The Third Stage of Corporate Governance

The recent announcements from major institutional investors about issues such as gender diversity and climate change seem like reactions to social ills.  But they are not unmoored from investing. They are logical expressions of a relatively newly empowered, third phase of corporate governance that tries to improve risk-adjusted return through the use of systems-level risk mitigation.

For example, London-based Legal and General Investment Management (LGIM) announced it will vote against the chair of any board of directors that is not at least one-quarter female. It joins State Street Global Advisors, which paid for the “Fearless Girl” statue on Wall Street, as a champion of gender diversity. LGIM is explicit about its reason for activism: “We also work towards changing wider market standards, policies and regulations to make the financial system more sustainable…. The ultimate goal is to protect and enhance the investment returns for the benefit of our clients’ interests.”[1]

In a similar vein, the largest asset owner in the world, Japan’s Government Pension Investment Fund (GPIF) announced that it would fund managers focused on environmental and social issues, aiming primarily to lower risk and increase returns over the long term in the overall market.[2] Meanwhile, the CEO of the largest asset manager in the world, Blackrock’s Larry Fink, has warned that corporations must make “a positive contribution to society”[3]. And, of course, much of the asset management world strongly supported the Paris accords to fight climate change.

As much as institutional investors may seem to be taking on government’s traditional role of improving society, we believe they are engaging in the third stage of modern corporate governance and attempting to solve the major conundrum of modern portfolio theory (MPT), for which Harry Markowitz won the Nobel Prize. The centerpiece of MPT is diversification: A portfolio of seemingly risky investments is less volatile than each of those investments individually, as long as some have return patterns that zig while others have patterns that zag. A full description of MPT is beyond the scope of this brief article, but a key point of MPT is that, even though you can diversify the idiosyncratic risk of a particular security or sector,  the overall risk and return of the market – which investors call “beta” –  are beyond an investor’s ability to diversify.

The conundrum is that beta has far greater impact on the value of an investor’s portfolio than do the specific securities in the portfolio, even when those stocks, bonds, or other securities have been selected by experts. That leaves investors in an uncomfortable position – what they can control matters much less than what they cannot, when considering the absolute level of returns.  That is one reason so much of the asset management industry focuses on so-called relative returns – how manager x performs relative to the S&P 500 or some other index.  Using relative returns effectively neutralizes beta, allowing observers to see the difference between the return due to trading and portfolio management and the return due to the overall market, which MPT says is exogenous to an investor’s actions.

However, the actions of LGIM, GPIF, Blackrock and other investors directly refute MPT’s assertion of exogeneity. We maintain that, until now, theory has lagged practice. But, before detailing some of investors’ efforts to mitigate systemic risk, we briefly describe the first two stages of corporate governance.

The first stage emerged in the 1980s[4].  Sparked by perceptions of imperial CEOs, greenmail, and corporate raiders, institutional investors began to fight back. The Council of Institutional Investors was formed in 1985 amidst a rallying cry of “one share one vote.”  The council’s focus was on structural reforms to American corporate governance, such as confidential voting, boards with a majority of independent directors, independent audit and nominating committees, and, later, majority voting.  In retrospect, those reforms seemed aimed at systemic problems but were actually focused on bringing fairness to specific companies. The goal was to reduce economic rent-seeking by raiders and entrenched managements.

About two decades later, galvanized by the Exxon Valdez oil spill and the “Troubles” in Northern Ireland, and encouraged by the development of the Principles for Responsible Investing, investors in the second stage of corporate governance began focusing on environmental and social issues but again primarily addressed the problems of individual companies.[5]

The third stage dealt with the essential MPT conundrum that diversification only mitigates idiosyncratic risk, leaving investors fully exposed to the systemic risks of the real world. Those risks are incorporated into market beta and end up affecting an investor’s portfolio far more than does the selection of securities in that portfolio. Even a cursory review of recent efforts aimed at environmental, social, and governance (ESG) issues reveals many instances of portfolio decisions or actions by investors designed to have systemic impact. This is “beta activism.” Unlike the type of company specific activism practiced by investors such as Carl Icahn, these investors’ efforts are designed to affect the market as a whole, not just an individual security’s price.

The Investment Integration Project has identified 10 “tools of intentionality”[6] used by 50 institutional investors to affect systemic risk (and opportunity). They often go beyond selecting certain securities and involve running campaigns to change market practice.  So, for example, the 2 Degree Investing Initiative focuses on climate change awareness, and the New York City Comptroller’s office’s “Board Accountability Project” has effectively changed corporate governance across the U.S. large-capitalization public-equity market by successfully making proxy access the market standard. More generally, the new Investor Stewardship Principles, promulgated by 50 U.S. and international investors with some $22 trillion in assets under management, “are designed to establish a foundational set of investor expectations about corporate governance practices in U.S. publicly-listed companies”[7]

These and many other developments are not one-time efforts to deal with climate change, gender diversity, or governance standards but differentiated manifestations of the third stage of governance designed to reduce systemic risks.  This is complementary to the traditional trading activities of investment management, which focus on selecting securities to try to match or exceed the market risk and return.  Third stage governance, at long last, solves for the MPT conundrum and focuses directly on the systemic risks that contribute to beta.  The beta activism of these investors seeks to raise ESG standards and reduce systemic risks. In other words, the goal of third stage governance is to create a better beta.


[1]  Accessed May 11, 2018.

[2] Kenji Shiomura, ‘Efforts and Future Prospect of ESG Investment in GPIF’, November, 2017, no. 387. (translated from the Japanese).

[3] Accessed May 11, 2018.

[4] Certainly, there were governance efforts before this, some stemming back to Isaac Lemaire’s activism at the Dutch East India Company in 1609.  Similarly, when we note below the widespread adoption of ESG as a focus in the mid 2000’s, we do not mean to minimize the efforts of socially responsible investors and religious investors, who had been advocating for considering such issues decades before. Rather, we are dating the first and second stages of corporate governance to when those efforts gained widespread traction across a substantial portion of the investment universe that did not seem particularly concerned with the real world impacts of their investments but with the generation of risk and return of those investments.

[5] Hawley, James P. and Williams, Andrew T., ”Shifting Ground: Emerging global corporate-governance standards and the rise of fiduciary capitalism,” Environmental Planning A: economy and space (37:11) November 2005, pp. 1995-2013. Also at:

[6]William Burckart, Steve Lydenberg and Jessica Ziegler, “Tipping Points 2016: Summary of 50 Asset Owners’ and Asset Managers’ Approaches to Investing in Global Systems,” IRRC Institute and The Investment Integration Project (2016).

[7][7] Accessed May 11, 2018.

This post comes to us from James P. Hawley, professor emeritus at St. Mary’s College of California and head of applied research at TrueValue Labs, and Jon Lukomnik, managing partner at Sinclair Capital and executive director at IRRC Institute. It is based on their recent paper, “The Third, System Stage of Corporate Governance: Why Institutional Investors Need to Move Beyond Modern Portfolio Theory,” available here.