose" wants to be met, then it needs to start at government level preferably led by society demand.

As to the suggestions themselves, I do think it's interesting going back to thinking about the social purpose of finance and how that can be made better, but I do not have any clear answers here. I do think (as I have referrred to previously) the very eloquent work (althiough not necessarily "correct") of Milton Friedman in the 1970s has perhaps not been answered as eloquently by critics, although certainly the stakeholder model (eg see Amir-Zadeh) can answer it.

In any case, I am no expert in matters of policy or macroeconomics, so wil leave it to bigger brains than me to solve.

The current Arts blog, cross-over, the current Investing blog. Cross fertilise, some thoughts on autism. Discover what the last arts/business mingle was all about (sign up for invites to the next event in the list below).

My Op-Ed in the Financial Times (My Financial Times opinion article) about asking long-term questions surrounding sustainability and ESG.

Some popular posts: the commencement address; by Nassim Taleb (Black Swan author, risk management philosopher), Neil Gaiman on making wonderful, fabulous, brilliant mistakes; JK Rowling on the benefits of failure. Charlie Munger on always inverting; Sheryl Sandberg on grief, resilience and gratitude.

How to live a life, well lived. Thoughts from a dying man. On play and playing games.

A provoking read on how to raise a feminist child.

An examination of the Generation Z cohort and how they differ from Millennials.

Generation Z. A look at their different qualities versus Millennials

July 7, 2018 Ben Yeoh

Source: Barclays, Patel et al (June 2018), Generation Z:Step aside Millennials — Source: Barclays, Patel et al (June 2018), Generation Z:Step aside Millennials

“Sorry Millennials, your time in the limelight is over. Make way for the new kids on the block – Generation Z – a generational cohort born between 1995 and 2009, and larger in size than the Millennials (1980-1994). The current fixation with Millennials makes them the most studied generation, which in turn has caused the use of this term to simplify to a label for anyone that may be young today. The irony here is that Millennials are not necessarily young anymore and we run the risk of overlooking the next cohort – Generation Z – who are now coming of age.

Survey-based research from a range of sources suggests there are fundamental differences separating Generation Z from the Millennials (Figure 1), material enough for marketplaces to take note today. And yet, even as Generation Z enter their prime, many companies have yet to prepare for their arrival. We fear they are either still trying to adapt their business models to the Millennials or hoping simply to re-use whatever strategies they’ve developed for Millennials on Generation Z. We argue that adopting such a homogenous approach will deliver unsuccessful results as it fails to identify the two generational cohorts as different.

We believe this coming of age is worth capitalising on now, with Generation Z in the US already having $200bn in direct buying power and $1tn in indirect spending power as they command significantly more influence on household purchases than prior generations (IBM, Iconoculture). By 2020, Generation Z are expected to be the largest group of consumers worldwide, making up 40% of the market in the US, Europe and BRIC countries and 10% in the rest of the world (Booz Co). " Barclays Sustainable & Thematic Investing team lead by Hiral Patel in a June 2018 report.

ource: Barclays, Patel et al (June 2018), Generation Z: Step aside Millennials — ource: Barclays, Patel et al (June 2018), Generation Z: Step aside Millennials

What makes Gen – Z different?

There are different ways to define a generational cohort; however, no matter how you do it, the attitudes, passions, strengths and weaknesses of each generation are moulded by the world around them. We believe there are three broad trends that shape a generational cohort: i) parenting & household dynamics, ii) world economy & international affairs and iii) technological advances

1) Parenting & household dynamics

At the root of the discrepancy between the two current generations of youth (Generation Z and the Millennials) are differences in parenting & household dynamics, or more specifically the differing generations that raised them.

Coining the phrase ‘helicopter parents’, Strauss and Howe have argued that Millennials are in part a by-product of overprotective, indulgent parents (Ipsos Mori: Millennial – Myths & Realities). Millennials were raised by encouraging Baby Boomer parents during a time of economic prosperity and opportunity. This created a new set of middle-to-upper class parents that were desperate to maintain their family’s escalated social standing (Quartz – How Baby boomers ruined parenting forever), using extra-curricular activities and hectic student schedules as a way to demonstrate their status as the parental elite.

