Views on improving the integrity of global capital markets
03 May 2021

ESG Q&A: Moving Beyond Modern Portfolio Theory

Posted In: ESG, Investment Topics

We are talking today with Jon Lukomnik and James Hawley about their new book Moving Beyond Modern Portfolio Theory. Jon is a long-time institutional investor and managing partner at Sinclair Capital and James is senior environmental, social, and governance (ESG) adviser at Factset and professor emeritus at St. Mary’s College of California. This book takes a look at modern portfolio theory (MPT), including where it came from, the potential limitations of MPT in factoring in ESG information, and the systemic risks we increasingly see in our investing world.

CFA Institute: Jon and Jim, can you tell us how this book came about and discuss a little more about the main argument of the book.

Harry Markowitz won the Nobel Prize for inventing MPT in 1952 for good reason. His insights into the nature of diversification changed investing. But MPT’s key tool, diversification, works best on idiosyncratic risk. By contrast, MPT says that you cannot diversify away systematic risk since the volatility correlates.

This is what we call “the MPT paradox.” There are two major elements to the paradox. The first is that systematic risk determines 75–94% of your return, leaving as little as 6% of risk able to be diversified. So, in effect, MPT tells us that you can affect what matters least. The second part of the paradox is that MPT is wrong about systematic risk: Yes, systematic risk affects portfolios, but contrary to MPT, portfolios and investing activity also affect systematic risk, for better or worse. Feedback loops abound. Just think about risk on/risk off markets, or index effects.

So the question becomes can you deliberately impact the systematic risk/return of the market? Again, the answer is yes. The largest investors in the world actively try to mitigate the environmental, social, and financial systemic risks which often cause systematic risk in the capital markets. Their actions seek to impact the overall risk/return profile of the market.

Practice has clearly led theory. We felt it was time to examine this and understand what was going on in a holistic way.

CFA Institute: You talk about some of the shortcomings of MPT in your book. Without giving away too much, can you briefly tell us about some of these shortcomings?

There is an ecosystem of theories that intertwine with MPT, including the efficient market hypothesis (in all its forms), the ideas that humans are rationally risk-adverse, and random walk theory. They enable MPT by hermetically sealing it away from the real world. Combined, they create the perfect myth: Easy to understand yet mathematically complex and therefore powerful in its explanatory power, and wrong.

Yet somehow the myth persists. One result is that investing has become self-referential. For example, we measure success against relative return capital market benchmarks. If a portfolio manager outperforms by 2% in a down 10% market, that PM has demonstrated skill. But is that the purpose of investing? Or even of Markowitz’s original least mean variance portfolio? The end investor still only has 92 cents on the dollar to retire upon, to fund a mortgage, etc. The least mean variance portfolio should be inclusive of the total risk/return. Benchmarks, relative returns, and alpha have become omnipresent, but false, goals.

As a result, we focus on security selection, trading, and portfolio construction—all internal to the capital markets. (Even the majority of indices are capitalization weighted, which means that the internal focus has been mechanically transferred to passive investors.) Think of it this way: If the entire market were a portfolio, we should be focused on how to improve the Sharpe ratio of the market as a whole, over time, not just on how to extract the best possible return from it as it stands today.

CFA Institute: CFA Institute is undertaking a project on materiality, to help ameliorate some of the confusion around the world surrounding these issue and to highlight best practices. Can you talk a bit about your views on materiality and how it informs your research? If you say something extremely clever, we are likely to “borrow” it for our project.

Norm shifts and new understandings, once adopted by a critical mass of investors, firms, the general population, and sometimes regulators, become financially relevant and sometimes legally “material.” Though fascinating, that is not new: The social construction of markets has been widely studied by sociologists, anthropologists, economists, organizational theorists, and others.

What has attracted less attention is the confluence of how the world invests today and materiality. Materiality in the United States relates to what facts a reasonable investor would consider in making an investment decision regarding a particular security. Yet most investors hold diversified portfolios. For a diversified investor, systematic risks to the market overall, rather than to a particular company, drive the majority of risk and return. We could call this the scope and focus of the reasonable investor. This is new. The question for that investor, then, is both how a particular risk factor, such as climate change, affects a particular company, but also how does that company affect the systematic risk that climate change poses for the overall portfolio. In other words, it is not just outside-in materiality, or what the world does to a particular company, that a diversified investor needs to understand, but inside-out materiality, or what that company does to the world.

CFA Institute: You talk about how investors can work better now to mitigate systemic risks, and therefore improve the risk/return dynamics of the market as a whole. Can you give us examples of investors doing this?

