What Gets Measured Gets Managed

CDP (formally the Carbon Disclosure Project) is a not-for-profit organization with headquarters in London that is one of the more important advocates for the SRI investors concerned about climate change. For over ten years, CDP has been leveraging market forces to encourage companies to disclose data related to their environmental stewardship.

Despite offering guided support, companies like Pioneer Natural Resources Co (PXD) still do not disclose their carbon footprint along with other pollutants (NOx emmissions, SOx emissions, hazardous spills). Failing to disclose these environmental impacts suggests that either Pioneer Natural Resources Co has something to hide or they don’t care.

Some have come to believe that the only companies that fare well in these ranking systems are companies like Tesla Motors but this isn’t the case at all. Spectra Energy Corp (SE), a natural gas distributor, receives CDP’s highest ratings for disclosure and for their environmental stewardship.

A failure to communicate on material issues leaves investors with unknown environmental risks which all too often have economic consequences. I would like to see the day when the majority of investors refuse to buy stock in companies that fail to disclose material non-financial data.

Principle #1: Remain Vigilant on Fees

The biggest challenge for the Sustainable, Responsible, Impact (SRI) investor is avoiding excessive fees. High fees have plagued the entire SRI industry and have, unfortunately, left many to forgo the pursuit of any values alignment in one’s portfolio.

Most investors don’t know that they pay excessive fees because they don’t even know what to look for. If you’re buying a fund, start by making sure that it’s a no-load fund. The markets are too volatile to have a commissioned sales person get 5% before you’ve even put your money to work in the markets.

The next thing you need to understand is the expense ratio. The expense ratio is the ongoing fees charged by the fund and, while it comes out daily, it’s measured as an annual percentage fee (e.g., 0.5%).

If you plan to invest in a US Stock fund, there’s no reason to pay more than 0.5% in fees. If you’re investing the assets in a large family foundation or a university endowment, you won’t have any problem finding funds that charge less than this benchmark. But if you don’t have access to institutional pricing, fees can take a big bite out of your returns.

If you go to the US Sustainable Investment Forum (USSIF) mutual fund member list, you’ll only find one retail mutual fund that meets this 0.5% max fee criteria and it’s the TIAA-CREF Social Choice Equity fund, which has a 0.44% fee for the retail share class and only requires a $2,500.00 minimum investment. By keeping its fees competitive, this TIAA-CREF fund has only slightly underperformed the cost-less benchmark over its ten-year history.

All of the other funds on this list that meet the 0.5% criteria are institutional funds and require a much larger starting investment, often as high as $1 million. The remainder of the US Stock funds available on this list to retail investors have an average expense of 1.06% and even go as high as the 1.68% for the Praxis Small Company A fund. As I alluded to earlier, there’s a lot of expensive garbage in SRI investing and the stink has contaminated the general perception of the industry as financially irresponsible.

Another US stock fund with reasonable fees is the Vanguard FTSE Social Index fund (VFTSX), which charges 0.25% for its entry level “investor shares.” Two Exchange Traded Funds (ETFs) that meet the fee benchmark are the iShares MSCI USA ESG Select ETF (KLD) and the iShares MSCI KLD Social 400 (DSI), both of which charge 0.5%. New lost cost ETFs that seek sustainable profits will be added every year.

Until recently, investors needed very large nest eggs to access low cost ESG options in the foreign markets. Now, BlackRock offers the iShares MSCI EAFE ESG Select ETF (ESGD) which covers developed markets and offers a very reasonable 0.4% expense ratio. The iShares MSCI EM ESG Select ETF (ESGE) which covers emerging markets is priced at 0.45%.

Some in the industry will argue that high fees are necessary to offer a high level of shareholder advocacy. By this, they believe that their efforts petitioning the board and executive team to make improvements mean needing to spend your retirement dollars. Most of these organizations don’t have the scale to be anything but an annoying fly. (In Part 2 of this series, I’ll share some ways to consider joining the efforts of others that don’t require excessive fees.)

Jack Bogle, founder of Vanguard Funds, illustrates the importance of watching fees with his Relentless Rules of Humble Arithmetic. Here’s the equation he offers:

Total Stock Market Returns − Total Fees from Finance Industry = Average Investor Return

If the total market of stocks for and bonds are expected to yield 7% on average (from a balanced portfolio) and total fees from the finance industry equals 2%, this leaves 5% as the average net return. This humble arithmetic concludes that the more extracted in fees, the less remains as a reward for the risk undertaken by investors.

