Matt Orsagh, CFA, CIPM, senior director of capital markets policy at CFA Institute, spoke with former hedge and pension fund manager and adviser Jon Lukomnik about reexamining modern portfolio theory with the advent of environmental, social, and governance investing.
When Nobel Prize–winning economist Harry Markowitz introduced modern portfolio theory in his landmark 1952 paper “Portfolio Selection,” his central idea around the importance of diversification ultimately may have undermined the theory’s long-term relevance, according to Jon Lukomnik, co-author of the book Moving Beyond Modern Portfolio Theory: Investing That Matters.
At the time the Markowitz paper was published, the markets were 92% retail. But modern portfolio theory unleashed a wave of diversified products, such as mutual funds, which ultimately institutionalized the markets. Today, the institutional–retail balance is in direct opposition to where it stood in 1952. This means the market is not made up of price takers, as retail investors can be described, but rather of price makers, which highlights the influence of institutional investors. As a result, diversification may remove company risk, but depending on which body or research you adhere to, that represents between 6% and 25% of the total risk that investors face. The majority of risk that investors face, Lukomnik says, is systemic.
He notes, however, that as the ESG-related risks, especially the environmental risks, become more, they change the calculus of the risks investors face. Investors no longer face just company-specific risks and systemic risk, but now also face company, systematic, and ESG risks. For these reason, Lukomnik suggests that the foundations of modern portfolio theory need to be reexamined.
Lukomnik suggests that one response of the finance sector to the shifting risk landscape is the rise of beta activism, which is a more coordinated form of coalition around governance actions to effect change, and not just for specific companies in the way proxies and other activist strategies support change, but rather for entire industries. He notes that more than 100 beta activism campaigns are now focusing on items such as deforestation, biodiversity, gender diversity, climate change, and board composition.
As an example, he cites the SEC’s approval of Nasdaq Inc.’s push for greater diversity on corporate boards with a provision for gender and race standards in its listing rules. He says beta activism represents the third iteration of the corporate governance standards that began with the Dutch East India Company, which started some 400 years ago. With this latest iteration, he says, the finance market got it right.