systemic sustainability risks need to be integrated into modern portfolio theory

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Currently, changes in materiality and the risk / return profile of capital markets are considered entirely exogenous by MPT

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Viewed with historical distance and perspective, the links between societal norms, law, regulation, and corporate behavior are quite obvious. What is considered socially acceptable (in the market) changes over time and place, sometimes slowly and sometimes quite quickly. Slavery, although still controversial among non-slaves (barely controversial among slaves), was an integral part of early capitalism, but was eventually made illegal (although we do note that quasi-slavery and clandestine practices continue ). The same goes for child labor, occupational health and safety standards, working hours, workplace discrimination and a host of other issues.

Businesses and investors traditionally view values, during the period when they are merging into societal norms, as “non-financial”. A better term might be ‘not yet financial’, making it clear that changes in standards and new understandings, once adopted by a critical mass of investors, businesses, the general population and sometimes regulators, become financially. relevant and sometimes legally “important”.

Companies and investors who are sensitive to this process of generalization of problems, then seen as creators or destroyers of value, can benefit from positioning themselves where the company is evolving, rather than where it was. Indeed, the social construction of markets has long been studied by sociologists, anthropologists, economists, organizational theorists and others.

Of course, standards are not just about ethics and morals, but encompass all changes in what society considers acceptable behavior. Our better understanding of science also requires us to confront these ideas. For example, it has been known for millennia that groundwater can be contaminated, which impacts not only the ecosystem, but also the production and livelihoods that depend on potable and useful water. But, as these understandings deepened and changed, new norms of behavior developed. From these, new regulatory and legal standards have developed, most often in the face of intense opposition from polluting companies. Today, issues such as climate change, how to deal with the pandemic and loss of biodiversity continue these science-driven changes.

Externalities, although a central idea in standard economics, are foreign to the mindset of modern portfolio theory.

Materiality from this point of view is not a state of being but a dynamic process of becoming over time, as human knowledge and beliefs evolve. Jean Rogers and George Serafeim suggest that the catalyst for the process of “becoming material” occurs when business practices and social norms diverge sufficiently. Stakeholders (including investors and regulators) are responding to these changes. In turn, companies often – but far from always – react if they see an opportunity or if their interests and reputation are threatened.

However, as we explore more in depth in our new book, Going Beyond Modern Portfolio Theory: Investing That Matters, modern portfolio theory (MPT) does not respond to changing standards that create systemic risks or opportunities. Every portfolio has been washed down by the global financial crisis. Every portfolio experienced a sharp drop and recovery at the start of the pandemic. Every portfolio is threatened by climate change. Systemic risks in the real world create systematic, non-diversifiable risk in capital markets. Such changes in materiality, and the resulting change in the risk / return profile of capital markets, are considered entirely exogenous by MPT.

Fortunately, the practice led to the theory. Investors appreciate the dynamic process of ‘getting material’ and are increasingly taking action to mitigate systematic risks such as climate change, lack of diversity, industrial issues such as mine safety and scientific developments such as the growth of bacteria resistant to antimicrobials.

Two relatively recent major changes affect the context of the process of “becoming material”. One is how the world invests today. Legally, materiality in the United States relates to the facts that a reasonable investor would consider in making an investment decision regarding a particular security. Yet most investors hold diversified portfolios, such as in an S&P 500 index fund. For a diversified investor, systematic risks to the market as a whole rather than to a particular company determine the vast majority of risk and return. . The question for that investor is then both how a particular risk factor, such as climate change, affects a particular company, but also how that company affects the systematic risk that climate change poses for the entire portfolio. . In other words, it is not just about outer-inner materiality, but also inner-outer materiality. Indeed, the impact of the externalities of the companies on the other companies of a given portfolio – what one could call “inside-out” (for a company) leading to impacts “outside-in” – is a problem. universal owner classic. But, this dynamic is foreign to MPT. Externalities, although a central idea of ​​standard economics, are foreign to the mindset of MPT.

This concept of “double materiality” is increasingly recognized around the world, both for the reason for the diversified portfolio cited, and for another contextual change: the sheer size of today’s global companies. The impact of business on the information you absorb, how and what you eat, your health and your wealth is far greater than it was a generation ago. The impact of business on our daily lives rivals if not exceeds that of government. Small actions that deviate from social norms, which a generation ago would not have been seen as having a societal impact, are doing so now. For example, when each local banker made their own lending decisions, it would have been unfair and illegal for your local bank to make sexist lending decisions, but it would not have affected the population enough for it to be a risk. systematic, assuming the next bank was unbiased. But, when the credit of each is calculated by only three companies, any systematic bias of one of them would affect the whole economic and social system.

Dual materiality resolves the issue from the inside out or out, but creates the paradox of materiality: as part of the assessment of how developments affect systemic health, an investor, an investor, a supplier, customer, employee or simply citizens in general could reasonably be interested in the impacts of a company on society, the economy and the environment. But companies are often not attuned to their systemic importance, or unwilling to bear the costs of disclosures or business process changes that are important to an investor’s investment portfolio or to corporate needs. company, but which have no impact on individual businesses. PL

The ethical, intellectual and scientific advancements we are making as a species – combined with changes in the way capital markets facilitate investment and the exponential growth in business impact – have redefined the dynamic scope, scale and the process of “becoming material”. In many ways, this more holistic view of material becoming promises a healthier economy, society, and environment. But it will be a challenge for some companies and investors. As always, some will thrive and others will lag behind, all the while lamenting that the rules have changed.

Jon LukomnikJim hawley

Jon Lukomnik and Jim Hawley are the co-authors of the new book, Going Beyond Modern Portfolio Theory: Investing That Matters. Jon is a Managing Partner at Sinclair Capital. Jim is a Senior ESG Advisor at Truvalue Labs and Professor Emeritus in the School of Economics and Business at Saint Mary’s College of California.

Jon and Jim to talk about systems-level investing and modern portfolio theory (MPT) at a special, free event RI Book Launch Q&A Webinar on July 7



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