Companies don’t operate in seclusion; they are part of a larger inter-related system made up of variables that interact in unpredictable ways. Yet, traditional models used in portfolio construction do not sufficiently account for companies’ interaction with, and impact on, other firms, actors and variables within the system.
These impacts can have serious and far-reaching consequences for both the business ecosystem and society. When viewed in the long-term, many un-sustainable companies are, at present, over-valued and many sustainable companies under-valued.
The SDGs provide a useful framework to help companies and investment managers implement a systems-thinking approach that considers the impact of decisions on future resources. Company performance assessed holistically in this way safeguards portfolio returns by better synchronizing the short-term assets with the long-term liabilities of universal asset owners.
Michael van der Meer
CFA, Senior SI Analyst,
The Firms grows up
In this paper, we continue on a theme highlighted in last year’s RobecoSAM yearbook regarding the importance of adopting social responsibility into a company’s business strategy. Initially, companies adopted a firm-centric view of the world in which their existence revolved around solely maximizing profits; and good behavior was only to avoid government fines. Later, as companies recognized their roles as agents within a larger economic ecosystem, they began to accept and adopt basic principles of corporate responsibility (see Figure 1).
Still, corporate responsibility was associated with corporate philanthropy. Corporations are now beginning to recognize the merits of a fully-integrated approach to sustainability — one that incorporates corporate responsibility and strategic decision-making — as an imperative to ensure long-term success.1
Perceived short-term inefficiencies (e.g. paying above the minimum wage) increase the longer-term durability of portfolios and should therefore be integrated into investments.
1 “Capitalism coming of age: using the SDGs to bridge business strategy and social responsibility”, Hengerer (2017) https://www.spglobal.com/esg/csa/yearbook/articles/capitalism-coming-of-age-using-the-sdgs-to-bridge-business-strategy-and-social-responsibility
Figure 1: Stages of moral development
We expand on this view here by arguing that, to meet their return requirements in the long-run, investors also need to be aware of the inter-dependencies of the environment in which companies operate. In this context, the UN’s Sustainable Development Goals (SDGs) are a useful framework for helping evaluate whether companies are producing products and services that have long-term value for society. Only these companies will have the potential to adapt and thrive in the long run, making them sustainable investment choices.
We further argue that perceived short-term inefficiencies (for example, paying above the minimum wage which contributes to a number of SDGs including no poverty, decent work, as well as good health and well-being) increase the longer-term durability of portfolios and should therefore be integrated into investments.
To meet their return requirements in the long-run, investors also need to be aware of the inter-dependencies of the environment in which companies operate.
Reductionism vs complexity
Fair criticism has been leveled at the SDGs for being too broad and complex for effectively setting priorities, especially for governments.2 Yet, the SDGs’ evolution from the simpler Millennium Development Goals (MDGs) provides more complete coverage of the world’s challenges and their interdependencies. From this perspective the SDGs are a useful investment framework for long-term portfolio construction as it moves us beyond the traditional “reductionist” world view that prevails in finance. This reductionist worldview, which is based on a determinism exemplified by Newtonian physics, in which all things
can be known given enough information.3 Problems scale linearly - like adding grains of sand to a bucket, and the total mass of a bucket of sand is simply the sum of the mass of the individual grains.
It is a simple process – additive, linear, and completely predictable.4 This concept is caricatured in Figure 2, where, if true, a duck’s nature (its actions and behavior) are reduced to the sum of its parts (a hose and series of mechanical gears) and therefore should be completely explainable and predictable. Reality, however, proves otherwise.
2 “The 169 Commandments”, The Economist, (March 26, 2015)
3 See also Cartesian rationalism and Laplace’s demon, the concept in which if someone (the Demon) knows the precise location and momentum of every atom in the universe, their past and future values for any given time are entailed; they can be calculated from the laws of classical mechanics.
4 Example borrowed from a presentation by Dr. Uttam Kumar Sarkar “Financial Markets and Complex Systems” (undated)
Figure 2: Reductionist model of a duck
In traditional finance investments are assumed to be independent and uncorrelated. This thinking is exemplified in firm-specific analyses, such as a discounted cash flow model applied in isolation.
While straightforward to implement, such models suffer from short-term time horizons (3 – 5 years) which means that non-linear events materializing in the long-term typically get excluded (see Figure 3).5
In traditional finance investments are assumed to be independent and uncorrelated.
