Unlike tech investors on the eve of the dot-com bubble, or homebuyers in the run up to the great recession, today we are already aware that the future is going to be drastically different on a particular front: the world’s relationship with carbon. Investors are grappling with what this means for investment portfolios, and whether the efficient capital markets theory, the underpinning of modern asset management, is sufficient to prepare for this inevitable change.

We widely accept that financial markets, often deemed to be the standard bearer of efficiency, do not always appropriately price in negative externalities or systemic risks, and are inadequate in private markets where information is not widely available. It shouldn’t, therefore, come as a surprise that we cannot rely solely on the efficient capital markets theory to price the future of uncertain environmental changes, regulatory overhaul, and new consumer preferences. Prudent investors must reconcile the growing financial implications of investing a future that is moving towards sustainability.

The efficient capital market theory postulates that all known information is priced into markets and that the neutral starting point for most investors is to own public securities in proportion to their relative size, as measured by market capitalization in the case of stocks or debt outstanding in the case of bonds. While many investors try to do better than this purely passive approach through active management, the proverbial benchmarks to beat are passive indices. 

While we take it for granted now, the application of the efficient capital market hypothesis did many good things for investors’ portfolios: it gave investors an objective standard with which to evaluate active investment managers, focused active managers and drove down the cost of investing. It also ushered in an era of more robust portfolio construction, better diversification and more effective risk management. 

But, it did not encourage investors to think about systemic risks latent in a portfolio where large permanent changes in value could be driven by future events quite different than the past. It also did not particularly encourage investors to actively engage with the companies they own on how they pursue business in the context of the broader environment. Fundamentally, it was a framework that assumed the future is well known by the market today and that future returns would look a lot like historical ones. 

Enter sustainability. Many investors who prioritize sustainability believe that the future will be fundamentally different than the past, and some are even taking steps to bring this future closer with urgency. This consideration of the future poses a potentially large challenge to efficient capital market theory. Is it really the case that the effect of necessary government policies and changing consumer preferences are already reflected in the prices of all securities? Many investors who care deeply about sustainability would say that this can’t be the case. Some go further and point to big dislocations in markets that a passive approach failed to anticipate or protect investors from. The financial crisis and dot-com bubble being two recent ones. Perhaps the need to decarbonize is another? 

In reality, there is no a priori optimal mix of the integration of sustainability considerations into a portfolio, but rather a range of equally plausible mixes from which an investor can choose. The first step in the integration, however, is to take the efficient capital market hypothesis seriously, if not wholly literally. Look at the efficient market hypothesis as being about risk management and a fundamental awareness around what constitutes rewarded versus unrewarded risk. It implies a degree of rigor in the construction of portfolios and an objective evaluation of them. It also reminds investors to make sure they are thoughtful in shifting a portfolio to adapt to an expectation that the future will be different than the past. Let me offer four principles to consider in bringing these points of view together: 

1. If you are going to deviate from the market cap portfolio, make sure there is an economic basis for doing so; consider the risk management arguments for assessing a portfolio’s resilience in a world where lowering carbon intensity is urgent.

2. Quantify the degree of difference a sustainable portfolio may have in terms of tracking error to a market-cap based alternative—which you hope will bear fruit—and make sure you are comfortable with that risk budget; it is important to understand your tolerance up front so you can stay the course during periods of potential underperformance. 

3. Be an engaged shareholder. If you believe a company in which you are invested could do better on issues of sustainability, let them know; CEOs, boards and the companies they run are not static, but they need to know that these metrics matter to their shareholders.

4. Consider what is available in less efficient, private asset markets, which are important to building portfolios that benefit from and reinforce trends toward greater sustainability. By definition, most market-based equity portfolios are disproportionally allocated to the world’s largest companies, about which a great deal of information is widely known, and that are the focus of the efficient capital market theory. 

The theory holds less well in areas of the market where less or little information is known and where shares are not freely or easily tradable, such as private markets. Investors who allocate to private equity have chosen to embrace an asset class that by definition does not play the averages and comfortably embraces disruptive business models preparing for a future that is different than the past. In many ways, private market investing is the most direct way investors can use their capital to advance sustainability. 

Ultimately, a focus on sustainable investing is about anticipating and encouraging a more sustainable future. It does create a tension with more backward looking theories of investing, but both perspectives have something to offer. Together, they result in a continuum of possibility, not a binary choice between “good” sustainable portfolios and “bad” non-sustainable portfolios. 

To the skeptics, there is room for you. Even the most ardent advocate of efficient market theory has to acknowledge systemic risks can lurk in portfolios—the leverage built up prior to the financial crisis reminded us of that. At a minimum, ask yourself, “Is my portfolio prepared for a lower carbon world that virtually all of us now agree we need?” For those who are impatient with the slow pace of change, put your energy and activism to good use. But, don’t do it by disregarding sound principles of investing. Instead, give yourself an appropriately sized sustainability risk budget. Engage with the public companies you hold and look to private market investment opportunities to advance innovation in sustainability. There is room on the continuum for virtually all investors, leaving virtually no excuse to ignore the ways in which sustainability considerations can be integrated into all portfolios.

Hugh Lawson is global head of ESG investing at GSAM.