Can Private Finance Really Serve Humanity?

Private finance boom

Private capital has exploded with financial deregulation from the late 20th century. Global finance increased 53% from 2000 to 2010, reaching some US$600 trillion (ten times annual world output), and was projected to reach US$900 trillion by the end of this year.

In its 2018 annual report, Principles for Responsible Investment (PRI) – an investor initiative in partnership with UN offices – estimated that investors with over US$80 trillion in combined assets had committed to integrate ‘environmental, social and governance' (ESG) criteria into their investment decisions.

According to the IMF, between US$3 trillion and US$31 trillion in assets are managed by ESG funds, depending on the definition used. It also notes problems in evaluating ESG criteria, such as reducing emissions or raising labour standards, and hence fears ‘greenwashing' financial investments with false claims of ESG compliance.

From active to passive investing

From 2006 to 2018, almost US$3,200 billion left actively managed equity funds globally, while over US$3,100 billion has gone into equity index funds, constituting "an unprecedented money mass-migration from active to passive funds". The shift has given index providers considerable private authority and influence in global capital markets.

Mutual index funds have been available since the late 1970s, while the first exchange traded funds (ETFs) were launched in the early 1990s. The growth of passive or index funds has greatly accelerated in the decade since the global financial crisis (GFC).

Attracted by the much lower fees charged, passive funds had US$11.4 trillion globally by November 2019, five times more than in 2007. Jan Fichtner, Eelke Heemskerk and Johannes Petry discuss some implications of this money mass-migration to index funds for corporate governance, market competition and investment flows.

Wall Street's new titans

Consequently, corporate ownership is increasingly concentrated and largely held by the ‘big three' passive asset managers: BlackRock, Vanguard and State Street, already the largest owners of US corporations. In 2019, actively managed US funds were overtaken by passive funds. Some estimate that index funds will have over half the US capital market by 2024.

Describing passive investors as the true "titans of Wall Street", Jill Fisch, Assaf Hamdani and Steven Solomon fear that passive investing's rise raises new concerns about conflicts of interest due to ownership concentration and common ownership of rival firms, thus undermining competition.

In traditional investment funds, managers decide how and where to invest, e.g., which shares to buy. Instead of depending on fund managers, passive funds track selected constructed indices. This is increasingly done algorithmically, instead of reflecting or responding to price and other movements.

Index providers set standards

When investors invest via index funds, their decisions are effectively shaped by the indices the passive funds track. The three most influential index providers are the MSCI (Morgan Stanley Capital International), the FTSE (Financial Times Stock Exchange) Russell and the S&P (Standard and Poor) Dow Jones.

The main emerging markets indices have tremendous influence, particularly the MSCI Emerging Markets Index, which includes large and medium-sized companies in 26 countries, including China, India and Mexico. Thus, MSCI effectively sets criteria for countries aspiring to qualify as emerging markets, requiring financial authorities to ensure free access to and exit from national stock markets for foreign investors.

Deciding what to include in indices is not just an objective or technical matter, but inherently political and subjectively discretionary, typically benefiting some over others. Setting criteria for inclusion thus endows index providers with the authority and power to greatly influence regulation and policies.

Indices influence capital flows

In the past, index providers only supplied information to financial markets. But with passive funds, index providers have considerably more authority in markets. With trillions of dollars invested worldwide, capital has been reallocated by index providers' decisions, as innocuous as they may seem.

These often influence international capital flows much more than economic fundamentals. Massive portfolio investments typically flow into the financial markets of countries chosen for inclusion.

When China was added to key emerging market indices in 2018, reportedly after heavy lobbying, it was expected to attract portfolio capital inflows of up to US$400 billion.

Adding Saudi Arabia to the benchmark MSCI emerging markets index in 2018 was expected to bring up to US$40 billion into its stock market. This did not materialize, perhaps due to the Jamal Khashoggi murder scandal, treated by financial markets as a ‘reputational risk'.

Thus, the big three's indices greatly influence global investment flows. Meanwhile, investors may unwittingly acquire controversial or problematic investments, either by investing in index funds, or by choosing options heavily invested in such funds.

Divesting for progress?

Clearly, the three biggest passive fund managers and three major index providers greatly influence portfolio investment choices, while the world remains largely oblivious of their biases, influence and impacts, wishfully hoping for the best possible outcomes.

BlackRock, the world's largest investor, with US$7 trillion in funds under its management, gained approving attention by announcing divestment of its actively managed funds from firms making more than a quarter of their revenue from coal.

But, as most BlackRock funds passively track indices, these continue to invest in coal until such stocks are removed from the indices. Moreover, its CEO has made clear that it will continue to invest in controversial assets, including coal.

Following BlackRock, Vanguard and State Street have also announced they will increase their ESG funds. But ESG criteria are defined, interpreted and acted upon by the index providers, who use different, often problematic and non-transparent methods and data.

UN ‘blue-washing'?

ESG-rating firms disagree about which companies qualify, producing different sets of ostensibly ESG compliant stocks. Meanwhile, the IMF has not found any consistent differences in rates of return between the investment portfolios of ESG funds compared to conventional ones.

In August 2019, Vanguard dropped 29 stocks, noting they had been ‘erroneously' classified as ESG by FTSE Russell. The rejected stocks included a gun manufacturer, a private prison operator, a restaurant and a pharmaceutical company.

Neither Vanguard nor FTSE Russell explained how and why the ‘error' had happened, or the criteria involved. Most ESG indices include ‘industry leaders' in almost all, including the most controversial sectors, only excluding the very worst offenders, which are quite subjectively, if not arbitrarily determined.

The Economist has noted, "Tobacco and alcohol companies feature near the top of many ESG rankings. And many funds marketed on their green credentials invest in Big Oil…the scoring systems sometimes measure the wrong things and rely on patchy, out-of-date figures. Only half the 1,700-odd companies in the MSCI world index reveal their carbon emissions".

Unless there are more meaningful and effective means to ensure that private finance equitably and appropriately serves public needs, indiscriminate UN endorsement of ostensible efforts to mobilise private finance for sustainable development runs the serious risk of legitimising a massive fraudulent exercise in financial ‘blue-washing', referring to the colour of the UN flag.