Institutional investors are increasingly facing pressure from their clients and others to focus more on ensuring that their investments promote corporate sustainability. Such expectations are reinforced by leading institutional investors’ commitments—such as those included in 2020 Larry Fink’s annual letter—to do well by doing good.
In a forthcoming article, I shed fresh light on the role of leading institutional investors in the transition toward stakeholder capitalism. I show that, while institutional investors may encourage the adoption of sustainability-oriented policies by corporations, their importance in the shift toward a more sustainable economic model may be overstated.
To begin with, the increasing attention paid by institutional investors to environmental, social and governance (ESG) factors and stakeholder interests is probably not prompted by altruism but rather the belief that such investors are likely to achieve higher returns at reduced risk and a shift in the preferences, and make-up, of investors. Indeed, while some argue that an increase in attention by largely diversified institutional investors on ESG factors can lead to risk-adjusted return for their clients by mitigating systematic risk at portfolio level, there is no doubt that the preferences of end investors have changed. Demand for funds that incorporate ESG factors into the investment strategies has been growing exponentially, increasing almost ten-fold between 2010 and 2019. Moreover, this trend is set to increase as more investment choices are made by Millennials (people born between 1981 and 1996), who—as is demonstrated by their initiatives to attract public attention to climate change—are particularly attuned to such issues.
What is more, institutional investors’ commitment to pursue sustainability objectives faces several limitations.
First, promoting more virtuous conduct by investee companies entails significant costs and can affect investment returns. Therefore, institutional investors devote relatively limited resources to stewardship activities that are key to promoting more virtuous conduct. For example, stewardship teams of the major institutional investors are significantly smaller than necessary to investigate most portfolio companies, leading those teams to rely on pre-determined voting policies or proxy advisers, the accuracy of whose analyses is a matter of debate.
Second, the proliferation of passive funds can impinge upon the capacity of institutional investors to encourage the adoption by investee companies of policies that pursue sustainability.
On one hand, growth in the number of ‘socially responsible’ passive funds could encourage managers to invest more resources in stewardship initiatives aimed at promoting sustainability policies. That could help to reinforce the fund’s socially responsible aspect, thereby attracting investors that are more sensitive to these issues and resulting in more fees that could justify greater investments in stewardship.
On the other hand, the issues are different where institutions track a third-party index, the composition of which the fund manager cannot influence. This is clear from the letter sent by top managers at BlackRock to their own clients, which clarifies that the intention of selling any listed securities (bonds and equities) in companies that generate more than 25 percent of their revenues from the production of thermal coal is limited to active funds. It is not possible to adopt this type of policy for passive funds that track a standard index, such as the S&P 500, as they are required to maintain the securities of the companies in their portfolios for as long as they are included in the benchmark index. Passive funds are thus unable to use the threat of divestment as a way of exerting pressure on the portfolio companies in order to influence particular choices; they can only rely on the exercise of voting rights and engagement.
All of this casts doubt on how much institutional investors can influence the shift toward stakeholder capitalism and, more generally, benefit society as an alternative to governmental or regulatory intervention. It is unrealistic to expect institutional investors to, say, fight to counteract climate change when such a task does not align with their clients’ and their own interests. Indeed, the expectation that institutional investors will invest resources to promote socially responsible conduct and ESG implies that institutional investors will absorb the costs of doing so, which can lead to lower net earnings for them and lower returns for their clients.
Consequently, public intervention seems necessary to introduce measures aimed at limiting the effect of potential disincentives for institutional investors. In addition, BlackRock’s Larry Fink has stated that pursuing causes such as sustainability, environmental protection, and a low-carbon economy, is a ‘challenge [that] cannot be solved without a coordinated, international response from governments.’ For example, institutional investors cannot stop climate change by systematically selling securities in companies that produce thermal coal without any additional legislative measures to promote the conversion of the still high number of coal-fueled industrial facilities.
Even if market forces were alone sufficient, vesting institutional investors with the task of pursuing objectives of general interest would not necessarily benefit society, given the potential consequences of increased concentration in the asset management sector and the effects of ‘common ownership.’
This post first appeared on the Columbia Law School Blue Sky blog here.