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Viewed with historical distance and perspective, the connections between societal norms, law, regulation and corporate behaviour are quite apparent. What is considered socially (market) acceptable changes over time and location, sometimes slowly and sometimes quite rapidly. Slavery, while always controversial among non-slaves (hardly controversial among enslaved people), was part and parcel of early capitalism, but eventually made illegal (though we note that quasi-slave and clandestine practices continue). The same with child labour, labour health and safety standards, hours of work, workplace discrimination and a host of other issues.
Companies and investors traditionally regard values, during the period when they are coalescing into societal norms, as ‘non-financial’. A better term might be ‘not-yet-financial’, making it clear that norm shifts and new understandings, once adopted by a critical mass of investors, firms, the general population and sometimes regulators, become financially relevant and sometimes legally ‘material’.
Companies and investors that are sensitive to this process of how issues become widespread, and then viewed as value-creating or value-destroying, can benefit from positioning themselves where society is moving, rather than where it has been. Indeed, the social construction of markets has long been studied by sociologists, anthropologists, economists, organisational theorists and others.
Of course, norms are not just about ethics and morality, but encompass all evolutions in what society considers acceptable behaviour. Our improved understanding of science also forces us to confront those insights. For example, it has been known for millennia that groundwater can be contaminated, thereby impacting not just the ecosystem but production and livelihoods that depend on potable and useful water. But, as those understandings deepened and changed, new norms of behaviour developed. From these, new regulatory and legal standards developed, most typically over intense opposition of the polluting firms. Today, issues such as climate change, how to deal with the pandemic, and loss of biodiversity continue those science-driven changes.
Externalities, while a core idea in standard economics, are foreign to the Modern Portfolio Theory mind-set
Materiality from this perspective is not a state of being but a dynamic process of becoming over time, since human knowledge and beliefs evolve. Jean Rogers and George Serafeim suggest that the catalyst for the ‘becoming material’ process occurs when firm practices and social norms diverge enough. Stakeholders (including investors and regulators) react to these changes. In turn, companies often – but far from always – respond if they perceive either opportunity, or if their interests and reputations are threatened.
However, as we explore in more depth in our new book, Moving Beyond Modern Portfolio Theory: Investing That Matters, modern portfolio theory (MPT) doesn’t respond to changing norms that create systemic risks or opportunities. Every portfolio got pommeled by the global financial crisis. Every portfolio experienced a sharp decline and recovery at the onset of the pandemic. Every portfolio is threatened by climate change. Systemic risks in the real world create non-diversifiable systematic risk in the capital markets. Such changes in materiality, and the resultant change in the risk/return profile of the capital markets, are taken as entirely exogenous by MPT.
Thankfully, practice has led theory. Investors appreciate the dynamic ‘becoming material’ process, and increasingly act to mitigate systematic risks such as climate change, lack of diversity, industry issues such as mining safety and scientific developments such as the growth of antimicrobial resistant bacteria.
Two relatively recent major changes affect the context of the ‘becoming material’ process. One is how the world invests today. Legally, materiality in the US relates to what facts a reasonable investor would consider in making an investment decision regarding a particular security. Yet most investors hold diversified portfolios, such as in an S&P 500 index fund. For a diversified investor, systematic risks to the market overall rather than to a particular company, drive the vast majority of risk and return. The question for that investor then is both how a particular risk factor, such as climate change, affects a particular company, but also how that company affects the systematic risk that climate change poses for the overall portfolio. In other words, it is not just outside-in materiality, but also inside-out materiality. Indeed, how companies’ externalities impact other companies in a given portfolio – what could be called ‘inside-out’ (for a company) leading to ‘outside-in’ impacts – is a classic universal owner problem. But, that dynamic is foreign to MPT. Externalities, while a core idea in standard economics, are foreign to the MPT mind-set. 
This ‘double materiality’ concept is increasingly recognised around the world, both for the diversified portfolio reason cited, and for another contextual change: the sheer scale of global companies today. Corporate impact on what information you absorb, how and what you eat, your health and your wealth, is far greater than it was even a generation ago. Corporate impact on our daily lives rivals if not exceeds that of government. Small actions that deviate from social norms, which a generation ago would not have been perceived to have societal impact, now do. For example, when every local banker made his/her own lending decisions, the fact that your local bank may make gender-biased credit decisions would have been unfair and illegal, but it would not have affected enough of the population for it to be a systematic risk, assuming that the next bank over was not biased. But, when everyone’s credit is calculated by just three companies, any systematic bias by one of them would affect the entire economic and social system.
Double materiality solves the inside-out or outside-in question, but creates the materiality paradox: as part of assessing how developments affect systemic health, an investor, a supplier, a customer, an employee or just the general citizenry might reasonably be interested in a company’s impacts on society, the economy and the environment. But companies often aren’t attuned to their systemic importance, or don’t want to bear the costs of disclosures or business process changes that are material to an investor’s portfolio of investments or to society’s needs, but which are not impactful to that individual company’s P&L
The ethical, intellectual and scientific progress we make as a species – combined with changes in how capital markets facilitate investment and the exponential growth in business impact – has redefined the dynamic scope, scale and process of ‘becoming material’. In many ways, this more holistic vision of becoming material promises a healthier economy, society and environment. But it will be a challenge for some businesses and investors. As always, some will thrive and some will lag behind, all the while bemoaning that the rules have shifted.
Jon Lukomnik
Jim Hawley
Jon Lukomnik and Jim Hawley are co-authors of the new book, Moving Beyond Modern Portfolio Theory: Investing That Matters. Jon is a Managing Partner at Sinclair Capital. Jim is Senior ESG Advisor at Truvalue Labs and Professor Emeritus in the School of Economics and Business at Saint Mary's College of California.
Jon and Jim will be talking about systems level investing and Modern Portfolio Theory (MPT) at a special, free to attend RI book launch author Q&A webinar on July 7
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