Interview with Jon Lukomnik

Seven Pillars Institute had an email interview with Jon Lukomnik, the co-author of a recent paper “The Purpose of Asset Management”. Jon and his co-author, Dr. James Hawley, presented their paper in the British House of Commons and to UK regulator, the Financial Conduct Authority. 

SPI: Can you tell us the purpose of your paper “The Purpose of Asset Management” which you co-authored with Dr. James Hawley?

JL:  The Pension Insurance Corporation (PIC) In London Is exploring the purpose of finance. It’s a fascinating project, because finance, while not creating food, shelter, or education, culture, enables all those societally useful things to be available at a scale previously unknown In history. Our paper was the first deep examination into a specific sector of the finance Industry.  Finance and investing are certainly studied robustly, but virtually never from the starting point of “what is it that investing should be accomplishing”. So you get lots research that is not necessarily focused on how aligned is finance or investing to its fundamental purpose. Unless you ask that question, it’s hard to know if finance is efficient; after all, efficient towards what?  By starting with purpose, you get some very Interesting analysis and answers about how to Improve the delivery of Investing’s fundamental societal purposes.

SPI:  Your paper was recently presented at the British Parliament. How did this come about and how was the paper received?

JL:  We had a draft of the paper In December, and I was asked to go to London to preview It to leaders In the Industry, regulators and policy makers. At the same time PIC sent the paper around to some key Members of Parliament. So by the time we launched the paper formally a few months later, It had generated a fair amount of conversation.

But we were not prepared for the level of attention. That was a very pleasant surprise. One of the Members of Parliament who had read the paper asked us to present to the All Party Parliamentary Group on Inclusive Capitalism. It was an honor to present In the House of Commons to a bi-partisan group that was trying to understand the Issues and move us forward, rather than just score talking points.

We also presented to the Financial Conduct Authority (FCA), the UK regulator. The FCA put almost every asset management regulator Into a large media room, with a televised link to its staff in Edinburgh. They explained that our Ideas about how to mitigate systemic risk — of climate change, Income Inequity, and financial markets — were Innovative and of Interest.  We also spoke at a, major launch event, at a think tank, at the European Fund Managers’ Association and at a host of one-on-one meetings.  I think one reason so many people wanted to discuss the paper was that It put a theoretical framework around what Investors were already doing In practice. This was definitely one case where theory lagged practice, so the real world examples were relatively easy to see.

SPI:  Purpose, or telos, is an ancient Greek concept, which fell out of favor during the modern and postmodern era. Why do you think “purpose” is being rediscovered in finance?

JL:  I think the reception Jim and I received In London suggests the response. We had expected a fair amount of push-back, because what we propose Is different than current practice; the industry’s internal focus — rather than its focus on what it does for society — has caused some divergence from purpose. But my experience over more than a third of a century Is that most people In asset management are well-Intentioned, smart and dedicated. They are responding, logically, to misdirected Incentives and regulation. So many were honestly happy to hear suggestions for how to realign with purpose while improving the asset management industry overall. In fact, I would say the reaction was 80-20 positive.

SPI:  What do you identify as the two purposes of asset management?

JL:  Finance overall has a number of purposes, but the two key ones for Investing are risk mitigation and Intermediation. Those are fancy terms, but simple concepts. Risk mitigation means finding an optimal balance between risk and return, which are Inextricably linked (otherwise a lotter ticket would be the same as a government bond).  Of course, finding the absolute optimal return per unit of risk Is an Impossible task, but that Is the goal. Intermediation, or capital allocation, Is taking money from point “A” In the real economy where It Is, to point “B” where It Is needed.  So, for Instance, aggregating your retirement or college savings with other like-situated people to fund a new business or your mortgage.

One thing that Is notthe purpose of asset management Is “making money” for the asset management firms.  Now, I’m a capitalist, and I’m not minimizing the need for firms to make money. Absent the ability to make money, the firms would not be able to attract talent or Invest to fulfill investing’s societal purposes.  But saying that making money for asset management firms Is the purpose of asset management Is akin to saying that the purpose of life Is breathing. That’s a condition necessary, but not a purpose.

SPI:  In what ways do the purposes driving asset management today differ from your two purposes? More specifically, you suggest Modern Portfolio Theory or MPT has misdirected the purpose of asset management. How has this occurred?

JL:  Let me start by saying that MPT Is brilliant.  The Idea of diversification Is so well thought out and so entrenched In our collective Investment psyche that It’s hard to remember how revolutionary It was when Harry Markowitz wrote about It In 1952. It earned him a Nobel prize.

