Addressing System-Level Risks In Order To Maximize Long-Term Financial Returns

I have written about the polarization around ESG and how some Republicans are even weaponizing the concept, to the detriment of their own voters. Most recently I have taken a small step to help reduce the heat in this rhetorical war by offering to meet with anyone in the GOP who would be willing to have a conversation with me about their concerns regarding ESG. This offer is in its very early stages. But I’m pleased to say that I have a few initial takers. Furthermore, my liberal friends who have contacted me are all supportive of this idea. Preliminary returns suggest that members on both sides of the aisle realize this rhetorical war isn’t going to solve the problems we are all facing and must solve them together.

This can only be done by having companies which can create sustainable long-term value, and this requires system-level issues which will inhibit their ability to do so. In this regard, new research from The Investment Integration Project (TIIP) is a very useful contribution. Approaching the Tipping Point: Recommendations for building the marketplace for system-level investing provides data and detailed analysis on the current state of the investment industry and its ability to successfully address system-level issues, something it must do in order for it to meet the needs of its ultimate beneficiaries. (I am a member of TIIP’s Advisory Council.)

The report was informed by a wide-ranging survey of nearly 100 investors and other industry stakeholders which was distributed by Intentional Endowments Network, Transform Finance, Mission Investors Exchange, NextBillion, and among others. TIIP also convened focus groups and conducted interviews with representatives from California State Teachers’ Retirement System (CalSTRS), CFA Institute, Harvard Management Company, Legal & General Investment Management (LGIM), Money Management Institute, NYS Common Retirement Fund, Thornburg Investment Management, UN PRI, and other industry leaders.

What TIIP found is that investors are aware of the need to tackle systemic social and environmental risks like climate change, income inequality, and others, but they do not necessarily know how to begin implementing these strategies. This finding mirrors the broader industry concern around “greenwashing” of ESG—that current sustainable investing processes are such in name only, with ESG funds unable to implement processes that achieve true environmental and social results.

Let me also make clear that these investors aren’t addressing these issues based on a “Woke Agenda” of social engineering which some, such as Vivek Ramaswamy, are criticizing them for. Rather, they are doing so because they have a fiduciary duty to maximize the long-term financial returns for their clients and beneficiaries. Take, for example, CalSTRS, the second largest U.S. pension fund, with $314.8 billion in assets under management (AUM), representing more than 949,000 public school educators and their families in California. “CalSTRS has made a commitment to integrate system-level investing strategies into our portfolio,” said Harry Keiley, Board Chair of CalSTRS.“ Creating long-term returns for the assets of our members requires us to tackle market-spanning challenges like climate change to support long-term value and a secure pension for California’s public educators and their beneficiaries.”

CalSTRS was part of a focus group that included LGIM, an asset manager with $1.8 trillion in AUM, which works with a range of global clients, including pension schemes, sovereign wealth funds, fund distributors and retail investors; and the New York State Common Retirement Fund, with $279.7 billion in AUM, providing retirement security for over one million members, retirees, and beneficiaries. Each institution represents a wide range of clients and beneficiaries, yet the unifying thread is their long-term time horizon. Central to this time horizon is their fiduciary duty to protect both current and future beneficiary returns, and a majority of these returns for beneficiaries are influenced by systemic risks. Further, with life expectancy of an average CalSTRS male member being 88 and a female member being 91 years old, these long-term time horizons will affect both the current and future generations.

“Whether it’s climate change, income inequality or a host of other stressors, systemic challenges are pushing investors to a tipping point,” said TIIP CEO William Burckart. “The long-term financial performance of investments and global well-being will depend not only on acknowledging systemic issues, but on taking bold action to do something about them.”

TIIP’s report provides a detailed analysis of what actions investors and other market participants can take over the next two to five years to quickly equip the financial industry with tools and strategies to manage existing systemic social and environmental challenges in order to deliver long-term financial performance and drive broader industry transformation. These steps can help us move from the current unproductive rhetorical morass we find ourselves in with respect to ESG, and evolve towards a more robust industry that appropriately tackles the challenges we face in order to ensure long-term returns for shareholders.

There are four sequential steps for doing so:

Uncoordinated Innovation: Investors operate in silos, engaging in disparate approaches to tackling systemic issues, with little clarity around standards. Most currently operate in this phase, limiting overall financial returns of the market. As James Hawley and Jon Lukomnik have pointed out, overperformance of the market (i.e., “alpha”), misses the point. Investors on the whole benefit from the performance of the overall market, driven in large part by the performance of the economy. These “beta” returns would be strengthened through greater coordination.

