Best Interest Standard – Part 2

In a previous post it was argued that a best interest standard is necessary to protect financial consumers from the pervasive conflicts of interest in the wealth advisory industry. The arguments against adopting the standard fail on two accounts: uncertainty is a burden that is better carried by financial advisors than by financial consumers and, more importantly, financial advisors should not be regarded as salespersons but rather, as stewards of their clients’ financial well-being.

However, a fiduciary standard is not a panacea for ensuring the financial well-being of individual investors (retail investors). At worst, the standard could actually undermine clients’ interests by unintentionally cutting off access to investment opportunities that align with their social and environmental values. Millennials, in particular, show a strong interest in investment opportunities that allow them to contribute to positive social and environmental benefits for communities, while also generating a financial return on their investments.

As Canadian securities regulators deliberate over adopting the fiduciary standard for financial advisors this fall, it is essential that their analysis includes consideration for how the standard could impact individual investors’ access to socially responsible investment (SRI) products and investment products that generate positive social and environmental benefits (impact investments). In other words, the concept of investor protection must be extended beyond traditional concerns for conflicts of interests and transparency to include consideration for social and environmental risks and opportunities.

At issue is whether a fiduciary standard would have similar unintended consequences on the average individual (a.k.a ‘retail’) investor, as it has on institutional investors.

For many pension funds, fiduciary standard is widely regarded as a constraint for innovative investment strategies, including socially responsible investment (SRI) strategies and impact investment. For example, a 2004 study of Canadian investors finds that pension fund trustees’ interpretation of fiduciary duty constrains their ability to address full range of relevant corporate responsibility considerations’.

But interpretations of the legal concept have evolved in recent years to reflect a more progressive understanding. For example, one frequently cited legal interpretation argues that trustees’ fiduciary duty actually requires trustees to take into consideration ESG issues when  (i) they are financially material; (ii) the financial risk/return of two investments are equivalent  (iii) they have a mandate from the trust to do so, and (iv) when beneficiaries request non-financial criteria. More recently, regulators in the US and the UK have clarified that fiduciary duty does not preclude the inclusion of material environmental, social and governance (ESG) issues.

However, fiduciary duty continues to be seen as an obstacle to sustainable and responsible investment. The 2015 UN-backed PRI Report ‘Fiduciary duty in the 21st century’ finds that “many asset owners cite their fiduciary duties as the reason why they are yet to integrate ESG issues into their investment processes.”

In applying fiduciary duty to retail investors and their financial advisors, some scholars suggest that the retail sector provides a more generous space than the institutional investor context.  “The debate about the role of social responsibility criteria in the fiduciary obligations of trustees of pension funds is important but it is seldom relevant in the usual settings of financial advisors.”

In particular, Statman (2007) notes that clients of financial advisors are most often also the sole beneficiaries of their portfolios. If the client/beneficiary requests the inclusion of social or environmental criteria in investment portfolio, the advisor’s fiduciary duty of loyalty (impartiality) is not a constraint to doing so. In contrast, pension fund fiduciaries and other institutional investors – by definition – have often thousands of beneficiaries, and incorporating ESG criteria that are not unanimously agreed upon by all beneficiaries would violate fiduciaries’ duty of loyalty (impartiality). To summarize, fiduciaries with individual clients have much lower hurdles in recommending SRI and impact investment products to clients than do fiduciaries that are responsible to multiple beneficiaries at the same time (e.g., pension fund trustees).

But there are other constraints on retail financial advisors to SRI and impact investing that a fiduciary standard would likely impose. In particular, the duty of prudence, which requires that fiduciaries use care, skill and prudence exercised by similar fiduciaries, continues to be seen as a major barrier to SRI by many scholars. This is because measuring prudence with reference to the performance of other investors leads to herding effects, since fiduciaries are afraid to stand out among the herd, even if standing out means better managing portfolio risks and enhanced returns. Financial advisors fearing litigation under a new fiduciary standard may be even more sticking to conventional practices and avoiding customized advice and strategies for their clients.

Initiatives to overcome the challenges to SRI that the duty of prudence presents are underway in the institutional investor context. Many scholars, and even some regulators, are beginning to argue that the duty of prudence actually requires that fiduciaries take into consideration ESG factors when making investment decisions on behalf of beneficiaries, since these sustainability issues present material financial risks to their portfolios.

As Canada’s securities regulators contemplate adopting a fiduciary standard for financial advisors, it is essential that this decision includes consideration for the risks of unintended consequences of cutting off clients’ access to the emerging SRI and impact investment opportunities that are now available to retail investors in Canada, and strategies for mitigating these risks.

Some reccomendations for regulators that are contemplating the adoption of the best interest standard for financial advisors include: 

  • Know your client (KYC) form should include questions that consider the client’s values and social impact investment goals. This information should be given equal weight as the client’s financial risk preferences and return objectives.
  • Advisors should be knowledgable about material environmental, social and governance risks of the products that they are offering to their clients. 
  • Financial stewardship must replace financial salesmanship as the ultimate guiding principle for actions of financial advisors. Stewardship invokes a more holistic approach to advising clients on their wealth management.

Finally, it is important that regulators recognize that fiduciary duty is not the only obstacle to SRI and impact investment opportunities. As one scholar points out, “this obsessive focus on the supposed fiduciary law barrier to SRI can overlook other institutional [and organizational] obstacles to its practice.” Advisor education, misaligned incentives and lack of standard approaches to measurement of impact and social returns remain significant constraints to extending SRI and impact investment opportunities available to institutional investors to retail investors. These barriers, among others, are  highlighted in the Retail Impact Investing Guidebook for Canadian Credit Unions, authored by Purpose Capital and the Canadian Credit Union Association.


