I have previously written about the importance of system-level investing for managing systemic risks. In essence, this involves an investor considering the negative externalities being created by its portfolio of assets, a portfolio that could be earning an attractive return. Over time, these externalities will make it hard for a large investor to earn the necessary returns for its beneficiaries. In other words, there are feedback loops between the real world, where value creation and value destruction occur, and the capital markets, where they are priced. Each affects the other. Thus I’ve also writtenabout why asset owners need to hold their asset managers to account for the impact of their portfolios on the physical and social world.
While the notion of system-level investing is gaining currency, there is the challenge that the core of investing remains based on Modern Portfolio Theory (MPT), developed by University of Chicago-trained Harry Markowitz in 1952. MPT focuses on how to create portfolios from the capital markets, not on how to improve the overall return of the markets, since it does nothing to take account the impacts of these portfolios on the real world. In fairness to MPT, it was developed long before systemic risks, such as climate change and resource scarcity were an issue, or like inequality in its various forms were recognized as an issue.
Jon Lukomnik realized that more than 25 years ago, when he was in charge of the investments for the five New York City pension funds. At that time in aggregate they were the tenth largest pool of institutional capital in the United States, with some $80 billion in assets under management. (Today they now have more than $250 billion.) His epiphany occurred when he realized that he faced a simple but daunting challenge: Where to put $80 billon to earn a real rate of return above inflation? Forever.
Lukomnik quickly realized that healthy capital markets depended on healthy real-world environmental, social, and financial systems and that MPT provided no tool to help. Not surprising given the ideological basis of financial economics. Furthermore, in searching for other models, theories, and insights, Lukomnik came up empty. This is also not surprising since the notion of sustainable investing was in its early infancy. It is only recently that investors have come to recognize the importance of material environmental, social, and governance (ESG) issues at the stock and portfolio level. An important step but system-level investing is a step beyond that which requires a whole new theoretical basis.
The foundation for this, a quarter of a century later, is the new book “Moving Beyond Modern Portfolio Theory: Investing That Matters” by Lukomnik and James P. Hawley. This book is rapidly gaining attention in both the academic and practitioner communities. The two co-authors met while Lukomnik was at the New York City funds in the late 1990’s, when Hawley interviewed him as part of research Hawley was doing on institutional owners and corporate governance. Hawley went on to co-author what would become the seminal book on Universal Ownership, “The Rise of Fiduciary Capitalism.” Hawley explained that diversified investors should care about the externalities generated by the companies they own, such as greenhouse gas emissions, because those costs come back to bite them elsewhere in their portfolios.
Together, they have shown how Universal Ownership theory can be put into practice. Their book is the first coherent finance theory to explain why investors should devote resources to fight climate change, encourage diversity, combat antimicrobial resistance, and many more real-world systemic risks that some criticize as political grandstanding, outside the proper function of investors. However, Lukomnik and Hawley have written a finance book, neither a political nor social one. They explain how such actions mitigate risk to overcome a weakness in MPT.
Here is what they call the MPT paradox. Diversification works well, but only to mitigate idiosyncratic risk. The problem is that non-diversifiable or systematic risk, often caused by systemic risks to the environmental, social, and financial systems in the real world, actually matter much more to returns than do risks associated with any individual firm or security. In fact, the academic literature says such non-diversifiable risks affect 75-94% of the variability of your return. MPT – and many investors — just assume those non-diversifiable risks are exogenous and that investors can’t do anything about them. That is why the asset management industry benchmarks itself to relative return benchmarks such as the S&P 500, rather than to your ability to pay for retirement, a college education, or a mortgage. By measuring itself relative to the overall market, the industry washes its hands of responsibility for the overall state of the markets themselves which is a consequence of washing their hands over the state of the world.
The authors are having none of it. As the world changes, theories for how to operate in that world must change as well. Lukomnik and Hawley have provided the necessary new theory. They show a myriad of ways investors affect non-diversifiable risk and the overall market, both unintentionally and intentionally. They even cite economists from Adam Smith to Milton Friedman to show how singular MPT is in ignoring the real-world activities that create and destroy value. As Berkeley Law Professor Frank Partnoy said about the book, it is “a takedown of modern portfolio theory (and) a roadmap of how we should think about these important issues of systemic risk and ESG. And it’s a great read.”
This is anything but a modest book. It shouldn’t be because of the hammerlock MPT and financial economics have had on the investment industry for decades. Lukomnik and Hawley rightly and boldly challenge MPT, for which Harry Markowitz was awarded the Nobel Prize. They call the efficient market hypothesis “the perfect myth: Easy to understand, powerful in its explanatory power, and wrong. They then redefine investing so that that the feedback loops from portfolio externalities are central to investing, rather than ignored. They explore how investors have interceded to increase gender diversity on Boards of Directors, improve mining safety, combat anti-microbial resistant bacteria and, of course, combat climate change. Their objective isn’t to throw out the baby with the bath water in MPT. Rather, they show its limited place of maximizing the benefits of diversification while understanding that there’s a lot more to investing than stock picking.
I can only hope they succeed in their desire to change what the world considers “investing” to be. In many ways, their book is the perfect complement to another recent book, “21st Century Investing”, which I wrote about here. The strength of “21st Century Investing: Redirecting Investment Strategies to Drive Systems Change” is that it shows investors “how” to think about systems and the contexts in which their portfolios exist. “Moving Beyond Modern Portfolio Theory” explains why they should.