A Paradigm Shift in Three Dimensions

Last week, I participated in an energizing symposium organized by Capital Institute called “Beyond Sustainability. The Road to Regenerative Capitalism”. In connection with this symposium, John Fullerton, Founder and President of Capital Institute, shared a discussion draft of a white paper he is writing on Regenerative Capitalism.

Reflecting on the proceedings and on John’s paper over this past week is leading me to see that much of what we see as unsustainable in the current global financial system is actually symptomatic of the profound paradigm shift that is taking place today, simultaneously, but asynchronously, in three different, but parallel, dimensions.

One is a fundamental shift in our story of place, from infinite expansion into a boundless frontier, to learning to live well within planetary limits. This, it seems to me, is the primary focus of John’s current thinking and writing on Regenerative Capitalism, which is good stuff.

A second is a corresponding shift in our sense of purpose, from short-sighted, self-centered self-interest that will somehow, overall, result in everything working out well for all of us (sometimes it does, other times, not so much), to a more deliberate ownership of both the intended and the incidental impacts of our actions on ourselves and others, and also on our future, and on the future for our children, and our children’s children going on for successive generations.

A third is a shift in technologies for connectivity, from the telegraph and telephone (our current corporate finance system is built on the ticker tape, which is an ingenious adaptation of telegraph technology) to Cloud computing, and the many powerful technologies we now have for establishing connectivity among diverse persons in remote locations, in real time, or each in his or her own time. 

This last shift in technologies for connectivity is of particular importance to the evolution of new portfolio design paradigms for pension plans and other stewardship investors, and therefor to much-needed transformations in finance and the economy, more generally. 

This technology gives stewards of perpetually entrusted funds the power to use their powers of size, purpose and longevity to develop the sophistication they need to reduce their participation in speculative trading of derivatives (all financial assets are derived more or less directly from the use of physical assets to create new wealth in the physical economy, and so are derivatives) and increase their participation in physical wealth creation, more directly.

Derivatives trading, and corporate finance more generally, are built for liquidity. Pension plans, and other stewards of perpetually entrusted funds, are built for longevity.

Over 40 years of experimentation with such derivatives trading by perpetual stewardship investors using "Asset Allocation according to Modern Portfolio Theory" as a portfolio design paradigm is showing that when we choose liquidity to fund longevity, the results are not what we are looking for.

It is a form of borrowing short (closed-loop, zero-sum trading in corporate shares and other financial assets) to lend long (paying benefits to retirees). That is a strategy the commercial banking industry long ago learned always ends up in disaster.

Pensions learned that, too, in 2008.

Empowering Values-driven Business Leadership by Ending Speculative Trading with Perpetually Entrusted Funds

Before we can get to the challenges of empowering values-driven business leadership, we first have to fix the problem of perpetually entrusted funds caught in a trap of closed-loop trading of financial assets.

Many of the most pressing problems of sustainability and social responsibility can be traced to the changes in fiduciary laws made in 1972, that allowed stewards of perpetually entrusted funds to begin speculating in the stock market. Speculating with other people's money entrusted for some other purpose has always been considered under the law as a breach of fiduciary duty. It still is. But in 1972, the Uniform Management of Institutional Funds Act codified the view that diversification can be used to effectively manage volatility within a properly constructed portfolio of trading positions in public equities. This was premised upon the validity of Efficient Market Theory and Modern Portfolio Theory, although neither theory is actually endorsed in the law.  The law just states that prudence in investing evolves and the laws of fiduciary duty must evolve to keep pace with new knowledge and experience.

Knowledge evolves in context, and the context in which the knowledge of Efficient Markets Theory and Modern Portfolio Theory evolved did not include market participation by large, purposeful, powerful stewards of perpetually entrusted funds. The markets of the day were characterized largely by individuals investing their own money, for their own account, mostly on changing cash needs. As individuals, we buy stocks when we have money available, and sell when we need the money back. In between, there may be some trading on price, in an effort to get a better return, but mostly we just buy and hold. Even when we do speculate, we speculate with our own money.

Not so with pension funds and other stewards of perpetually entrusted funds. First, they never have a need to sell. They always have a need to be invested. So, when they sell, they always sell on price (except for small amounts of selling, to fund their fiduciary responsibilities). Second, they are not investing their own money. They are investing money entrusted to them by others, to be used to accomplish a very specific purpose, which is to generate fiduciary returns equal to or in excess of their fiduciary obligations.