The Paradox of Standard(s)

As summer vacation season sets in, an important debate is taking place over the potential for the Securities and Exchange Commission (SEC) to require corporate disclosures on matters of sustainability. Contrary to what one might expect, this debate is taking place between investor coalitions themselves.

In a harsh letter addressed to the Sustainability Accounting  Standards Board (SASB), the Investor Environmental Health Network (IEHN) identifies an uncomfortable tension that is plaguing investor coalitions seeking corporate sustainability disclosures: the need for single set of standards to legitimize corporate sustainability disclosure and the limitations that a dominant set of standards has on future innovation.

The SASB has taken the approach of advocating for a single standard for corporate sustainability disclosure, recognizing that many competing and conflicting sustainability reporting standards and definitions of materiality has undermined progress in this area thus far. Drawing an analogy to the evolution of financial reporting standards from a a collection of confusing and conflicting frameworks to a single recognized standard (FASB), the SASB implies that the same evolution in sustainability standards is necessary if sustainability is to be taken seriously.

But as the IEHN points out, the SASB approach relies on a narrow definition of what counts as material information for investors. Materiality as a legal concept is widely used to determine what information a corporation should disclose to its investors, and it is defined as “the information alters the total mix of information in a way that could alter the reasonable investor’s decisions.”

The SASB definition of materiality stops short at information that affects corporate valuation. In its letter to the SEC advocating for the adoption of SASB standards, SASB notes that “If financial materiality and the link to financial impact could not be demonstrated for a particular topic, the topic was not included in the standards.”

To be sure, some efforts are made to account for systemic and cross-cutting issues that affect whole industries, but as IEHN letter points out, this has been ad hoc and lacks transparency. Systemic risks are those that impact whole financial, social and environmental systems and may not be identified at individual or even portfolio level. Systemic risks interact with portfolios and corporate valuations in complex ways and future, particularly for universal owners such as pension funds and sovereign wealth funds, these risks are paramount.

If the SASB intends to be the standard setter for corporate sustainability disclosure, the SASB itself must be held to some standard of accountability. For example, the IEHN notes that SASB seems to have cherry picked climate change as an important systemic risk, but with no transparency over how this risk was selected and why other systemic risks were not.

“The practical reality is that as a market leader, SASB and its standards do not only provide information that investors seek – it effectively plays the role of advising investors as to the type of information that they should seek.” – IEHN, 2016

So on the one hand, the SASB offers up a tested and unambiguous framework that stands a good chance of earning widespread legitimacy if their standards are adopted by the SEC. But on the other hand, the approach that the SASB proposes is frustratingly similar to what conventional finance already does. As the IEHN argues:

“Sustainable accounting…standards as initiated by SASB are a necessary corrective to the failure of market forces and securities regulators to address environment, human rights, governance and other issues of great importance. The poor availability and inconsistency of this data is due in part to siloed economic decision-making; the SASB should not repeat this problem in its Conceptual Framework…”

How, then, are we to make meaningful (i.e. innovative) progress on corporate sustainability disclosures, while also avoiding the confusing and stalemate of multiple and conflicting frameworks vying to set the standard for what counts as relevant sustainability information?

The IEHN suggests that “multiple actions should be considered by the SEC that more adequately reflect the range of investor interest in sustainability disclosures and especially investors whose fiduciary duties necessitate attention to crosscutting and systemic risks.”

But I suspect that the SASB already recognizes the limitations. For example, a recent webinar co-hosted by the SASB, it is suggested that the SASB standards might be complemented by other frameworks, such as the Investment Integration Project, an initiative that aims to help investors identify the interdependence between risks within their portfolios and systems-level risks. And Founder Jean Roberts hints at how these frameworks might complement each other.

In other words, the SASB framework does not necessarily rule out the possibility of building diversified approaches that sees tangible progress on sustainability disclosures, while other ‘parallel’ frameworks continue to push the boundaries necessary for innovation. But if this is the case, then the SASB must make this possibility more explicit in its communications with the SEC and its stakeholders, and refrain from insinuating that the SASB should be the ONLY standard.

And SEC has its part to play in ensuring that on-going dialogue and deliberation over the merits and limitations of whichever sustainability standards are adopted is encouraged.


Uncertainty and the ‘Best Interest’ Standard

On a recent episode of Last Week Tonight, comedian John Oliver made the stuffy topic of financial advisors’ fiduciary duty to their clients both entertaining and informative. To be sure, his analysis skims many of the important nuances of the debate over the fiduciary standard in favour of comic effect. Nonetheless, the point is loud and clear: regulatory changes are needed to mitigate the conflicts of interest between incentives for financial advisors and the financial well-being of their clients. 

In the United States, it is estimated that these conflicts of interest cost investors $17 billion each year in the form of fees and other kickbacks paid to financial advisors. Until the new Department of Labour rules come into full force, it is legal for some financial advisors to recommend high-commission products to their clients, even if these products are not in their clients’ best interest. Add to this the lack of financial literacy among the general population, and it is clear that the average financial consumer requires greater protections.  For example, researchers find that financial advisors encourage their clients to take high degree of risk, while failing to provide customized advice despite charging their clients high fees. And fees eat up a significant portion of an investor’s returns. 

