The Brazilian Institute of Corporate Governance (IBGC) is organizing a book on issues related to the contribution of good governance, ethics and compliance to the development of integrity in the Brazilian business environment. The book will be launched in November. I published a brief excerpt from my contribution to the book here. This is a second excerpt that summarizes why Modern Portfolio Theory and related investment practices creates all the wrong incentives in the investment industry.
Maximizing Value in the Investing Chain
The concept of value maximization for shareholders dominates the capital markets, as I have described elsewhere. The circumstances that lead to shareholder primacy involve both legal rules and investor practices, and find support in academic theories of both corporate law and finance. Theorists start with the premise that investors will seek out companies that provide them the greatest return: as a result, market forces inexorably lead to shareholder primacy.
This idea is complicated by the fact that investing is generally a multilayered relationship. For example, a worker’s pension funds may be managed by a pension trustee. That trustee may hire investment advisers, who provide guidance on where to invest. Some of those investments will go to stock funds that invest in array of companies, and those funds will have their own managers and advisers, who ultimately decide where to invest and how to vote shares in companies in which they have invested.
Ignoring Critical Systems
Each adviser and manager in this chain will want to maximize the return to the link above. But when measuring success, all of these participants compare success to others invested in the market. Thus, success in the investment world is measured by beating (or at least keeping up with) the average investor. This metric of success is encourage by Modern Portfolio Theory (MPT), the bundle of concepts that dominates the modern investing world. These concepts lead to investors ignoring the performance of the market overall – under MPT, investors assume that they cannot have any effect on market performance, and try only to beat the market.
But this assumption leads the investment community to miss an opportunity (and shirk a critical responsibility). The ultimate investors and the intermediaries who serve them have the collective power to control all of these corporations, which comprise the most powerful force in the economy. Their activity does, in fact, have a huge effect on the performance of the market, as well as our society and the environment. When these corporations contribute to financial risk, environmental degradation and social instability, they decrease the value of the economy, as well as the quality of our lives. But MPT ignores these systemic effects.
Making $200 Hamburgers
In other words, in its focusing on comparative returns, the investment industry creates incentives to beat the market, rather than improve it. This system rewards companies that can increase their own financial return with actions that harm the rest of the market; this in turn creates an impetus to externalize environmental and social costs, leading to more $200 hamburgers that waste valuable resources. [A World Bank economist has calculated that the costs such as carbon footprint, water use, soil degradation and healthcare resulting from the production and sale add $198 to a fast food burger’s nominal $2 price.] Thus, by focusing on maximizing their own return as against the market, the investors and corporations degrade the quality of life for the global population and future generations.
This investment industry structure creates a prisoner’s dilemma that makes it difficult to overcome the short-termism that dominates the market. But investors and companies must escape this cycle. Our increasingly fragile and interdependent systems must be carefully managed to avoid catastrophic events like the crash of 2008, an event caused in large part by individual companies chasing ever-higher returns. Thus, as sustainability becomes a critical issue, glossy CSR reports will not be enough; corporations will have to truly integrate their performance and its measurement.