THE ETHICAL CAPITALIST - PART 2

In Part 1, I discussed how we are entering the dawn of the Ethical Capitalist. Most of part 1 was dedicated to describing the current environment, this time I will go a little deeper and address some of the rebuttals I got in the form of comments and discussions.

At the core of most rebuttals is this notion that, in general, the incentive to act unethically will always exist and that this incentive is core to capitalism. A slight variation on this idea is that acting unethically is not core to capitalism, but the capitalist system is indifferent to ethics, and as a result is indifferent to unethical actions. Another corollary is that if agents are only acting based on the weighting of incentives and deterrents, then it is not a true moral action, just one that might seem to be moral incidentally.

For the past few years I have found the cynicism surrounding the incentive to act unethically very interesting. I’m not entirely sure where this belief comes from. Maybe it comes from the personal experience of many people who overcame an urge to do something unethical, or maybe it comes from roots of the Abrahamic religions that claims about 50% of the world’s population and has doctrine that states that we are all born with an original sin (I know that the three Abrahamic faiths have a different take on original sin, but there is an underlying theme that remains constant – we are all flawed since our genesis).

Proponents of this view, regardless of religious alignment, suggest that responsible oversight and regulation is the best answer to this structural flaw. But the major issue with this view is that it falls prey to an infinite regress, namely “who watches the watchers?” Why work under the assumption that those who run regulatory bodies are somehow separate from the incentives of private industry?

The belief that incentives are skewed toward the unethical is a myth based on a misunderstanding of the origins of ethics. Consider the moth that flies into a flame. The moth is driven by an instinctive and prehistoric navigation system that it inherited from its ancestors. The fact that the moth, and many of his colleagues, die from this course of action does not destroy the moth population because the action is offset by the birth rate of the population.

Now let’s move up the evolutionary chain a bit. Piranhas are known for their ability to consume large animals by overwhelming them with sheer numbers. A common question regarding the piranha is, “why don’t they eat each other?” The short answer is, they do.

Like the moth, the piranha population has a certain allowed amount of self-destructive behavior, but unlike the moth, this kind of behavior is far rarer in the piranha than in the moth. The reason for this is that there is a huge penalty for the piranha population if it were unable to work as a team. The cooperation of the piranha community allows it to consume animals that would otherwise resist their attack, or eat them as individuals in a counterattack.

This favoritism for cooperation in a feeding frenzy over their tendency to attack one another is an example of proto-ethical behavior. In this stage of the evolutionary chain, the behavior can hardly be considered ethical by human standards, but we do see an incentive toward a sense of community over the individual.

As humans, we try to separate ourselves from this model, but in reality our morals are just as driven by deterrents and incentives as the piranha and moth, the only difference is our ability to plan further into the future. Those who would say that Natural Selection is free from ethical concerns would be correct, but our moral compass is still a product of Natural Selection as is any other part of our cognitive makeup. Consequently, our separation of ethical decisions from any other decisions is an artificial distinction for our convenience, and the study of ethics is simply the study of repercussions with a longer time horizon.

By the same reasoning, capitalism is free from ethical concerns, it is merely driven by the forces of supply and demand. Therefore, if an ethical corporation is to succeed, it must drive demand independent of its ethical status. The Ethical Capitalist is in some trouble at this point if the cost of ethical actions keeps the capitalist agent from being competitive with its indifferent, or unethical, competitors.

There are three reasons why this line of thinking is flawed. First, consumers are willing to pay a premium for a perceived ethical product. The success of companies like Bullfrog power and Tom’s shoes, as well as a slew of other cause-marketed companies, is built on this premium. The reason that these companies are able to function profitably is because capitalism ultimately reflects the demands of the consumers, and the consumers are, for the most part, ethical agents. Investors in the space are also willing to lower their required rates of return for investments in these types of companies because of their ethical alignment.

Second, ethical actions do not need to cost more than unethical or neutral actions. Google’s motto of “don’t be evil” is a statement that costs almost nothing, but sets the corporate culture for the people that work there. The company has found ways to profit off of ethical actions such as providing internet to low-income markets and giving much of their product out for free. Yes, these are done with long-term profit in mind, but that’s precisely the point! It would be dishonest to say that an action is ethical only if it results in a cost rather than a gain.