Under the new ‘best interest’ standard, most financial advisors in the US will be considered fiduciaries of their clients. This means that advisors have a legal obligation to make investment decisions in their clients’ best interests. Fiduciary duty involves a higher standard of responsibility than what is provided to a client through a contract.

It seems hardly surprising that some are advocating for this same legal concept to be applied to Canadian wealth advisors. According to Morningstar, Canadian mutual funds have some of the highest fees in the world, and pervasive conflicts of interest in the Canadian wealth advisory industry are widely documented.

But the most recent round of Canadian Securities Administration consultations reveals a nation divided, with regulators in Ontario and New Brunswick both in favour of the principle and Alberta, Manitoba, Quebec and Nova Scotia expressing strong reservations. British Columbia is outright opposed to the adoption of a fiduciary standard. 

Among the regulators that support the adoption of a best interest standard, it is argued that requiring advisors to make decisions that are consistent with the best interests of the client is necessary under conditions of uncertainty. A fiduciary standard can “guide registrants in addressing situations not covered by a specific rule.” 

Interestingly, the same appeal to uncertainty is used by those regulators that oppose the adoption of a best interest standard: The British Columbia Securities Commission is concerned that “the introduction of a regulatory best interest standard over and above the proposed targeted reforms is vague and unclear and will create uncertainty for registrants.” Their point is that the relationship between clients and their financial advisors is often complex. Consider the following example:  “Would an advisor have a fiduciary obligation to disclose to his or her client that a competing advisor offers the same services at a lower cost?” 

So which is it? Does fiduciary duty serve to guide financial advisors’ in an uncertain environment, or does the best interest standard contribute to creating uncertainty for these same advisors? It is probably a little of both. But the more relevant question is who is better able to manage uncertainty?

In the absence of a fiduciary standard, financial consumers will continue to make important decisions about their personal wealth in a cloud of uncertainty. To be sure, disclosure and transparency rules are an important step in the right direction. But these rules are not sufficient. This is because many financial consumers do not have the competencies to make use of this information to make better decisions. Moreover, studies suggest that the average consumer is unable to determine the extent to which advisors are offering them biased advice

Adopting a fiduciary standard means shifting the uncertainty burden from the (mostly) financially illiterate consumers to the financially savvy advisory industry, which is arguably better equipped to manage uncertainty. And at this point it is important to recall that the goal of regulators is to protect consumers, and not to protect the business model of the wealth advisory industry. 

At the heart of this debate then is the question of whether the fiduciary standard would have adverse impacts for financial advisors that would be passed down to their clients. 

One way that these unintended and negative impacts of fiduciary standard could be passed down is by increasing advisors’ compliance costs. It is frequently argued that a best interest standard would significantly increase monitoring and operational costs to ensure compliance. Compliance costs would create a less efficient market structure, where only the largest advisory firms would be able to stay in the market. The end result, it is argued, is that advisors would no longer find it financially viable to serve less wealthy clients, thereby cutting off their access to financial services.   

There are several reasons to be skeptical of these claims. A study of the US market for financial advice finds that despite the difference in adoption of fiduciary standards across states, there was no significant difference in competitiveness of advisory firms, nor does fiduciary standard prevent access to less wealthy clients to financial advice.  In other words, there is no evidence that the fiduciary standard leads to negative impacts for advisors or their clients.  Some advisory firms are even voluntarily adopting the fiduciary standard. And as financial consumer advocate Elizabeth Warren unabashedly points out, some of the most vocal critics of the standard contradict themselves in statements to their shareholders by claiming that fiduciary duty does not present significant challenges to their business model.

Another concern often raised by its critics is that fiduciary duty would adversely impact clients by contributing to a false set of expectations. In a brief summarizing the CSA consultations, it is noted that “clients may expect that all registrants have an unqualified duty to act in their best interest, not understanding that some conflicts would still be permitted.” The brief goes on to note that “it is not possible to require a salesperson of proprietary products only to act in a manner that is truly in an investor’s best interest.”

But this criticism makes forcibly the case for why a fiduciary standard is necessary in the first place; financial advisors should not be regarded as salespersons. We trust our financial advisors with our plans for retirement, our children’s education and our first house. Buying a mutual fund is not the same as buying a vacuum. We share with advisors our most intimate dreams and hopes for the future and we trust our advisors to guide us through a complex set of decisions in order to make them a reality.  Financial advisors must be strongly encouraged to regard themselves as stewards of their clients wealth and aspirations, and not as salespersons. 

Future posts will consider the ways in which financial advisors acting as stewards can add value for their clients and the implications of adopting a fiduciary standard for the availability of socially responsible and impact investment products. 



For an excellent review of literature on the topic, see Punko, N. (2015). Should Canada’s Financial Advisors be Held to a Fiduciary Standard?


Applying a Migrant Lens

In recent work with Purpose Capital and the Carleton Centre for Community Innovation, we argued that investors should refrain from viewing settlement and integration as an ‘impact sector’ in the same way that they view impact sectors like affordable housing or renewable energy.  Instead, the settlement and integration of migrants and refugees is better understood as an investment ‘lens’ in the same way that  gender is considered to be a lens.

Unlike a sector approach, a lens can be applied to all investment decisions and across asset classes (e.g., public listed equities, private equity, alternatives, etc.) and across a range of ‘impact sectors’ (e.g. refugees and affordable housing).

The following provides some concrete examples of how investors might apply a migrant lens to their investment decisions.

