| Abstract: | Conventional wisdom holds that the performance of investment managers should be measured against some broad market index such as the S&P 500. The broad market averages provide a useful benchmark because they are assumed to be beyond the influence of investment managers and provide a way of capturing what financial economists call “systematic risk,” which is the part of total risk that cannot be avoided through portfolio diversification. But one clear limitation of such an approach to performance evaluation is that by focusing on risks and rewards at the portfolio level only, it fails to consider risks and rewards at a systemic level, where the performance of all portfolios is increasingly likely to be affected. The author begins by making the case that the performance evaluation and collective decision‐making of investment managers could have the effect of increasing the level of systematic risk in both the markets and the real economy. Then, after suggesting that the strength or weakness of environmental, social, and governance (ESG) frameworks can have substantial effects on overall market returns, he discusses a number of efforts currently underway to integrate ESG factors into portfolio‐level decision‐making. The author closes by urging asset owners to take the following three steps to help bridge the gap between investment decision‐making and ESG consequences: (1) acknowledge the connection between investment decision‐making and systems‐level risks and rewards; (2) determine which systemic frameworks are most appropriate and useful for their purposes; and (3) implement investment practices that allow them to manage systemic‐level risks and rewards while simultaneously achieving competitive financial returns in their portfolios. With the help of new measurement and management tools, asset owners can strengthen systemic frameworks, communicate the importance of ESG performance to their investees and investors, and align their efforts with those of governmental and non‐governmental organizations to limit systemic risk. |
