Hopeful Signs from a Difficult Year

Let’s face it: 2021 brought plenty of disappointments. The pandemic ground on, democratic ideals appeared to be in retreat around the world, and the planet continued to accelerate toward and even past critical boundaries.

But if we look upstream, 2021 also provided cause for hope. While each of these problems raise unique challenges, they all share a root cause: an economy that uses individual companies’ financial return as the primary measure of success, allowing and encouraging corporate behavior that exacerbates existential threats, as long as the behavior increases a company’s alpha, or return relative to the market. But we believe 2021 also provided hopeful signs that multiple stakeholders are beginning to recognize the dire implications of our alpha fetish.

A World Built Upon Alpha

David Foster Wallace’s memorable Kenyon College commencement speech began with this parable:

“There are these two young fish swimming along and they happen to meet an older fish swimming the other way, who nods at them and says, ‘Morning, boys. How’s the water?’ And the two young fish swim on for a bit, and then eventually one of them looks over at the other and goes, ‘What the hell is water?’”

For most of us, considering an enterprise’s financial return as a measure of success is so engrained that we don’t even think about it, let alone question it. Want to incentivize a CEO? Give her stock options, and make her hold them for a long time, so she will want to increase the company’s share price over the long term. Which hedge, private-equity, and venture capital funds should a pension fund seek out? Those that deliver the highest return so that the fund will be able to satisfy its obligations. Which asset managers should be paid the most? Those who deliver the most positive alpha, in order to deliver the greatest return to their clients.

Those answers seem so intuitive that we forget they are based on deep assumptions about the way markets and economies work. But those assumptions are wrong and increasingly dangerous. The truth is that companies (and thus CEOs and asset managers of all types) can create alpha by externalizing enormous environmental and social costs, and these costs threaten critical systems and human prosperity, as well as the value of diversified portfolios that rely on a healthy economy. But when we reward CEOs and asset managers, we don’t distinguish cash flow generated by exploitation from cash flow generated by innovation and hard work. (For a much more detailed discussion of these issues, you can check out this recent comment letter to the SEC, or just spend some time perusing our website.)

None of this should be news: “universal owner” theorists have spent more than two decades pointing out that most investors are locked into diversified portfolios that internalize the costs individual companies externalize. But even as companies and investors have recently recognized the need to be more socially and environmentally responsible, they have continued to focus on “financial materiality” and “enterprise risk,” assuming the market will magically reward the more responsible companies, so that financial return alone will be an adequate North Star to preserve critical systems.

This upstream failure to recognize the divergence between the financial success of an enterprise and the needs of diversified shareholders and other stakeholders underlies our most pressing concerns, as companies continue to be rewarded for monetizing disinformation, deforestation, inequality, and a multitude of other value destroyers.

The Good News from 2021

But 2021 was different. We fish are starting to understand the water we’re in, a necessary precursor to addressing the existential issues we face. Here we highlight a number of those signs that have occurred in the United States, the jurisdiction in which alpha primacy is most entrenched; signs that its markets may reorient towards systems stewardship is very good news for the global economy.


A Touchstone emerges. In early 2021, Routledge, the world’s largest academic “soft science” publisher, released Beyond Modern Portfolio Theory, a thin, tightly reasoned volume that explains how investing (and business itself) has become untethered from the needs of investors and the world’s population. The book, written by industry veteran (and TSC board member) Jon Lukomnik and James Hawley—an early universal-owner theorist—
has grabbed the imagination of investment professionals. Lukomnik reports:

“I’ve spoken at more than 50 events about the book, to institutional investors with more than $1 trillion in AUM. That is not to say that they all are moving to systems-level thinking; clearly the vast majority are not. But moving beyond MPT has now become central to the discussion in the investing community. You can see it in the acceleration of climate pledges and in various stewardship efforts focused on systemic risks. Other recent indications of how far we’ve come include a pension plan asking me to help them think through a systems-level statement of investment beliefs and a professor telling me that he was assigning chapters from the book for his course.”

A Law Firm Emphasizes the Need for Fiduciaries to Move Beyond Alpha. The legal implications of the damage alpha-chasing causes are emerging. A report international legal powerhouse Freshfields issued over the summer clarified that fiduciaries should prioritize healthy social and environmental systems over financial returns at any individual company:

“The more diversified a portfolio, the less logical it may be to engage in stewardship to secure enterprise specific value protection or enhancement. Diversification is specifically intended to minimise idiosyncratic impacts on portfolio performance…

“Yet diversified portfolios remain exposed to nondiversifiable risks, for example where declining environmental or social sustainability undermines the performance of whole markets or sectors… Indeed, for investors who are likely to hold diversified portfolios in the long-term, the question is particularly pressing since these are likely to be the main ways in which they may be able to make a difference.”