  1. Social Finance Models Targeted at Refugees

        a. Micro-lending models for entrepreneurship

Refugee Integration Fund (EU): The fund is in pilot phase in Germany, Sweden and France, and for first four years it will provide grants to micro-finance institutions in Europe that provide loans to refugees for entrepreneurship. Over time, the fund will use a collateralized loan obligation structure that blends capital from a variety of investors (including pension funds, foundations, development FIs, etc.) with different levels of risk tolerance.

        b. Investing in the settlement of refugees

Humanitarian Investment Fund for Refugees: The model proposes the establishment of an endowment fund capitalized by donations for refugees living in overseas camps, that would be used to invest in the settlement and integration of refugees in their new host societies.

        c. Affordable housing and social infrastructure

Council of European Development Banks: Loans to member states for affordable housing initiatives for refugees, such as in Germany. The program also provides loans for micro-loan programs targeted at refugee entrepreneurs.

New Market Funds: Affordable housing investment fund (market-based) launched in Nov 2015, and while it does not have explicit focus on refugees/migrants, the model could be applied to migrants.

      d. Social enterprises/innovations for refugees

Council of European Development Banks Social Innovation Competition: The theme of this year’s competition is innovation to address the refugee settlement and integration crisis in Europe. The competition will award funding to three social innovation proposals. Information on the 30 shortlisted candidates (with some interesting examples of social enterprise) is available here:

  1. Shareholder engagement with companies on migrant/refugee issues

Human rights abuses: e.g., A number of pension funds have either divested from or engaged with Transfield Services, a private firm that has been contracted by the Australian Government to operate off-shore asylum / refugee detention centers. The firm has been accused of a number of human rights abuses, prompting investors that own shares in the firm to divest on ethical grounds, or to engage with the company to change its behavior. Nordea (one of the largest asset mangers in Scandinavia) has recently said that it will be integrating refugees and immigrants into its responsible investment decisions. Sustainalytics, a firm that provides ESG data to investors, has suggested that investors will need to pay more attention to in the future to issues related to refugees and migrants.

Corporate board diversity/diversity at senior management level: The Shareholder Association for Research and Education, which provides engagement services to smaller and mid-sized investors has focused on engagements that push beyond gender diversity to include dimensions such as racial and ethnic diversity on corporate boards and in senior management positions. Engagement on diversity is underpinned by a business case. That is, more diversity leads to better decisions made by companies, ultimately leading to outperformance. McKinsey study provides a good starting point for understanding the business case for racial and ethnic diversity.

Another dimension to this issue is diversity within investment institutions themselves – so for example, investors that are making capital allocation decisions – do they themselves have diverse board and management? California Public Employees Retirement Fund recently emphasized the importance of diversity within their own organization. This could also apply to foundations, social investment funds, credit unions, etc. – are newcomers/refugees represented in institutions that decide where capital is allocated in society?

Corporate complicity in forced migration: Some investors take into consideration factors such as whether a company or its suppliers are contributing to forced migration. For example, Potash Corp. has been the target of engagement by some investors, for sourcing phosphate from Western Sahara on the basis of human rights and forced migration that corporate activity in this region is causing.

  1. Funding for service provider organizations

Immigrant Investor Programs (EB-5 in the US): Academics propose using funds to support investments in refugee- and newcomer-serving social enterprises and organizations.

  1. Others that are interested in SF and integration:

Big Society Capital has recently published a high-level paper addressing the potential of social finance for refugee integration, and it is interesting to note that Canadian models are featured in their initial scan.

Following the first-ever UN Summit on Refugees and Migrants, George Soros announced that he will be investing $500 million in the integration of refugees and migrants.

Poetry and Finance

For most people poetry and finance reflect two intellectual extremes. The former represents the evocative use of symbols and aesthetics to express layers of meaning. The latter represents the scientific use of symbols and technology to express convergence of meaning.

In this post I argue that financial decision-makers have a lot to learn from poets. In particular, investors can improve their decision-making by drawing attention to the layers of meaning and the problems and opportunities of interpretation in finance.

Poetry is celebrated for its layers of meaning and the challenges it poses for interpretation. As with any discipline, there are competing schools of thought about what counts as knowledge.

For some literary scholars, interpretation problems can be resolved through the common sense approach of deferring to the author’s intentions. So when faced with with a confusing and abstract verse, students of poetry are advised to think about the author’s context and intention in order to make sense of the prose. There is only one ‘right’ way to interpret the poem.

Other scholars reject the author-as-authority thesis. In particular, the new criticism tradition emphasizes the importance of focusing on the text and ignoring historical context and the intentions of the author. This view invites a significant degree of scepticism into poetry reading. What one verse means to you may mean something very different to me, and that is ok. There are several ‘right’ ways to interpret the poem.

Somewhere in between the common sense view and the sceptical view lies ambiguity. Ambiguity allows the poet to elicit the reader’s imagination and to communicate complex ideas and tacit knowledge. Ambiguity in a poem is not meant to be resolved. Nevertheless, “ambiguity is not satisfying in itself, nor is it considered as a device on its own, a thing to be attempted. It must in each case arise from and be justified by the peculiar requirements of the situation”.[1] There is no right answer, but this does not mean that everyone’s interpretation is right. There are limits to what counts as a reasonable interpretation, but there is still room for different interpretations.

Consider the famous poem by Robert Frost, the Road Not Taken. The poem is most often interpreted as a reflection of our desire to attribute meaning to our actions. Frost is celebrating non-conformist values associated with forging one’s own path.

