Sustainable Investing Lecture Summary PDF

The text is a summary of a lecture on sustainable investing, specifically focusing on the stewardship pillar, which involves exercising ownership rights to influence company behavior. The two tools in this pillar are engagement and voting. Engagement is defined as discussions between institutional i...

The text is a summary of a lecture on sustainable investing, specifically focusing on the stewardship pillar, which involves exercising ownership rights to influence company behavior. The two tools in this pillar are engagement and voting. Engagement is defined as discussions between institutional investors and companies on Environmental, Social, and Governance (ESG) issues, and can be done individually or collectively. It is an informal ownership right, not a legal requirement, but is generally wise for companies to participate in. The lecture mentions Black Rock as an example of an institutional investor that holds many direct engagements with companies. Bullet points Week Two of Sustainable Investing Last week, the concept of ESG investing and the integration tool kit were introduced This week, the focus is on the stewardship pillar, which includes the tools of Engagement and Voting Stewardship means exercising the rights that accrue to you as an owner Stewardship applies to when you own an asset and what you do with that ownership Engagement as a Tool in Stewardship Engagement is about discussion between institutional investors and companies on ESG issues Engagement is an informal ownership right, not a legal requirement Engagement can be done individually, with one investor and a company, or collectively, with a group of investors and a company Institutional investors, such as Black Rock, often hold direct engagements with companies to exert influence and align behavior to their interests Importance of Engagement for Institutional Investors Institutional investors typically hold a significant portion of a company\'s share register Engagement allows institutional investors to exert influence on companies and align behavior to their interests Engagement can lead to improved performance and reduced risk for the institutional investor Engagement Mechanics Engagements can be one-on-one or with a group of investors Black Rock, one of the biggest owners of companies, held over 3700 direct engagements in 2023 with over 2500 companies Engagements can be in person, over the phone, or through written communication Understanding Investor Engagements on ESG Issues Investors engage with representatives of the board and management on ESG (Environmental, Social, and Governance) issues Responsible investment teams often meet with the board, while equity analysts meet with management Types of Investor Engagements Individual engagement: when an investor meets with a company alone Collaborative engagement: when a group of investors meet with a company together Reasons for Investor Engagements To address ESG issues with the company To influence the company\'s behavior and decision-making Benefits of Collaborative Engagements More powerful message due to larger number of shareholders contributing Greater influence and reason for the board or management to listen More efficient use of resources as the same message is shared among multiple investors Academic Evidence on Successful Engagements Research by Elroy Dimson analyzed proprietary data from a large US pension fund on their engagement data Successful engagements (where the investor got the behavior change from the company they were seeking) were followed by positive returns BlackRock\'s Engagement Strategy BlackRock has over 3,700 engagements a year Engagements aim to realign the company with the interests of shareholders Organizations that Undertake Collaborative Engagements ACSI (Australian Council of Superannuation Investors) is an example of an organization that undertakes collaborative engagement on behalf of around 40 Australian and international super funds and pension funds Benefits of engagement in environmental and social issues Collaborative engagements increase the success rate of environmental and social initiatives Company is more likely to make changes when there are discussions in a collaborative setting Management or the board are more inclined to listen in a collaborative engagement setting Collaborative engagements can lead to specific company actions, such as greater disclosure Examples of engagement leading to company action Rio Tinto engaging with global investors and investor groups on First Nations rights and cultural heritage Investors playing a role in pushing companies to make changes or announcements Companies being explicit about the role of investors in pushing them in a certain direction Topics covered in engagement meetings Governance issues, climate and natural capital, and company impacts on people are common topics Multiple topics are covered in each engagement meeting Breadth of topics shows the importance of engagement in various areas Takeaway Engagement can lead to specific company actions and is a valuable tool for investors Companies are more likely to listen in a collaborative engagement setting Multiple topics are covered in each engagement meeting, highlighting the importance of engagement in various areas Understanding Engagement and Voting in Shareholder Stewardship Engagement is a form of communication between companies and their shareholders. It is an informal process, with no law requiring companies to engage with shareholders. The purpose of engagement