On the other hand, Generation Z, it is argued, were raised by the more discerning Generation X, as they grew up in a recession, making them more conservative by nature. Generation Z witnessed first-hand the struggles their older siblings faced and resolved to do things differently. They are characterised as pragmatic when it comes to financial decision-making and have already shown the propensity to move back to traditional views of success (money, career, education) (Millennial Marketing).

2) World economy & international affairs

Though Millennials were raised during a time of economic prosperity, they were old enough to understand the relevance of 9/11 in 2001. Generation Z were either too young or were yet to be born, and thus relate more to the global financial crisis in 2008. This was followed by a wave of global terrorism, which has led to Generation Z growing up during a time of increased existential threat (perceived, if not actual) compared with the Millennials (Guardian).

Furthermore, the internet and social media have significantly impacted the way global news is disseminated. Generation Z appear to be more affected by world events than the previous generation thanks to a 24-hour news cycle that relentlessly pushes out information. For example, we now see widespread awareness of single-topic issues such as global warming, cancer research, the Trump presidency and the European migrant crisis. This makes Generation Z by default more aware of international affairs at a younger age, which, it is argued, is creating a more conscientious generation.

3) Technological advancements

While Millennials were digital pioneers witnessing the introduction of broadband internet, smartphones and social media, Generation Z are digital natives, not knowing a world any different to the hyperconnected one in which we live today. For example, a Millennial would remember the pain of experiencing a floppy disk error or having to experience the social pressure of maintaining an ‘online’ MSN messenger status using dial-up internet. However, Generation Z can’t remember a time without technology at their fingertips. One of the biggest worries for this generation is whether or not they have enough battery life.

Although all such reports have flaws and generalisations, it’s good food for thought on how Gen Z are different. In the way, Millenials are different before them.

From a business point of view, a company needs to be flexible enough (or have a business model geared to ) to accommodate the shift to Gen-Z when arguably many were late to the shift to Millenials already.

You can reach Hiral through LinkedIn for a full copy of the report.

My Op-Ed in the Financial Times (My Financial Times opinion article) about asking long-term questions surrounding sustainability and ESG.

How to live a life, well lived. Thoughts from a dying man. On play and playing games.

A provoking read on how to raise a feminist child.

Morgan Stanley: ESG survey of asset owners

July 5, 2018 Ben Yeoh

Morgan Stanley: "Sustainable Investing has gone from a niche investment idea to attracting enough capital to start having an impact on global challenges at a meaningful scale. The intensity of recent growth has been driven by a fundamental shift in how investors and asset owners view environmental, social and governance (ESG) factors."

MS polled 118 asset owners.

- 84% of asset owners surveyed are at least “actively considering” integrating ESG criteria into their investment process

- 60% of asset owners integrating ESG into their investment process have only begun doing so within the last four years and 37% within the last two

(Me: This suggests movement is still in early days, though MS argue it is moving mainstream)

-78% of respondents listed risk management as an important factor driving their adoption of sustainable investing.

-77% of respondents also focused on generating returns.

The link to the survey paper is here. It chimes with the CFA ESG survey I posted about previously.

I do think that answer that 37% of asset owners only started thinking about ESG in last 2 years suggests that this might still be the early days of the movement - and if asset owners eventually reflect the end beneficiaries, which for the most part is the "person n the street" and if she increasingly younger and more interested in sustainability, then the movement has legs...

Amel-Zadeh: ...ESG information is material to investment performance. However, which information is material likely varies systematically across countries (e.g. a country where water pollution is a more serious issue versus a country where corruption is a more serious issues), industries (e.g. an industry affected dramatically by climate change versus an industry affected by violations of human rights in the supply chain) and even firm strategies (e.g. firms that follow differentiation versus low price). For example, Khan et al. (2016) show that the vast majority of ESG data for any given industry is immaterial to investment performance and that the material information varies across industries within a sample of US stocks. Understanding how the materiality of ESG information varies across countries, industries and firm strategies therefore is of primary importance...”