Simply reducing your fees by 1% over a 35-year career can add an additional 20% to your total retirement savings. This means that if your goal is to accumulate $1 million, an extra 1% in fees can cause you to fall $200,000 short.

In conclusion, keep your US stock fees at or below 0.5% and you’ll have a found a solution that passes the first principle of SRI investing. International fund fees may be a bit higher and fixed income fees should be a bit lower. Your portfolio seeking a more sustainable future should also have fees that are sustainable to your own nest egg.

Shareholders Need New Advocates

In his 1914 collection of essays called Other People’s Money and How the Bankers Use It, Louis Brandeis argued that powerful men such as J.P. Morgan leveraged unbalanced control of the public’s assets to their own benefit. Over one hundred years later, not much has changed. If Brandeis were alive today, you can be sure that he would be advocating for new systems of financial accountability for those on top of the financial hierarchy.

The world now has more stock owners than ever before. Increased ownership is a triumph for the free markets, but it also diminishes the influence of individual investors. While John Pierpont “J.P.” Morgan can use his influence to stuff the board of directors of Standard Oil with “Morgan Men,” John the UPS driver might not even realize that he owns a small piece of Exxon stock in his 401(k) plan. In fact, if John the UPS driver owns Exxon stock through a mutual fund, he lacks a single vote to determine the board of directors.

The very funds that make it possible for average investors to access the capital markets also carry the responsibility to vote their shares. But many question whether institutional fund companies take this responsibility seriously. Institutional ownership has grown by leaps and bounds, from 6.8 percent in 1945 to more than 60 percent today. The fund company has become the so-called “legal owner,” and the role of folks like John the UPS driver is relegated to that of “beneficial owner.” This means that the fund company retains the power and influence of ownership, but it is still considered an agent of the beneficial owner.

Delegating investment management offers many potential benefits to the majority of investors who lack the time and expertise to understand and respond to corporate matters. As aggregators of many investors, some fund companies are very powerful. For example, Vanguard, Black Rock, Fidelity, and State Street are the largest shareholders of Apple Inc., the world’s biggest company by market value.

However, fund companies have generally been accused of being more content to quietly side with corporate management than to stick up for their investors. This has not stopped the founder of The Vanguard Group, John C. “Jack” Bogle from becoming an outspoken critic of his own industry for failing to live up to their responsibilities as stewards of other people’s property.

Bogle points to spiraling executive compensation as a symptom of a larger problem. As Bogle explains in The Clash of the Cultures, since 1980 executive compensation has risen twice as fast as the earnings growth rate at America’s large corporations. During that time, CEO compensation relative to average worker pay started at a ratio of 42-to-1 and now stands at 320-to-1. Fund companies have been largely silent about this trend until recently forced to make their opinion public on so-called “say-on-pay” votes.

Fund Companies Have Conflicts of Interest

Investors have every right to question whether a fund company like Fidelity can cast an impartial vote on an executive compensation package while those same corporate executives are deciding whether to invest their 401(k) and pension plan assets with Fidelity. Recent studies suggest that the largest fund companies exhibit the most corporate-friendly voting patterns. Neither group has much incentive to criticize the other, and Bogle calls this moral hazard a “happy conspiracy.”

If all corporate management teams were always looking out for the best interests of their shareholders, you would expect more common outcry when their close friends and family members were offered positions on the board of directors. Or when executives award themselves the promise of an overly generous golden parachute in the event of acquisition. But executive elites have little reason to follow best practices in corporate governance if the shareholders fail to demand it.

Without significant outside pressure, I don’t expect fund companies to respond to Jack Bogle’s calls for increased fiduciary support of shareholders.

Investment Advisors Lack Motivation

Registered investment advisors (RIAs) have a fiduciary duty to serve the best interests of their clients, but most of them are largely silent on issues of corporate governance. Fund companies are required by the SEC to vote proxies on behalf of those who entrust their investments to them, but RIAs are under no such obligation. Most state explicitly on their ADV disclosure that they do not vote proxies and leave the responsibility with their investors. These firms have determined that the benefit of voting individual share proxies is not worth the effort and liability.

My attempts to inspire RIAs to work together in pursuit of a more robust shareholder advocacy effort suggests that this group is not ready. In 2014, I wrote the headline article for our association journal titled RIAs and Corporate Governance: Ready to Take the Lead? and the editor was very excited but I am still waiting for the first comment from a practitioner. This was followed up by a shareholder advocacy seminar given to our 2015 NAPFA national conference which received a similar response.