is to encourage companies to change their practices, particularly in relation to Environmental, Social, and Governance (ESG) issues. Voting as a Shareholder Right Shareholders have the right to vote, which is attached to each share they own. The typical principle is one share, one vote. Voting functions in the same way as a democracy, with each shareholder having the right to vote on matters put before them. Shareholders can vote on various issues, including remuneration, director appointments, and executive pay. Shareholders can also propose resolutions to be voted on by other shareholders. Exercising the Right to Vote Shareholders can exercise their right to vote at annual general meetings (AGMs), which are typically held once a year. AGMs provide shareholders with the opportunity to vote on issues put forward by the company and to propose their own resolutions. An example of a shareholder resolution is a proposal to align the company\'s operations with the goals of the Paris Agreement. Understanding shareholder voting If you have a share, you have a right to vote This is important for institutional shareholders, such as BlackRock, who are large shareholders and own probably 5% of every company Institutional shareholders can use their right to vote as a tool BlackRock\'s voting statistics BlackRock is a passive manager and owns a little bit of everything They have a huge number of companies at which they need to vote They have an enormous number of meetings and unique companies where they vote They vote against management at a small percentage of the meetings Shareholder proposals Shareholders are proposing more and more items on environmental and social topics This reflects the increasing importance of these issues to investors More investors are taking these issues seriously and signing up to principles for responsible investment BlackRock\'s disclosure on shareholder proposals BlackRock discloses the number of proposals they had to vote on that were not put forward by the board The number of proposals on governance is staying relatively flat The number of proposals on company impacts on people and climate change is increasing every year Contrast between BlackRock and Monroe Partners Monroe Partners is a much smaller firm with a much lower amount of funds under management They have a much lower number of meetings and unique companies where they vote They vote against management at a higher percentage of the meetings Importance of voting and shareholder proposals Voting and shareholder proposals are important tools for shareholders to influence company decisions They allow shareholders to express their concerns and preferences on environmental, social, and governance issues Breakdown of the discussion Definition of integration: Considering Environmental, Social, and Governance (ESG) factors in investment decisions to increase risk-adjusted returns Reason for integration: To increase portfolio return by incorporating ESG factors Stewardship to support integration: Using engagement and voting to push for ESG integration and tilt companies towards sustainability Examples of stewardship in action Engagement: Meeting with companies to push for ESG integration Voting: Using voting power to influence decision-making towards ESG considerations Real-world example Company with poor safety performance: A company that performs poorly in safety may be engaged with to improve their safety standards and practices Question for further discussion Why might collaborative engagement be more successful than individual engagement? Note: The text provided is a transcript of a conversation between multiple speakers, and the above bullet points are a summary of the main points discussed. Impact of safety performance on engagement and valuation Companies with bad safety performance are inherently more risky A company with no public reporting on safety performance may be assumed to have poor safety measures in place Discovering that a company has excellent safety measures after engagement can positively impact valuation and integration Engagement can provide insights into a company\'s safety measures beyond publicly available information Engagement as a source of information Engagement can provide information that is not material nonpublic information but still valuable Asking questions and observing the CEO and other executives can provide insights into the company\'s culture and values These insights can improve the investor\'s scoring of the company on ESG (Environmental, Social, and Governance) factors Examples of insights gained through engagement An investor can assess management quality through engagement by observing how the executives interact with others, present themselves, and answer questions These observations can help the investor make a better-informed decision about the company\'s risk profile and potential returns Example of assessing management quality in the mining industry After the destruction of cultural heritage at Juukan Gorge by Rio Tinto in 2020, a roundtable with mining analysts was held to discuss whether the issue was foreseeable Engagement can help investors assess the company\'s management quality and risk profile in a more nuanced way than relying solely on company disclosures Why might collaborative engagement be more successful than individual engagement? A group of shareholders may hold a larger proportion of shares, which can give their engagement more weight Collaborative engagement can help to reduce personal bias, as a group of shareholders may come to