Two roads diverged in a wood, and I –

I took the one less traveled by,

And that made all the difference.

While uncertain about what lies ahead on both paths, the traveller is guided to the one right answer by appealing to the value of taking the path less travelled.

A closer and less appreciated reading of the poem reveals there was no right answer. The evidence for which path was least travelled was ambiguous. Consider the verses below.

And both that morning equally lay

In leaves no step had trodden black.

Though as for that the passing there

Had worn them really about the same,

The traveller had to invent a reason to justify her choice to herself and to others after her choice was made. This second interpretation of the poem evokes a dramatically different sentiment than the first interpretation. Rather than a celebration of non-conformity, this second interpretation evokes a godless sense of having to choose without some underlying value to guide us. The use of ambiguity over the relative worness of the two roads allows the poet to communicate this deeper layer of meaning; that is, the irreconcilable conflict between our desire to attribute meaning to our actions and our sheer lack of ability to do so.

A student of finance might be tempted to suggest the traveller could improve her position of uncertainty to one of risk by gathering more information. The traveller might survey other travellers to learn about the relative worness of the two roads. But reducing uncertainty is not the same as reducing ambiguity (indeterminacy). This new information might make the traveller less uncertain about how worn the two roads are. But the new information would still not help the traveller determine which road to choose. This is because the traveller lacks a guiding value for choosing a road in first instance.

It is only after the traveller is recounting her tale to friends that the value of non-conformity is adopted. By attempting to resolve uncertainty and ambiguity (indeterminacy) into one, we overlook the confused state of mind that Frost is trying to convey. That is, by trying to resolve ambiguity, we overlook this interpretation of the poem. The question of which road to choose is an ambiguous one; that is, there is no right answer. But we still must choose. And that is the point.

Questions of this nature fall into a category that conventional finance theory has deemed irrelevant. That is, a question that has no right answer is not worthy of scientific inquiry.[2] For example, what does it mean to be an ethical investor in public equities? What distinguishes a long-term investment from a short-term investment? How can investors manage risks of climate change when fossil fuels are deeply integrated into modern life? How do investors distinguish an impact investment from a conventional investment when the counterfactual (e.g., not making the investment) cannot ever be known?

These questions have no right answers. But these are precisely the type of questions that institutional investors are confronted with in increasingly complex and interdependent global financial markets. It is only by staying with the indeterminacy – by acknowledging the layers of meaning – that investors can make sense of these questions and chart a meaningful way forward.

[1] William Emspon (1947:235) Seven Types of Ambiguity, New Directions: New York.

[2] Fraser Sampson, G. (2014) The Pillars of Finance. Palgrave.

Inventing the Market for Retail Impact Investment

Consistent with emerging international evidence, a new Canadian survey finds millennials have a strong interest in ‘investments that are dedicated to solving social or environmental problems.’ If the demonstrated benefits of differentiation were not enough to convince financial institutions to offer social investment products to their customers, this new market research should lead to more interest. On a societal level, retail impact investment products represents the potential to democratize finance by ensuring that, in the words of Robert Shiller, ‘opportunities afforded to Wall-Street investors are available to Wal-mart shoppers.’

But to date, impact investment products are not being supplied to the masses of retail investors. To be sure, Canada is home to a handful of retail impact investment products, including at least five community bonds and a couple of term deposit products. In the US, the Calvert Foundation allows individuals to invest as little as $20 in a range of impact opportunities through an on-line platform. While these examples show that it is possible to develop investment products that meet an investor’s financial return objectives while also creating positive social and environmental impacts for communities, what they do not show is the possibility of scale that is required to achieve the democratization of finance.

There are many reasons why supply falls short of demand. One explanation is that the barriers to entry are too high. Common barriers to entry include economies of scale, natural monopolies and high switching costs for consumers. Retail impact investment products do not share the characteristics of a product market that has high barriers to entry. For example, banks and credit unions can leverage their existing distribution channels and there are no natural monopolies associated with retail impact products. 

Another commonly cited barrier to supply is restrictive securities regulations. Securities regulations are intended to protect individual investors from unmanageable risk and fraud. Nova Scotia’s securities regulations are often the source of envy; co-operatives are permitted to raise capital for investing in local businesses through a simplified offering document. In other provinces, an offering memorandum exemption that is required of co-operatives seeking to raise capital for investment in local business or social enterprise can prohibit market entry (~$15,000- $20,000, plus on-going costs). 

But regulatory barriers do not explain the lack of deposit retail impact products. Products like term deposits and guaranteed investment certificates are not governed by securities regulations. These products are backed by the balance sheet of the lending institution and are therefore not considered risky for individual investors. Creating new deposit products requires approval from deposit insurance authorities.  Some Canadian credit unions have already successfully navigated the approval process. Even among securities products, regulatory barriers do not explain why there has not been a flood of new retail impact investment products in regions where regulations are more favourable. 

If regulatory barriers and barriers to entry cannot explain the dearth of retail impact investment products relative to the demand, what does explain the mismatch?

High transaction costs provide a more comprehensive explanation for the lack of supply. Transaction costs refers to the costs of using the price mechanism to coordinate production. These costs include search and information costs, and costs of negotiating price and terms of exchange and monitoring. Factors like frequency of transaction, uncertainty, complexity and asset specificity affect the cost of the transaction. In conventional economic accounts of transaction costs, the market is synonymous with the price mechanism. In other words, the market is waiting to be used, and as products and services for exchange become less complex and less uncertain over time as more information becomes available, firms will move to market to coordinate their production. 

