Sustainable investing is hot. Investment firms spend billions on stewardship activities and in search of data. Investors submit nearly 500 environmental and social proxy proposals a year to U.S. corporations. Investor-led coalitions fight for diversity, against antimicrobial resistant bacteria, for mining safety, and, just this week, for seats on the board of Exxon in a climate fight. Why?
There are three standard answers: First, those who integrate environmental, social, and governance factors into their security analysis seek to outperform by considering risks and opportunities that others miss. Second, socially responsible investors attempt to align their portfolios and values. Third, impact investors try to improve society and the planet.
But we believe there is a fourth reason, and it is transforming finance. These activities form a coherent challenge to the limitations of modern portfolio theory. MPT, the dominant investment paradigm in the world, focuses on diversification to minimize risk.
MPT is unique in being largely self-contained. It is unconcerned with the feedback loops between capital markets and the real world. Risk and return are judged against market-relative benchmarks such as the S&P 500 index. Price and volatility can transmit some limited and typically immediate information between capital markets and the real world, but MPT is uninterested in the causes of price variability. For MPT, volatility is the only risk metric. MPT is designed to extract the optimal risk/return portfolio from the extant market at a point in time.
That approach creates a paradox. Systematic risk that affects the whole portfolio, not stock selection or portfolio construction, determines the vast majority of your return, 75% to 94%, depending on which academic study you cite. Diversification, the core tool of MPT, powerfully mitigates idiosyncratic risk, but is impotent when real world events like the global financial crisis or the pandemic affect virtually all securities. Systematic risk causes correlations to converge toward 1.0.
In other words, diversification is a great tool to affect 6% to 25% of the variability in your return. But MPT says you cannot escape or affect systematic risk; you just have to accept it. That is what most investors have done traditionally: Either accept the vagaries of the market by investing passively through an index, or seek to outperform through security selection, even though it affects only a minority of the total return. Effectively, MPT says that you can’t affect the overall market, so you might as well focus on what you can control. In that way, investors focus on what matters least. This is the MPT paradox.
However, your investments do affect the overall risk/return of the market. Think about risk-on/risk-off markets or index effects. Those are investors having an impact on the overall market, albeit unintentionally. The question is, can investors intentionally improve the risk/return profile of the overall market?
Here is where the causes of volatility matter. Systematic risk virtually always is caused by real-world events, especially changes to environmental, social, and financial systems. Other causes include central bank actions and political developments.
Consider all of the resources that investors bring to bear in the name of sustainability. Investor-led campaigns attempt to reduce risk across the entire market or across entire industries or segments, rather than pick securities. This is “beta activism,” which seeks to reduce systemic risk in the real world before it can become a nondiversifiable systematic risk in the capital markets. Notably, there is a significant difference between such beta activism and the type practiced by Carl Icahn or Nelson Peltz, which focuses on the financial performance of a single company.
This type of beta activism should be recognized as attempts to mitigate nondiversifiable systematic risk in a way that MPT never contemplated. Investors have misunderstood what’s at stake for two reasons. First, to be a material, systematic risk, the root causes need to be big. As a result, they are usually dramatic and newsworthy, as climate change and gender diversity are. When investors tackle those issues, their actions are often viewed as a series of one-off social or political efforts. Second, many investors, academics, and even regulators have been indoctrinated over the past half-century of MPT’s ascendance to think of trading and portfolio construction as the heart of investing, even if stewardship activities can have more impact on total returns. Many of these nontrading activities involve policy, private-sector standard-setting, investor and stakeholder education, proxy battles, and other nontrading activities.
To people accustomed to a cloistered view of finance, engaging risk in the real world may seem radical. But it is modern portfolio theory that is artificial in viewing investing as disjointed from the causes of value creation and destruction. It is time for theory to catch up with practice and to recognize investors’ actions for what they are: sequential manifestations of attempts to improve the overall market/risk dynamic in a way that modern portfolio theory cannot. They are extending investment risk-management to the real-world root causes of systemic risk that create market volatility.
Jon Lukomnik is managing partner of Sinclair Capital. James P. Hawley is senior ESG advisor at Factset and TruValue Labs, a FactSet company. They are the authors of Moving Beyond Modern Portfolio Theory: Investing That Matters.
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