Data Intervention

Lately I've been thinking about how developments in data technology have helped responsible investing ideas and practices become more mainstream. Improving the collection and flow of information could be considered the essence of responsible investing.  More information makes it possible for investors to calculate risks and opportunities more accurately and on longer time-scales.  Then the financial markets can reward more responsible business practices and facilitate the spread of better practices.  Making ESG data more easily available could be considered a kind of policy intervention as opposed to command and control regulation or market incentives.  I wrote a blog post about this on my company blog.

I also did a short talk about it at Phage's fundraiser for Brainlove!  I made a simple website with the key points.

Defending the Establishment

When this primary season started, I was dead-set against voting for Hillary Clinton because I believed that she was corrupt.  I thought that even if she was effective, all the progress would be for naught if a scandal erupted.  It could discredit the progressive cause for at least two election cycles and possibly more.  I wasn't quite feeling the Bern, but he seemed promising.  I have now done a pretty dramatic 180 on Hillary, and I guess a less dramatic -90 on Bernie Sanders.

After looking into the past scandals involving the Clintons, I found that they were all pretty much engineered by Republicans.  Given how much Republicans hate them and how much they've been investigated, I now really doubt that the Clintons are really corrupt or that there is a scandal waiting to be exposed.

With that out of the way, I am more supportive of Hillary for president.  She is a believer and practitioner of incremental change.  Sanders is a proponent of a "political revolution."  I certainly ascribe more to her theory change, particularly for the presidency while Congress is still dominated by Republicans and the Tea Party.  I expand on this train of thought in an essay, where I use examples from my professional field of responsible investing.

Dreaming of Incremental Change




The one thing that really still bothers me about Hillary is that she is too much of an interventionist on foreign policy.  This is where I often diverge with liberals because they usually want to go in to every conflict and support every rebel and of course posture at China!  I don't really think she's a neocon, though, but rather she is in line with the foreign policy elite in the US.  She seems like the classic bleeding heart liberal, actually.  I hope that after working with Obama and Biden that her views have moderated.  With that said, maybe it's more important that the foreign policy elite's views moderate.

Plea for Long Term Thinking in Business and Finance

Public companies in the US are required by law to report their quarterly earnings.  As a result, they are often under a lot of pressure from investors to maximize earnings and reduce costs on a quarterly basis in a dynamic referred to as "short-termism."  This can often hurt long-term performance for example by laying-off employees to reduce costs.  It also often results in irresponsible environmental or human rights practices.  At the same time it's really difficult to address these issues since they almost certainly require a multi-year commitment.

Larry Fink, the CEO of BlackRock, periodically sends letters to investors and companies imploring both groups to get beyond short-termism.  Last week he sent his latest letter to S&P500 companies.  Fink has been a prominent figure in advocating for good corporate governance, which typically refers to having board members that are not related to each other and subjecting the executive leadership to board oversight.  He says,

Generating sustainable returns over time requires a sharper focus not only on governance, but also on environmental and social factors facing companies today. These issues offer both risks and opportunities, but for too long, companies have not considered them core to their business – even when the world’s political leaders are increasingly focused on them, as demonstrated by the Paris Climate Accord. Over the long-term, environmental, social and governance (ESG) issues – ranging from climate change to diversity to board effectiveness – have real and quantifiable financial impacts.

At companies where ESG issues are handled well, they are often a signal of operational excellence. BlackRock has been undertaking a multi-year effort to integrate ESG considerations into our investment processes, and we expect companies to have strategies to manage these issues. Recent action from the U.S. Department of Labor makes clear that pension fund fiduciaries can include ESG factors in their decision making as well. We recognize that the culture of short-term results is not something that can be solved by CEOs and their boards alone. Investors, the media and public officials all have a role to play. In Washington (and other capitals), long-term is often defined as simply the next election cycle, an attitude that is eroding the economic foundations of our country.

Public officials must adopt policies that will support long-term value creation. Companies, for their part, must recognize that while advocating for more infrastructure or comprehensive tax reform may not bear fruit in the next quarter or two, the absence of effective long-term policies in these areas undermines the economic ecosystem in which companies function – and with it, their chances for long-term growth.

A particularly interesting and bold recommendation was to reform the capital gains tax.

...tax policy too often lacks proper incentives for long-term behavior. With capital gains, for example, one year shouldn’t qualify as a long-term holding period. As I wrote last year, we need a capital gains regime that rewards long-term investment – with long-term treatment only after three years, and a decreasing tax rate for each year of ownership beyond that (potentially dropping to zero after 10 years).

*clap clap clap*

Who manages your 401k, and what are their positions on corporate governance, short-termism, and ESG?

Debate About Fairness of the Stock Market

Throwdown!

