What Is
system-LEvel investing?
using systems Thinking TO improve Risk and return
System-level investing addresses the impact of investments on the underlying social, environmental, and economic systems and the effect of that impact on long term financial returns. Particularly relevant for diversified portfolios, the concept builds upon what is known as “universal owner theory,” that (1) diversified investors are essentially invested in the performance of the entire economy and (2) the economy depends upon underlying systems such as a stable climate, a healthy workforce, and well-functioning institutions.
“Systemic risks are important for all investors and intermediation chain stakeholders as they affect the performance of markets that underpin all investments.”
System-Level Investing Recognizes that...
A Portfolio Approach to Investor Action
Adopting a system-level lens means that investors should drive companies to be more sustainable when it increases overall portfolio value even if doing so decreases enterprise value at a particular company.
It can lead to a range of possible actions that go beyond mere asset allocation decisions to influencing investment philosophies and mandates, stewardship strategies, collaboration, public policy advocacy, communications, research, and thought leadership, among others.
It is increasingly used by influential actors like asset owners, asset managers, governments, standards setters, academics, and shareholder advocates. For more info about who is adopting system-level investing, see here.
System-Level Investing Compared to Other Approaches
System-level investing is distinct not only from traditional investment approaches, but also from other approaches that explicitly take into account social and environmental issues like ESG and impact investing. System-level investing can complement these approaches while also providing an alternative that addresses their inherent limitations.
Examples of ESG and Impact Investing
- ESG Investing: Considering risk of new environmental regulations to publicly traded fossil fuel companies
- Impact Investing: Investing in a cage free egg company to promote animal welfare
System-Level Investing Examples
- Considering the total economic / market effects of greenhouse gas emissions from high emitters in addition to the potential effects on those companies specifically
- Considering anti-bacterial resistance risk to the entire economy / investment portfolio, not just a risk to companies who may contribute to it
The Limitations of Alternative Approaches
- Traditional investing focuses on the financial returns of individual companies without regard to social and environmental risks and opportunities. It doesn’t include the potentially substantial impact that social and environmental impacts have on both company and porfolio returns on the whole.
- ESG investing accounts for the link between social and environmental impact and financial performance on the individual companies invested in. The research regarding this link, however, is mixed, as many profitable business strategies impose serious costs on people, communities, and the planet. It does not address the social and environmental effects that create significant economic and portfolio costs when they do not effect the individual company.
- Impact investing considers impact in addition to financial returns. This approach is not relevant for those only motivated by financial returns, and in fact may not be appropriate for investors with a mandate to optimize financial returns only. It has tended to be applied in a private market context and as a subset of an entire portfolio, and as such also does not address the social and environmental effeects that create significant economic and portfolio costs on the whole.
- System-level investing addresses these limitations by being applicable at a whole portfolio level, across asset classes. It has a comprehensive financial justification for the investor to improve returns, and given its comprehensiveness, can enable bridgebuilding and complementarity across all other investing approaches highlighted above.
What System-Level Investing Isn't
System-level investing should not be confused with ESG or impact investing. While all three relate to social and environmental issues, system-level investing is unique in its portfolio-wide lens and financial justification. It does not incorporate impact for its own sake, nor does it rely on the potential influence of a company’s social and environmental profile on its own financial performance. System-level investing is complementary to and can enhance ESG and impact investing.
System-level investing is not just…
While system-level investing has a clear financial justification – improving absolute returns – it runs counter to the norms that currently exist in the investment industry, which are focused on measuring and incentivizing performance on a relative, alpha basis. As a result of these norms, contribution to beta from individual companies is disincentivized.
“The focus on externalities means that universal owners may at times have different interests than company management. This is in stark contrast to traditional financial thinking where an investor could think favorably of a company that profits from shifting part of its production cost in the form of negative externalities to other companies or society at large.“
WhY system-level investing?
system-level investing makes financial sense for diversified investors
It builds on established financial theory and practice, while expanding that theory and practice to better optimize returns.
The current design of the financial system favors beating a low benchmark over a higher absolute return even though it isn’t in the best financial interest of asset owners and their beneficiaries.
Established financial theory and practice
Modern investment practice rests on diversification to optimize risk and return. From sovereign wealth funds managing billions to workers saving for college and retirement, diversification enables investors to capture the higher returns of risky assets while mitigating the idiosyncratic risk of overexposure to any single company or sector.
This diversification means the most important factor determining investment returns over the long term will be the return of the market itself, rather than whether any particular company in a portfolio does better or worse than the market.
Expanded to better optimize returns
Decades of experience and research demonstrates that predictably and consistently beating the market over the long-term is very difficult for most investors. System-level investing recognizes this reality and concludes that some of the resources investors spend on efforts to beat the market may be better spent on raising its overall return.
Moreover, investors’ current focus on measuring, managing, and incentivizing alpha actually undermines overall market returns because it encourages companies to seek profits from practices that externalize costs that threaten the social and environmental systems that underpin the whole market.
System-level investing re-balances the orientation between alpha and beta in a way that is more aligned with the best interest of asset owners and their beneficiaries. Alpha still matters, but only to the extent it drives absolute returns. System-level investing takes a purely financial approach based on achieving optimal financial performance results for investor portfolios, which are – by definition and best practice – diversified.
It also provides a powerful and evidence-based common ground across the spectrum of investors and their orientation towards sustainability issues – traditional, ESG, and impact investors can all collectively benefit from system-level investing.
For more information about the theory and implications of system-level investing, go to the Knowledge Lab, including the Resource Library featuring the foundational sources that have influenced these practices.
Together, we can fundamentally transform our financial system. Get involved today.