But MPT presents Investors with a major conundrum.  It assumes that our Investments are buffeted by the overall market, which Investors call beta, but do not affect the overall market. It also assumes that beta — the risk and return of the market — Is multiples more Important to your absolute savings than Is any Investment manager’s ability to pick stocks or construct portfolios. So here Is the MPT conundrum: That which you can’t affect matters ten times more than that which you can.

I’ll get to the perverse Incentives that creates in a minute, but first let me suggest that the Idea that you can’t affect systemic risk Is nonsense. You can’t diversify It, but you can affect It. “Risk on, risk off” markets are the result of Investing flows.  There Is a wide universe of academic papers suggesting how Indexation creates Index effects, which are basically changes in beta.

The Inability to diversify systemic risk doesn’t mean you can’t mitigate it. Investors have been attempting to do that for some time.   On climate change, the Investing community came together to support the Paris climate accords and created the Climate Action 100 which Is attempting to reduce the carbon emissions of the 100 largest corporate carbon emitters.   On gender diversity, State Street not only sponsored the “Fearless Girl” statue on Wall Street, but also wrote to every major US public company with an all-male board.  The UK’s largest asset manager, Legal and General (LGIM), will vote against  the Chair at any company with fewer than 25% female directors.  Both State Street and LGIM have also created  funds designed to Increase gender diversity.

Investors affecting systemic risk has a long history. Many Investors fought apartheid through the capital markets In the 1970s and 1980s, the Council of Institutional Investors eliminated the capital market blackmail called  “greenmail” in the 1980’s, CalPERS’s efforts changed Philippine law which the pension fund thought unfair In the 2000s.

The benefits of building a better beta are enormous. But they accrue to all end Investors and users.  From a purpose standpoint, that Is desirable. But It does not help Individual asset management firms differentiate themselves from their completion.

The result Is that the Industry spends an enormous amount of effort and resources trying to distinguish one firm from the other through trading, even though the returns available from “alpha” commonly thought of as returns due to the skills of the portfolio team, are perhaps one-tenth as Important to the ultimate Investor (and society) as that of beta.  All that trading may contribute to the Issue of short-termism.

Another way firms try to differentiate themselves Is through product proliferation.  In 2016, there were 110,271 funds In the world. I don’t know the optimal number, but I’m willing to bet Its something materially less than 110,271.

That trading and those fund launches have costs.  Some of those costs are both unavoidable and worthwhile, but some exist merely to differentiate oneself from competitors. So the problem with MPT Is that It encourages activities which effectively are zero-sum — one firm wins and one firm loses — because they are focused Internally on competition within the Industry, rather than externally on benefits to the ultimate saver and user.  Building a better beta has much more Impact on the efficiency of the asset management Industry when looked at from the point of view of society.  We don’t suggest that security selection and portfolio construction and unimportant or should whither; rather, we suggest rebalancing the Industry’s efforts to Include an understanding of the feedback loops between Investing and the systemic risks which create beta. We call this systems-level Investing.

SPI:  How much does the neo-liberal economic tenet that economic agents should maximize utility (i.e. increase shareholder value, a legal requirement for corporations in the US), drive the purpose of asset management companies?

JL:  I have no qualms about Increasing shareowner value. The Issue Is how that has come to be Interpreted.  Traditionally, shareowners own only a claim to the residual value in a company; to what’s left after paying others — workers, customers, lenders, etc.  So, traditionally, maximizing shareowner value could only happen by balancing a number of competing Interests.  Shareowners — and I am one and have been a significant one as the Investment advisor or a trustee for more than $100 billion In my career — were content to be what I call “long-term greedy”.   We liked for a company to build long-term value for all. As Warren Buffet once said, “our favorite holding period Is forever”.

But somewhere along the way a shorter-term investment horizon became the norm.  Andy Haldane at the Bank of England calls this “the short long” and notes that Investors Irrationally hyper-discount cash flows which are In the future.  As a result, the market began to reward highly-levered companies since the leverage typically results in better cash flows when things are going well. But they are fragile.   When things go poorly, it’s still a problem for investors, but we have diversified portfolios. We can still profit overall, as long as enough of our holdings are zigging when disaster causes one of these levered companies to zag.  Others are not so well insulated. For example, workers’ future earnings are not diversified; they are tied to a specific company.  Effectively, the combination of shorter-term holding periods combined with diversification shields shareowners from the worst of any particular corporate failure.

I do think a number of major Investors have recognized these Issues and are seeking to reinsert a long-term, more balanced focus Into the market. We’re seeking to be good owners of companies, not just good buyers and sellers of stock. For example, some 50 major US and international investors have created a stewardship code — a code of conduct for how shareowners should interact with companies. So far, investors with more than $22tn in assets invested in US public companies have signed on. The trend for shareowners to recognize our ownership responsibilities Is a very positive development.

SPI:  Can maximizing utility constrain asset management companies from serving the purposes you set out?

JL:  No.