This to my mind, along with this study on the benefits of Active Ownership and ESG engagement and if one puts this work together with the work on the outperformance of Global Equity managers described here, one can start to build a defense of Active Management for global managers for those using ESG....

If you'd like to feel inspired by commencement addresses and life lessons try: Neil Gaiman on making wonderful, fabulous, brilliant mistakes; or Nassim Taleb's commencement address; or JK Rowling on the benefits of failure. Or Charlie Munger on always inverting; Sheryl Sandberg on grief, resilience and gratitude or investor Ray Dalio on on Principles.

Cross fertilise. Read about the autistic mind here.

Financial Reporting Advisory Group and Lab conference

June 23, 2018 Ben Yeoh

I’ve joined the investor advisory group (IAG) of the Financial Reporting Council (FRC, tiny news release) and this week I spoke at the FRC Lab conference.

The IAG aims to “provide a regular forum for the FRC to engage with representatives from across the investment chain on various issues, including our strategy and plan and new policies and standards, on governance, stewardship, reporting and audit matters.”

Business has more than investors as stakeholders (it includes YOU and civil society etc.), so if there is any item in the corporate reporting agenda that you wish to communicate to the FRC – first, you can write direct to the FRC! but second, feel free to tell me and I will pass the views on as part of my work in this area.

I joined Sallie Pilot and Stephanie Maier and Douglas Radcliffe for a discussion at the FRC Lab conference this week. If you'd like to share a view on corporate reporting, ESG, intangibles, wider-metrics, GAAP, Non-GAAP and what would be useful to you as an investor or wider stakeholder then do get involved with a Financial Reporting Lab project (see link here).

I made the point that intangibles are a large part of companies values today but many aspects are poorly reported (eg human capital, brands, innovation). See blog post on Intangible Capital.

AI and technology will impact future reporting, but arguably we are not using the tools today as effectively as we could.

From the corporate side, the demands are ever increasing. It will be up to boards and management to self-define what is material and sustainable to them, (and to convince their stakeholders) but if key items are missing then pressure will be seen from investors, wider stakeholders and regulators.

Other discussion centred around are disclosures:

Clear on how they are aligned to strategy
Transparent in regard to calculation and adjustments
Contextual, including description of both performance and position and what went well an what went badly.
How the metrics are reliable including information on monitoring
Clear on the level of consistency year on year and across time

My Op-Ed in the Financial Times (My Financial Times opinion article) about asking long-term questions surrounding sustainability and ESG.

How to live a life, well lived. Thoughts from a dying man. On play and playing games.

A provoking read on how to raise a feminist child.

Divesting sectors. The impact on returns. Evidence that oil divestment may not impact returns.

June 22, 2018 Ben Yeoh

Source: Jeremy Grantham, writes (see link to LSE talk  here): note cavests below. — Source: Jeremy Grantham, writes (see link to LSE talk here): note cavests below.

Grantham and colleagues have looked at the S&P500, over the last 28 years, 60 years, and 90 years; excluding a major sub-component sector each time. Grantham’s overall conclusion it that it didn’t make much difference in return - although some might argue at the max range of 50bps that compounded over 28 years may be significant. Others might suggest that the power of diversifcation and time, also makes this conclusion unsurprising.

Caveats could include: not peer reviewed (although I have found similar conclusions with slightly different data sets), different exclusions may produce different answers (specifically Tobacco might come up as a narrow exclusion; cf Dimson’s data set on “sin stocks”), and that S&P500 is not world representative (however it has the best long run data set, and is a widely used index that does represent a facet of corporate America).

Grantham writes (see link to LSE talk here)

“So my colleagues and I finally carried out a test to see exactly how an investment portfolio would have been affected by divesting from a group of companies that are listed in the Standard and Poor’s 500, the index based on the market capitalisations of 500 large companies listed on the New York Stock Exchange or NASDAQ.

These companies can be divided into 11 sectors (not including real estate). We considered the 10 long-term sectors (real estate was added relatively recently), and analysed how the index performed without each sector.

Initially, we considered the period from 1989 until 2017. [The results are shown in Figure above]. You will see how dramatically the index changes with the removal of each sector – there is only a 50 basis points difference between the best and the worst. They are basically all the same!