Third, the statement does not consider the cost of doing an unethical action. The tech giant Uber has currently been in the news due to many questionable tactics that it has used to gain ride sharing supremacy. The use of perceived unethical tactics has cost Uber a considerable loss of business and given some market share to its competitors such as Lyft, Hailo and Sidecar. If Uber is able to come out of this tailspin, it will be due to a change in public perception about its ethics as a corporation.

I can already hear the cynics' cry something like “public perception is the key, not ethics.” And the cynics would be right, but this is the same thing as saying that survival is key, not cooperation. This is why, in part 1, I stated the importance of decentralized media, not just social media, to draw attention to what is actually ethical and what is just perceived as such. A corporation engaged in greenwashing or a charismatic C-level executive is no longer enough to fool the public into seeing PR as true ethical action. Decentralized media is becoming more sophisticated and decentralized with time and will only continue to do so in the future.

As with all organisms, there exists deviant behavior that threatens to destroy a population, and the same can be said for capitalist agents. The examples of Bullfrog Power, Google and Tom’s shoes are primitive proto-ethical agents that are acting more like a piranha then a human being. But as consumers become more aware, businesses will either have to evolve to the new, more advanced, consumer or be replaced by a competitor.

Mistakes will happen and, in turn, consumers will punish these mistakes with the loss of patronage. The end-game is that capitalist agents will reflect the ideals of the consumers as a whole, so the drive to change and improve ultimately exists at the consumer level. If the consumers are ethically minded, then the corporations must adapt to reflect these ideals to survive in an ever-changing marketplace and become ethical capitalists.

Thanks for reading!

STAMFORD IS TAKING OVER AMERICA’S PENSION PLANS

This post is in response to a post on the Intercept which can be found here. In case you don’t feel like following a link, the story goes something like this:

Financial lobbyists are looking to divert America’s pension plans’ funds to higher risk and higher fee alternative assets. The article suggests that instead of investments in these products, pension funds should make allocations to local economies thereby supporting the growth of businesses where the pensioners live.

To be fair, the article identifies a couple issues correctly. First, lobby groups in the United States have too much power over policy, but this is not exclusive to Wall Street lobbyists. Second, the managers of alternative asset classes often charge higher fees than their more conventional counterparts. The issue of fees is one that that pension funds are very aware, and is usually a point of negotiation between a fund and its potential investors. The old model of “2 and 20” is going the way of the dodo as the balance of power shifts to investors that are becoming more savvy and are demanding an alignment of interests.

There is, in fact, a very good reason as to why pension funds (and not just American pension funds) are increasing their allocations to alternative asset classes, and it has more to do with the current environment than lobbyists. The case study “Yale University Investments Office: February 2011” by Josh Lerner and Ann Leamon at Harvard Business School explains the necessity for external managers and an increased allocation to alternative assets for institutional investors.

But the following is my take on it.

The Current Environment

Put yourself in the shoes of a pension fund manager, and consider your objectives. First, you need to provide cash flow to service current and future pension obligations. Second, you need to preserve the capital in your portfolio in order to be able to do complete the first objective in future years.

Traditionally, pension funds have allocated the majority of their funds to fixed income, and fixed income-type, products in order to meet these objectives. These products would pay out a regular cash flow stream to the pension which could then be distributed among the beneficiaries, accomplishing the first objective. The remainder of the portfolio would be allocated between several asset classes, primarily public equities, in order to grow capital and meet future obligations.

Today, however, investing in fixed income does not have the same effect that it once did. Persistently low interest rates means that the coupon on safe debt instruments is no longer enough to keep up with pension obligations. Also, if interest rates rise at any time, this would erode the value of the pension’s fixed income portion of the portfolio. The other side of the portfolio, which would be largely in public equities, would be very vulnerable to market downturns, an effect that pension funds need to avoid. Most pension funds are content to sacrifice the upside of market bull runs if it means that they will also avoid the downturns during market panic.