Figure 3: Theory and Reality Diverge
Modern portfolio theory (MPT)6 made progress by understanding that different assets behave and interact differently. This recognition of basic inter-dependencies is what we now consider conventional finance. Other approaches which broaden the analysis include looking at country-risk or other exogenous factors which influence expected returns.
But systemic inter-dependencies and non-linear risks have yet to be integrated into fundamental analysis. In science, the shift towards a systems-thinking approach already occurred in the first half of the 20th century.7
Economics too, adopted a systems-thinking approach as demonstrated in the idea that all economic activity is “embedded” within formal and informal institutional constraints.8 From this perspective it is counter-productive to disassociate economic activity from other societal objectives.
This embeddedness of business activities within a wider economic and social system, only recently became recognized in the investment world by accounting not just for the economic factors considered in MPT, but also environmental, social and governance (ESG) factors. This approach, usually called sustainability investing, recognizes that systemic factors interact in unexpected ways with investments increasingly producing “fat tail” outcomes.9
It is counter-productive to disassociate economic activity from other societal objectives.
5 2°ii & The Generation Foundation (2017) “All Swans are Black in the Dark”
6 Markowitz (1952)
7 In physics the adoption of Einstein and Heisenberg’s Uncertainty Principle were the first steps beyond determinism; in the biological sciences the shift moved from molecular to a more fundamental science (C. Woese, 2004)
8 Polyani (1968); North (1990)
9 Taleb (2007) describes this as a shift away from what he calls “Mediocristan” towards “Extremistan” in which the bell curve is a reductionist model inappropriately applied to a complex system. In investing this trend is apparent from the increasing contribution of intangible factors to company performance (Haskel & Westlake, 2017).
Universal Owners—central to aligning investors and society goals
“Universal Owners” are institutional investors with highly diversified, long-term portfolios that are representative of global capital markets - for example pension funds.10 It is said that Universal Owners have a disproportionate interest in ensuring the sustainability of their portfolios because they must achieve returns not just today, but essentially in perpetuity. For example, in the US, investors with such long-term liabilities (more than 10 years) own nearly half of domestic equity markets.11
Ultimately though, as the direct and indirect beneficiaries (or perhaps the ultimate liability holders) of the decisions of Universal Owners, all of society has a stake in their ability to achieve a sustainable return on capital invested. In other words, Universal Owners are embedded within wider societal goals, and should evolve along with societal goals.
Using regulations to force universal owners to align investment policies with society’ interest, is overly prescriptive and doesn’t allow for an appropriate and diverse set of solutions to be implemented. Universal Owners can only be expected to be aligned with societal goals when their broader fiduciary duties, which include ESG factors, are fully integrated in their governance structures.12
Universal Owners can only be expected to be aligned with societal goals when their broader fiduciary duties, which include ESG factors, are fully integrated in their governance structures.
The Universal Owner’s Dilemma
One complicating factor is the free-rider problem13 where some managers may achieve short-term advantage by borrowing against future, longer-term, performance. The free-rider problem is illustrated when a fund manager outperforms the index by investing in tobacco stocks. Here, short term financial performance borrows from the future health and well-being (never mind the medical expenses) of its citizens.14
This moral hazard15 explains why investment portfolios still, on aggregate, borrow from the future in order to outperform in the present. Such portfolios have a net present value (NPV) that is negative if stretched into perpetuity (NPV∞<0). The mistake being, following from MPT, that all non-market risks were assumed to have been diversified away.
However, accounting for all systemic risks (not just market beta) would recognize that the portfolio may not have addressed the resource needs of other current, or future, portfolios (possibly even owned by the same Universal Owner!). An example of this is where a company pays below a living wage, which is perhaps a good financial decision in isolation, but which then takes away purchasing power from the workers on which other current or future portfolio companies may rely.16 For a discussion on how investments in human/social capital can positively impact firm profits, see the article, “Fair Wages - a key to effective social capital management” within this Yearbook issue.
Investment portfolios still, on aggregate, borrow from the future in order to outperform in the present.
10 “Universal Ownership: Why environmental externalities matter to institutional investors” (UN PRI 2011)
11 “The Long and Winding Road” (Mercer, 2degrees investing initiative (2°ii) & The Generation Foundation, 2017)
12 Regulators are recognizing this as reflected by the Final Report 2018 by the High-Level Expert Group on Sustainable Finance which states that the fiduciary duties of institutional investors and asset managers includes explicitly integrating material ESG factors and long-term sustainability.
13 In economics, a free rider is someone or something who benefits from a good or service without paying (or bearing the cost) for it.