You will see that excluding the information technology sector made a small difference for a few years around the turn of the millennium. That was the technology bubble. Beyond the burst of the bubble, all of the indices track together again, as if nothing had ever happened.

But basically, all of those 10 variations of the index track between 1989 and 2017 as if they were the same. So we decided to see what happened if we chose a different period, incase there was something extraordinary about the past 28 years. We extended the analysis, first to start from 1957, and secondly to begin in 1925.

You will see in chart above that changing the period of analysis does not make much difference. The difference between the best and worst is 54 basis points instead of 50. So over 90 years, it would not have cost an investor to have divested from any one of the sectors.”

Grantham further writes:

“Who knew that the stock market was that efficient? It may be hopeless in bubbles and busts, but it has evidently priced these groups of big companies pretty well. And there is no advantage to an investor of choosing the high-growth information technology sector over, say, utilities. Utilities are priced down and information technology is priced up, but they produce the same returns. It is amazing.

What does this mean for divestment? It means that if investors take out fossil fuel companies from their portfolios, their starting assumption should not be that you have destroyed the value. Their starting assumption should be until proven otherwise. that it will have very little effect and is just as likely to be positive by 17 basis points as negative. That is an amazing contradiction to what every investment committee has ever said, as far as I am concerned.

It obviously takes a major miscalculation to move the dial when it comes to divestment. I think that decarbonisation is just such an event. And the reason I think that is that the oil companies and the chemical companies are not rolling with the punches. They are fighting decarbonisation tooth and nail. They are still funding obfuscation programmes in North America. And if you do that as a corporation, as a capitalist, you are likely to bite the dust if you are facing a major change, if you fight it. And they are fighting it. If they rolled with the punches, they might do quite well, and bleed off their capital and pay big dividends. But they are not doing that.”

I’d like to add a thought or two on the theoretical framework here. There are two to note one is

The Active Law of Fund Management which suggests the bigger the investment universe the better the risk/return potential, and,

The Efficient Market Hypothesis which suggests information is priced in efficiently such that it is hard to outperform large diversified markets

Both are theoretical although backed up by certain lines of empirical evidence (I’ve been drafting a long blog on the EMH for a while, hopefully out one day), although both are not considered perfect to explain what we can observe empirically.

As Grantham alludes to, this suggests the power of reasonable large scale diversification, and time. It seems to suggest over long periods of time, no one sector has such strong outperformance that it significantly dwarfs a large fairly diverse group of companies/stocks. I’m guessing there are always 400 to 450 stock left in any one excluded portfolio.

It’s an interesting challenge to certain notions of thematic and smart beta ideas as well, although those assessed differently.

Many of us are in the forward looking future prediction game. Although again, this might suggest, as Warren Buffet and Jack Bogle do that the average investor is then best off in low cost trackers (although note possible limited stewardship??!!), and if they wish to lose a sector or two it’s not likely to be a big impact (perhaps a small plus or minus in the order of 25 to 50bps; and arguably hard to predict although as Grantham argues, it might be oil, chemicals but for business related reasons).

I actually see Grantham’s work replicated in shorter run indices. You can look them up put the ex-Tobacco or ex-fossil-fuel type indices over the last 5 to 10 years have all done better or in the same ball park than the standard index. 5 years is short run, but might suggest that something has happened in the last 5 years perhaps different to eras further back.

In any case, back to oil divestment, so you need to know Grantham has a long time view (bias) here and sponsors the Grantham institute. Might mean he is right and has spent a long time thinking about this. He’s being doing investment (albeit more macro and asset class lens) for much longer than me.

Still, this is a decent evidence base and theoretical framework for arguing for the divest – stranded asset argument. It also highlights the area for engagement, if it can help bend these companies at all.

This all comes from a talk given in April 2018 at the LSE.

Source: LSE lecture (link here), although Grantham is quoting HSBC work

In the lecture, Grantham is mainly focused on climate, weather and food. Slides here, talk below.

On climate - click here for more carbon related posts. There's an argument made by risk philospher and Black Swan author Nassim Taleb on why we should lower pollution regardless of models.