There are scores of [examples]. Climate change, deforestation, biodiversity, gender and ethnic diversity, antimicrobial resistance, income inequality, the governance of technology are some of the better known. Let’s talk about a down-and-dirty one, literally, mining safety. First, it’s a really good example. And, second, some of the most interesting beta activism work is organized around a specific industry, because all companies in an industry are exposed to the same systemic risks.

Many mines discard and store by-products in tailings pools. Those pools can be toxic and are held in place by tailings dams. Unfortunately, tailing dam collapses have been fairly frequent. In January 2019, in Brazil, a dam collapsed, sending a tailings wave seven kilometers downstream and killing 259 people. Eleven are still missing. The market value of Vale, the mining company, plunged $19 billion.

Galvanized by the disaster, a coalition of asset owners and asset managers, with an aggregate $13 trillion under management, formed the Investor Mining and Tailings Safety Initiative. First, they advocated for “a new independent and publicly accessible international standard for tailings dams based upon the consequences of failure.” The resultant standard-setting effort, co-convened by the Principles for Responsible Investing, the United Nations Environment Program, and the International Council of Mining and Metals, issued the Global Industry Standard on Tailings Management in 2020. Second, the investor coalition tackled the lack of transparency around tailings and mining by-product storage. There was no database or inventory of all tailing dams globally. The investor coalition wrote to 727 extractive companies, seeking specific public disclosures about tailings dams and safety initiatives. More than 65% of the industry has now fully and publicly disclosed the information.

CFA Institute: There are a number of efforts to establish standards from better disclosures around ESG data and climate change, with the Sustainability Accounting Standards Board (SASB) and the Task Force on Climate-Related Financial Disclosures (TCFD) being two of the most prominent. In your opinion are such standards working as intended or do we need something else?

The answer to your question depends on what you think the intention was. They have certainly provided rallying points, turbocharged the discussion, and accelerated action. Of course, many will say too slow. But their effect has been major and directionally correct. A recent example is the coming together of the IIRC [International Integrated Reporting Council] and SASB in the form of The Value Reporting Foundation.

But even their advocates would agree we need something else. The question is what that “else” is. Right now there is a consensus about the directionality—relevant, robust, comparable, and assurable—but no agreement about how to apply that or even how to reach agreement. That said, we view the current chaos as an irresistible force, heading in the right direction. No one can keep up with all the private market, regulatory, scientific, and academic developments around standard setting. The private market and governmental efforts are all over the place, like a teenager trying out his/her rapidly growing body. It might take a few years, but eventually that force will mature into a set of disclosures that will be robust, comparable, and assured.

CFA Institute: As most of our readers know, the EU is far ahead in developing policy around disclosures and regulation to address some of the unpriced systemic ESG risks you talk about in your book, with such efforts already underway in some markets, and the United States just starting down this road. What role do you see such policy and regulation playing in addressing the issues you highlight?

Here in the United States, we were thrilled to see that 94% of all investors disagreed with the 2020 DOL [Department of Labor] proposals which suggested ESG was about social preferences. And we were even more excited that a number cited the ability of investors to address systemic risks through ESG. The new administration seems determined to encourage investors to tackle climate change, and perhaps other systemic risks, though we caution that it’s early days yet.

In the United Kingdom, the FRC’s [Financial Reporting Council’s] Stewardship 2020 report made it clear that the government expected asset managers and owners to address systemic risk issues as investment issues. In the EU, they are far down the road to codifying the idea of “double materiality” or the outside-in/inside-out materiality we just discussed. So government, around the world, is moving towards understanding the potential for systems-aware investing, although there is significant pushback as indicated over the current EU debate over the Taxonomy.

CFA Institute: You state in your book that we are in the third stage of corporate governance, in which we are just starting to get our heads around how to deal with systemic risks. Can you explain briefly how we got here and how you see this third stage evolving?

Stage zero started with the Dutch East Indies company. It set the broad standard of corporate governance for about 350 years. Despite scandals around piracy, insiders growing mysteriously wealthy, and either not paying promised dividends or paying them in nutmeg rather than money, the executives of the company ruled with an iron fist. Clearly, the specifics changed over three and a half centuries, and varied by jurisdiction and company, but really, the locus of power didn’t change.

Stage one, where power began to be more equally balanced between executives, the board, and investors, began in the mid-1980s. Asset management had been institutionalizing largely as a result of MPT’s influence, which created a desire for professionally managed and instantly diversified investment product. That institutionalized asset base had not really been activated, however. With the advent of greenmail in the 1980s—the capital market equivalent of blackmail and cyber-ransom attacks—the newly empowered institutional investors started to fight back. You saw the creation of the Council of Institutional Investors in the United States, the Cadbury report in the United Kingdom, and the OECD [Organization for Economic Cooperation and Development] governance principles globally, along with a host of corporate governance reforms in various jurisdictions.