a more realistic conclusion than an individual Explanation of the benefits of collaborative engagement Collaborative engagement allows shareholders to pool their resources and expertise, which can make their engagement more effective A group of shareholders may be able to present a more united front to the company, which can make their engagement more difficult to ignore Collaborative engagement can also help to build a sense of community and solidarity among shareholders, which can make them more effective advocates for their interests Examples of collaborative engagement Shareholders may form a coalition or alliance to engage with the company on a particular issue Shareholders may work together to file a joint resolution or proposal on a particular issue Shareholders may collaborate with other stakeholders, such as employees, customers, or advocacy groups, to engage with the company on a particular issue Conclusion Collaborative engagement can be a powerful tool for shareholders to advocate for their interests and influence the company\'s decisions By working together, shareholders can pool their resources, expertise, and credibility, which can make their engagement more effective and increase their chances of success Summary of the pitch for ASCI (Australian Shareholders Collaboration Initiative) The idea is for large super funds to collaborate on engaging with companies to influence them on various issues Collaboration can lead to a consensus view on issues, which is more likely to be taken seriously by the company The two tools used in this process are voting and engagement Voting can be used as a threat to influence the company, as directors need 50% support from shareholders to be appointed The company is more likely to engage in the first place because of the implicit threat of using voting power Additional points on the influence of engagement The threat of using voting power is implicit in the engagement process The company is more likely to listen if they know that the shareholders are willing to use their voting power The threat is not always explicit, but the company is aware of the potential consequences of not listening to the shareholders Summary of the benefits of collaboration Collaboration allows for a consensus view on issues The company is more likely to take the view seriously if it is a consensus view Collaboration also allows for a larger and more influential proportion of the shareholder base to be represented Importance of investor engagement in companies Investors bring a broader perspective as they look across all sectors Management is often focused on running the company and may not have time to look at best practices across sectors Investors can provide valuable insights on industry best practices, which can help management improve their company Motivation for management to engage with investors Management is often motivated to improve their company to increase investment, which drives share price and improves bonuses or increases clout Improving the company can also lead to better performance and higher returns for shareholders Leverage for investors in engaging with companies Investors can use their position as shareholders to influence company decisions Investors can communicate their views on best practices and ethics to management Investors can use their voting power to support or oppose company decisions Introduction to ethical investing The objective in ethical investing is to maximize returns while adhering to a specific set of ethics An example of ethical investing could be avoiding companies that profit from addiction and associated health problems from smoking tobacco Unconventional oil and gas Tar sands and fracking are examples of unconventional oil and gas A company should not be included in a fuel-free portfolio if they make any revenue from unconventional oil and gas Revenue threshold for fuel-free portfolio A company should not make any revenue from coal, oil, or gas to be included in a fuel-free portfolio If a company makes 95% of their revenue from renewable energy and 5% from gas, they are still included in a fuel-free portfolio Banks and project finance Banks that lend to fossil fuel companies for project finance are acceptable in a fuel-free portfolio Companies that service fossil fuel companies A company that provides mining equipment, testing, or transportation for coal and makes 50% of their revenue from it, is not included in a fuel-free portfolio A company that provides cleaning up the waste from oil and gas companies is acceptable in a fuel-free portfolio Challenges in building a fuel-free portfolio Excluding 30% of the investable universe can introduce additional risk to the portfolio Managing a portfolio with certain tracking error, restrictions, or different risk tolerances and return hurdles can be challenging with a fuel-free portfolio Ethical investors Ethical investors are those who make investment decisions based on ethical and moral principles Understanding Ethical Investing Ethical investing is avoiding activities or products that are contrary to one\'s beliefs or values Examples of ethical positions translated into investment portfolios: Faith-based institutions may avoid alcohol, tobacco, gambling stocks (sin stocks) Funds that invest in line with Sharia law may exclude businesses selling pork or engaged in lending practices 21st century ethical funds consider the demand of investors who want to invest in ethical products Other examples of ethical positions include nuclear power, animal testing, GMOs, child