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:
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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.
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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.
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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.
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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.