The Legal Academy Recognizes the Need for Fiduciaries to Move Beyond Alpha. The powerful logic behind system stewardship has led John Coffee, a highly regarded Columbia law professor, to predict in a working paper that activism meant to increase the share price at an individual company will shift to activism aimed at lifting the market by limiting externalizing behavior:

“This latter form of activism [system stewardship] is less interested in whether the target firm’s stock price rises (or falls) than in whether the activist investor’s engagement with the target causes the total value of this investor’s portfolio to rise (which means that the gains to the other stocks in the portfolio exceed any loss to the target stock). This recognition that change at one firm can affect the value of other firms in the portfolio implies a new goal for activism: namely, to engineer a net gain for the portfolio, possibly by reducing “negative externalities” that one firm is imposing on other firms in the investor’s portfolio.”

Jeffrey Gordon, another leading Columbia law professor, also has a paper out that clarifies
that investment fiduciaries are failing their beneficiaries if they don’t move beyond the one-company-at-a-time paradigm:

“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.”

Substantive Changes: Three Important “Firsts”

S&P 500 Company Publishes First Report Highlighting the Trade-Off between Its Profitability and Social Costs. YUM! Brands, the owner of Pizza Hut, Taco Bell, and KFC, published a report about its efforts to decrease the use of antibiotics in its supply chain. (The overuse of antibiotics creates antimicrobial resistance (AMR), which poses a significant threat to the global economy, with estimates of economic damage ranging as high as $100 trillion through 2050.) Unlike typical corporate reports on sustainability, the YUM report does not simply detail its own efforts. Instead, it soberly surveys the problem, and spells out the tension between market pressure for alpha, and the need to preserve antibiotic efficacy:

“AMR is a significant healthcare challenge facing society today. AMR impacts are not only measured in direct and indirect financial costs, but also in the cost of human lives and other societal costs. … This research appears to show that one of the most significant barriers to meeting the challenge of AMR is the balance between the rewards of proactive AMR mitigation and the cost of changing established husbandry practices.

“The challenge of individual costs and widely distributed societal benefits, a situation common in many sustainability issues, plays a key role in antimicrobial resistance. This may make it difficult to pursue AMR mitigation while remaining competitive on costs and highlights the need for strong collaboration between both the public and private sectors.”

This is what waking up to water looks like: a public company explaining that human lives are being lost because competition prevents companies from adding costs that would save those lives.

World’s Largest Proxy Advisor Establishes System Stewardship Position on Climate Change. The large proxy advisory firms have been very clear that their advice is based solely on an analysis of enterprise risk. When researching a social or environmental proposal, they recommend votes in favor only if adoption would improve the company’s financial performance. This alpha-first position has been a major hurdle to system stewardship
(because, frankly, sometimes systemic health demands that a company cease behaving in a manner that would maximize its own financial returns).

But ISS, the largest of the proxy advisors, has adopted a 2022 policy of voting against directors at companies that are not taking adequate steps to mitigate climate damage ”to the larger economy.” This is the first time a large proxy advisor has adopted a policy that is explicitly designed to manage companies’ impact on the system, rather than enterprise risk.

World’s Largest Asset Owner Supports Corporate Structure Allowing System Stewardship. BlackRock manages close to $10 trillion of assets and owns 5 percent or more of many large, publicly traded companies. A review of its literature on shareholder engagement reveals a strong bias toward enterprise risk-based engagement. But in its just-released proxy voting guidelines for 2022, BlackRock announced a new policy of supporting management proposals to convert companies into “benefit corporations.” Benefit corporations are expressly permitted to give systemic issues the same priority that they provide to financial return. Accordingly, this new policy recognizes pursuit of financial return to the exclusion of other interests is not necessarily in the best interests of BlackRock’s investor clients.

A Cultural Shift

The press is also recognizing that the old alpha-first paradigm serves investors poorly. Matt Levine, a Bloomberg columnist, recently wrote about the proposed amendments to an SEC Rule that would require broader disclosure about fund voting on ESG issues. His analysis recognized the shift toward system stewardship:

“I am kind of fond of this rule? It seems somehow postmodern; it seems to acknowledge a shift in corporate governance. In the olden days, what mattered was the corporation; particular things happened at the corporation, and the shareholders cared very much about that corporation and had particular views on what it should do. In modern markets, the paradigmatic shareholder is broadly diversified, and there is less reason to care about what any particular company does. What you want is for the huge diversified shareholders who have influence over every company to use that influence in a broadly desirable way. Companies are just data points; what you care about is aggregates. We talked the other day about a shareholder proposal at Fox Corp. that explicitly argued that the proposal might be bad for Fox’s bottom line, but will good for all the other companies that Fox shareholders also own. That is the way of the future.”

