The Third, System Stage of Corporate Governance: Why Institutional Investors Need to Move Beyond Modern Portfolio Theory

Abstract

This paper focuses on underlying causes for the emerging systemic emphasis among major corporate governance institutional owners. It does this by building incorporating three stages of corporate governance: structure and process as governance (stage I), broadening to include E and S factors (stage II), and stage III, a system focus. By looking at system focus this paper breaks ground by arguing one must examine the role modern portfolio theory (MPT) in the investment processes and explore how MPT impacts corporate structure, behavior and governance.

We focus on the dynamics of a portfolio, and of multiple portfolios (the market) becoming part of governance analysis and actions, challenging the idea that portfolio investment risk is limited to diversifying idiosyncratic risk through security selection assuming that will have no impact on beta. There are strong feedback loops between portfolio risk management, beta and systemic risk: they are conjoined.

Keywords: Modern Portfolio Theory; Systemic Risk; Institutional Owners; Universal Owners; Asset Management

JEL Classification: G3