The Limits of Portfolio Primacy

Abstract

According to a theory that is gaining increasing support, we should expect large asset managers (and, in particular, index fund managers) to become “climate stewards” and force companies to reduce their impact on climate change. According to this theory, by maximizing the value of their entire portfolio (portfolio primacy) rather than the value of the individual company (shareholder primacy), index fund managers are incentivized to reduce climate externalities and therefore to steer companies toward decarbonization.

This Article offers the first systematic critique of this theory and identifies four crucial limits that undermine its practical impact: mispricing of climate mitigation, portfolio biases, fiduciary conflicts, and insulation from index funds stewardship.

First, the stock market underestimates the social benefits of climate mitigation. In particular, stock prices do not accurately incorporate climate risk, and private investors discount the distant future at a much higher rate than the social discount rate.

Second, index funds are not real “universal owners”; rather, they invest in subsets of the economy that are relatively less vulnerable to climate change. Many of the Big Three index funds with the largest holdings in the top U.S. oil companies have incentives to oppose aggressive carbon mitigation measures, and even index funds with the broadest market bases internalize global climate externalities in a very limited way.

Third, climate stewardship would create unsolvable fiduciary conflicts on multiple levels: between fund managers and fund investors; between large asset managers and undiversified shareholders; and between corporate directors and the individual company.

Fourth, even if index fund managers undertook the role of climate stewards, most firms across the world would be partially or totally insulated from index fund stewardship, because they are privately held, are owned by state governments, or have a controlling or influential shareholder.

The analysis of this Article reveals the serious limits of portfolio primacy and shows that this approach offers no adequate answer to the crucial threat of climate change. Policymakers should not rely on portfolio primacy as an effective substitute for climate regulation.

Keywords: corporate governance, index funds, climate change, portfolio primacy, corporate social responsibility, ESG, stewardship, common ownership

JEL Classification: D21, G30, G34, K22, Q5