But as some scholars point out, the costs of searching, negotiating price and establishing contractual arrangements depend not only on the price mechanism but on a wide range of market institutions. The existence of market institutions is not given.  In other words, the market needs to be invented before a large number of firms can participate in it. “A transaction may be highly complex and specific at one point in time, but much less so once market institutions are developed to support it.” 1

The authors demonstrate this co-evolution of market institutions and industry structure, using an example of a mortgage. Initially, a mortgage was a complex and rare financial product that was coordinated internally by the bank. But over time, standard securitization contracts allowed the banks to sell loans to investors, creating vertically disintegrated market structure. But this required a range of market institutions to support this disintegrated market structure, including “standardized contracts to facilitate sales of loans, institutions for transferring foreclosure rights, rating agencies … and functioning markets to allow investors who have bought securities to later sell them.” The authors conclude that transaction costs are dependent on market institutions.2

For retail impact products, we are beginning to witness the evolution of new institutions to facilitate transactions, such as new distribution platforms for impact investment and the emergence of impact measurement standards. Similarly, as contracting standards for investment management services are established, cooperatives and financial institutions will have more options to outsource production of retail impact products and reduce internal costs of coordinating these services. Indeed, several community bonds in Ontario use the investment administration services of the Toronto Renewable Energy Corporation

But paradoxically, the same institutions that are required to democratize finance also have the potential to undermine the democratization of finance. As mortgages became easier to coordinate in the market and securitization became possible, investors were able to move risks off of their balance sheets through packaging loans and selling them to other investors, creating a complex chain of incentive problems. Indeed, many sophisticated investors and intermediaries profit from complexity.

Peer-to-peer lending platforms are another cautionary tale. Initially viewed by many as a mechanism for the democratization of credit as lending was dominated by retail investors, Wall Street investors are now participating in these lending platforms and securitization has led to a new era where, as the Financial Times reports,” what started as peer-to-peer lending has become enmeshed in the machinery of Wall Street.” (Jan 11, 2016 – Alphaville). 

The good news is that if market institutions are invented and not simply given as is often assumed, then we can shape these institutions in ways that lead to more socially desirable outcomes. Providing access to impact investing to the masses of retail investors in a way that is consistent with democratization of finance will require its architects to invent  new market institutions and avoid the temptation to import of existing market infrastructure.



1 Bresnahan, T. and Levin, J. (2013). Vertical Integration and Market Structure, in the Handbook of Organizational Economics. eds. Robert Gibbons and John Roberts. p 879

2 ibid pg. 879








The Perception of Certainty

“The demand for certainty is one which is natural to man, but is nevertheless an intellectual vice.” – Bertrand Russell

Sustainability issues present multiple and often conflicting problems for firms and investors. Environmental, financial and social issues interact across different time horizons, geographies and logics and it is possible to interpret their significance in multiple different ways. It is increasingly accepted that managing successfully in this environment requires professionals to have a high degree of ambiguity tolerance. Indeed, ambiguity tolerance among business leaders has been correlated with positive outcomes including improved financial and market performance and an increased willingness to take risks, break with routines and devise innovative solutions by resisting the temptation to choose between the choices that are given to them.

Despite the widely appreciated benefits of ambiguity tolerance, empirical research suggests that in general, decision-makers are poor at remaining open to alternative interpretations of the same information. Sometimes, our attempt to resolve ambiguity is a conscious process. We intentionally close off our interpretation process by looking to convention, norms and standards to guide us to the right answer. In other instances, we may not even realize that we are trying to resolve ambiguity. We may unintentionally fixate on a particular interpretation, depending on our emotional state or the context in which the information is presented to us, and shut out other possible ways of seeing the same information.

Why do we seek certainty, even when we are aware that a belief in certainty is not good for us? Insights drawn from cognitive and brain science research often informs theories of how decision-makers process complex and ambiguous information.

Cognitive biases influence our decision-making in two ways. The first is by directly affecting the components that make up our decision-making frameworks, such as belief systems, values and judgment. The second is by affecting the inputs for decision-making; that is, by shaping our perception of external stimuli.

Perception is the process of identifying, organizing and interpreting sensory stimuli. Cognitive sciences explain how perception interacts with decision-making frameworks in complex ways. Insights from cognitive research are considered by conventional finance to be ‘soft science’ and reserved for those working on the margins of finance.

In contrast, conventional finance relies on brain sciences to form the core of its conception of human decision-making. While detailed expositions of neurological processes rarely appear in finance papers, the strictly physical system of processing information is almost always assumed. The brain receives signals from external sensory stimuli and assigns to them unambiguous meaning to inform the most appropriate or rational response. Beliefs are probabilities that are formed by observing frequencies of events. We can update our beliefs with new information (the facts) and we can enhance the confidence in our beliefs with repeated observations. Subjective and objective beliefs respond in the same way to new information. Individuals’ perception and emotion have no bearing on aggregate market outcomes.

A unique branch of cognitive and brain sciences study the way that humans process ambiguous information – that is, stimuli that induce multiple stable perceptions. The majority of this research focuses on visual stimuli. Most people will be familiar with the image below. Can you see the duck? Now what about the rabbit? Researchers have used these Gestalt images to understand what explains reversals in our perceptions of multi-stable sensory stimuli. That is, why do we switch between seeing the rabbit and the duck?

duckThe predominant view in the literature suggests visual sensory functions, referred to as lower-level processes (physiological structures in the brain), are responsible for changes in our perception. The ability to perceive multiple interpretations of the same image is the result of a process referred to as reciprocal inhibition. This process works to suppress all but one of the interpretations of an ambiguous image. Over time, the brain grows physically tired of suppressing one version and the balance in the sensory network reverses to bring into cognition the alternative interpretation. This is described as a random process.

