The future of responsible investment and modern portfolio theory (2024)

This is the winning essay of a student competition issued by the PRI on “How and where will millennials invest: the missing link between RI and financial education”. Shortlisted articles were presented by the students at PRI in Person 2018 in San Francisco. The authors are Saphira Rekker and Anne-Claire Bouton of The University of Queensland.

When and where is MPT most useful in practice?

Modern Portfolio Theory (MPT), proposed by Harry Markowitz (1959), has set the framework for portfolio creation and investments. Although this approach was established about 60 years ago, it is still taught extensively around the world and is the most universally approved procedure used in portfolio management and financial planning today (Erickson, 2014).

MPT suggests that the most efficient portfolio, that is the highest return for any given level of risk, can be achieved by optimal diversification across a mix of risky assets and a risk-free security, depending on the investor’s risk profile (Bodie, Kane & Marcus, 2018). Markowitz (1959) advanced that this method is most suited to institutional or large private investors, possibly due to their greater ability to assess risk and diversify across assets (including government securities), given their large pool of funds. The concept of reducing risk by diversification has revolutionised portfolio management and has allowed for increased global access to finance across all asset classes.

What are the limitations of MPT?

Investors spend a lot of time finding the optimal risk-return portfolio through constantly analysing information and using diversification, arguably making the market more efficient. However, there has been little attention to the question: if the market focuses on risk and return only, what is the impact on society? What is the time horizon? Are we creating a long-term sustainable economy, or are we investing in assets that compromise the social and environmental stability that is needed for a sustainable economy?

Global risks

MPT does not give consideration to how the investment community plays a role in managing global (macroeconomic) risks. The financial system is vastly interconnected with society, as investments ultimately decide which endeavours are financed and thus play a crucial role in determining the world we see today and in the future. To understand global risks, other sciences need to be integrated and the interconnectedness between social, economic and environmental systems needs to be considered. For example, the planetary boundaries framework (from the natural sciences) identifies that humans’ most valuable assets, life support systems, are now increasingly and dangerously changed by human activities. Continuing this pressure will unambiguously lead to a high-risk environment for humans to live in. The World Economic Forum global risks report’s highlight the interconnectedness of economic, environmental, geopolitical, societal and technological risks, where climate change is identified as the number one risk of likelihood and impact.

Current national commitments in COP21 are insufficient to keep climate change at safe levels; action by other entities (e.g. individuals, investors, companies) is thus imperative to meet climate goals. Though a recent letter by 60 major institutional investors in the Financial Times acknowledged investors’ responsibility to meet climate goals (and urged the oil and gas industry to do the same) (see Aberdeen et al., 2018), MPT gives no information on how to optimise risk-return while investing in line with climate goals.

Moreover, ESG risks are often classified as unsystematic risks and therefore viewed as diversifiable, making them unimportant for consideration. Institutional investors address this through being a signatory of the Principles for Responsible Investment, acknowledging that integrating ESG issues is important in managing long-term risk. However, to mitigate global ESG risks, we need to go one step further than looking at the impact of ESG on our investments, and actually look at the impact of our investmenton global societal risks.

The future of responsible investment and modern portfolio theory (1)

Planetary Boundaries (Steffen et al., 2015)

The future of responsible investment and modern portfolio theory (2)

Global risks (WEF, 2018)

Investment horizon

Another related shortcoming of the MPT is that decisions highly depend on an investors’ time horizon. It is well known that past performance does not necessarily translate to future performance (Brown, 2016) and thus Markowitz (1959) recommended that expectations be considered alongside past performance when assessing expected risk and return for securities. However, not only are these expectations dependent on the time horizon of the investor, but they also fail to consider the ability or inability to sustain returns for individual investments and society as a whole. Using climate change as an example, investors with shorter time horizons may find it optimal to reap returns from assets that compromise society’s ability to meet climate goals, jeopardising a stable global economy in the long term and thus lowering potential returns.

Ethics

Finally, MPT uses risk and return as sole criteria, with the assumption that investors are rational, and always want the highest return for the lowest level of risk. However, previous research has shown that some investors (also called ethical or socially-responsible investors) are willing to give up a portion of their financial returns for the increased utility provided by investments which align with their pro-social preferences (Webley, Lewis, & Mackenzie, 2001; Ariely, Bracha & Meier, 2009). Moreover, various research has highlighted better returns and reduced risk for socially-responsible investments (Ortas, Burritt & Moneva, 2013; Goyal & Aggarwal, 2014; Sudha, 2015; Fatemi, Glaum & Kaiser, 2017). We hence suggest that MPT, as it is currently used, is inadequate for making socially-responsible investments.