Like the fund companies, I don’t expect to see much movement on corporate governance issues until investors start demanding it. This begins by developing awareness and asking some penetrating questions of your investment managers. One preliminary question is simple: “Please share with me what you are doing to manage my shareholder voting rights.”

A Mission Statement Worth Reading

Responsible investment is an approach to investment that explicitly acknowledges the relevance to the investor of environmental, social and governance factors, and of the long-term health and stability of the market

The PRI, the world’s leading proponent of responsible investment, has 1500 signatories and this represents $63 trillion dollars of assets under management as of April, 2016. If your investment manager isn’t aware or engaged in this initiative, it’s time to start asking some questions. It won’t be long before investment manager’s who ignore the SRI movement will be in the minority.

Jack Bogle: The Father of Passive Funds Gets Active

Jack Bogle is a believer in mutual funds, particularly the index variety. But there’s one area he thinks they come up short: They aren’t shareholder activists, pushing back on issues like executive pay.

For investors, it always pays to listen to Bogle. What he says has a way of eventually coming to pass.

For those who are not familiar with the founder of Vanguard, Bogle is also known as the father of the index fund. No one has done more to provide value and insight for the average investor. He is famous his insistence that buying and holding passively managed, low-cost index funds, like those offered by Vanguard, is a smarter strategy than any star fund manager can offer.

At a recent National Association of Personal Financial Advisors conference, Bogle gave a speech calling for more activism among shareholders and their agents. It seems rather ironic to hear the father of passive index fund investing calling for a more active stance on shareholder issues, but his reasoning is quite sound.

He received a long standing ovation from my colleagues before even beginning to deliver his prepared speech. Afterward I was especially moved to hear one NAPFA advisor after another share that Jack Bogle inspired them to join the financial planning profession as a fiduciary and work on doing what is best for investors.

In his speech and also in his recent book, The Clash of the Cultures: Investment vs. Speculation, Bogle describes a revolution in corporate ownership that led to disengaged shareholders. In 1945, 92% of U.S. equity ownership was held by individuals. Today, it’s just 30%. The remaining stocks are held by pension funds, insurance companies, hedge funds and mutual funds such as those of Vanguard.

The success of the mutual fund industry, which now includes exchange-traded funds (ETFs), has come about by creating cost-effective methods for small investors and retirement plan savers to access institutional money managers and diversify. Funds sold in increments as low as $50 have democratized investing. Vanguard helped bring about this change. However, lowering the barrier to entry has also exacerbated some weaknesses of the financial industry. Even the best fund companies have struggled to fully exercise the responsibilities entrusted to them.

Bogle argues that fund companies should be doing a better job challenging the excesses of corporate managers. He points to spiraling executive compensation as a symptom of the larger problem. Executive compensation at publicly traded corporations has increased at an unjustifiable rate, he says. Since 1980, chief executive officer compensation rose twice as fast as the earnings growth rate at these same companies. During that time, chief executive officer compensation relative to the average worker’s pay started at a ratio of 42-to-1 and now stands at 320-to-1.

What response has the fund industry offered in defense of their shareholding owners? A recent study of proxy votes shows that the four largest mutual funds – Fidelity, Vanguard, American Funds, and Black Rock exhibit the most corporate-friendly voting patterns. The foxes are guarding the hen house. Very rarely do these large fund companies vote against the policies of their corporate brethren.

Bogle directs much of his criticism at the mutal fund industry and even Vanguard itself.  In fact, Bogle points out that Vanguard scored as the least shareholder-friendly manager, only supporting shareholder restraints on executive pay 2% of the time. The irony of this story is that Vanguard helped drive fund management fees down across the industry – yet it does very little to vocalize these ideals to corporate America on behalf of their shareholders. He’s still a big supported of the company he created (he’s no longer involved in its management), but he doesn’t mince words when calling for greater industry accountability.

The Investment Company Act of 1940, which governs all funds, states that all mutual funds must be “organized, operated, and managed” in the interest of their shareholders. In a chapter titled “The Silence of the Funds,” he argues that the fund industry strays far from these stewardship principles.

If the mutual fund industry wishes to remain the gold standard for investor opportunities and protections, they ought to heed the wisdom of Jack Bogle. If so, the industry will become not only accountable for their own management compensation but also crying foul when corporate management begins reaching too far into shareholders’ pockets.

Investors and their managers will demand this type of stewardship from their fund management companies as they become more educated on these topics. As we experience a reality of slower growth in the U.S. compared to decades past, I would expect less tolerance for this type of industry excess.

-This article was first published as a post for Marotta On Money.