My Op-Ed in the Financial Times (My Financial Times opinion article) about asking long-term questions surrounding sustainability and ESG.

How to live a life, well lived. Thoughts from a dying man. On play and playing games.

A provoking read on how to raise a feminist child.

The dawning of Japanese Corporate Governance

June 20, 2018 Ben Yeoh

Source: Board Independence graph is Yanagi's book quoting ISS survey 2012-13

I recently finished a positive stewardship engagement with a Japanese company on the nature of independent directors. ESG ignored 10 years ago, is increasingly in focus in Japan. In my view, this trend is set to continue.

One resource to examine in this area is Ryohei Yanagi’s new book on corporate goverance in Japan (Amazon link here). Yanagi has a book event in London 4 July 2018 (link to event here).

Yanagi examines the Ito review (cf UK Kay review, a blog on Kay here), the corporate governance and stewardship codes in context of Abe’s reforms, and gives the historic background of why Japanese corporates are managed and governed like they are today.

Source: the RoE (Return on Equity) chart is based on RoE average primary index of each country (cap weighted), on 4Q (2004-2013( by Bloomberg data, from Moving the Mountain study group, 2014 from Yanagi (2018)

He discusses RoE (Return on Equity) and RoE - cost of capital spreads.

Since the work of Stern Stewart and others on EVA (Economic Value Add) from the 1990s and before (see a background paper here) which focus on Return on Invested Capital (or for some in modern day expressions Cash Flow Return on Investment) over some assumption of cost of capital, this thinking has been a dominant feature in US and EU corporate thinking and finance. Less so, seemingly in JP corporates.

Yanagi then synthesises this with ESG and intangibles and coins a concept of RoESG.

Yanagi suggests many Japanese corporates view some of their intangible ESG/CSR management as good (although again one can debate on reporting on it). (I also think many non-Japanese investors may not concur with what Japanese manager tout on CSR)

He then suggests that intangible/ESG management and management of RoE are two lens which are not opposed – in fact almost could be joined more symbiotically.

Not an entry level book, it draws practical thinking about how to look at financial and non-financial metrics for corporates and investors alike and roots it in the historic and cultural context of Japan.

Impact Investing in the UK

June 16, 2018 Ben Yeoh

Impact Investment Opportunity in UK, this week I was listening to Elizabeth Corley and expert speakers on the opportunities and challenges for impact at a social impact investing conference.

Some questions raised:

What are the dangers and advantages of speaking about ESG and Impact in the same breath? How important is a common language? Taxonomy? Standardised outcomes?

Fear of unintended consequences of regulation? “Backed by regulators” not equal to “regulated” ? Is it beyond the wit of the industry to find a better way to represent individuals wishes re: Impact ?

Will SDGs used as part of "SDG washing" - something that looks good for marketing but doesn't make real impact.

There is debate in impact world on if you can make market returns and still have measured deep impact. This notion of a continuum or spectrum of thinking about these ideas is one which is taking shape.

However, when thinking about this in mainstream instiutional or retail investment, I think it has a long way to go before it's embedded in thinking. I base this observation on the minimal mainstream press or adviser coverage and the small knowledge base / marketing at retail or adviser level. Still, the movement is growing and ideas which start here will hopefully go on to seed bigger things in the mainstream too.

My Op-Ed in the Financial Times (My Financial Times opinion article) about asking long-term questions surrounding sustainability and ESG.

How to live a life, well lived. Thoughts from a dying man. On play and playing games.

A provoking read on how to raise a feminist child.

The best time to be born is now

June 7, 2018 Ben Yeoh

“Everything is not fine. We should still be very concerned. As long as there are plane crashes, preventable child deaths, endangered species, climate change deniers, male chauvinists, crazy dictators, toxic waste, journalists in prison, and girls not getting an education because of their gender, as long as any such terrible things exist, we cannot relax. But it is just as ridiculous, and just as stressful, to look away from the progress that has been made.”

These 32 charts suggest the world is better over the last 50 years and that the best time in the world to be born is now.

Source: Hans Rosling’s book Factfulness

And more

Worth a read if interested in the area: my previous blog (including Rosling's quiz) on Rosling’s book.