Efficient Market Theory and Modern Portfolio Theory may work well in the context out of which they evolved, but more than 40 years of experience is showing they do not work so well in the context of markets heavily influenced by speculative trading by perpetual trusts. Buy-and-hold becomes buy-low-to-sell-high, becomes buy-high-to-sell-higher, as the markets gyrate through ever larger, and more frequent, cycles of boom that go bust, with catastrophic consequences to the markets, to portfolios of perpetually entrusted funds and to the economy and society, more generally.

Underneath this all remain the challenges of empowering values-driven business leadership, but before we can get to those big challenges, we need to first deal with this small systemic fix. We need to get perpetual funds out of the markets, so the markets can return to authentic trading on changing cash needs.

Access, Egress, Liquidity and Instability

Today, I saw another mention by people who advocate for impact investment in social enterprise in praise of the development of stock exchanges for social enterprise.

Do we really want to financialize social enterprise?

Stock exchanges were invented in the 19th Century to aggregate investment in small increments from individual investors to form large pools of capital to fund large-scale industrial enterprise. They work remarkably well. They provide individuals access to investment, a means for exiting the investment when the time comes, and a mechanism for realizing returns on investment.

The problem is, they do all three through the same, single point of value: the share price.

The enterprise is turned into a financial asset. The asset is broken up into bite-sized shares. Individuals can buy and sell shares among themselves, without involving the enterprise in each sale.

It's hard to see why this system isn't great, isn't?  Except that it is built upon an assumption/expectation that of perpetual growth at the enterprise/industry level. When this belief in perpetual growth collides with the reality of the organic growth curve, we get what is euphemistically called "the business cycle:, but what is more authentically described as a recurring pattern of booms that always, eventually, go bust, as investment is made to manufacture growth in productive capacity that is not supported by customer demand.

Do we really want to extend boom-and-bust into social enterprise? Can't we find a better way?

Valuation vs. Wealth Creation

Once again I find myself entering a conversation dominated by Economists, this time to de-construct the problems of underfunded pension liabilities relative to their need to exceed actuarial returns on their investment portfolios.

Each time I turn towards Economics, I am impressed by the extent to which economists do not actually study the economy. What they study is prices, and valuation.  Ever since the days of David Ricardo, it seems, economists have pursued the Holy Grail of intrinsic value, driven by a need to believe that there is one, perfect, absolute and enduring "right" price for everything.

They need to let go. Over 150 years of experience with share price trading in the exchange-based marketplace has shown us what most of us already know: a thing is worth what someone else is willing and able to pay for it. Value is situational, provisional and contextual, driven by need and expectation within a shifting population of prospective purchasers who all, for the most part, have other things they would rather be doing.

I appreciate that industrial production requires standardized pricing, and that pricing strategy is an important part of mass merchandizing, but we can only do what we can do. In the end, pricing is more art than engineering.

When it comes to valuing an enterprise, so we can buy or sell shares in that enterprise, this existential reality manifests itself as volatility. Nobody really knows what an enterprise is "really worth", and so the actual prices at which shares do trade bounce around, driven as much, if not more, by emotion than reason. Net Asset Value is a report of history, actually a report of a precise moment in history. It is not a measure of future reality. The past is important to investing, as to all things human, as a guide to what we can expect in the future, but investing is really all about the future.

For investors whose only option is to participate in the public markets, I understand that is cold comfort. It is easy to see why they prefer to believe.

But for large, purposeful, perpetual investors, like pension plans, that do, or should, have other options, more satisfaction will be realized if they focus their energies on wealth creation, and let go of valuation.

Instead of trading on price, pension plans, and their plan sponsors and participants, will be better served if they concentrate on sharing in cash flows.

We cannot predict cash flows, but we can manage them. Share price cannot even be managed. Not, that is, without rigging the system. Which is against the law.

Pension Funds Belong in Enterprise. But how do we get them there?

The evidence is overwhelming that pension funds do not belong in the public markets.

Financial crisis. Boom-and-bust. Responsible Investing. Socially Responsible Investing. ESG. Sustainable Investing. Sustainable Capitalism. Sustainable Finance. Long Finance. Failed performance. Excessive Fees. Misalignment of interests. Inverted reward systems. All of these, and more, are symptoms of this fundamental mismatch between pension funds and public markets.

The problem is that Exchange trading (which is what the public markets are all about) is built to function like an intergenerational relay race. Pension funds turn it into a game of trading baseball cards. The consequences are as above.

This is not to say that pension funds do not belong in enterprise equity.  They do. The question is: what is the right way to get them there?