As risk averse investors, pension funds have been slowly experimenting in alternative assets to meet their objectives in a low interest rate environment. They began by testing the waters while increasing their understanding of the products in the space. If the only thing driving an increase in alternative assets were powerful lobby groups, then we would not see the same thing happening where these lobby groups do not have as much power – but we do see just that. In Canada, where lobbyists do not have the same sway as in the United States, we have seen an increase in private equity allocation by pension funds. In fact, CPPIB (Canada’s largest pension fund) is currently the world’s largest private equity investor and a world leader in pension fund performance. CPPIB has accomplished this through a strategic combination of direct investment and external managers.

Alternative Assets

The article talks broadly about alternative assets as high-risk and high-fee investments. This definition misrepresents the asset class. The right way to think about the space is that alternative assets is to the investment space what the technology sector is to business at large. Like the technology sector, the alternative assets space is very diverse and is constantly trying new business models. Managers in this space might include high-risk investments in the form of highly leveraged arbitrage, venture capital and private equity funds, but can also include less risky investments like market neutral, private corporate debt and infrastructure funds.

What fits into the alternative asset bucket is ultimately decided by the individual pension fund. The CFA Society, for example, lists real estate as an alternative asset class, but most pension funds will allocate to real estate and infrastructure as separate asset classes distinct from their allocation to alternatives. It is likely that as certain parts of the alternative assets space mature, those managers will be lumped into a category outside of alternatives.

Transparency

The article states that alternative asset classes “are often arcane and opaque”. I tend to agree that it is difficult to articulate exactly how the alternative asset class invests, but this runs parallel to the technology sector whose revenue models are often poorly understood until a specific company reaches a certain stage of maturity. Within the alternative assets space there do exist certain funds that will function as a sort of “black box”, but institutional investors will rarely (if ever) give these kinds of strategies the time of day unless they open their “black box” and grant full disclosure.

An institutional investor has to walk a tightrope between two spaces. In the first space products are very well understood, but because of this they are also close to market efficient and all potential gains have been priced in. In the second space products are “arcane and opaque”, but the potential gains are greater due to the inefficiency of the market. The institutional investor is therefore looking for a manager that can exploit the gains of an inefficient market while understanding the drivers of that manager’s strategy.

The “arcane and opaque” nature of the space is mostly in the eyes of public perception. Strategies that must remain secretive or cannot be understood are currently frowned upon by managers and investors alike. I recently attended a panel where four major hedge fund managers spoke about various global macro issues. During the question portion of the evening, I asked the panel a question about their respective policies regarding transparency and the articulation of their strategy. All four managers agreed that full disclosure was foundational to their business with the exception that they would not always publicly disclose current positions due to concerns around market manipulation. The reason we know the managers were telling truth is because two of their investors were also in the room and were adamant that they would not invest in those funds if they did not understand the strategy driving their returns.

Fees

Anyone who works in investment management knows that there is a lot of discussion and news around fees. The goal of a good fee structure is to align the incentives of managers and investors while minimizing informational asymmetry and possible conflicts. Institutional investors are very aware of the discussion and perception of fees claimed by external managers and as a result are negotiating hard to have fees restructured to match their needs. The pension funds and other institutional investors, really have the balance of power in their favor since they ultimately control the allocation of funds. Large, powerful managers like Blackstone and the Carlyle Group are the exception, not the rule, when it comes to the size of asset managers. Ironically, smaller assets under management (AUM) is correlated to better performance (as seen here and here) but this performance does not always result in bargaining power since the investor still holds the check book.

External Managers

Any responsible pension fund manager will need to use external managers for at least a portion of their portfolio. If a fund reaches a certain critical mass then it may make sense to bring an external manager in-house thereby saving fees, but external managers offer a valuable, and irreplaceable, service to pension funds in a variety of ways. I will cover two of those ways here.

First, an external manager might be more familiar, or have better relationships, within a particular industry or strategy of interest. Bringing such a manager, or similar manager, in-house means that you must either hire the manager, robbing them of their independence and other investors or compete with the manager in question with no guarantee that you can match their performance. Bringing the manager or strategy in-house may erode your returns, create bad will in the industry or be prohibitively expensive. 