labor Screening as a Tool for Ethical Investing Screening, also known as exclusion-based investing or norms-based screening Primary motivation for this tool is ethical Divestment is a type of screening where the fund sells stocks that no longer meet their value set Divestment is not the same as selling for other reasons such as changes in valuation Divested funds will not reinvest in the stock simply because the price changes Examples of Divestment A fund may divest from fossil fuel companies due to concerns about climate change A fund may divest from firearms manufacturers due to beliefs about gun control A fund may divest from companies with poor human rights records Impact of Divestment Divestment can put pressure on companies to change their practices Divestment can send a message to the market about the importance of certain issues Divestment can lead to a shift in investment towards more ethical options Divesting from tobacco: an example of ethical investing Funds divest from tobacco as part of ethical investing, meaning they have no intention of buying tobacco stocks in the future, regardless of price This is an extreme position, as it means that even if the price of British American Tobacco dropped to a dollar, an ethical investor would not buy it The decision to sell was motivated by ethics, and the decision to buy again would also be motivated by ethics, such as a change in the product or behavior of the company, or a change in the investor\'s values Negative and positive screening Negative screening is the most common and obvious tool used by ethical investors, where they exclude certain sectors or companies based on ethical considerations Positive screening is when ethical investors add or overweight companies that they deem to be doing the right thing ethically For example, an ethical investor may have a negative screen on fossil fuel companies, but a positive screen on companies that are taking action on climate change Stewardship: another tool used by ethical investors Although screening is the primary tool of ethical investors, it may not be the only tool they use More and more ethical investors are using tools of stewardship, where they invest in companies that are adjacent to the sector they have excluded, but use their influence to try to change the behavior of those companies For example, an ethical investor may exclude tobacco companies, but invest in supermarkets that sell tobacco products, with the goal of influencing the supermarkets to change their behavior need to know for the purposes of this course. Ethical investing and portfolio implications Ethical investors may use stewardship to push companies to stop selling tobacco or to electrify their vehicles Screens used by ethical investors may have negative impacts on investment returns, as they reduce the potential investable universe Removing companies from a portfolio can move it away from the efficient frontier Tracking error is a measure of the difference in returns between a portfolio and a benchmark, and is used to assess the performance of superannuation funds A larger tracking error indicates a greater difference in returns between a portfolio and a benchmark Superannuation funds that exclude whole sectors may find it more difficult to follow the returns of a benchmark, leading to a larger tracking error Style bias is another portfolio implication of screens, and refers to the tendency of a portfolio to overweight or underweight certain styles or factors Positive and negative screens of ethical investors Positive screens are used by ethical investors to direct investment decisions towards their vision and mission Negative screens are used by ethical investors to exclude companies or sectors that do not align with their values or mission An example of a faith-based ethical investor is You Ethical, which is affiliated with the Uniting Church and uses positive and negative screens to direct investment decisions John Dark and coding John Dark is an expert in the use of coding to analyze the portfolio implications of screens Students can use coding to see the impact of screens on their potential investable universe and portfolio returns Conceptual understanding of portfolio implications of screens The portfolio implications of screens are generally negative from an investment returns perspective Excluding companies from a portfolio can move it away from the efficient frontier and increase tracking error Style bias is another potential portfolio implication of screens Tracking error and superannuation funds Tracking error is a measure of the difference in returns between a portfolio and a benchmark Superannuation funds that exclude whole sectors may have a larger tracking error, as it is more difficult for them to follow the returns of a benchmark John Dark and coding John Dark is an expert in using coding to analyze the portfolio implications of screens Students can use coding to see the impact of screens on their potential investable universe and portfolio returns Positive and negative screens of ethical investors Positive screens are used by ethical investors to direct investment decisions towards their vision and mission Negative screens are used by ethical investors to exclude companies or sectors that do not align with their values or mission An example of a faith-based ethical investor is You Ethical, which is affiliated with the Uniting Church and uses positive and negative screens to direct investment decisions Conceptual understanding of portfolio implications of screens The portfolio