Proxy Voting as if Systems Matter. Investors currently get essentially the same voting advice if they are broadly diversified or if their investments are highly concentrated. That doesn’t make sense if they are attempting to use their votes to enhance their financial returns. It also may not make sense strategically, even if they are concerned with environmental and social issues, given current predominant views on fiduciary duty. Proxy voting based on systems risk may be a better approach for most than proxy voting to maximize returns at any given company in our portfolio.
Proxy Voting as if Systems Matter: How We Invest
Sound investment practice mandates that fiduciaries adequately diversify their portfolios. This allows investors to reap the increased returns from risky securities while significantly reducing their overall risk. This insight defines Modern Portfolio Theory. This core principle is reflected in legal regimes that govern investment fiduciaries, such as ERISA, the federal law that governs private pension plans. ERISA requires plan fiduciaries to act prudently “by diversifying the investments of the plan.” [29 USC Section 404(a)(1)(C); see also Uniform Prudent Investor Act, § 3 (“trustee shall diversify the investments of the trust” absent extraordinary circumstances.].
The late John Bogle, founder of one of the world’s largest mutual fund companies, summarized the wisdom of a diversified investment strategy: “Don’t look for the needle in the haystack; instead, buy the haystack.” (The Little Book of Common Sense Investing: The Only Way to Guarantee your Fair Share of the Stock Market)
Thus, accepted investment theory and fiduciary standards require adequate diversification. However, once a portfolio is diversified, the most critical factor determining return will not be how the companies in that portfolio perform relative to other companies (“alpha”) but rather how the market performs as a whole (“beta”). “[A]ccording to widely accepted research, alpha is about one-tenth as important as beta [and] drives some 91 percent of the average portfolio’s return.” (What They Do with Your Money)
This distinction between individual company returns and overall market return is critical because shareholder return at an individual company does not reflect its “externalized” costs, i.e., those costs it generates but does not pay. Externalized costs may include harmful emissions, resource depletion, and the instability and lost opportunities caused by inequality. Diversified shareholders (including the Company’s clients) absorb the collective costs of such externalities because they degrade and endanger the stable, healthy systems upon which corporate financial returns depend.
Thus, while individual companies can externalize costs from their own narrow perspective to “maximize shareholder value,” diversified shareholders experience and, in a sense, “internalize” such costs through lowered returns on their portfolios. [Externalities and Corporate Objectives in a World with Diversified Shareholder/Consumers, Robert G. Hansen and John R. Lott, JOURNAL OF FINANCIAL AND QUANTITATIVE ANALYSIS, 1996, vol. 31, issue 1, 43-68 (abstract) (“If shareholders own diversified portfolios, and if companies impose externalities on one another, shareholders do not want value maximization to be corporate policy. Instead, shareholders want companies to maximize portfolio values. This occurs when firms internalize between-firm externalities.”)] Stewardship of the externalizing companies can reduce externalities (even profitable ones) to increase portfolio-level return.
In many instances, decision-making on proxy voting focuses on the effect that environmental and social behaviors may have on the financial performance of companies whose activity is at issue and not on the external costs such behaviors create. In so doing, the shareholder or fiduciary may be undercutting the 91% of potential return attributed to market return to maximize the 9% that comes from outperformance. Externalized social and environmental costs can play an outsized role in that 91%.
Voting on a system stewardship basis might involve, in particular instances, asking a company to forgo an activity that would improve its financial performance. However, that would also materially harm the economy due to the damage it causes to the environment. Decision-making focusing on the impact of externalities on portfolio-wide returns can help ensure better-rationalized voting decisions that reflect the effects on beneficiaries’ short- and long-term returns.
Proxy Voting as if Systems Matter: Current Advice is Inadequate
Current proxy voting advice could be said to be based on a pre-Modern Portfolio Theory of investing. If so, it was outdated before the major proxy advisory firms even existed.
Glass Lewis’ 2024 Proxy Guidelines – United States voting guidelines state: “Glass Lewis evaluates all environmental and social issues through the lens of long-term shareholder value. . . When evaluating environmental and social factors that may be relevant to a given company, Glass Lewis does so in the context of the financial materiality of the issue to the company’s operations.” (Emphasis added).
ISS takes the same position in its description of its “Global Approach” to “Social and Environmental Issues” in its United States voting guidelines: “While a variety of factors goes into each analysis, the overall principle guiding all vote recommendations focuses on how the proposal may enhance or protect shareholder value in either the short or long term. . . Management and the board should be afforded the flexibility to make decisions on specific public policy positions based on their own assessment of the most beneficial strategies for the company.” (ISS 2023 Proxy Voting Guidelines Benchmark Policy Recommendations).
