One of the most thoughtful and experienced people in the corporate governance field is Jon Lukomnik, who has a rare combination of solid quantitative skills and a deep understanding of the culture and policy of institutional investing. His new paper, “Why Investors Might be Climate Allies: Corporate Governance Today” (in full below), based on his recent Adam Smith Lecture at Pembroke College, Cambridge, is a vital contribution to the conversation about climate change as a factor in risk assessment. In this excerpt he talks about looking for beta (overall market risk) instead of alpha (individual stock investment risk).
My co-author, Jim Hawley, and I call this the MPT paradox: by ignoring the systematic risks that shape beta, MPT focuses us on that aspect of investing that we can control, but which matters least: security selection and portfolio construction. Now, let me be clear. Harry Markowitz is a genius and the Nobel Prize he received, largely for developing MPT, was well deserved. A full review of MPT is far beyond the scope of this talk, but suffice it to say that without MPT, we would be stuck in a much poorer world, because portfolio theory allowed us to make investments in areas and through a set of securities that might have been considered too risky if not considered in a portfolio context. That enhanced both the private function of asset management – creating a desirable risk-adjusted return for individuals – and the societal role of intermediation, or, as the third Lord Rothschild once said, taking money from point A, where it is, to point B, where it is needed.
The fact that MPT improved the efficiency of those functions is not a hypothetical conclusion: until 1996, three state pension funds in the United States were not allowed to invest in stocks, or venture capital, or real estate, or almost anything else, but only in bonds, and primarily in those issued by the US government. That was because the laws on the books in those states reflected how risk was managed pre-MPT.
We have entered a third stage of corporate governance.
The third phase builds on stages one and two. But it differs in that it directly targets material systematic risks that shape beta – the systematic risk/return of the market. Remember, MPT does not provide a tool to do that, so stage three corporate governance activism is additive to MPT. In effect, it creates the third leg of a three-legged stool. MPT already suggested security selection and portfolio construction as the first two legs; third stage corporate governance suggests a third leg, designed to deal with systematic issues. We call this beta activism.
I find the suggestion that companies report using SASB and TCFD frameworks particularly noteworthy; standard setting across the market is definitely a stage three corporate governance tool.
Reporting on ESG factors has been, and to some extent, remains, a ball of confusion, as governments and traditional accounting standard-setters like the IASB here and the FASB in the US have, until now, refused to regulate disclosure standards. So there has been an alphabet soup of disclosure frameworks. A 2018 report that I commissioned at the IRRC Institute noted that 78% of the S&P 500
companies issue sustainability reports, but that they had virtually zero standardization.
Ninety-seven percent of them customized their reports, picking and choosing from the various frameworks as they like – one referenced six of those alphabet soup frameworks – or using no framework at all.
BlackRock’s attempt at standard setting seems destined to be a game-changer here. Already, within days of Mr. Fink’s letter going public, SASB was inundated by inbound inquiries from corporations.