implications of screens are generally negative from an investment returns perspective Excluding companies from a portfolio can move it away from the efficient frontier and increase tracking error Style bias is another potential portfolio implication of screens Tracking error and superannuation funds Tracking error is a measure of the difference in returns between a portfolio and a benchmark Superannuation funds that exclude whole sectors may have a larger tracking error, as it is more difficult for them to follow the returns of a benchmark Impact of excluding certain industries on tracking error Excluding industries such as fossil fuels, fur, alcohol, and gambling can result in tracking error The largest impact is seen in fossil fuels due to its large size in the index Excluding a significant portion of the index can increase the deviation of the portfolio from the index Impact of excluding fossil fuels on investment style Excluding fossil fuels can reduce exposure to certain investment styles, such as value Fossil fuel companies tend to be value stocks with lower valuations and higher dividends Excluding fossil fuels can reduce exposure to high dividend companies, which can impact income for investors Considerations for financial advisors Financial advisors need to consider the impact of excluding certain industries on the overall portfolio and the investor\'s goals Excluding fossil fuels can reduce exposure to high dividend companies, which can impact income for retirees who rely on dividends for their retirement income Summary of Impact of divestment on a company\'s stock price It is difficult to directly link each individual action of divestment to a change in a company\'s stock price However, there are examples where divestment has raised awareness and potentially impacted the reputation of companies Examples include a Scottish university endowment and the Australian National University divesting from fossil fuel companies Thought experiment on the impact of screening on engagement If shareholders divest from a company due to ethical concerns, only those who do not share those concerns will remain as shareholders This can impact engagement with the company, as the remaining shareholders may not push for change in the same way as those who divested For example, if shareholders divest from a company that sells both chocolates and tobacco due to concerns about tobacco, only those who do not share those concerns will remain as shareholders This can impact engagement with the company, as the remaining shareholders may not push for change in the same way as those who divested Potential negative effects of screening If a large number of shareholders divest from a company, it can lead to a decrease in the company\'s stock price This can potentially harm the company and its stakeholders, including employees and customers Additionally, if only shareholders with a particular viewpoint remain, it can impact engagement and the ability to push for change within the company Ethical Investment: Divestment vs. Engagement Divestment: Selling shares of a company due to ethical concerns Engagement: Staying invested and using shareholder power to influence company behavior Potential issues with divestment Shares may end up in the hands of investors who don\'t share the same ethical concerns Decreased shareholder base may reduce influence on company behavior Potential benefits of engagement Increased shareholder base may increase influence on company behavior Possibility of encouraging the company to align with ethical investor\'s values Factors to consider when deciding to engage or divest Company\'s willingness and ability to change Type of product or conduct in question Likelihood of success through engagement Examples of successful engagement Utility company transitioning from coal to renewable energy sources Company improving employee treatment Examples of difficult engagement Tobacco company transitioning away from tobacco production Company manufacturing weapons or exclusively selling alcohol Engagement vs. divestment: A case-by-case decision Each situation is unique and requires careful consideration of the company, product, and conduct in question Summary It may be smarter to stay invested in a company that treats employees badly if their core business is not related to the mistreatment Ethical investing and ESG (Environmental, Social, and Governance) investing have similar goals but ESG also considers ethical views An ethical view can turn into a widely held social movement, which can then become laws or regulations affecting all investors Ethical investors can act as a \"canary in the coal mine\" for financially material issues Task for the group Is it ethical for a hospital endowment to invest in gambling companies? Is it ethical for Australia\'s sovereign wealth fund to invest in tobacco companies? Is it ethical for a fund whose beneficiaries are climate scientists to invest in companies that generate and sell electricity from fossil fuels? Additional notes The speaker mentions a past example of an ethical view becoming a widely held social movement: the prohibition of alcohol in America in the 19th century The conversation is directed towards a group of people, who are tasked with coming up with ethical viewpoints on different scenarios Ethical arguments for the Australian Sovereign Wealth Fund investing in tobacco companies The Australian Sovereign Wealth Fund could use its influence as a shareholder to encourage tobacco companies to adopt better practices, such as reducing the