Introduction

The authors examined the evolving landscape of corporate governance, particularly the shift towards a systemic emphasis among major institutional owners. The authors highlight two significant statements: the Japanese Government Pension Investment Fund’s (GPIF) focus on enhancing market beta through corporate governance stewardship and BlackRock’s CEO Larry Fink’s call for companies to make positive societal contributions. These statements signal a shift from traditional company-specific governance activism to a broader systemic focus, which the authors term ‘stage III governance’. This new stage incorporates environmental, social, and governance (ESG) concerns and systemic risks like climate change and inequality due to their potential impact on market risk and return.

What does it mean to own and manage assets?

The authors define asset management as the management of financial assets by a third party on behalf of a client. They argue that finance should be a service function to society, with asset managers responsible for risk mitigation, return generation, and capital allocation to the real economy. The authors introduce the concept of ‘extended risk mitigation’, which considers both financial returns and the broader context in which those returns are used. They also discuss ‘extended intermediation’, which focuses on the efficient allocation of capital for society and the minimisation of alienation between savers and their investments.

Asset management and the impact of Modern Portfolio Theory

The authors critique the dominance of Modern Portfolio Theory (MPT) in asset management. MPT, they argue, has led to several sub-optimal practices, including a focus on relative rather than absolute returns, short-termism, and a neglect of systemic risks. The authors attribute these issues to MPT’s assumption that systemic risk is exogenous to portfolio investment decisions. They propose a shift from MPT to modern systems theory, which would incorporate systemic considerations into investment decisions. This approach would involve beta activism, where investors intentionally use their portfolios to mitigate systemic risks and improve the overall risk/return profile of the market.

Systemic risk and beta activism: Stewardship as beta ‘investment’

The authors provided examples of ‘beta activism’, where investors use their influence to affect systemic risk. These examples include CalPERS’ divestment from the Philippines due to unfavourable laws for foreign investors, investor coalitions advocating for the Paris climate accord, and BlackRock’s communication with companies to encourage a long-term focus. The authors argue that these actions demonstrate the potential for investors to intentionally mitigate systemic risks and improve market returns.

A better way forward

The authors propose a shift from modern portfolio theory to modern systems theory as the dominant paradigm in asset management. This shift would involve a three-fold approach, considering security, portfolio, and systems levels. The authors argue that this approach would allow for more effective risk mitigation, improved returns, and positive externalities for society. They also suggest incorporating ‘agency theory’ into risk management to better understand the complex dynamics of financial systems.