Modern portfolio theory “ill-equipped” to aid ESG integration – OECD

Modern Portfolio Theory (MPT), one of the cornerstones of traditional portfolio management, is “ill-equipped” to model environmental, social and governance (ESG) risks, according to a new report from the Organisation for Economic Cooperation and Development.

MPT was introduced by economist Harry Markowitz in the 1950s, for which he was awarded the Nobel Prize, but the OECD backs the view that it’s “unsupportive” of the integration of ESG into investment governance. That’s because, it’s argued, it’s inadequate given the complexity of today’s markets and because it leads to a herd mentality amongst investors.

In a wide-ranging review of the state of ESG integration, the OECD says: “This makes MPT unsupportive of the integration of ESG factors into investment governance: while it does not necessarily rule out the use of ESG factors in financial modelling when it is anticipated that they will have a financial impact on an investment, it is ill-equipped to model the types of discontinuous risk associated with climate change (for example, a one-time change in policy on carbon pricing or subsidies to clean energy, that causes a sudden re-pricing of related assets); this situation is unlikely to improve because MPT is not forward looking so it discourages innovation in investment strategy.”

The study cites Steven Lydenberg’s argument that widespread adoption of MPT has not simply encouraged an over-reliance on and distortion of the duty of care, but that it has also diminished the duty of loyalty.

“In his view,” the OECD says, “it has led to an over-emphasis on ‘rationality’ – financial self-interest – at the expense of ‘reason’ – that is, taking a more comprehensive view of the interests of beneficiaries in addition to considering the impact of investment choices on the broader community.” Lydenberg – the “L” of KLD – is currently Partner, Strategic Vision for Domini Impact InvestmentsThe 54-page OECD document is called Investment governance and the integration of environmental, social and governance factors and was prepared by Emmy Labovitch of the OECD Directorate for Financial and Enterprise Affairs under Pablo Antolin, Head of the Private Pensions Unit at the Directorate.

It builds on OECD work on the regulation of insurance company and pension fund investment and is linked to OECD instruments, in particular the OECD Principles of Private Pension Regulation and the G20/OECD High-Level Principles of Long-term Investment Financing by Institutional Investors. It also supports the OECD’s work on responsible business conduct which aims to assist multinational enterprises in the financial sector in applying the OECD Guidelines for Multinational Enterprises.

The report concludes that “regulatory, practical and behavioural barriers” to ESG investing remain – despite regulators having taken a number of steps to clarify that institutional investors may consider ESG factors in their investment decisions where consistent with their financial obligations.

“Policymakers may wish to address these barriers in order to encourage ESG integration in a manner that is consistent with the prudential standards that govern investor behaviour and other obligations of institutional investors,” the Paris-based body says – adding institutional investors may benefit from “greater clarity about the role of ESG integration in prudent investment governance”.

And it suggests that policymakers could support proposals to develop standardised investment terminology and consistent corporate ESG reporting to make it easier for institutional investors to acquire ESG data and assess its financial impact.