It's Brad Katsuyama, the founder of IEX, a new exchange that touts itself as being more fair for investors.  Michael Lewis joins him in defending what he wrote in Flash Boys.  On the attack on behalf of HFT is Bill O'Brien, then president of the BATS exchange.



Since the debate, the BATS exchange had to issue a statement correcting something O'Brien said, and O'Brien has gotten fired.

http://www.efinancialnews.com/story/2014-07-22/bats-global-president-william-obrien-exits?ea9c8a2de0ee111045601ab04d673622

Job Pitch

I'm going on the job market!

I wrote up a pitch about what I want to do.  I will probably want to keep editing it a bit.

Investors as well as environmental activists could be more effective if they better understood the pressures corporate boards face from the finance industry. For example, perverse incentives in the financial system may make long term planning difficult.
Corporations should sometimes be insulated from these pressures. I want to analyze how financial incentives influences corporate governance regarding climate change. Then I can help environmental organizations and long-term investors develop ways to respond.  Ways that corporations benefit from managing their emissions may also need to be identified and better publicized to the financial industry.
I'm also interested in improving corporate data management for GHG emissions. These software systems help corporations manage emissions reduction as well as report results to stakeholders such as investors or consumers. These systems always need to be customized for each organization because the operations of different organizations vary so much. As a result, experimentation and iteration is always needed. However, in order for the information to be useful for external stakeholders, these systems also need to be compatible with each other to some extent. For example, managing and reporting the emissions of a supply chain where suppliers have many other customers, can be challenging.

Public Corporations and Investors: Theory vs. Reality

It's conventional knowledge, in the business world at least, that a corporation's primary purpose is to maximize shareholder value.  A corporation can only hope to maximize benefits to everyone through maximizing shareholder value. This idea is often presented as a law of the universe as immutable as the laws of physics.  In The Shareholder Value Myth by Lynn Stout makes a persuasive case that maximizing shareholder value is not always the best for the corporation, the market, or society.  Stout is a law professor at Cornell specializing in corporate governance law.  She argues that corporations are not legally required to maximize shareholder value at the exclusion of other goals.  Furthermore, the focus on stock price leads corporations to destroy fundamental value in favor of short-term gains, which is against the long-term interests of many shareholders as well.  Instead, corporations should invest in their employees and their communities to maximize long-term benefits.

I recommend anyone who is interested in corporate governance, business management, economics, finance, or social entrepreneurship to read this.  It is a fairly short and quick read, but since many people still won't read it, I will summarize the main points here.




        Shareholder primacy is the principle that the corporation's sole purpose is to increase shareholder value because this maximizes the welfare of the corporation as well as society at the same time.  This means that a corporation's performance is based completely on one number, and that is the stock price.  Yes, it is very conceptually elegant, not to mention convenient, if this were true.  This idea became popular in the 1980's coinciding with the rise of neoclassical economic theory.  (Although there is nothing wrong with neoclassical theory itself, it is often misapplied.  More on this later).  Since then, conviction in shareholder primacy became so strong that everyone believes that corporations have a fiduciary duty to maximize shareholder primacy and that this duty is enforced legally.

It's Not Legally Required
        Lynn Stout's first point is that shareholder primacy is actually not a legal requirement.  The case that is typically cited to demonstrate legal fiduciary duty to shareholders is Dodge v. Ford 1916 where Dodge was a minority shareholder in Ford Motor Company.  The court ruled that Henry Ford could not reduce the dividends to shareholders such as the Dodge brothers to build more plants and pay his employees more while profit was increasing.  Stout argues that the ruling is outdated as well as irrelevant because

1. Ford was not a public corporation.  It was a closely held corporation where the majority shareholder (Henry Ford) had a duty to look out for the interests of minority shareholders (Dodge).  
2. The comment that supports shareholder primacy, "a business corporation is organized and carried on primarily for the profit of the stockholders" was a "dicta."  In other words, it was not part of the legal rationale for the decision and therefore does not set legal precedent.
3. It is an old ruling. 
4. It was a ruling from the Michigan Supreme Court, which is not considered an authoritative source for corporate law compared to Delaware, where many more companies are incorporated.

        Instead, directors of public corporations have protection under the "business judgment rule," where corporations can do anything as long as it is lawful and directors do not have personal conflicts of interest.