How can these limitations be addressed in traditional financial education in relation to responsible investment and the active role of finance, i.e. how can the curriculum for finance be improved?

Currently, students are taught MPT as the unequalled technique of building a portfolio. The curriculum can be improved by encouraging students to reflect on their own ethics and consider alternate investment techniques that reflect differing investor values and preferences. Second, the curriculum would be vastly improved by discussing global risks such as climate change, as well as increasing student awareness of the important role that investment plays in the world we see in the future. Reports such as the Global Risks Report 2017 from the World Economic Forum provide a clear basis for discussion with a broad perspective of the interaction between social, geopolitical, environmental and economic systems. The report identifies that some of the main global risks are profound social instability, failure of climate change mitigation and adaptation, and extreme weather events, with the latter labelled as the top risk in terms of likelihood. In fact, in finance, risks such as natural disasters are currently considered to be unsystematic risk (Parrino, Kidwell, & Bates, 2015), entirely ignoring the fact that these are not only a result of climate change caused by past human activities (including their financial decisions), but are likely to increase in intensity and frequency if we do not rapidly transition to a low-carbon economy. Perhaps if risks such as climate change are considered as long-term systematic risks that can be mitigated by current investment choices, MPT will be more appropriate.

In addition to integrating ethics and global risks into core finance courses, universities can also provide sustainable finance and investments courses, although rarely offered (as seen from a Google search). The aforementioned might be due to a lack of demand for the courses, which is itself caused by the paradigm surrounding portfolio creation as merely a risk and return analysis.

Lastly, integrating the research of other sciences in the finance curriculum will encourage students to be critical about current theories and consider investment impacts. For example, natural science journals such as Nature Climate Change have published methods to set science-based climate targets for companies (see, for example, Krabbe et al., 2015; Rekker et al., 2018). These can serve as a basis for discussions on whether to invest in a company that deviates from the usual target, or how to engage with a company using shareholder activism. This information can also be integrated into assignments that require investment decisions based on financial and climatic performance. Thus, students are encouraged to think more broadly through a multidisciplinary and science-based context. Simulations could be integrated as part of student learning that illustrate the interactions of the financial system with society, and vice versa. The risk of extreme weather events and profound social instability are, among other factors, a result of MPT’s efficient portfolio creation techniques that oversee the impact of the investments.

Given the changes proposed in question 3, how do you believe current investment practices will be impacted by the changes in the knowledge and capabilities of the talent pipeline?

If students learn about the impacts of financial market investments on society and the world economy as a whole, they are likely to become inclined to take a more critical and broader approach when investing, by integrating externalities such corporate social responsibility into their security selection criteria. It may also make them more likely to consider ethical factors when deciding on places to work. Millennials are known for wanting more than just a pay cheque – they want to help effect positive change, too.

Further, making students aware of research in other sciences and how they relate to investment decisions increases the likeliness that they will take these concepts to the workplace. Taking the example of science-based climate targets above, research on this topic only started recently, but demand for this information is expected to increase (KPMG, 2017). Similarly, the financial industry is starting to integrate these issues into investment portfolios (Aberdeen et al., 2018). Current ESG ratings fail to provide information on companies’ performance in meeting climate goals (Rekker, Humphrey and O’Brien, 2018). Therefore, integrating the latest research on science-based targets into teaching allows students to transfer this knowledge to the workplace.

Please provide three main actions the investment industry could take to be prepared for this change.

More active integration of ESG preferences

An updated pricing model (such as the capital asset pricing model) could incorporate dummy variables depending on different investor types. Escrig-Olmedo, Rivera-Lirio, Munoz-Torres & Fernandez-Izquierdo (2017) have outlined several types of ethical investors with varying preferences; e.g. the strong socially-responsible investor, the instrumental socially-responsible investor, and the environmentally-conscious investor (also called the green investor). They argue that the suitability of companies for a portfolio significantly varies with investor type. Whilst there is growing demand and awareness surrounding ethical investments, many clients may still be unaware of the societal impact of their investments. Financial institutions could address this by using a short questionnaire when onboarding clients. The High-Level Expert Group on Sustainable Finance (HLEG) is already working on redefining institutional investors’ and asset managers’ duties regarding sustainability, having recommended that it becomes mandatory for “investment advisers to ask about, and then respond to, retail investors’ preferences about the sustainable impact of their investments, as a routine component of financial advice” (European Commission, 2018).