Second, an external manger offers added diversification and risk mitigation. Say, for example, a pension fund with a $100 million allocation to an asset class can make about 10 direct investments in that asset class and an average of $10 million per investment. Instead of direct investing, the pension fund could allocate $10 million to 10 fund managers. Each fund manager would then use their own diversification criteria to diversify further. A 2009 study conducted by the consulting and research firm Capital Dynamics (found here) showed that investing in 15 private equity funds per year over 15 years mitigated almost all risk out of the private equity portion of a hypothetical portfolio. You can argue the merits of using a simulated portfolio till you’re blue in the face, but it does not change the fact that diversification mitigates risk, and the statement becomes even stronger the more inefficient the asset class is. It is practically impossible to reach this level of diversification in an industry with minimum investment requirements without an impractically large allocation. The only way to achieve this level of diversification and reasonable allocation is through the use of external managers.

Local Investment

The article suggests that pension funds should steer funds into communities where pension beneficiaries live. It mentions the Quebec government pension fund as an example. It's a good suggestion, and it’s why many pension funds will invest in infrastructure of the local economy, but the motivations are not altruistic, they are motivated by risk and return. By investing in local infrastructure, an investor can avoid currency risk and stay in a familiar regulatory environment.

I am skeptical about the long term repercussions of the example of the Quebec government pension fund given in the article. The Quebec government is currently very supportive of investment within the province and often offers subsidies, grants and co-investment opportunities. The support of these investments is looked upon favorably by investors who see an advantageous risk/reward profile. But a Quebec government pension fund investing in something that is supported by the Quebec government seems like a type of pyramid scheme that will eventually collapse in on itself.

While some investment in the local economy is prudent, pension funds necessarily need to allocate a larger portion outside of the economy so that the growth of the fund can outpace the economy in which it exists. Virtually all Canadian pension funds, like CPPIB, OMERS, OTPP and others, have to invest outside of Canada to get the return and diversification needed to meet their objectives. The Canadian economy is simply too small, and does not have enough growth potential, to support pension fund commitments. American pension funds are typically smaller than the Canadian pension plans mentioned, and therefore have more opportunity to invest locally. But even American pension funds look outside the United States for investment opportunities in order to mitigate the possibility of a stagnant US market.

The Lobbyist’s Agenda

The fact that lobbyists have considerable control over public policy in the United States will get no opposition from me, but I doubt that the core of the agenda that these lobby groups have is to siphon public dollars into alternative investments in order to gain higher fees. It is far more likely that lobbyists, advocating on behalf of alternative asset managers, would be trying to keep a favorable regulatory environment. In Europe, public pressure has caused policy makers to enact the AIFMD (Alternative Investment Fund Managers Directive) which is aimed at closing the perceived regulatory gap between alternative assets and their vanilla counterparts. A similar directive in the United States would put many alternative asset managers under a very uncomfortable magnifying glass that would standardize transparency and reporting requirements.

Ultimately the AIFMD and the Intercept are guilty of the same fallacy; the belief that all alternative assets should be treated the same way and have the same problems. Returning to the analogy of the technology sector, this kind of painting with one-brush would be the equivalent of treating a company like Uber as if it were Facebook. Both companies are certainly in the technology sector, but to say that the risks or revenue model in both are the same, or even similar, would be misleading.

It would be equally misleading to say that there are no issues in the investment industry - because there are major issues. But lobby groups are not exclusive to Wall Street, and investors are more aware than ever of conflicts of interest, informational asymmetry and alignment of incentives.

THE ETHICAL CAPITALIST - PART 1

Capitalism is an economic system fraught with many problems, but it’s the system in which we work, so we should learn to make it the best that we can. To many people today “Ethical Capitalism” seems like an oxymoron. In the 2003 movie The Corporation, Mark Achbar and Jennifer Abbot point out that a corporation acts like a psychopathic person with no regard for ethics unless constrained by consequences. It’s absolutely true that if a corporation acts like a person then it acts much more like a person without a functioning moral compass than one with such a compass. You might think that this line of thinking means that we are locked into a paradigm in which these psychopathic corporations will inevitably commit misdeeds because of their nature.

I don’t believe this is true. In fact, I think that we are in a very exciting time, the dawn of the Ethical Capitalist. I know that you are likely reading this with great skepticism, but I hope that, with a little patience, I can convince you that the future of morality in capitalism is brighter than the present.