The Theory is Flawed
        Stout's second and perhaps more interesting point is that economic theory is being misapplied to corporate governance.  The theory behind shareholder primacy is that shareholders are the owners and thus residual claimants of a corporation's profits.  They are the principals while directors are the agents and therefore if the agents maximize the welfare of the principals, welfare should be maximized overall.  This idea was popularized by Milton Friedman, a prominent neoclassical economist.  However, Stout argues that the principal-agent relationship isn't really descriptive of the relationship between the shareholder and corporation because

1. Shareholders do not legally or practically own corporations.  In fact corporations own themselves.  Shareholders own a share, which is a contract with some limited rights.
2. Shareholders are not the residual claimants.  The idea that they are comes from bankruptcy law, where the shareholders get whatever is left over after other contractual obligations are fulfilled as a company is being liquidated.  However, a company being liquidated is completely different from a living company, which has to plan for the future.
3. Shareholders are not principals.  Corporations are created before there are shareholders, but principals should exist before agents.  
4. The share price alone (probably) cannot be used to measure the worth of a company.  First of all, it doesn't really make sense to use something that fluctuates constantly.  Second of all, because of frictions that come with doing business in real life, a corporation can cause many externalities (public harm) while privatizing the benefits.  These externalities ultimately lower the quality of life of the public, including shareholders.  Stout claims that externalities can and do harm the private sector as well, stunting the growth of the market overall.

Justifying Myopic Behavior in the Finance Industry
        Another very rich topic that Stout digs into is how the realities of the finance industry interact with shareholder primacy to encourage myopic behavior in corporations and investors.  Short-term investing has been increasing.  By 2010, public stock is held for four months on average compared to eight years in 1960.  Therefore, even though investors should theoretically be primarily interested in long-term corporate performance, clearly many are profiting from short term gains.  An investor who only plans on holding a stock for a short time can and do lobby for actions that increase the stock price in the short term, after which the investor sells, thus relinquishing her interest in the long-term success of the corporation.  In fact, it would be good for these investors if the stock price subsequently went down so that she can invest again and start the cycle over.  Myopic behaviors include cutting back on R&D or marketing or laying off employees to boost quarterly earnings reports.  They also include splitting up the company, selling off assets, and getting acquired.
       These things happen because shareholders (and thus investors) are heterogeneous in their expertise as well as incentives.  Also, information is expensive and time consuming, especially more qualitative information as opposed to prices.  Long-term investors profit from the overall performance of the market.  They will hold diversified assets in order to reduce risk.  As a result, they "suffer" from rational apathy.  There is too much information and their stake in each company is so small that it is not worth it to investigate whether a company's earnings went up because of myopic behavior or because of a particularly successful new product or operational improvements.  In contrast, shareholders who are more involved in corporate governance are usually short-term investors who profit from buying and selling.  They will hold relatively large stakes in a small number of companies, and it is in their interest to create "news" that will change expectations one way or another.  Yes, the market eventually "corrects itself," but the profits and losses from the error and subsequent correction are real.  Misallocation of financial capital, hurting employee morale, losing talent, slower innovation, lower quality products, reduced customer loyalty are sometimes also tangible and lasting effects.  Another dynamic that exacerbates the prevalence of these behaviors is that long-term investors such as institutional investors, who invest on behalf of pensioners for example, hire active managers to manage large portions of their assets.  These active managers are judged by their quarterly performance.  As a result, they are often short-term investors because those strategies are more reliable as well as profitable.


Recommendations
        Ok, that sounds like a hairy mess.  Stout's recommendations aren't as crisp as her analysis of the situation.  Even so, there are four potential solutions that stood out to me.

1. Stop promoting shareholder democracy and giving shareholders more power.  This is one of Stout's main recommendations.  Shareholders do not act like responsible principals and cannot be counted on for effective corporate governance.  For example, even after the Great Recession and subsequent bailout, shareholders opted not to diffuse the power of the CEO and chairman of JPMorgan Jamie Dimon, much less fire him. 
2. Her second recommendation is to encourage companies to maximize stakeholder value.  She introduces the concept of team production, which expands on maximizing stakeholder value as a more descriptive theory of how corporations create value.  Basically, value is created as corporations build trust and commitment among employees, creditors, managers, consumers, and the community.
3. Institutional investors should change how they evaluate active managers.  Stout did not focus on this probably because she does not think that institutional investors have enough incentive to reform this.
4. Make information cheaper for long-term investors.  Stout also does not focus on this possibly because it is unclear if it is technically feasible.  However, I am personally very interested in this kind of solution.

Carbon Metrics for Investors

Interest in measuring the GHG footprint and the GHG intensity of investment portfolios is growing!  On the one hand, it's not saying much since so few investors cared in the first place.  Still, it's enough to sustain a growing industry for generating these carbon metrics such as Trucost (and CAMRADATA?).  In fact, Bloomberg terminals (computers for traders) now have a Carbon Risk Valuation Tool.  For the investors that don't care, activist organizations such as 350.org have started calling for them to divest from fossil fuels.  There are also (maybe?) individuals who want to better understand the carbon impacts of their own savings, investments, and retirement plans.

