Hawley and Lukomnik on Portfolio Theory

There is no one we respect more than Jon Lukomnik, especially when it comes to portfolio theory. Every fiduciary fund manager should read his new article with James P. Hawley. An excerpt:

Two recent statements, one by the world’s largest pension fund and the other by the largest asset manager, are harbingers of future corporate governance challenges. Both indicate the changing scale and scope of governance.
The first is the recent initiative by the Japanese Government Pension Investment Fund (GPIF)– (the largest public pension fund in the world, AUM +/-$1.32 trillion) to focus on improving and enhancing beta, which it defines as the market as a whole, through corporate governance stewardship.2 Hiromichi Mizuno, the fund’s CIO and Executive Managing Director, noted that as a ‘universal owner’ (UO), the GPIF’s returns (especially long-term ones), due to its sheer size, are overwhelmingly a function of the market and of the systemic risks which affect the real-world economy, rather than beating a benchmark and achieving alpha, or a skill-based return above (but sometimes below) a specific financial market benchmark3 As we discussed below, we call this type of a macro market and system risk focus ‘beta activism.’ Indeed, unlike the vast majority of institutional investors which either try to beat the benchmark through alpha-seeking trading, or which merely accept the return of the market through a passive indexation investment strategy, GPIF sees seeking alpha as entirely irrelevant to its investment strategies while it views the dominant risk/return concepts and metrics of the market as sub-optimal.

The second statement is by BlackRock’s CEO and Board Chair Larry Fink. In January 2018 letter to corporate CEO’s in its vast portfolio Fink said firms must be about ‘making a positive contribution to society’. Thus, in addition to financial performance socially positive, sustainable contributions are over the long-term part and parcel, indeed the sine qua non, of ensuring continuing financial performance. This is another way to put ‘building a better beta’. As Fink puts it (emphasis in original): “…to prosper over time, every company must not only deliver financial performance, but also show how it makes a positive contribution to society.”4 If both public and private firms do not have or develop this sense of purpose they will, Fink suggests, lose their license to operate from key stakeholders specifically identified as shareholders, employees, customers and communities in which they operate. Companies as part of this focus cannot ‘succumb to short-term pressures’ to distribute profits at the expense of investments in employee development, innovative research and development and long-term capital projects. Fink links this core focus to BlackRock’s fiduciary obligations to the ‘ultimate long-term investors’: the clients of and investors in investment management institutions like BlackRock. The letter sees its clients as the ultimate “company’s owners”, for whom BlackRock sees itself as their fiduciary agent. In many ways this is a throwback to the idea of a social license to operate5, and very much a repudiation of the portion of modern investing which sees securities as bloodless numbers and collections of risks, somewhat distanced from the companies which issued them, and the red-blooded owners, employees, customers and communities which own, work for, buy and support those companies. (Additionally these ideas reject the Friedman simplistic concept that the social responsibility of the firm is to make a profit or to maximize profits. Period.)

That the world’s largest asset owner and largest asset manager very recently explicitly focused their corporate governance on system-wide (market ‘beta’ issues) is highly significant, and represents a change from the company specific (and occasionally sector specific) focus which has been the dominant paradigm of governance activism for the past quarter century.

The purpose of this paper is to provide what the authors see as underlying causes for this emerging systemic emphasis. In addition, the contextual real-world state of asset management is explored to understand why this systemic focus is emerging at this time.

The Third, System Stage of Corporate Governance: Why Institutional Investors Need to Move Beyond Modern Portfolio Theory

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