Introduction

This Handbook responds to the evolution in the ownership of companies and financial assets over the past thirty to fifty years. It also is concerned with the more recent widespread failure of pensions and other long-term savings vehicles to deliver on sustainable financial security goals for the individuals whose monies they are investing.

The volume highlights important changes in the landscape of finance, especially with regard to institutional investors: those large financial institutions entrusted to manage most of our savings, pensions, retirement funds, insurance assets and national wealth reserves. It primarily focuses on the changing legal understanding of the role and purpose of these institutions in many countries. This includes recognition of the influence that collective investment practices of institutional investors have on society and the greater economy, as well as the corresponding influence that economic health and social stability have on the sustainability of institutional investors’ performance and their ability to succeed in meeting long-term goals for the beneficiaries who depend on them and who collectively constitute the societies in which they exist. The Handbook is also a testament to the rapidly evolving nature of academic research and public policy discourse concerning institutional investment and financial markets.

The world currently faces increasingly complex governance challenges. While there is a growing recognition that we urgently need to take a longer-term view in order to deal with them successfully, many of the incentives that shape the thoughts and actions of leaders encourage myopia in the private and public sectors alike. Strategies with a high probability of success are available but not pursued because powerful short-term incentives are increasingly misaligned with the timeframes required for the solution of growing problems with profoundly destructive inter-generational impacts.

Thus far, legislators have not adequately addressed these inter-generational issues. In previous eras, when obvious and invidious injustices grew to intolerable scale due to the protracted paralysis of leaders, the necessity for action has often found its venue, by default, in the judiciary. Now, once again, courts – responding to specific fact situations – may well play a critical role in breaking this logjam. One likely legal strategy is based on the concept of fiduciary duty – the legal obligation to act in the best interests of others.

Introduction

Events of the past decade have challenged the efficient market hypothesis and the use of modern portfolio theory that is at its core as the basis for prudent investment and risk management practices. Accordingly, such questioning may – and we argue should – impact the legal framework governing pension fiduciaries. For example, it is now broadly accepted that most funds’ returns come from general exposure to the market (beta) rather than seeking market benchmark outperformance strategies (alpha) (Ibbotson 2010). This makes systemic market factors more critical to fiduciary responsibility. It also raises the question of whether large, highly diversified institutional “universal owners” should even attempt to employ alpha-seeking investment, or active management, as a major part of their portfolio (Hawley and Williams 2000). We argue that it is questionable at best and perhaps bad investment strategy at worst to devote significant resources to seeking above-market returns. Indeed, we suggest it raises questions about consistency with fiduciary obligations, since achieving alpha means besting the average return, which is a mathematical impossibility for the average investor. Additionally, alpha-seeking, if linked to leverage and/or use of derivatives, may contribute to systemic risk as well.

Our argument is as follows: alpha, or active management, has been, among both practitioners and academics, used in two quite different ways. In much but not all academic theory it is defined as above-market (risk-adjusted) returns (RAR) within an asset class (e.g., equity, real estate). This typically involves active trading (that is, stock picking/asset picking and cross asset investments of various types) rather than indexation. Yet it has also been widely used to mean seeking above-average return across asset classes. That is, typically using various alternative, sometimes leveraged investments (e.g., private equity, hedge funds, commodities) to increase portfolio-wide returns. Indeed, since the financial crisis this has been a pronounced trend for many defined benefit plans, as we discuss below.