By James Hawley, Professor Emeritus School of Economics and Business, Saint Mary College of California, Head of Applied Research, TruValue Labs and Jon Lukomnik, Executive Director of the Investor Responsibility Research Center (IRRC)
Despite numerous academic studies demonstrating that the effect of market beta on an investor’s portfolio dwarfs any returns achievable through security selection, few traditional investing styles attempt to influence beta. This is primarily because the near universally adopted modern portfolio theory (MPT) put forward by Nobel laureate Harry Markowitz in 1952 is blind to the effect of portfolio investment on the capital markets’ overall risk/return profile and on the macro systems upon which the market relies for stability (the global financial, environmental and social systems). MPT doesn’t account for investors’ actions affecting systemic risk.
From unintended impact…
In reality, however, normal investment activities’ effects on systemic risk are many and manifest. Capital flows create risk-on/risk-off markets, for instance, and passive investment has become so popular (more than a third of the US stock market is now invested through some type of index fund) that it has begun to affect the marketplace, through the super portfolio effect.
The super portfolio effect means that simply being in a portfolio can affect the underlying securities. Super portfolios tend to herd, increasing systemic risk. This is a perfect example of how adherence to MPT drives certain types of portfolio investment, which then affects the beta of the market overall.
Studies have shown securities changing price merely due to being included in an index, as well as the capital flows into or out of an index affecting prices of the securities within. The super portfolio effect sees the prices of the component securities in an index begin to move together, and float away from the other market participants, not because of individual security decisions, but merely because they are included in an index or other communally traded structure. The effect of indexation can even affect how the companies themselves operate: studies have revealed changes in everything from the structure of the Board of Directors and other governance areas to a reduction in research and development spending after a company is included in an index.
…through the rise of the institutional investor…
But if portfolio investment can unintentionally affect systemic factors, can investors intentionally influence systemic risk factors, such as governance problems and climate change, so as to mitigate such risks? This type of action would seek to change not the price of an individual security (as with the more publicised type of ’shareholder activism’), but the nature of a market. That would suggest a path to both decreasing market risk and improving financial, environmental and social systems. We call this beta activism.
Before we examine it, let’s ask a foundational question: if feedback loops between portfolio investment and systemic risk are possible, why were they not included in Markowitz’s brilliant, original MPT theory? Why did he think alpha and beta were disjointed?
The answer is the rise of the institutional investor. To give an analogy: every individual on earth has a gravitational effect on the orbit of the moon, which varies as they move. However, it is immeasurably small, so has no meaningful effect, and there’s so many other individuals that when you walk in one direction, someone else is inevitably walking in a different direction – so at a systemic level, they average out anyway. That, effectively, was Markowitz’s world, where institutions only owned about 8% of the US equity market, and individuals’ relatively small portfolios zigged and zagged in various directions, largely cancelling out any systemic impacts. Today, however, institutions own nearly 80% of the US equity market and a similar proportion of most others. Structural changes such as the rise of indexation, the creation of exchange-traded funds, and instantaneous communication combine to create super portfolios, as mentioned above. The sheer size of institutional portfolios makes manifest the feedback loops between the investments and the systems surrounding the financial markets.
Markowitz’s wonderful theory has become a victim of its own success: MPT has contributed to the rise of the concentration and institutionalisation of assets, and yet much of the practical implementation of MPT works well only as long as not too much of the market uses it.
…to exerting deliberate influence: beta activism
Large investors, or groups of investors, can intentionally attempt – and often succeed – to mitigate systemic risks and affect beta. For example, political risk is considered external to portfolio investment: investors try to understand and price the risk, but generally do not try to change it.
Perhaps they should. In 2002, when the California Public Employees Retirement System (CalPERS) announced that they were divesting their holdings in the Philippines because of objections to how foreign investors were treated under Philippine law, the Philippine stock market fell 3.3% in a day and the Philippine government began negotiations with CalPERS. Two years later the laws were changed. In the real world, unlike in MPT theory, there are feedback loops between portfolio activity (disinvestment in this case) and the environmental, social and financial systems that create systemic risk.
Other examples include the New York City pension funds’ proxy access campaign, which attempts to change the governance landscape of the US equity market by changing how directors may be nominated; Blackrock’s efforts to get companies to focus the longer term; the Ceres coalition’s focus on environmental issues; and the Investor Stewardship Group’s goal of improving governance for the companies listed on US exchanges.
Beta activism has costs, borne by the beta activist but with the benefits accruing to all. This presents a free rider problem, where any given investor may be dissuaded from incurring costs to themselves in the hope that another will act for them. Institutional investors, however, have enough assets over which to spread the costs to be in a position where the absolute benefit to them can far outweigh the costs, mitigating the free rider effect.
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.
Beyond modern portfolio theory
These developments put in question a number of MPT’s tenets, though those such as the ability to diversify idiosyncratic risk, continue to be central and relevant. While MPT remains enormously valuable, it is clear that many of the hallmarks of today’s MPT-dominated investing need a fundamental rethink. Those who blindly seek alpha may find that the joke is on them. Changing beta holds far greater promise.