The principal proxy advisers provide voting guidance on maximizing returns at each company they cover. However, both services offer overlays aimed at addressing investor values that go beyond maximizing returns.
For example, ISS’s Socially Responsible Investing Guidelines overlay a focus on the impact on society as a whole. The Guidelines state: “socially responsible institutional shareholders are concerned not only with sustainable economic returns to shareholders and good corporate governance but also with the ethical behavior of corporations and the social and environmental impact of their actions.” (Emphasis added). It also states: “On matters of corporate governance, executive compensation, and corporate structure, Social Advisory Services guidelines are based on a commitment to create and preserve economic value and to advance principles of good corporate governance consistent with responsibilities to society as a whole.” (Emphasis added).
Proxy Voting as if Systems Matter: Fiduciary Duty
Many fiduciaries might not be able to support proposals focused on broad societal interests given their singular mandate to invest in the best interest of their beneficiaries to increase portfolio returns rather than improving the plight of society as a whole. For example, the Employee Retirement Income Security Act of 1974 (ERISA) requires fiduciaries to “discharge his duties… solely in the interest of the participants and beneficiaries” [29 U.S. Code § 1104(a)(1)] ERISA also requires that the fiduciary diversify the investments of the plan). [29 U.S. Code § 1104(a)(1)(C)] Similarly, most state laws contain language that requires trustees of public pension funds to act in the “sole interest” of the beneficiaries. (Freshfields, A Legal Framework for Impact)
Controversy over proxy voting – primarily environmental, social, and governance (“ESG”) proposals, increases risk. (Corporate Democracy and the Intermediary Voting Dilemma) Proxy voting, using currently available advice, can be reasonably criticized from all sides.
Proxy Voting as if Systems Matter: Accounting and Legal Concerns
Creating the International Sustainability Standards Board (“ISSB”) to establish uniform environmental and social disclosure standards that companies worldwide will use to report to investors is a start in the right direction. However, ISSB drafters should recognize the risk of excluding beta (impacts on the costs that companies externalize to the economy, which affect overall securities market returns)
could, at the margins, lead to the omission of decision-critical information for investors concerned with company impact on social and environmental systems that support other portfolio companies. The increasing recognition of the importance of beta to investors could make a beta-free ISSB standard obsolete from the start.
Diversified investors are interested in ensuring companies in their portfolios do not threaten the rest of their portfolios when individual companies prioritize their financial returns over systems critical to diversified portfolios. Practically, this can mean maximizing profits by externalizing social and environmental risks to the detriment of other companies. (Climate Change & The Engagement Gap)
Law firm Freshfields Bruckhaus Deringer has explained why fiduciaries need to integrate social and environmental concerns into their analyses of company performance. They argue institutional investors are legally compelled to prioritize systemic issues such as climate change, inequality, and biodiversity loss over the financial performance of individual companies. ESG engagement focused on individual company financial performance is less important than efforts to preserve critical social and environmental systems.
Proxy Voting as if Systems Matter: Leading the Way
As far as I know, no one has developed anything like a comprehensive proxy voting policy based on voting to maximize portfolio-wide returns. However, The Shareholder Commons is leading the way with nascent beginnings. For example, they developed a variety of texts to emphasize a systems-first approach in describing investment beliefs, voting in director elections, mergers, etc. Another brief paper addresses why proxy voting policies should incorporate beta.
The Shareholder Commons recently outlined Model System-Stewardship Investments beliefs & Proxy Voting Policy. They have also become more granular, highlighting upcoming 2024 proxy votes that address diversified investors’ common interests. Portfolios On The Ballot (POTB) will flag
shareholder initiatives that feature a strong systemic argument. This broad, market-wide perspective distinguishes system stewardship from strategies that focus solely on the enterprise value of the stewarded company. This fact sheet explains why the shift to system stewardship is the right next step to further protect the long-term value of investors’ portfolios, as well as the environment and social institutions.
Stay informed. Sign up for periodic updates. You will see many of my proposals on their POB lists. I hope to have even more in the future.
System stewardship is an approach that can be endorsed by red and blue states — those concerned with maximizing returns and advancing environmental and social issues. It will focus first on proxy issues with the most significant likely impact.
While it may make sense for corporate directors to focus on their company since that’s where their fiduciary duty lies, the same is not valid for portfolio managers and those advising them on how to vote. The vast majority of portfolios are broadly diversified. Since 91% of their potential returns are attributable to market returns, their proxy votes should be focused on minimizing systemic risk. Unfortunately, most are not voting to meet their fiduciary duty to fund holders. Instead, they vote as if they are corporate directors at each company in the fund’s portfolio.
The sooner proxy advisors and funds develop proxy voting policies to minimize systemic risks, the sooner we will enjoy better returns, a more harmonious society, and a salubrious environment. Let’s get started.