Written By: Sarah Wilson
Chief Executive
Minerva Analytics

Sarah Wilson of Minerva Analytics encourages investors to update their thinking on the risks facing investment today and take more account of factors including climate change, governance and cyber threats

Regulators require that investors are told that “past performance is not indicative of future results”. Yet, every year for over half a century, retirement money has been managed on the basis of a theory that predates the first successful heart transplant; the Apollo moon landings; the UK’s entry to (and pending exit of) the European Union; the fall of the Berlin Wall; not to mention multiple market crashes. I’m talking of course of Harry Markowitz’s Nobel prize winning Modern Portfolio Theory (MPT).

In 1952 market risk concepts were of an entirely different nature than today. Moreover, that dominant paradigm was built around a specific North American/European view of economic systems. Post WW2, the primary risks that stalked the developed western world were the fear of communism and the threat of nuclear annihilation. Today, risks are more diverse, more complex and seemingly more intense and more global. Back then, the concept of ESG having an influence on the market wasn’t considered – not just because the term ESG didn’t exist, but MPT had no conception of the rise of what we might call “Post-modern Portfolio Impacts”. What do I mean by that? Firstly, MPT was developed at a time when retail investors dominated the landscape and their active stock picking created different impacts. Compare 1952 to today’s intense concentration of a handful of institutional investment brands which largely follow the same index-based investment strategy and voting using the same old models.

Another fundamental concern about MPT is that it treats the securities that are traded as if they are, in effect, casino chips, entirely unconnected to the companies that issued them. The model has no room for the environmental, social or governance impacts of the company and its stakeholders. Let’s also not forget that the model assumes another sacred tenet: all economic actors are rational, and markets are efficient. However, as subsequent Nobel prize winners Kahneman and Taversky demonstrated, whenever people are involved, perfection and efficiency fly out the window.1

Climate change – coming soon to a pension near you
Climate change is the 21st century’s core existential risk impacting business, the economy, markets – and in turn LGPS members’ pensions. Climate change is a real risk to long-term sustainability, meaning that LGPS funds need to consider the implications on their specific investment strategies – even if MPT doesn’t.

Tackling poor standards of sustainability, governance and risk management in investee companies should be a key priority. Whilst the current LGPS Investment Regulations haven’t yet gone as far as the DWP for other pension schemes, the LGPS Scheme Advisory Board has some recommendations coming down the line to close this gap.

To highlight one specific aspect of climate change risk – acute weather-related events like floods, storms and droughts could substantially reduce the value of assets, decrease investment income and increase insured and uninsured losses, according to numerous academic studies. In a little over 30 years, the US’ 238 weather and climate disasters have cost the country over $1.5 trillion – or to put it in pensions terms – 10% of US AUM according to OECD data.

What does the ESG data say?
“But isn’t it just enough to buy an off-the-shelf ESG strategy, track one of the big brand indexes?”, I hear you ask. Well, it’s certainly one way to tick a box. It certainly seems plausible on the face of it. Lots of ESG data neatly packaged can’t be wrong, surely?

Data is seductive. On the surface it promises a seemingly quantitatively proven “comfort blanket”. However, it’s worth remembering that data is a fundamentally human construct; it’s what we, or some faceless individuals, choose to measure or ignore. For sure, data is helpful, but it is limited by our biases and imperfections. Data is only as good as the human beings who firstly chose what to measure and then chose how to collate it. What if the theories currently embedded in the dominant index models are as backward-looking as MPT? As we’ve seen in recent years, whether its fat vs. sugar, drug testing, fracking or the problems of the wrong kinds of incentives embedded in executive pay, the wrong data in the wrong hands can have well-meaning, but ultimately devastating unintended consequences.

And what about the ongoing stewardship? Indexes don’t vote themselves or engage with investee companies. Here is, I believe, the paradox in the shift towards integrated ESG – it’s the one size fits all model and the assumption that the prevailing dominant model is THE definitive truth of the matter. I would argue this is dangerous thinking – particularly when the fate of the planet is on the line. After all, there’s little point having great fund returns when your pensioners have a climate change impacted life and its attendant costs.

“Why so downbeat, Sarah, surely stewardship has been a great success?” When looking back to the Cadbury Report which really kicked off the stewardship debate, we seem to have made great strides – and yet we need to reflect that real progress has been unbelievably slow in the 27 years since its publication. Only now are boards getting to grips with the consequences of misaligned incentives, poor succession planning, audit failures and emerging issues such as cyber or climate. “Maybe this time it’s different”, I hear you say, maybe because the planet is on the line “somebody will get it sorted quicker”. Or maybe not.

In The Structure of Scientific Revolutions,2 the American physicist and philosopher Thomas Kuhn wrote, “Successive transition from one paradigm to another via revolution is the usual developmental pattern of mature science.” The Cadbury Report was, like MPT, in its time, truly ground-breaking, revolutionary, a real paradigm shift. The LGPS has certainly been at the forefront of stewardship since Cadbury, but elsewhere in the market, a vote against management is still seen as a heretical act that will upset boards. It’s just not the “done thing”. Writing annual letters to investors/clients and then voting against improved climate disclosures seems to be the limit of some investors’ ESG stewardship.

What now?
Modern Portfolio Theory uses corporate earnings forecasts as the meat of the investment sandwich, in that they are at the heart of the Discounted Cash Flow (DCF) model of asset valuation. The DCF model is therefore a critical component for how investors should be fundamentally integrating ESG/Climate Change/Voting factors into asset valuation. Following on from this, we believe that there are three key questions that LGPS funds should be asking their investment managers, to find out how they’re handling the structural changes we’re now experiencing:

1. They might want to ask their investment managers how they value assets they buy on their behalf

2. They might also ask if and how they value/quantify ESG/Corporate Governance/Climate Change and Voting risk factors at a sector and industry level

3. They might then ask how they combine the two to come to an asset value that truly reflects the key investment risks of the 21st century and enables investors to fulfil their fiduciary duties in the wake of this ESG paradigm shift.

I will leave the last word to Kuhn who argued that as measurement becomes more precise, we start seeing anomalies in our current theories paving the way for new ways of understanding the world. Evidence (data) can therefore support paradigm shifts. But when data reinforces old ways of thinking, it can also hinder progress. Investing today is a very different game to 1952. Yet despite the profound changes in our understanding of the complex systems in which investee companies operate and their impacts, many investors continue to steward their portfolios with one eye on a distorted rear-view mirror and an outdated map.


1. Kahneman, D. (2011). Thinking, Fast and Slow. Penguin.
2. Kuhn, T. S. (2012). The Structure of Scientific Revolutions. University of Chicago Press; 50th anniversary ed edition (30 April 2012).


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Published: August 1, 2019
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