Episode 15: System Level Investing

Sustainability In Motion

Episode Overview: In this episode, Matt Orsagh and Nawar Alsaadi of ED4S sit down with Jon Lukomnik, a leading figure in sustainable finance and co-author of Moving Beyond Modern Portfolio Theory. Jon explores the limitations of Modern Portfolio Theory (MPT) in addressing long-term, systemic risks like climate change, highlighting the evolution toward "system-level investing."

Key Takeaways:

1. Limitations of MPT:

   • MPT is designed for idiosyncratic risk (individual asset variance) but fails to account for systemic risks, which cannot be diversified away. Lukomnik notes that while MPT focuses on market-relative risk, it overlooks larger economic and environmental factors that affect the entire market.

2. System-Level Investing:

   • Lukomnik advocates for a shift towards system-level investing, where investors engage in strategies to mitigate systemic risks like climate change, inequality, and biodiversity loss. This approach involves collaborative stewardship and policy engagement to reduce overall portfolio risk.

3. Collaboration and Collective Action:

   • Collaborative efforts, such as Climate Action 100+, enhance the impact of investors on global issues. Though the free-rider problem exists, Lukomnik observes that collective initiatives are crucial in addressing systemic challenges.

4. Practical Approaches:

   • Practical tools for system-level investors include investment enhancements (e.g., climate-aligned private equity and infrastructure projects), stewardship, policy advocacy, and setting clear boundaries for ESG targets. Engaging with policymakers and stakeholders strengthens the collective response to systemic risks.

5. The Role of Policy:

   • Effective systemic risk mitigation requires a synergy between investors, policy, and NGOs. Policy is critical in shaping sustainable practices, yet investor engagement and capital flow remain vital in driving actionable change.

____________________

Transcript:

Hello, everyone! Welcome to the Sustainability in Motion podcast, brought to you by ED4S. Our focus is on the fast-moving world of sustainability, helping the business community better understand and navigate the environmental and sustainability challenges we face. I'm Matt Orsagh, Chief Content Officer at ED4S.

And I’m Nawar Alsaadi, Founder and CEO of Kanata Advisors and Senior Advisor to ED4S. Today, we’re excited to bring you a thought-provoking conversation with someone we’ve been fortunate to know for many years: Jon Lukomnik.

Jon has had a distinguished career in the financial world. He’s a former investment advisor for New York City’s pension fund, co-founder of the International Corporate Governance Network (ICGN), and an adjunct professor and Brennenmeyer Fellow at Columbia University. He’s also the co-author of several books on corporate governance and finance, including his latest: Moving Beyond Modern Portfolio Theory, which we’ll dive into today.

Jon, welcome to the podcast!

Jon Lukomnik: Thank you! It’s a pleasure to be here.

The Limitations of Modern Portfolio Theory (MPT)

Matt Orsagh: Let’s start with your 2021 book, Moving Beyond Modern Portfolio Theory, co-authored with James Hawley. In it, you discuss the limitations of MPT in addressing long-term systemic risks like climate change. Could you elaborate on these limitations?

Jon Lukomnik: Certainly. While MPT is a powerful tool for constructing portfolios with the best risk-adjusted returns based on existing market data, it has critical limitations.

First, it assumes market levels are exogenous, meaning it doesn't account for the factors that influence the overall health of the market, such as systemic risks. Studies show that 75% to 94% of variability in total returns comes from the general price level of the market—something MPT doesn’t address.

Second, MPT focuses on idiosyncratic risks—risks specific to individual securities or sectors—and manages them through diversification. However, it does not address systemic risks, like climate change or inequality, which affect the entire market.

Lastly, MPT's reliance on historical data and static assumptions can disconnect it from the real-world dynamics that drive long-term value and risk. As a result, it falls short in guiding investors on how to address risks and opportunities arising from systemic changes.

Introducing System-Level Investing

Nawar Alsaadi: Building on that, Jon, it seems like MPT encourages investors to focus on what they can control, even though what they can’t control—systemic risks—has a far greater impact on portfolio performance. This leads us to system-level investing. How does it differ from traditional approaches, and why is it essential for tackling risks like climate change or inequality?

Jon: That’s a great question. System-level investing differs fundamentally from traditional approaches in its focus. Traditional investing, as framed by MPT, focuses on relative performance—comparing investments against the market or peers. In contrast, system-level investing looks at the broader picture, aiming to improve the overall health and performance of the market by mitigating systemic risks.

For example, climate change is a systemic risk that cannot be diversified away. It creates systemic vulnerabilities that ripple through the economy and financial markets. System-level investors recognize that addressing these risks in the real world—through stewardship, policy engagement, or collaborative action—can reduce systemic risks and improve portfolio performance over the long term.

System-level investing complements MPT by first addressing the underlying health of the market and then applying MPT’s tools to construct portfolios within a more stable and resilient market environment.

Practical Steps for System-Level Investing

Matt: This is fascinating. Could you share some practical steps for investors looking to incorporate systemic thinking into their portfolios? Are there specific tools or frameworks available?

Jon: Certainly. Here are some key steps and tools:

1. Enhancing Existing Practices:

   • Stewardship: Move beyond company-specific issues to engage on system-wide challenges. For instance, participate in initiatives like Climate Action 100+ to drive collective action.
   • Thematic Investments: Focus on areas like renewable energy, green infrastructure, or climate solutions that align with system-level goals.
   • Policy Engagement: Work with policymakers to support regulations that mitigate systemic risks, such as carbon pricing or sustainability disclosure requirements.

2. Setting Goals and Boundaries:

   • Define clear investment beliefs that incorporate systemic risks. For example, PGGM, a Dutch pension fund, has adopted a “3D” approach: risk, return, and impact.
   • Align compensation structures with long-term, system-wide outcomes rather than short-term