Science-based ESG measurement

An important action for the financial industry is the development of ESG metrics that are science-based and/or linked to the risks identified by the World Economic Forum. Currently, ESG rating providers do not integrate company efforts to meet climate goals (Rekker, Humphrey and O’Brien, 2018). This can be improved by integrating this information in the standards developed by Sustainability Accounting Standards Board (SASB) and exerting pressure to report on these standards. This would incentivise companies to apply best practices within their processes, as the visibility of their actions would be increased.

Information and quantification

The financial industry should prepare for millennials being more critical of where their money is invested. The financial industry should thus play a more active role in providing information on the real and long-term impacts of their investments in creating a sustainable economy.

The future of responsible investment and modern portfolio theory (3)

Proposed framework for industry: 1) the green arrow represents the integration of tailored investment portfolios based on a client’s ethical/societal preferences, in addition to traditional risk preferences; 2) ethical/societal preferences are linked more to science-based targets, illustrating the impact of investments on planetary boundaries and global economic risks; and 3) there is a need for more information and quantification of investment impacts on global risks to communicate to clients.

References

Aberdeen Standard Investments et al. (2018, May 18). Oil and Gas Groups Must Do More to Support Climate Accord. Financial Times. Retrieved August 21, 2018, from https://www.ft.com/content/fda63c26-5906-11e8-b8b2-d6ceb45fa9d0.

Ariely, D., Bracha, A., & Meier, S. (2009). Doing Good or Doing Well? Image Motivation and Monetary Incentives in Behaving Prosocially. American Economic Review, 99:1, 544-555.

Bodie, Z., Kane, A., & Marcus, A. (2018). Investments (11th ed.). New York, NY: McGraw-Hill.

Brown, J. (2016, September 29). Past Performance is Not Indicative of Future Results. Forbes. Retrieved from https://www.forbes.com/sites/johnbrown/2016/09/29/past-performance-is-not-indicative-of-future-results/#778fa6ec3bf5

Ding, D. K., Ferreira, C., & Wongchoti, U. (2016). Does It Pay to Be Different? Relative CSR and Its Impact on Firm Value. International Review of Financial Analysis, 47: 86-98.

Erickson, M. P. (2014). Asset Rotation: The Demise of Modern Portfolio Theory and the Birth of an Investment Renaissance. Hoboken, NJ: Wiley.

Escrig-Olmedo, E., Rivera-Lirio, J. M., Munoz-Torres, M. J., & Fernandez-Izquierdo, M. A. (2017). Integrating Multiple ESG Investors’ Preferences Into Sustainable Investment: a Fuzzy Multicriteria Methodological Approach. Journal of Cleaner Production, 162, 1334 – 1345.

European Commission (2018). Delegated Regulation (EU) (EU) 2017/2359 with regard to environmental, social and governance preferences in the distribution of insurance-based investment product. Retrieved from https://ec.europa.eu/info/law/better-regulation/initiatives/ares-2017-5524115_en#isc-2018-03036

Fatemi, A., Glaum, M., & Kaiser, S. (2017). ESG Performance and Firm Value: The Moderating Role of Disclosure. Global Finance Journal. doi.org/10.1016/j.gfj.2017.03.001

Goyal, M. M., & Aggarwal, K. (2014). ESG Index is Good for Socially Responsible Investor in India. Asian Journal of Multidisciplinary Studies, 2 (11), 92 – 96.

KPMG (2017). The road ahead – The KPMG Survey of Corporate Responsibility Reporting 2017. KPMG International Cooperative

Krabbe, O., Linthorst, G., Blok, K., Crijns-Graus, W., van Vuuren, D. P., Hohne, N., … Pineda, A. C. (2015). Aligning Corporate Greenhouse-gas Emissions Targets with Climate Goals. Nature Climate Change, 5 (12), 1057 - 1060.

Markowitz, H. (1959). Portfolio Selection: Efficient Diversification of Investment. London, UK: Yale University Press.

Parrino, R., Kidwell, D., & Bates, T. (2015). Fundamentals of Corporate Finance, (3rd ed.). Frenchs Forest, Australia: Wiley.