health risks associated with tobacco use or implementing stricter marketing regulations to prevent the targeting of children and vulnerable adults. Investing in tobacco companies could potentially bring in significant profits for the Australian Sovereign Wealth Fund, which could then be used to benefit the Australian people through the provision of public services and infrastructure. If the tobacco companies in question are based outside of Australia, it may be ethical for the Australian Sovereign Wealth Fund to invest in them, as the funds would be used to support the Australian economy without directly contributing to the health risks associated with tobacco use within Australia. Ethical arguments against the Australian Sovereign Wealth Fund investing in tobacco companies It may be considered unethical for the Australian Sovereign Wealth Fund to invest in tobacco companies, as the Australian government imposes high taxes and strict regulations on tobacco products within Australia, and investing in these companies could be seen as contradictory to these efforts. The Australian Sovereign Wealth Fund is intended to benefit the Australian people, and investing in tobacco companies could be seen as supporting an industry that is harmful to public health, rather than contributing to the well-being of the Australian population. The Australian Sovereign Wealth Fund has a responsibility to consider the ethical implications of its investments, and investing in tobacco companies could be seen as a violation of this responsibility, as the funds would be used to support an industry that is associated with significant health risks and societal costs. Topic: Universal Ownership and ESG Investing Definition of Universal Ownership: An institutional investor with a large, diversified portfolio (across asset classes, sectors, and geographies) that is effectively invested in a slice of the economy. Characteristics of a Universal Owner: A universal owner has a broad diversification of the portfolio, and the outcomes of the portfolio are tied to the overall performance of the economy. Examples of Universal Owners: Examples of institutional investors that can be considered universal owners include pension funds, sovereign wealth funds, and large mutual funds. ESG Investing for Universal Owners: ESG (Environmental, Social, and Governance) investing is the integration of ESG issues at the company level and the system level. Universal owners are interested in ESG investing to maximize shareholder value and mitigate systemic risks in their portfolios. ESG Issues at the System Level: Universal owners consider ESG issues at the system level because the performance of their portfolios is tied to the overall performance of the economy. For example, a universal owner may consider the impact of climate change on the economy and invest in companies that are taking steps to mitigate those risks. Pressure on the Australian Sovereign Wealth Fund: A real-world example of the pressure on a universal owner to divest from tobacco companies due to ethical considerations and the potential impact on the healthcare system. Note: Universal ownership is a relatively new concept for many people. ESG investing is a way for universal owners to maximize shareholder value and mitigate systemic risks in their portfolios. ESG issues at the system level are important for universal owners to consider because the performance of their portfolios is tied to the overall performance of the economy. Discussion Questions: What are some examples of ESG issues at the system level that universal owners should consider? How can universal owners balance ethical considerations with financial returns when making investment decisions? What are the potential benefits and drawbacks of divesting from companies that do not meet certain ESG criteria? Understanding Universal Ownership and its Impact on ESG Considerations Universal ownership is a concept that changes the perspective of ESG (Environmental, Social, and Governance) considerations from a company\'s performance to the portfolio\'s overall performance or the economy\'s performance Universal owners are tied to the overall health of the economy and are concerned with the systems that influence the overall health of the economy The Interaction of Systems and the Health of the Economy A sustainable company operates in the light green section between the ecological ceiling and the social foundation The environmental system provides an ecological ceiling for the economy, while the social system provides a social foundation for the economy The financial system is also a significant system that forms the basis of investment opportunities The significant deterioration or collapse of any of these systems will have significant implications for the health of the economy The Importance of Systems Thinking for Universal Owners Universal owners can think about systems thinking to consider the impact of externalities and the effects that they could have on their portfolio Systems thinking is a way of understanding the complex interactions between different systems and how they affect the economy and investment portfolios Universal owners can use systems thinking to identify risks and opportunities in their investment portfolios and make more informed decisions The Role of ESG Investing in Systems Thinking ESG investing can help universal owners to consider ESG issues in their investment decisions and manage risks associated with externalities ESG investing can also help universal owners to identify opportunities