The interaction between cognitive and brain sciences offers a richer explanation for why decision-makers tend to fixate on one interpretation and deny the possibility of other equally valid interpretations. In particular, some researchers conclude that it is the interaction of our higher-level functions – those cognitive functions responsible for processes such as analytical thought, belief and planning – with the lower-level sensory (physical) processes that allow us to alternate between interpretations of the same sensory stimulus. Put another way, the sensory area of the brain is guided and influenced by higher-level cognitive functions. Moreover, the process of reorganization in the brain that is required to alternate between different perceptions of a stimulus is itself an expression of behaviour. In this way, perception is not an automated and random response to sensory stimulus but rather, an active response that can be conditioned and controlled, to some extent.

What researchers find that we are poor at doing is to combine the alternative perceptions into a single hybrid image. While we may be capable of perceiving both the rabbit and the duck, we cannot see both at the same time. Our brain has one conceptual frame for a duck and another frame for a rabbit. Similarly, when presented with binocular rivalry, where each eye is shown one of two mutually incompatible images such as a letter and a number, participants were found to fixate on one of the stimuli and eliminate the other completely from consciousness.

This tendency to fixate on one interpretation at a time has been explained by the idea that the brain works in categories, concepts and analogies, colloquially described as ‘chunks’ by cognitive scientists. These chunks allow us to perceive information in a way that constitutes a complex but coherent system. Once we build up complex concepts into simple unified wholes, we lose sight of their internal components. Scholars often use the example of Wikipedia. We can convey this complex concept in a single word without having to think about its constituent parts, such as encyclopedia, networks, peer editing, publishing and computers.

Because we think in conceptual chunks, cognitive scientists believe that changes in our perception occur as a unified shift from one global concept to another. For example, when shown a series of sketches that progressively change from a dog to a cat, researchers were able to identify the point at which most participants switched from claiming to see a dog to claiming to see a cat. Similarly, when we move to a low interest environment, the conceptual edifice shifts with it (e.g., inflation, increased investment). We economize on thinking by using conceptual chunks to stand for a whole range of complex and interdependent concepts.

This difficulty in perceiving multiple stable stimuli is particularly relevant for finance. In finance we are not dealing with the multi-stability perception problems of the duck-rabbit variety. Financial data are complex, with many different inflection points that could lead to a change in perception. The ability to continuously alternate between different interpretations of the same sensory stimulus is necessary to ensure we are adopting the most robust interpretation, within a given context.

To be sure, it is important that at some point we close off the interpretive process and act. This process of closing off allows us to respond to the situation. If we did not close off, it would be impossible to act. But the notion of a single ‘best’ interpretation in a complex and ambiguous decision environment is elusive. We must balance openness with the need to periodically close off the interpretation process in order to act, only to open back up again once decision is taken to alternative subsequent decisions.

While this is by no means a comprehensive review of the cognitive and neuroscience literature, the point is to highlight the scientific basis for explaining how perceptual changes occur when decision makers are presented with ambiguous stimuli. Perceptual change is increasingly understood to be the result of the interaction between cognitive and brain processes. The interaction between cognitive processes in the mind and the physical sensory processes in the brain is a promising area for new research in the decision sciences and its applications for complex sustainability problems.





Integrated Investing Requires Integrative Thinking

Sustainable Investors and Ambiguity Tolerance

The Principles for Responsible Investment Secretariat recently published guidance for investors on managing risks arising from interactions between climate change and local water supplies and the resulting impacts on companies higher up in the agricultural supply chain. Academics, civil society groups, beneficiaries and policy makers are increasingly challenging asset owners and their managers to incorporate complex and interdependent issues in their investment analysis that require several layers of analysis.

This is tall order for an industry that only a decade ago began to recognize that environmental, social and governance (ESG) factors could have an impact on the financial performance of their portfolios. But the emergence of sophisticated intermediaries, sustainability reporting standards, collaborative platforms and technology firms dedicated to structuring big data to provide real-time ESG analytics all provide reason to be optimistic about the capacity of investors to their investment portfolios.

Still, others are calling for deeper commitment, drawing attention to  systemic-level risks and opportunities that are intimately linked to performance at the portfolio-level. In the past, the portfolio-level was the only basis on which investors could reasonably be expected to manage risks. But as the significance of the financial industry relative to the economy grew, alongside the diminished influence of regulators on global financial markets, investors now require an integrated understanding of the relationship between portfolio-level risks and wider environmental, societal and financial systems-level risks (Lydenberg 2015).

What is surprising about such an ambitious agenda is its relatively low ambition for changing the infrastructure of financial decision-making. In listing the changes that would be required to shift to a focus on systemic frameworks the author suggests that,”asset owners will manage their investments along two parallel, but separate tracks – with differing metrics for measurement. Systems-level measurement would require directional and qualitative assessments of impacts on the sustainability and enhancement of systemic frameworks. The measurement of portfolio returns will remain much as it is today – that is, in relation to market prices (Lydenberg 2015, p. 25).”

But this conventional approach to managing investments is what has contributed to systemic risks so dangerous in the first place, as it requires ignoring externalities that cannot be risk and uncertainty reduced to risk. In other words, we can imagine instances where portfolio-level decisions and systems-level decisions would be in direct competition with each other.