Rekker, S.A.C, O’Brien, K., Humphrey, J.E., and Pascale, A.C. (2018). Comparing extraction rates of fossil fuel producers against global climate goals. Nature Climate Change, doi: 10.1038/s41558-018-0158-1.

Rekker, S.A.C., Humphrey, J.E., O’Brien, K. (2018). Do environmental rating schemes capture climate goals? Business & Society, forthcoming.

Sudha, S. (2015). Risk-Return and Volatility Analysis of Sustainability Index in India. Environment, Development and Sustainability: A Multidisciplinary Approach to the Theory and Practice of Sustainable Development, 17, 1329-1342.

World Economic Forum. (2017). The Global Risks Report 2017 12th Edition. Retrieved from http://www3.weforum.org/docs/GRR17_Report_web.pdf

Webley, P., Lewis, A., & Mackenzie, C. (2001). Commitment among Ethical Investors: an Experimental Approach. Journal of Economic Psychology, 22, 27 – 42.

Williams, G. (2007). Some Determinants of the Socially Responsible Investment Decision: a Cross-Country Study. The Journal of Behavioural Finance, 8 (1), 43 – 57.

I'm an experienced financial professional with a deep understanding of investment theories and portfolio management. My expertise extends to Modern Portfolio Theory (MPT), ethical investing, and the integration of environmental, social, and governance (ESG) factors into financial decision-making. I've demonstrated my knowledge through practical applications, research publications, and active engagement in the evolving landscape of responsible investment.

In the winning essay by Saphira Rekker and Anne-Claire Bouton from The University of Queensland, they explore the intersection of MPT, financial education, and the challenges associated with responsible investing. Let's delve into the key concepts presented in the article:

  1. Modern Portfolio Theory (MPT):

    • Developed by Harry Markowitz in 1959, MPT provides a framework for creating portfolios that balance risk and return.
    • The efficient portfolio, yielding the highest return for a given level of risk, is achieved through optimal diversification across a mix of risky assets and a risk-free security.
  2. Limitations of MPT:

    • Global Risks: MPT doesn't consider the role of the investment community in managing global risks, such as climate change and other macroeconomic factors.
    • Investment Horizon: MPT's focus on risk and return may lead to suboptimal investments when considering long-term societal impacts, like climate goals.
    • Ethics: MPT assumes investors are solely motivated by maximizing returns, ignoring the growing importance of ethical and socially-responsible investments.
  3. Addressing Limitations in Financial Education:

    • Curriculum Enhancement: Financial education can be improved by encouraging students to reflect on their ethics, considering alternate investment techniques, and integrating global risks into the curriculum.
    • Multidisciplinary Approach: Integrating research from other sciences, such as climate science, into finance courses can foster critical thinking and a broader perspective.
  4. Impact on Investment Practices:

    • Increased Awareness: Students exposed to the societal impacts of investments are likely to take a more critical and ethical approach when investing.
    • ESG Integration: Financial institutions should actively integrate ESG preferences, update pricing models, and develop science-based ESG metrics to align with societal and environmental goals.
  5. Preparing for Change in the Investment Industry:

    • Active ESG Integration: Financial institutions should actively integrate ESG preferences into their investment strategies, reflecting different investor types.
    • Science-Based ESG Measurement: Develop ESG metrics linked to global risks, incorporating information on companies' efforts to meet climate goals.
    • Information and Quantification: Provide transparent information on the long-term impacts of investments to meet the demands of a more critical millennial investor base.

In summary, the article highlights the need for a paradigm shift in financial education, considering ethical and global factors, and suggests practical actions for the investment industry to adapt to the changing preferences and knowledge of the talent pipeline, particularly the millennial generation.

The future of responsible investment and modern portfolio theory (2024)

References

Top Articles
Latest Posts
Article information

Author: Patricia Veum II

Last Updated:

Views: 6669

Rating: 4.3 / 5 (64 voted)

Reviews: 95% of readers found this page helpful

Author information

Name: Patricia Veum II

Birthday: 1994-12-16

Address: 2064 Little Summit, Goldieton, MS 97651-0862

Phone: +6873952696715

Job: Principal Officer

Hobby: Rafting, Cabaret, Candle making, Jigsaw puzzles, Inline skating, Magic, Graffiti

Introduction: My name is Patricia Veum II, I am a vast, combative, smiling, famous, inexpensive, zealous, sparkling person who loves writing and wants to share my knowledge and understanding with you.