for sustainable and responsible investing that support the long-term health of the economy and the environment Conclusion Universal ownership and systems thinking are important concepts for understanding the impact of ESG issues on the overall health of the economy and investment portfolios By considering the interaction of different systems and the impact of externalities, universal owners can make more informed investment decisions and support the long-term health of the economy and the environment Understanding Externalities and their Impact on Universal Owners Externalities, when expanded to include ESG (Environmental, Social, and Governance) factors, are most naturally suited to a universal owner perspective as they are the ones impacted by these externalities Example: A chemicals company and a fishing company are the only two companies in the world. Emissions from the chemicals company negatively impact the environmental system that the fishing company and the beneficiaries of the universal owner\'s investment rely on. Impact of Externalities on Universal Owners Emissions from the chemicals company can alter the quality of raw ingredients for the fishing company, impacting its profitability Beneficiaries may have lower quality food, impacting their health Climactic changes from carbon emissions can make it more expensive for beneficiaries to insure or repair their homes Double Materiality Lens A double materiality lens is useful for universal owners to understand which sustainability issues might affect the value of individual companies and how individual companies are impacting the world and their broader portfolio The two other impacts mentioned are about the impact of the externality created by the chemical company on the beneficiaries, which is important for universal owners to consider Why Externalities Matter Most to Universal Owners If an investor is only invested in the chemicals company, they only care about the environmental externality to the extent that it could become regulated and they might have to pay for it But if they are a universal owner, they care about the environmental externality not just because the company they own may have to pay for it, but also because it is impacting the profitability of the other companies they own Understanding Fiduciary Duty and Interests Fiduciary duty is the legal obligation to act in the best interests of another party In the context of investing, it means managing an investment portfolio in the best interests of the beneficiary A broader view of interests can include environmental and social concerns, not just financial returns Universal Ownership Refers to the concept that large institutional investors, such as pension funds, own a significant portion of the economy Cannot diversify away from systemic risks due to the size of their portfolio Must consider the positive or negative externalities of their investments on the system Contrasting ESG Investing and Universal Ownership ESG investing aims to protect individual portfolios from systemic environmental and social risks Universal ownership aims to mitigate those risks in the real economy Modern Portfolio Theory (MPT) A financial theory developed by Harry Markowitz that suggests diversification is the key to achieving optimal returns for a given level of risk Universal ownership challenges MPT by suggesting that systemic risks cannot be diversified away Questions to Consider How does a broader view of interests affect the way investment portfolios are managed? What are the implications of universal ownership for core financial theories such as MPT? Note: The concept of universal ownership is still in its infancy in terms of theoretical foundation The first book challenging the financial orthodoxy of MPT using the concept of universal ownership was published only a few years ago Modern Portfolio Theory (MPT) There are two types of risks that investors face: idiosyncratic risk and systematic risk (market risk) Systematic risk determines most of the returns (74-95%) Modern Portfolio Theory states that investors can\'t do anything about systematic risk, it\'s just what you have to accept by being in the market Idiosyncratic Risk vs Systematic Risk Idiosyncratic risk can be controlled by the investor through diversification Systematic risk, on the other hand, can\'t be diversified away, it\'s the risk of being in the market Environmental and Social Issues in MPT Environmental and social issues, such as climate change, biodiversity loss, water stress, inequality, and social unrest, contribute to market risk These risks are a subset of systematic risk, and can\'t be diversified away Universal Ownership and MPT Modern Portfolio Theory states that Universal owners must accept systematic risk, but with their size and influence, they can attempt to reduce these risks Universal ownership challenges the foundation of MPT, as it suggests that it may be possible to impact systematic risk Understanding Universal Owners Universal owners are large pension funds or companies that have billions of dollars under management across multiple asset classes, geographies, and sectors They are considered \"universal owners\" because they own a diverse range of assets and are impacted by systemic risks, such as climate change, that cannot be diversified away Influence of Universal Owners Universal owners have the power to influence systemic risks due to their large ownership of corporate capital They can exercise their power through stewardship and collaboration with other investors Free