Before I delve into why I think capitalism is headed down the path that it is, I want to point out an experiment on human nature by Dan Ariely, author of “The Honest Truth About Dishonesty: How We Lie to Everyone - Especially Ourselves”. Ariely did a series of experiments on how people perceive the ethics associated with an action. In one experiment Ariely placed either six packs of Coca-Colas or paper plates with six $1 bills in numerous communal refrigerators throughout MIT. Within 72 hours, all of the Cokes were gone, but none of the students had touched the money. Ariely suggested that a one-step removal from money was a more easily morally justifiable act than the theft of money directly. It’s important to note that Ariely does not make the claim that the students committed an act that was unethical, only how they perceived the act.

Are you able to put yourself in the shoes of one of the MIT students? Can you imagine thinking about taking one of the $1 bills? What about a can of Coke? Do you feel like there is really no harm in taking the Coke, but the $1 bills make you uncomfortable? It’s strange that our moral compass, in most cases, doesn’t give a second thought to the drinks. Ariely states that dealing with legal tender indirectly, say through electronic transactions, causes the same kind of one-step removal as with the cans of Coca-Cola. As business moves toward an increasingly electronic system, our individual moral compasses have a tougher time distinguishing right from wrong.

The limited liability corporation functions in much the same way. A group of shareholders create a corporation and then act through that corporation as a business. The shareholders do not act directly in terms of the business, which removes them yet another step from any tangible transaction. Being so far removed from the effects it causes, the corporation does indeed act very much like a psychopath. But psychopathy does not necessarily imply immorality, unless you are on television of course.

A psychopath will react to consequences and can, in that way, emulate moral behavior. So with the right set of incentives and deterrents, a psychopath can act in the same way as a moral agent without any sense of morality. It stands to reason that the same applies to corporations.

The knee-jerk reaction to the preceding paragraph is that this set of incentives and deterrents must be created through an impartial regulatory body of some sort. The truth about impartial regulatory bodies is that they are never impartial and function in very much the same way as the limited liability corporation. In order to work, the incentives and deterrents need to come from within the business and its consumers.

In 1988, Noam Chomsky and Edward Herman wrote “Manufacturing Consent: The Political Economy of the Mass Media” which counters my last point. Chomsky and Herman make the case that the powerful can essentially manufacture the consent of the public at large to do any action they deem advantageous. This system would encompass government and corporations as the orchestrators while consumers and voters are the targets.

Basically we are living in a system of psychopathic corporations that manufacture consent to do whatever they please, oh and by the way, the government is in on it so you can’t really expect them to help. Seems like the capitalist system is doomed. But I believe something has changed.

The balance of power is slowly shifting away from corporations and regulatory bodies and toward the consumer and voter. The reason this is happening, and at an increasing pace, is because of the decentralization of media and research. Censorship is becoming increasingly difficult as consumers and voters can find a wealth of information about almost any corporation that they deal with. And if it can’t be found today, you can rest assured that someone will uncover it in the near future.

Websites like Wikileaks.org, Pandodaily.com, Wikipedia.org and Snopes.com are all dedicated to finding out the truth behind the stories in the media and PR campaigns today, with each having different methodology and motivations behind it. Manufacturing consent is not as easy as it once was, and it will continue to become more difficult, as the population that is seeking to expose immoral acts continues to grow. This population is also educating itself on public relations techniques and is becoming aware of their use faster than corporations and governments can develop new ones.

In this emerging environment, acts that are seen to harm society will be punished with the lack of business, and businesses will be forced to act in accordance with societal demands to win business. These capitalist agents will adapt to this new environment, and will tend toward ethical behavior as set by societal norms. Thus the Ethical Capitalist is born.

At this point you might think this is just a thought experiment. It’s true that the Ethical Capitalist is still in its infancy, but there are some contenders in industry already - let’s call them proto-Ethical Capitalists. These agents will serve as the foundation for the future of their respective industries.

In subsequent posts I will explore some examples of these proto-Ethical Capitalists and I will address some common rebuttals to this position.  

If you have your own rebuttal or example, please comment or write me!