Systematic Stewardship.

• Author: Gordon, Jeffrey N.

INTRODUCTION 628 I. STEWARDSHIP FOR FULLY DIVERSIFIED PASSIVE FUNDS SHOULD HAVE A STRONG SYSTEMATIC FOCUS 638 A. Shareholder Voice: Active Managers 639 B. Shareholder Voice: The Rise of Broadly Diversified Passively Managed Funds 642 C. Shareholder Voice: Towards Systematic Stewardship 645 II. SYSTEMATIC RISK: THEORY AND CANDIDATES 648 A. The Nature of Systematic Risk 649 B. Candidate Systematic Risk Targets for Systematic Stewardship 652 1. Climate Change Risk 652 2. Financial Stability Risk 654 3. Social Stability Risk 655 III. IMPLEMENTATION OF SYSTEMATIC STEWARDSHIP 658 IV. ADDRESSING CERTAIN OBJECTIONS 666 A. Corporate Governance Concerns 666 B. Common Ownership 670 C. Overclaiming 672 CONCLUSION 673 INTRODUCTION

This Article aims to provide a foundation for a form of engagement by large institutional investors and asset managers with their portfolio companies and with the broader corporate governance environment that fits both their theory of investing and their low-cost business model. I call this "systematic stewardship," an approach that is suited to an investment strategy that creates diversified portfolios while also minimizing costs. The canonical candidate is the broad-based index fund, which is constructed to replicate the performance of the stock market as a whole while charging tiny fees, even zero fees, to its beneficiaries. "Systematic stewardship" can also serve as a guide to any institutional investor pursuing a strategy consisting principally of wide-scale diversification and cost-minimization.

The core of the idea is this: The insight of "Modern Portfolio Theory," which has served as the foundational investment strategy for the asset management industry, is that investors' utility takes account of risk as well as expected returns so that investors' objective is to maximize risk-adjusted expected returns. (1) Accordingly, investors compete to create diversified portfolios to eliminate risk and, thus, are generally compensated for bearing only the risk that cannot be diversified away. Risk that pertains to a particular company, so-called "idiosyncratic" risk, can be diversified away; risk that will affect returns throughout the portfolio, "systematic risk," remains. Engagements that may improve firm-specific performance are generally idiosyncratic; they will not improve the performance of the portfolio as a whole. The possible exception requires the perhaps heroic assumption that such engagements are part of a pattern designed to produce "governance externalities" that lift the performance of all firms on average, producing positive economy-wide effects.

The straightforward implication is that advisors of extensively diversified portfolios, especially broad-based index funds, should focus on addressing the systematic risk elements in their portfolios rather than new forays into firm-specific, performance-focused engagement. This could take many forms. For example, it could mean voting in support of the management of a systemically important financial firm in a face-off with activist investors who want the firm to take greater risks to enhance shareholder returns. As the financial crisis of 2007-09 vividly illustrated, the failure of a systematically important financial institution (SIFI) can indeed result in losses across an entire portfolio. In deciding whether to support the risk-loving activist, the index-fund advisor ought to consider not only the return proposition at a single firm but the systematic risk effects. Portfolio theory teaches that investors in the index fund are seeking to maximize risk-adjusted returns, and so assessment of systematic risk effects becomes even more important in this case than the impact on single firm returns, an idiosyncratic effect.

A salient form of systematic risk is climate change risk. The disruptions associated with various realizations of climate change risk will ramify across the entire economy and thus across a diversified stock portfolio; climate change risk is systematic. Failure to mitigate climate change risks will thus reduce risk-adjusted returns for an index fund investor. Here is the importance of bringing a portfolio theory perspective: Many arguments for a climate-sensitive engagement entail a trade-off between expected returns and the social value of avoiding the potential for severe climate change harms, "socially responsible investing." Systematic stewardship grounds engagement to reduce climate change risk in the economics of investor welfare. Such engagement aims to lower systematic risk and thus improve risk-adjusted returns for portfolio investors. There is no trade-off between investor welfare and social welfare.