Integrated investing requires integrative thinking. Integrative thinking in management studies is often used to explain otherwise indescribable quality of successful leaders that hold “conflicting ideas in constructive tension, and use the tension to think their way toward new and superior ideas.” Integrative thinkers have a higher tolerance for ambiguity.

While integrative thinking is often treated as a skill for leaders to cultivate, this ignores the institutional environment in which financial decision-makers operate. Integrative thinking is at odds with the institutions that govern investment decision-making. Accounting students exhibit a lower tolerance of ambiguity than students in other disciplines. In one study, researchers find that low ambiguity tolerant individuals perceive higher level of risk under same circumstances and are more likely to ignore or discount ambiguous information when ambiguity relates to positive information. Integrated thinking requires institutional and organizational level changes to introduce new decision -making frameworks and incentive systems that accommodate decision problems for which there is no right answer.

But this forces another question: why do our institutions and decision-making frameworks favour problems that have a right answer? What would lead us to assign more weight to the portfolio-level risks than to systems level risks in instances where there is a conflict between them?

In a thought experiment conducted in the 1960’s, Ellsberg provides a behavioural answer to this question. Agents are given the choice between selecting coloured ball from two urns; one urn where probabilities are known and the other where probabilities are not known. The result was that decision-makers have a strong preference for betting on the urn for which probabilities are known over the urn where probabilities are not known. The violated Leonard Savage’s Sure Thing Principle, a pillar of the subjective  decision-making theory that allowed decision-makers to extend the ‘machinery of probability’ to guide decisions under conditions of uncertainty (see Gilboa 2009). In other words, decision-makers should be indifferent between betting on the two urns.

A behaviouralist explanation for this result is that individuals are only averse to ambiguity when making decisions that they know will be compared to a more knowledgeable decision-maker. But when making decisions about events on which no one has sufficient information, ambiguity aversion disappears.

For many observers, behavioural biases justify the continued use of decision-making frameworks that assume all problems can be treated as risk or uncertainty that can be reduced to risk with more and better information and with subjective probabilities.  Once we give way to the possibility that uncertainty as permanent, we lose the war against uncertainty.

In his conclusion to “Against the Gods”, Peter Bernstein warns that ” we must avoid rejecting numbers when they show more promise of accuracy than intuition and hunch, where, as Kahneman and Tverksy have demonstrated, inconsistency and myopia so often prevail.”

But as Ellsberg and those following in the behaivoural tradition have shown, our need for certainty (and consistency)  is itself a bias, just like myopia, confirmation bias and other pathologies that affect our decision-making abilities. Certainty is an increasingly dangerous bias in a complex environment.  It leads us to continue to see problems in terms of rigid trade-offs, and to assume that there is always a right decision and that the remaining decisions are wrong. This thinking is the reason that systemic level problems arise in the first place. There will always be some externalities that are too messy to incorporate into financial decision-making, no matter how sophisticated our models and how ‘big’ our data.

Until the frameworks that govern investment decision-making change, sustainable investors that are willing to take up the ambitious goals of integrated investing will need to learn to think and act in shades of grey, but continue to justify their actions in black and white.

If this conclusion is unsatisfying, then perhaps we can find inspiration in other disciplines that have greater tolerance for ambiguity. Law has jurisprudence; a conceptual space where legal scholars and student of law can contemplate and debate legal systems and internal contradictions. Finance needs the same: a place where students of accounting and finance can contemplate meaning of financial systems and the problems internal to financial systems.*

* This idea is presented by Guy Fraser Sampson (2014) in ‘The Pillars of Finance’, Palgrave MacMillan.

Lydenberg, S. (2015). Portfolios and Systemic Framework Integration: Towards a Theory and Practice. Exposure Draft, November 16.









Investors Must be Part of the Solution to the Integration Challenge

Financial institutions, including credit unions, banks, foundations and pension funds, are paying increasing attention to the societal impacts of their lending and investment decision-making. Motivations and strategies for doing so range from long-term investors seeking to manage societal and environmental risks that adversely impact their investment portfolios and to identify new sources of value, to philanthropic and community-minded investors seeking alignment between their investments and their overall missions.

Against the backdrop of growing uncertainty in financial markets caused by the wave of anti-immigrant rhetoric dominating many nation’s political agendas, this article explores how these same investors on how to mobilize their investments to address urgent issues around immigration.




Diversity and Meritocracy: What Tradeoff?

As of January 2015, most publicly listed companies on the Toronto Stock Exchange are required to disclose details of their board diversity policy or to explain why they do not have a policy. The ‘comply or explain’ regulation reflects the latest in a spate of regulations introduced across global financial markets to encourage gender diversity in the boardroom. As the proxy circulars came filing in this spring, it became quickly apparent that many companies are held back by the perceived trade-off between selecting qualified candidates and incorporating diversity criteria.

To be sure, some companies, particularly in the finance, real estate and utilities sectors, have made great strides on board diversity. But outside of these sectors, companies could easily be mistaken for relics of the Feminine Mystique era of the 1950s. One sector that stands out in particular as a laggard is oil and gas. According to the 2014 Canadian Board Diversity Council survey, of the 608 directors in the sector, 9.7% or 65 are women. To be fair, the limited number of female candidates with experience in the sector presents a challenge for recruitment, as many companies explain. But a closer look at the explanations provided in proxy circulars reveals a much deeper form of resistance to diversity.

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