Marketplace Building: Infrastructure begins to develop, with investors taking system-level approaches and actively working together to ensure their strategies benefit broader systems to encourage long-term portfolio gains. In addition to TIIP, organizations like the Interfaith Center on Corporate Responsibility, Predistribution Initiative and The Shareholder Commons have begun specializing in various aspects of system-level investing. Investors working more collaboratively to address systemic risks, such as those related to climate change, can help stave off what researchers at Preventable Surprises characterize as potentially wide-ranging losses to institutional investors. The authors found that “detailed analysis . . . suggests that the probability that warming by 2100 will be enough to produce damage of 50% [to the global economy] is 3%.” They estimated that such a scenario would produce “a portfolio value impairment of around 10%”— or a net overvaluation of $7 trillion to the world’s equity markets.

Capturing the Value of the Marketplace: Support and infrastructure for system-level investing becomes mainstream, with easy access for investors. By utilizing an institutions’ fixed cost infrastructure investments, firms will have access to a wider variety of activities while maintaining the ability to become more specialized.

Maturity: System-level investing becomes a fully robust market, offering the next phase in evolution from our current sustainability practices. Through widespread market adoption, investors benefit from the increased investment potential and long-term returns stemming from stable, efficient, and properly functioning systems. The TIIP report outlines a path forward to get us to this final phase, starting with awareness and moving to adoption while laying out explicit goals associated with each phase of this path forward.

The first phase, building awareness, starts with ensuring investors understand what characteristics make an issue systemic in nature by providing definitional clarity on what system-level investing is and is not and the case on why they should adopt it. Next, investors must be empowered to begin the meaningful integration of system-level investing into their investment practices, thereby increasing the overall adoption of the philosophy. Initiatives to exclude asset managers based on “anti-Woke” criteria, such as those in Florida and Texas, will simply hurt the ability of investors to maximize returns. Finally, new opportunities for collaboration and peer exchange must be facilitated, leading to the overall improvement and widespread adoption of system-level investing. This greater collaboration and coordination can strengthen market infrastructure, improving the overall beta of the market and increasing financial returns for all investors.

“The Sant Paul & Minnesota Foundation recognizes we must go beyond traditional ESG strategies to fulfill the promise of sustainable investing,” said Shannon O’Leary, CIO of the Saint Paul & Minnesota Foundation. “Asset owners and asset managers must recognize this need and work to build a market around these next-level approaches and strategies.”

After establishing the overall awareness of system-level investing, investors must move to the second phase, adoption, to fortify industry structures and practices to bring the practice into the mainstream. To begin, investors will support the development and industry standardization of how to monitor, evaluate, and report investors’ impacts as they relate to systemic issues.

Finally, investors must advocate for regulatory change on a global scale. This change will focus on regulatory frameworks that promote the widespread adoption of system-level investing, taking down previously established barriers that have impeded adoption by the industry as a whole. Once barriers are taken down, investors truly will see the fruits of their labor through stable long-term returns, a wider array of investment opportunities, and the benefits of resilient systems to all investments across all asset classes.

“Taken together, the goals and activities outlined in Approaching the Tipping Point will help to shift the culture of the financial industry away from a near exclusive focus on short term profits and help to transform it into an industry that prioritizes minimizing systemic risks including human rights and environmental concerns, building value over the long-term, and developing resilient systems that support investment across all asset classes,” said Waseem Mardini, Manager, Forced Labor and Human Trafficking, at Humanity United.

TIIP has already begun to take some of these steps towards the next evolution of sustainable investing, with their launch of the Systems Aware Investing Launchpad (SAIL), a direct response to the findings in this report. SAIL is an online platform with two components: a plug-and-play solution investors can use to chart their course to become a system-level investor, and a community of practice aimed at driving broader industry transformation.

“Our members are increasingly coming to us with questions about ESG and sustainable investing implementation,” said Matt Orsagh, Senior Director, Capital Markets Policy for the CFA Institute. “Their clients are demanding these strategies and they don’t want to be ‘greenwashed.’ Tools and resources like what TIIP is offering are critical for our members and the industry.”

Let me conclude by pointing out the obvious significance of these quotes. They come from people who have a fiduciary duty to maximize returns or are experts in what is necessary to do so. While some may call them “Woke,” I call them thoughtful people who are looking out for the financial interests of the ultimate beneficiaries. People like you and me, in both Red states and Blue.