Beta Activism and Shareholder Primacy

In this spot-on article in RI Quarterly, James Hawley and Jon Lukomnik address how the investment theory followed by most portfolio managers, Modern Portfolio Theory, ignores overall stock market performance (“beta”), despite the fact that the effects  of that performance “dwarf” any returns that the portfolio managers can achieve through choosing particular securities or asset classes.

They discuss the unintended systemic effects of indexing, and then move on to discuss how investors can intentionally work to improve systems— financial, environmental and social, leading to increased overall market returns over the long run.  The article provides helpful examples of large, diversified owners (“universal owners,” as discussed in this recent post) using their influence to address systemic concerns, including the Ceres coalition’s focus on environmental issues.

These large owners, they point out, can gain benefits that outweigh their costs due to their size, overcoming free rider concerns:

Aggregating assets across a coalition further mitigates the free rider problem.  As the investors to whom it is individually beneficial to act do so, they improve the market for everyone.

These ideas– that large asset owners and managers can aggregate their power to manage systemic risk– can pave the way not just to improve long-term portfolio value, but to preserve critical environmental and social systems that are at grave risk.  The need for such “beta activism” should therefore be at the center of our public policy discussions, and not confined to the investment community.

Although universal ownership in the markets may address free-rider issues at the shareholder level, it does nothing to address the issue of shareholder primacy at the level of individual corporations.  These institutions are bound by law, by custom and by our financial system to focus primarily on the return they can provide to their shareholders, without regard to systemic cost, as I discuss in this article.  It is at the company level, where the economy actually happens, that the temptation is greatest to produce profits by externalizing costs, whether through resource exploitation, regulatory arbitrage, or human rights abuses.   This temptation is at cross purposes with the beta activism that Hawley and Lukmonic describe.

Thus, job one for universal investors ought to be persuading sustainability leaders in the corporate community to adopt stakeholder friendly corporate structures, like benefit corporation governance, which will ensure that management is not motivated to produce alpha by cratering beta.  Such system-friendly corporate governance can harmonize the goals of universal owners and corporate management– and provide a united front against short term forces in the market.



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