Although systematic stewardship seems most obviously to fit the broad-based index mutual fund or exchange-traded fund (ETF), it also can underpin engagement behavior by other institutional investors, such as defined benefit pension plans. Private-sector-defined benefit pension plans are subject to ERISA's "exclusive benefit" standard. (2) Although recent presidential administrations differ on the tightness of implementation, (3) the standard resists the trade-off of economic benefits for plan beneficiaries against other social values. But engagements aimed at reducing systematic risk do not run afoul of the "exclusive benefit" criterion; rather, they are in service to it. Indeed, pension fund managers who are not thinking about the systematic dimension in their engagements are falling short of the objective of maximizing risk-adjusted returns.

The insights associated with systematic stewardship also have implications for investment strategies that propose to "de-carbonize" otherwise fully diversified funds. The "business case" is that such strategies produce equivalent returns while avoiding association with objectionable investments and are perhaps even advantaged given the option value of gains if fossil fuel producers suffer severe losses from climate-focused regulation. (4) But once systematic risk is taken into account, this approach, along with other divestment strategies, can be defended only if "exit" is more likely to promote climate change risk-mitigation than "voice." Why? In the event of severe climate distress, the impact will be felt across the entire portfolio, the losses swamping any gains that may have been obtained through avoiding fossil fuel investments.

In one sense, there is nothing new in the claim that diversified institutional investors should and do, in fact, take a portfolio approach towards their engagement activities. For example, such investors generally have developed a normative model of "good" corporate governance expressed in "guidelines" that generates voting positions across the entire portfolio. To take a concrete example, institutions in general firmly reject classified boards, insist on annual say-on-pay votes, and argue for single-class common stock, not dual-class common. Supported (sometimes) by empirical evidence and other times by a certain logic about the value of managerial accountability to shareholders, such investors believe that adoption of these positions will increase the value of the firm, on average. These views are then uniformly applied across the portfolio, even though firm-specific analysis would surely produce governance heterogeneity. Surely some firms would benefit from the relative stability or other properties associated with a classified board, for example. The institutional investor response is yes, bespoke governance might be better for some firms, but given the cost, including follow-up monitoring required by such tailoring, uniformity will increase expected returns across the portfolio as a whole.

The portfolio approach is more pervasive, however. Diversified investors have a different approach to risk than undiversified investors. This affects the attitude toward business failure, meaning the optimal level of risk-taking and capital structure, and fundamental questions about the organization of the firm - against conglomeration and unrelated diversifying acquisitions, for example. A view that shareholders are obliged to take an "own firm" approach to corporate governance or voting cannot withstand widespread contemporary practice; nor can a claim that directors cannot manage what they know to be the preferences of diversified investors. (5)

Systematic stewardship also takes a portfolio approach. The distinctive twist is the focus not on how to increase expected returns across the portfolio but on how to reduce systematic risks and thus how to enhance risk-adjusted returns for the portfolio. This approach is not simply additive. It does not counsel: in addition to devising governance approaches that will increase expected returns, now also take into account systematic risk factors. Rather, reducing systematic risk may entail a trade-off with expected returns. For example, a diversified investor sensitive to systematic risk may have a different approach to risk-taking by large financial institutions and may favor rather than disfavor government regulation that targets such risk. It may regard its risk-adjusted returns as enhanced rather than reduced by measures that reduce expected returns on a portion of its portfolio.

In short, systematic stewardship provides a finance-based framework for the assimilation and assessment of concerns that fly under the flag of "ESG" (environmental, social, and corporate governance matters). (6) Some such concerns, climate change, for example, get quick uptake by systematic stewardship. Some elements may reflect shareholder preferences that do not have a strong systematic effect and thus may require a different justification. Not all issues that motivate ESG proponents will register on the systematic risk scale. For example, pressure for certain environmental measures may reflect an ethical belief that the firm should not impose externalities or should comply with applicable law and even engage in...