In the earlier column, Levine wrote about a shareholder proposal that emphasized the effect Fox Corporation has on the economy and diversified portfolios:

“The argument here is that (1) most of Fox’s shareholders are diversified (other than Murdoch of course), (2) diversified shareholders, in some sense, own the entire world, and (3) if a company’s activities are bad for the world, they are bad for its (diversified) shareholders, even if they are lucrative for the company. This is a theory that we talk about a lot around here, and it is in some sense a new theory. A decade ago there were plenty of diversified shareholders and index funds, but it was not common to talk to shareholders as though they were owners of the whole world. You would say, in your shareholder proposals, ‘this is good for Fox’s long-term value’ or whatever. You wouldn’t say ‘this is bad for Fox, but good for the world, and as a Fox shareholder you own a lot of other companies too so you should care about the world, not just Fox.

And while I see that sort of argument a lot now, this might be the first time I’ve seen it in a proxy statement. When Engine No. 1 LLC ran a proxy fight to replace several of Exxon Mobil Corp.’s directors in May, it positioned itself as a greener and more sustainable choice than Exxon’s board. But its rhetoric was all about creating better long-term value for Exxon Mobil. Engine No. 1 said things like ‘ExxonMobil has significantly underperformed and has failed to adjust its strategy to enhance long-term value’ and ‘a lack of successful and transformative energy experience on the Board has left ExxonMobil unprepared and threatens continued long-term value destruction,’ not, like, ‘you probably own real estate too, and if Exxon keeps drilling oil the rising oceans will flood it’ or whatever. ‘You own other stocks, so vote your shares of this company to maximize the value of your overall portfolio’ is still a weird thing to say, directly, to shareholders. But it makes sense, and it’s becoming less weird.”

Bloomberg Explains that “Sustainability Ratings” Focusing on Enterprise Risk to the Exclusion of Market Impact Are Worthless. In the fall, Bloomberg Businessweek published a scathing article noting the failure of MSCI sustainability ratings to actually protect any social or environmental systems. According to the article, the rating system fails because it only focuses on how sustainability issues will affect individual companies, and not how a company affects society and the environment:

“Yet there’s virtually no connection between MSCI’s “better world” marketing and its methodology. That’s because the ratings don’t measure a company’s impact on Earth and society. In fact, they gauge the opposite: “the potential impact of the world on the company and its shareholders.”

Leading Indexer Explains Why Market Return Should Trump Alpha: The need to prioritize system stewardship and market returns over enterprise value at individual companies was echoed in a recent essay by an index industry executive, who explained that a diversified shareholder should insist that a portfolio company with a powerful vaccine take steps that decrease its own enterprise value in order to boost the benchmark return.

“Why? From a narrow perspective, X should charge quite a lot for its vaccine, since it’s obviously worth a great deal. But from a universal owner’s perspective, X should give the stuff away (or at least sell it for marginal variable cost, which would be close to the same thing). X might well lose money, but an effective and plentiful vaccine would arguably cause the whole market to move upward sharply. Index funds would profit far more from the beta effect on their portfolios than from the alpha on a single stock.”


The last point makes a great segue to what this all means for 2022. Johnson & Johnson, which is fighting to preserve its patent rights worldwide, has received a shareholder proposal asking it to report on the tension between its desire to protect its own financial interest and the need to protect the global population and economy, both with respect to its COVID-19 vaccine. This is one of 20 proposals TSC is supporting in the 2022 proxy season, each asking companies for externalities analyses. Our regular January issue (watch this space) will be devoted to that campaign. We hope for your advance and vocal support on each of these proposals. Please contact Sara with any questions, or if you’d like to learn more about how you can help.

Looking Ahead

Frances Haugen, the Facebook whistleblower, testified:

“The company’s leadership knows how to make Facebook and Instagram safer, but won’t make the necessary changes because they put their astronomical profits before people.”

It marked a cultural moment, a clear recognition of the problematic water we have been swimming in for decades. The actions of BlackRock, ISS, YUM, Freshfields, and others described in this newsletter show that investors and businesses can begin the shift to a system stewardship mindset if the rest of us are ready.

But 2021 was just a beginning. Establishing the system-first investment field will take a concerted, collective effort to create a model that works better for all of us. It can be done with a willingness to put aside habit and tradition, and the courage to exercise some unused muscles.

We’re looking forward to 2022.


 Sign up for our newsletter here to get more updates from TSC on our work, research, and opportunities for action.