Morningstar - Q4 2022 - 37

Are We in a New Investment Paradigm?
Modern finance theories can't account
for systemic risk. Maybe ESG can.
Thomas Kuh
NEW PARADIGM
In his pathbreaking book, The Structure of
Scientific Revolutions, Thomas Kuhn argued that
science does not advance by the simple
accretion of knowledge through experimentation
and observation. There are periods when
there is broad consensus that the current theories
explain the phenomena they are intended
to explain. " Normal science, " as he calls it, is
practiced in the context of the prevailing scientific
paradigm. However, periodically anomalies
lead scientists to change their understanding of
the facts that shape their disciplines. Such
ruptures-such as the discovery that the Earth
revolves around the sun, not vice versa-
pave the way for the emergence of new scientific
theories. Kuhn dubbed these transformational
moments " paradigm shifts. "
Not surprisingly, the growing importance of
sustainable investing has motivated practitioners
and academics to grapple with questions
about its implications for finance theory and our
understanding of risk. Can it be assimilated into
current theory? Is it explained by a different
theory? Are we in the midst of a paradigm shift
in our understanding of investment risk?
We consider these questions from three distinct
perspectives: Modern Portfolio Theory and
the capital asset pricing model, behavioral
finance, and system-level risk.
The Rise of Sustainable Investing
The publication of Amy Domini and Peter Kinder's
Ethical Investing in 1986 and Investing for Good:
Making Money While Being Socially Responsible
(with Steven Lydenberg) in 1993 presaged
what we now call sustainable investing. Known
at the time as ethical investing or socially
responsible investing, SRI, the authors advocated
an approach that " examines the business
interests and practices relating to such ethical
concerns as minority hiring, environmental
hazards, and weapons manufacturing, and explains
how to make profitable investments without
sacrificing personal ethics. " So, SRI is about
enabling individuals and financial advisors to align
investment decisions with personal values
associated with their vision for a better world.
In 2004, the United Nations Global Compact
published a report endorsed by 20 major financial
institutions, along with the World Bank
and the International Finance Corp. " Who Cares,
Wins: Connecting Financial Markets to
a Changing World " articulated " guidelines and
recommendations on how to better integrate
environmental, social and corporate governance
issues in asset management, securities brokerage
services and associated research functions. "
The report reflected growing demand from global
asset owners and asset managers and offered
a blueprint for integrating these issues across
different actors in the investment value chain.
Framed in the vocabulary of mainstream finance,
the report was a catalyst in shifting the
conversation from the values orientation of SRI to
a focus on value-specifically, risk and opportunity
associated with environmental, social, and
governance factors in the context of the fiduciary
duties of institutional investors. And it gave
the world a new initialism, ESG.
Today, sustainable investing encompasses a range
of strategies including ESG, climate, and impact
investments. It is premised on the view that every
investment has real-world effects, whether
positive or negative. While diverse, these
approaches share the objective of leveraging
capital markets to generate more sustainable
outcomes. They also acknowledge implicitly
or explicitly that companies have an impact on
the world at the same time as the world has
an impact on companies.
What distinguishes sustainable investors from
investors exclusively focused on financial
considerations is their intention to integrate
analysis of ESG risks and opportunities, address
negative externalities of market activities,
and achieve positive impacts. In short, they
seek to change the framework and time horizon
for investment decision-making, though
achieving such ambitious aspirations remains
a work in progress.
The Rise of Modern Finance Theory
Finance theory in the 20th
century advanced
the understanding of risk by differentiating market
risk from the risk of individual securities and
showing how to reduce stock-specific risk
through diversification. It was founded on a set of
simplifying assumptions about the motivations,
behavior, and time horizon of investors, the
availability and cost of borrowing and lending, and
the efficiency of security markets.
In addition to offering a framework for managing
risk through portfolio construction, the elegant
theoretical framework enshrined broad
market-capitalization-weighted indexes as the
" market portfolio, " providing the rationale for
index-based investing. It elevated the role of
indexes from solely being performance gauges to
being an integral element of the investment value
chain and fueling the rise of passive investing.
The pillars of finance theory are Modern Portfolio
Theory, the capital asset pricing model, and the
efficient market hypothesis.
Modern Portfolio Theory, or MPT, is based on
the work of Harry Markowitz, which furnished the
first rigorous theoretical justification for portfolio
diversification. Developed independently
by William Sharpe and others, the capital asset
pricing model, or CAPM, builds on Markowitz's
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