There are several different ways to calculate the footprint for investments, often referred to as financed emissions.  There are then several different ways to calculate the carbon intensities of investments, where the carbon intensity is the carbon footprint normalized by something such as revenue.  This report by the 2 Degrees Investing Initiative presents a good overview of these different metrics.

Really, the metric one uses depends on what it is being used for, what decision it is informing.  These decisions depend on the investor (activist's) theory of change and ethics.  For example, an investor making decisions on how to allocate funds might be purely motivated to minimize exposure to carbon risks.  In other words, it is an investment strategy based on the theory of change that regulations and other future events will make carbon intensive companies less profitable.  The investor behavior is not based on the ethic that it is immoral to invest in carbon intensive companies.  It makes economic and professional sense that this investor should use a metric that will highlight the exposure to carbon risk.

An individual whose money is managed by said investor might think that it is immoral to invest in carbon intensive companies just as they might think it's immoral to invest in tobacco companies.  Then, regardless of what investment strategy was actually pursued, they might care about how much emissions his or investments are "responsible for."

I am working on a report that claims that the carbon metric used by investors to allocate investments doesn't have to be and in fact probably shouldn't be the same one used to evaluate the ethical (social?) responsibilities of the investments.

Impact Investing and Social Entrepreneurship

Two weeks ago I went to the SOCAP (Social Capital Markets) conference, an annual event hosted by Impact Hub Bay Area, which runs coworking spaces for social entrepreneurs.

The conference was at the Marina, a neighborhood along the northern coast of the peninsula.  There was a really nice view of the Golden Gate Bridge and the mountains behind it.

The aim of SOCAP is to foster and promote

...a new form of capitalism is arising that recognizes our ability to direct the power and efficiency of market systems toward social impact.

The conference brings together impact investors such as the Omidyar Network and social entrepreneurs such as myself.  Impact investing is on the rise right now as an alternative to traditional philanthropy.  Any arrangement where benefactors expect a less than 100% loss could be considered impact investing.  They might get 50% of the money back or even make a return on the investment.  According to standard economics and finance theory, this is less efficient than traditional investment, which maximizes returns, coupled with traditional philanthropy.  This is because you should be able to get the most returns from traditional investing and thus have more to give out.


Many businesses have some negative externalities, such as making some workers obsolete.  Even if this is "efficient" because overall welfare is increased, some people will be winning a lot while others unequivocally lose.  This could be prevented by having the winners compensate the losers, but in real life, there's no good mechanism for doing this.  One because it's hard to attribute one person's loss with another person's winnings.  But also because the % of winnings people might need to give up may be high and not many people would willingly give up that much.  If the winners are systematically undercompensating losers, things like neighborhood degradation could count as negative externalities.  Traditional investing lead to these kinds of situations, where philanthropy plays the role of redistributing winnings.  Then philanthropy is like the left hand handing out tiny band-aids while the right hand is periodically knocking people over.  Here are some reasons why impact investing might lead to better outcomes, though.

1. It might be better instead to invest in activities that have smaller returns but don't have as many negative externalities or that redistribute winnings systematically as part of the operations of the business.  In fact, economic theory also says that internalizing externalities would be more efficient.  Therefore, the lower returns are only artifacts of different system boundaries and differences in accounting.

2. Projects that rely on traditional philanthropy get good at applying for grants to get more funding rather than getting good at making an impact.  It is difficult to evaluate the effectiveness of a project within the context of traditional philanthropy.  It would be better if indicators of project success were generated as a part of the operations of the project.  If a project is able to make back 70% of the original grant, it could be a good indicator that the project is well-managed.  Plus, that money can be reinvested into itself.  The additional philanthropic dollar can be stretched much longer.  

3. Since a dollar can be stretched in impact investing, not as much is needed to make an impact project sustainable.  This means impact investing can be accessible to more people on the benefactor side.  It also opens up a variety of new kinds of financial arrangements, making financing more accessible to more people on the recipient side.

4. Encouraging projects to become financially sustainable also imparts valuable knowledge about management and finance to communities that need to build up human resources.  This is a very big and significant positive externality from impact investing that doesn't show up on the balance sheet.

Unleashing Big Money for a Green Economy

I just read the finance section of the Green Economy Report by the UNEP (UN Environment Programme), the Green Economy : Finance I am most interested in the section about new markets and instruments such as the carbon market, green bonds, and green property. The insurance industry is also an ideal vehicle for driving more environmentally sustainable decision-making.

To me, it is critical that assets controlled by the high net worth community, asset pools of insurance companies and pension systems, and the financial services and investment sectors get directed towards driving the transition to a green economy. I would like to do work or research on redirecting assets towards green industry and infrastructure, but I'm not sure where to start. I still need to figure out who works on this already.

Renewable Energy on NPR

Renewable Energy needs Federal Funding. because because because because becaaauuuuse... because of the wonderful things it does.