Rider Problem The free rider problem is the issue of universal owners not contributing to addressing systemic risks because they believe that other investors will do the work This can lead to a lack of action and a failure to address systemic risks in a timely and effective manner Questions for Reflection Can universal owners influence systemic risks? Should universal owners take action to reduce systemic risks? How can universal owners overcome the free rider problem and work together to address systemic risks? Note: The above summary is based on a conversation about universal owners and their role in addressing systemic risks, such as climate change The conversation touches on the power of universal owners, the free rider problem, and the need for action from these large investors Understanding the free rider problem in universal ownership There is a free rider problem in universal ownership where some investors may benefit from systemic risk management efforts without contributing to them However, if investors believe that addressing systemic risks can benefit their portfolio\'s performance, they may be motivated to use their influence Universal owners should try to impact systemic risks for the benefit of their portfolio, as their portfolio is invested in every single company Challenges in measuring the impact of systemic risk management efforts It is difficult to prove the impact of systemic risk management efforts on market returns Investors must believe in the argument and their efforts to see any effect, rather than being able to link it exactly to improved beta Investors must run a counterfactual that will never materialize to prove the impact of their efforts This can be demoralizing for investors and make it difficult to measure the impact of their efforts Real-world action motivated by universal ownership thinking There is real-world action being motivated by universal ownership thinking Investors who are confused or skeptical about this concept should know that there is a lot of action being taken in this area Understanding Beta Stewardship Beta stewardship is the use of influence as a universal owner to protect and enhance systems It involves applying influence to improve a system, rather than an individual company The objective is to align corporate behavior with the long-term health of the systems Tools for Beta Stewardship Engagement: discussions between investors and companies Beta engagement is engaging with a company to talk about its impact on the broader system, rather than for its own sake Advocacy: a new tool for universal owners Examples of Beta Stewardship Climate Action 100: investors engaging with companies to reduce their impact on the environmental system The objective is to get companies to consider their impact on real-world systems and make positive changes Concept of Beta Beta is the market, while alpha is individual outperformance beyond the market Beta stewardship is about influencing the market, rather than individual companies Note: Beta integration and stewardship are not covered in detail in this course The focus is on engagement, beta engagement, and advocacy as tools for beta stewardship Understanding the goals of shareholder activism Voting is a tool used to get a company to change for its own sake or to change in terms of its impact on real-world systems Example of a shareholder resolution put forth at McDonald\'s by the Shareholder Commons to address the issue of antimicrobial resistance in agriculture The resolution aimed to highlight the impact of antibiotic overuse on the health of humans and the ability of shareholders to access effective antibiotics Framing of the shareholder resolution The resolution was framed as a way to protect the interests of shareholders and the health of the stock market, rather than just a problem for McDonald\'s The resolution received 12% support, which is considered a good result for a relatively new concept Advocacy as a tool for shareholder stewardship Advocacy involves influencing governments, policy makers, and regulators to enhance and protect real-world systems Investors can use advocacy to address issues that impact their entire portfolio, such as climate change, by collaborating with each other and working with governments Why would investors use advocacy? Advocacy allows investors to address issues that impact their entire portfolio and to work towards a more sustainable and stable market Investors can collaborate with each other and with governments to amplify their voice and increase their impact Investor Group on Climate Change (IGCC) A membership body focused on climate change policy advocacy Members include institutional investors representing \$2 trillion Members hire a lobbyist named Irwin to advocate for climate change policies to the Australian and New Zealand governments The goal is to implement climate change mitigation and adaptation policies aligned with the Paris Agreement The IGCC\'s job is to engage with governments to create top-down, government-led change Other points: There is a difference in engaging with individual companies versus the government Investors have more leverage with companies because of shareholding and influence Investors have less formal power with the government, but still have some influence through lobbying The Paris Agreement is a global agreement to reduce greenhouse gas emissions and limit global warming to well below 2°C above pre-industrial levels Claire and Speaker 1 are finalizing an assignment and will post it before the next week\'s lecture