Those who claim It does define maximizing utility as how well a specific portfolio performs against the overall market, and usually over a short period of time.

But, In fact, the needs of an Individual saver (and society) are absolute, not relative to a market, and usually longer-term. As an example, If the S&P 500 Is down 10 percent In a year, and your stock portfolio Is down 8percent, then your portfolio manager has outperformed for the year and will likely get a nice bonus. But you have only 92 cents on every dollar you Invested. And If you were Investing for retirement, or to buy a home, or for your child’s college education, you’ve actually lost ground.

As I said earlier: Here Is the MPT conundrum.  MPT suggests that the overall return of the market is both exogenous  — unaffected by actions taken by investors — and also about 10 times more influential on the absolute return of an investor than security selection and portfolio construction. So, the traditional definition lot “maximizing” utility actually only attempts to maximize a very small part of the available risk/return opportunity, and over a short time period as it omits the impact of beta. By contrast, systems-level investing, which recognizes that investors can affect systemic risk, not only realigns investing with purpose, but has a potentially greater impact on maximizing utility.  It also reunites Investing with the real world economy.

SPI:  I understand you are a member of the Transparency Task Force which has done a great deal to increase awareness of costs and has pushed for cost disclosure in asset management. How does the issue of cost transparency enter into your paper?

JL:  Andy Agathangelou and the Transparency Task Force have done great work In this area;  If one of the purposes of asset management Is to optimize the risk/return available to citizen-savers, then every excess penny In fees decreases that optimal ratio. Of course, some fees are necessary, and many people work hard and diligently to earn those fees. But the Investment chain –the number of Intermediaries In moving that money from point A In the economy where It Is to point B, where It Is needed — Is Incredibly long. So while there has been Improved efficiency in most of those Individual transactions, the net result Is that today’s financial system has experienced no overall productivity Improvement In more than a century, according to NYU professor Thomas Phillippon’s meticulous research. That’s’ amazing and disturbing; the financial system which paid for the transcontinental railroads was as efficient as today’s finance sector that Is financing autonomous cars.  Talk about not maximizing utility….

One reason Is that the long chain of Intermediaries creates information asymmetries and fee opacity.  If we had cost transparency, the end beneficiaries would have a much better chance of negotiating a better deal. Who knows, perhaps some of those Intermediary steps could be eliminated altogether. To put It another way, I don’t know many economists who argue that markets work better when opaque.

SPI:  Do asset managers knowingly increase costs or are they as helpless in a seemingly sprawling, mechanistic system as their clients?

JL:  Asset managers themselves are actually undergoing a fee squeeze. That sounds like a paradox, but the fact Is that the average mutual fund and ETF fee In the United States fell to 0.518% in 2017, an 8% price drop In a year. Part of that was the Increased use of low-cost Index funds, but actively managed funds also cut fees.  But the other Intermediaries and service providers — the distribution platforms, transfer agents, record-keepers, custodians, etc. — keep overall costs higher than most people would like. And as we just discussed, many of those costs are not as transparent as they could be.

SPI:  Do you disagree with any of the criticisms or refutations given by executives of asset management companies in the stake holders response section?

JL:  Perhaps the most negative response was from the head of Allianz Global Investors, who wrote “Directing capital toward certain sectors/activities may have great societal (system) benefits but will likely lead to lower beta returns In those sectors as capital Is “wasted” from an efficient capital market perspective”.  We thought that was a thorough misreading of the paper as It divorced the Investment decision from the systemic risk analysis point.  We received support in our point of view less than two months after we released the paper, and from an unlikely source. Allianz Insurance, the parent company of Allianz Global Investors, announced that It would stop Insuring coal-fired power plants and coal mines.  Enough said.

SPI:  Now that your paper has been presented in Parliament, what are the next steps that will be taken?

JL:  Jim and I are working on a book proposal, so that we can more fully develop and document a number of the arguments, and also some of the adjacent theories we didn’t have room for In the paper.

More generally, we continue to push for the Industry to consider systemic risk Issues. We have spoken at a number of Industry events, Including the CFA Society of NYC and a State Street/Thompson Reuters/TruValue seminar and have a number more on the calendar.  We also continue to explore these Issues with regulators.

Clearly, we seem to be aligned with the zeitgeist of the moment. I think one reason Is that we are providing a coherent theory that explains what major Investors are already doing. The difference Is that before their actions were described as “one-offs” designed to deal with Issues like apartheid in the past or climate change and gender diversity today. So we’re actually not breaking new ground In practice, but providing a new framing theory that suggests these are differentiated systemic risk mitigation attempts, all designed to deal with the MPT conundrum, That is exactly what a purposeful Investor should do.

SPI:  Thank you for taking the time to do this interview, Mr. Lukomnik.