Stage two was delineated by the creation of the Principles for Responsible Investing in 2005, when the E and S started to become equal co-stars to the G. Stage two governance broadened the definition of performance from a somewhat narrow, purely financial statement performance focus to a more macroeconomic view. However, though stage two corporate governance expanded the focus from a narrow definition on financial performance and “traditional” corporate governance concerns (i.e., traditional from the mid-1980s) to include environmental and social concerns, the focus remained on individual companies, not on systems.

Following the global financial crisis of 2008–2009 and with the increasing acknowledgment of the climate crisis, large institutional investors began to focus on how systemic risks translated into financial risks. Though it builds on stages one and two and incorporates them, third stage corporate governance differs in that it targets systematic risks, not individual companies. In some ways, it is an extension of universal owner theory, which says that for a large, diversified owner, externalities from one company can be reinternalized by affecting other companies in the investor’s portfolio. But third stage corporate governance additionally recognizes the interrelationships between risk to the real-world environmental, social, and financial systems and the capital markets on a systemic level, not on a company-by-company level.

CFA Institute: You introduce the concept of “beta activism.” Can you explain what this is in practice and give us an example or two to illuminate the idea?

The investor coalition around mining and tailing safety was one example, but let’s talk about the Boardroom Accountability Project, initiated by New York City Comptroller Scott Stringer, on behalf the city’s pension funds. Frustrated by the inability to directly nominate directors at US public companies, Stringer announced an effort to do that through a mechanism called “proxy access.” At the time, in 2014, only six public companies in the United States featured proxy access.

The pension funds targeted 75 companies, chosen because they were exposed to other risks—for example, 33 were in carbon intensive industries, and 24 had little or no gender, racial, or ethnic diversity on the board.

Stringer and the New York City’s funds’ efforts to be beta activists has largely worked. As of July 2019, five years after the campaign’s launch, more than 600 US public companies feature proxy access.

The Boardroom Accountability Project [BAP] hints at the magnitude of impact beta activism can have. It has created a de facto standard for proxy access among large capitalization US public companies. It has (along with many other initiatives) increased diversity amongst the directors who oversee and guide US public companies. A recent academic paper has said that the companies targeted for environmental reasons have disproportionately decreased toxic emissions.

And it improved the risk/return of the overall market. Researchers found Stringer’s announcement caused those 75 companies to experience a 53-basis point excess return. At the time, the city’s funds held more than $5 billion in the stock of those 75 companies. Based on the 53 basis points of excess return, the BAP created some $26.6 million in excess return for the city’s pension funds. The total market impact was more than $25 billion in just those 75 companies. Were one to assume an equivalent reaction across the equity market, the increase in value caused by the funds’ beta activism would have been $132.5 in increased market capitalization. And the study suggested that on a marketwide basis, it would have been even greater.

As an aside, we estimate that globally all the various beta activist efforts have added about $2–5 trillion in global wealth to the public capital markets.

CFA Institute: What do you hope investors, issuers, and policy makers learn from this book? Five years from now, what do you hope that it has influenced in our understanding of markets and investing?

This is not a modest book. The purpose of this book is to redefine what investing is, how it’s done, and what it’s true north is. We want to reunite investing and finance theory with its real-world purposes of intermediation and creating an optimal risk/return portfolio (total risk and total return, not just on a relative basis). That is, reconnect in a positive way investing and finance with the broader socioeconomy. It already has effects, of course, but these are rarely on the investment radar screen save time of major financial crises.

To our knowledge this is the first book to suggest that investors’ efforts around issues such as climate change, gender diversity, mining safety, public health, and the governance of technology form a coherent challenge to the MPT paradox and MPT’s tenet of beta exogeneity, rather than being a series of isolated incidents. The ability to mitigate systemic risk changes almost everything about investing. It means improving the overall market return is both more powerful than beating that market return through security selection and that it is possible to do so. It means that much of today’s focus on relative performance is myopic, because focusing on system health over the long term will positively impact financial and economic returns more. And it portends a powerful new force in the fight against global warming, income inequality, gender, ethnic and racial discrimination, and other systemic risks that threaten to depress returns, not to mention disrupt society.

Photo credit @ Getty Images / Kiyoshi Hijiki

About the Author(s)
Matt Orsagh, CFA, CIPM

Matt Orsagh, CFA, CIPM, is a senior director of capital markets policy at CFA Institute, where he focuses on corporate governance, ESG, and climate change analysis. He writes and speaks frequently on these topics on behalf of CFA Institute. His paper, Climate Change Analysis in the Investment Process was named “Best ESG Paper” by Savvy Investor in 2021.

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