Domini’s Carole Laible: Modern Portfolio Theory must be modified or replaced

Money, at its essence, is a verb. Its primary role is as a universally understood means of exchange, which is an action. Money as an action can be positive, negative, or a mixture of both. For decades, responsible investors have been hard at work to ensure that their investment dollars have positive environmental, social, governance and financial impacts. The measurement of asset owners’ performance has, to date, been focused on the security-level with an eye toward how these securities collectively contributed to the overall portfolio. But a new era has come. Now is the time to “move to the next level” both literally and figuratively. The Investment Integration Project(TIIP) is an initiative designed to help us do just that.

Modern Portfolio Theory (MPT), which revolutionized finance in the late 1970s, assumes that risks inherent in the market are beyond the ability of the investment professional to influence or control. However, this assumption begins to appear increasingly doubtful as we spend more time thinking about how each security we own impacts society, then extrapolate this concept to our overall portfolio – and then further to the collective action of all portfolios. The collective impact of portfolios, whether positive or negative, does, in fact, influence the systematic frameworks critical to our financial markets. This observation conflicts with the notion that these risks are beyond our control. If we are to avoid unintended crises and strive to build strong systemic frameworks for our capital markets, then MPT as a generally accepted investment theory must be modified or replaced with one that acknowledges that each portfolio and the collective action of all portfolios is within the control of investment professionals and therefore should be managed and measured.The Investment Integration Project shows us a way forward with its goal of “an integrated understanding of the relationship between portfolio-level decisions and systems-levels impact” and the development of “metrics that enable managers to report on the impact of their investment policies and practices at the systemic-framework level.”

However, none of this important work is possible without demand from the asset owners. Investment professionals are unlikely to change their long-accepted views and assumptions without being encouraged, nudged, or even required to change by those that they work for. Peter Drucker once said, “What gets measured, gets managed.” Responsible investors have proven this to be true. Without demand for corporate social responsibility reports, it is unlikely that any of today’s 7,500 sustainability and corporate social responsibility reports would exist. Because of these reports, comparison and tracking on multiple environmental, social and governance data points is now possible, and improvement in corporate conduct often follows. The same can be expected of systemic-framework measurement: improvement will follow.

Asset owners hold the power to create the change that investment theory so desperately needs. Smooth, stable systemic frameworks will benefit portfolios as well as our financial markets, the environment and society. The Investment Integration Project gives us, the asset owners, the platform for this change. Let us take action because, after all, your money is already doing so.

Carole Laible is President of Domini Social Investments.