14 It is for reasons such as this that Robeco and RobecoSAM recently made the decision to adopt a company-wide exclusion of the tobacco industry from its mutual funds.
Figure 4: Managing both returns and resources
For this reason it is in the interest of Universal Owners to align manager incentivizes with a broader range of metrics so that a manager who outperforms financially, but then underperforms on other sustainability metrics, is recognized
as potentially having not created net long-term value (see Figure 4).17 Figure 5 below summarizes some of the differences in characteristics between a traditional and sustainable portfolio.
15 In economics, moral hazard occurs when someone increases risky behavior because they are protected from bearing the costs of the consequences (e.g via insurance schemes).
16 To the question “Why are you paying your workers so well?” Henry Ford famously replied, “Well, if I don’t pay them well, they won’t be able to buy a car”.
17 Hawley and Lukomnik echo this approach by calling for a shift away from a narrow alpha-only approach towards embracing system-wide issues representing a paradigm shift away the company specific (and occasionally sector specific) focus which has dominated governance activism for the past quarter century; “asset management ought to move from modern portfolio theory to modern systems theory as its dominant paradigm.”
”The Third, System Stage of Corporate Governance: Why Institutional Investors Need to Move Beyond Modern Portfolio Theory” (Hawley & Lukomnik, 2018)
Figure 5: The nimble mouse and the colossal dinosaur
Thus, over the long-term, where sustainable portfolios are not adopted, Universal Owners may potentially fail to meet their (i.e. society’s) long-term liabilities. Failure to account for long-term risks and opportunities implies a mispricing of assets today, with capital allocated sub-optimally.
This leads to underinvestment in projects that benefit society in the long-term or may induce the formation of bubbles, which, as they burst, often impose tremendous costs on society.18
Failure to account for long-term risks and opportunities implies a mispricing of assets today, with capital allocated sub-optimally.
We must adapt, to stay the same…
and in the game
So how do we achieve these aims? For starters, we need to integrate diversity and robustness to future-proof our portfolios. According to Ashby’s law19 a system needs to match its environmental complexity in order to survive.
As illustrated in Figure 6, a system which does not contain sufficient diversity to respond to diverse environmental challenges will fail.
Figure 6: System diversity and robustness
18 See also—2degrees-investing initiative (2°ii) & The Generation Foundation (2017), “All Swans are Black in the Dark”
19 First Law of Cybernetics, a discipline that studies the control and communication in the animal and the machine.
The challenge is that, superficially at least, this diversity can appear as redundant when challenges are not (yet) visible. Robustness is thus improved by the built-in “redundancy” for unforeseen circumstances in a system. This approach is contrary to the traditional goal of efficiency (though superficial) within companies as well as in MPT more generally.
Examples of apparent redundancies in a system may include: the Precautionary Principle; paying staff above the market rate; ensuring gender diversity; fostering biodiversity; rolling out renewable energy and decentralized governance institutions. In traditional finance where second-order effects are underestimated, these are dismissed as inefficient.
However, as Table 1 below illustrates, redundancies may be beneficial to the sustainability of a system and therefore efficient from a systems-theory perspective. It is no coincidence that many of these examples can be linked back to the SDGs, which are an attempt to improve the sustainable trajectory of global development.
Diversity can appear as redundant when challenges are not (yet) visible. In traditional finance where second-order effects are underestimated these are dismissed as inefficient.
Table 1: Appearances can be deceiving
We have argued that systemic factors are increasingly being recognized and will be part of future sustainable portfolio construction. While the SDGs alone do not cover exposure to all systemic sustainability risks, they are a useful framework with which sustainable portfolio construction can be realized. In this context it is also important to note that the SDGs do not put a hierarchy on the goals, appreciating their complex inter-dependencies.20
This means there is an opportunity for asset managers to take the initiative and align their portfolios with sustainable goals in a manner which is suitable to their clients.
Asset managers (on behalf of their clients) can thus be incentivized to manage their portfolios sustainably in a manner which does not take away from economic or societal interests elsewhere, present or future.
Moreover, company performance assessed holistically in this way safeguards portfolio returns by better synchronizing the short-term assets with the long-term liabilities of universal asset owners.
Questions or comments for the author can be sent to:
While the SDGs alone do not cover exposure to all systemic sustainability risks, they are a useful framework with which sustainable portfolio construction can be realized.
20 For example, the short-term realization of “Zero Hunger” may be in conflict with longer term goals of biodiversity on land and below water.