The Limits of Portfolio Primacy

According to a theory that is gaining increasing support among academics and market participants (“portfolio primacy theory”), we should expect the “Big Three” (BlackRock, Vanguard, and State Street) and other index fund managers to push companies to reduce their climate externalities and thus mitigate the threat of climate change. In a new paper, The Limits of Portfolio Primacy, I question the implicit and explicit assumptions of this theory and show its significant limits. My analysis reveals that the theory’s optimistic take on the social role of index funds is grossly overstated, and suggests that climate policy should not rely on index fund stewardship as a substitute for traditional regulation.

The basic premise of the portfolio primacy theory is that the goal of index fund managers and other diversified investors is not to maximize the value of individual companies (shareholder primacy), but rather to maximize the value of their entire portfolio (portfolio primacy). Index funds, the argument goes, mirror the whole economy and therefore internalize climate externalities. Even if an individual company has no incentives to reduce its own carbon emissions, index funds have strong incentives to push for such reduction.

But to what extent can index funds be expected to undertake the role of climate stewards? And how effective can they be in mitigating global climate risk? I identify four crucial limits of portfolio primacy: portfolio biases, mispricing of climate mitigation, fiduciary failures, and insulation from index fund influence. Taken together, these four limits should dramatically lower the expectations that portfolio primacy can be a powerful weapon in our fight against global climate change.

Portfolio biases

The first limit of portfolio primacy is that index fund portfolios do not necessarily mirror the entire economy. In fact, they might be overexposed or underexposed to particular industries, geographic areas, and companies of a certain size, and these portfolio biases may affect the fund’s incentives with respect to climate risk.

To illustrate this issue, I present a detailed empirical analysis of the Big Three’s holdings in ExxonMobil, one of the major carbon emitters in the world. This analysis shows that the 167 Big Three index funds investing in ExxonMobil are overexposed to energy companies, richer countries, and larger companies; therefore, their incentives are more strongly aligned with major carbon emitters as well as companies and countries that are relatively less vulnerable to climate change, and they are weakly aligned with industries, firms, and countries that are more vulnerable to climate change.

Furthermore, I simulate the exposure of Vanguard 500—the largest U.S. index fund—to local climate risk across the world, based on the geographic distribution of revenues of its portfolio companies. This simulation shows that Vanguard 500, due its overexposure to the United States and underexposure to Africa, India, China, and Middle East, internalizes only part of the global social cost of carbon and therefore inevitably underinvests in climate mitigation.

Mispricing of climate mitigation

The second limit of portfolio primacy is that stock markets underestimate the social cost of climate change and therefore create weak incentives for fund managers to invest in climate mitigation. To begin with, the emerging literature on climate finance casts doubt on whether stock prices accurately reflect climate risk, and a recent survey of asset managers shows that the prevailing belief in the industry is that stock prices underestimate future climate losses. Since stock prices do not incorporate the full benefits of climate mitigation, index funds have very weak incentives to push for those investments.

Furthermore, private investors, such as index fund managers, discount the distant future at a much higher rate than the “social discount rate”—the rate at which society should discount intergenerational climate damages. The consensus among experts is that future climate change losses should be discounted at a very low rate, comprised between 1% and 3%, and plausibly not higher than 5%. By contrast, a private investor in the S&P 500 uses a discount rate of about 7%.

To illustrate, consider an index fund that owns 1% “of the economy.” A fund that discounts future climate losses at a socially desirable 2% rate would be willing to pay up to $777 million today in order to avoid $1 trillion climate losses in 2150. By contrast, a fund that discounts future climate losses at the standard 7% rate would be willing to pay no more than $1.6 million to avoid the same losses. Hence, even if index funds perfectly mirrored the whole economy, they would massively underinvest in climate mitigation.

Fiduciary failures

The third limit of portfolio primacy is that index funds managers do not always do what is in the best interest of their clients. Therefore, even if the investors in the fund did benefit from climate mitigation, the fund managers would have very weak incentives to spend resources to engage in climate stewardship.

To begin with, index funds managers compete on low fees and can therefore only devote very limited resources to engagement and stewardship. Furthermore, any benefits created by climate stewardship would be shared with all competitors, even if the costs of the stewardship activity are borne only by the funds that actively engage in it.

Moreover, index fund managers manage dozens of different funds, which, due to their specific composition, might have conflicting incentives with respect to climate risk. For example, investors in an index fund focused on energy companies would not benefit from the same climate policies from which investors in a global equity fund would benefit. By pressuring companies to adopt climate policies that would favor one group of investors and harm another group, the investment manager that manages both funds (and is thus a fiduciary of both groups of investors) would face an irresoluble conflict of interests.

In addition to the problems affecting the fiduciary relationship between index fund managers and their clients, another important limit of climate stewardship is the absence of a fiduciary relationship between fund managers and other constituencies. Index funds invest in stocks and therefore their interests are aligned with those of stockholders but not necessarily with those of consumers, employees, local residents, and other stakeholders.

Taken together, all these fiduciary failures make the prospect of effective climate stewardship very unlikely, even in the instance in which index fund portfolios were to benefit financially from climate mitigation.

Insulation from index fund influence

The fourth limit of portfolio primacy is that most firms around the world, including most carbon emitters, are partially or totally insulated from the influence of index funds because they are privately held, are owned by state governments, or have a controlling or influential shareholder. Take, for example, the list of major carbon emitters recently compiled by the Climate Accountability Institute and widely circulated in the media. The list includes twenty companies that are allegedly responsible for one third of all global emissions. Most of these firms, however, are entirely owned by a state government (such as National Iranian Oil Co., Coal India, Petróleos de Venezuela S.A., and Abu Dhabi National Oil Co.) or, even if publicly traded, are effectively controlled by state governments (such as Saudi Aramco or PetroChina).

Or take the twenty largest stocks in the S&P 500, which account for almost 40% of the portfolio of the Big Three’s S&P 500 index funds. In half of these companies, the CEO-founder (or another main shareholder) has a significant equity stake in the company and, in most cases, is the single shareholder with more voting power. Private owners, state governments, and controlling or influential shareholders are unlikely to sacrifice profits in order to create portfolio gains for index funds and other maximally diversified investors. Therefore, even if index fund managers did engage in effective climate stewardship, vast portions of the global economy would be shielded from their influence.

Some policy implications

The analysis presented in the paper and summarized above has important policy implications. Policymakers can try to address climate risk through several different tools, including Pigouvian taxes, subsidies for abatement measures and renewable energy sources, cap-and-trade systems, and prescriptive regulation. Although portfolio primacy advertises itself as a powerful market-based mechanism to mitigate climate risk, the limits discussed above prevent it from being an effective weapon against climate change.

Policymakers should recognize the serious limits of portfolio primacy and reconsider its potential efficacy compared to traditional policy tools. Given the urgency of the climate threat and the significant limits of portfolio primacy, policymakers should focus their efforts on altering the incentives of individual companies rather than trust the portfolio incentives of index funds.

The complete paper is available for download here.