Journal of Sustainable Finance & Investment

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Investing for long-term value creation

Dirk Schoenmaker & Willem Schramade

To cite this article: Dirk Schoenmaker & Willem Schramade (2019) Investing for long-
term value creation, Journal of Sustainable Finance & Investment, 9:4, 356-377, DOI:
10.1080/20430795.2019.1625012

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JOURNAL OF SUSTAINABLE FINANCE & INVESTMENT
2019, VOL. 9, NO. 4, 356–377
https://doi.org/10.1080/20430795.2019.1625012

Investing for long-term value creation

Dirk Schoenmakera,b and Willem Schramade a,c

a
Rotterdam School of Management, Erasmus University, Rotterdam, The Netherlands; bEquity Department,
CEPR, The Hague, The Netherlands; cEquity Department, NN Investment Partners, The Hague, The Netherlands

ABSTRACT ARTICLE HISTORY

In the transition to a sustainable economy, companies are increasingly Received 21 March 2019
adopting the goal of long-term value creation, which integrates Accepted 26 May 2019
financial, social and environmental value. However, institutional
KEYWORDS
investors struggle to invest for long-term value creation and perform Capital markets; ESG;
the social function of finance. Traditional investment approaches, financial system; fund
based on the neo-classical paradigm of efficient markets and management; institutional
portfolio theory, only capture financial value in their financial risk investors
and return space. Attempts at ESG integration are typically too
shallow to overcome this problem. In this paper, we examine the set
of issues that make this problem so stubborn and we outline the
contours of an alternative paradigm, based on adaptive markets,
that is better able to pursue long-term value creation. This long-term
investment approach includes short investment chains, active
management that assesses companies’ transition preparedness,
concentrated portfolios, and deep engagement.

1. Introduction
The erosion of natural capital poses existential threats to national and global prosperity,
but political and economic systems are unprepared for responding to that risk (Cohen
et al. 2017). The sense of urgency is rising from a low base. The first climate bankruptcy
has already happened1 but governance, incentives and thinking are still misaligned. The
financial and corporate sectors could play an important role in turning the tide by truly
managing for long-term value creation. The concept of long-term value creation means
that a company aims to optimise its financial, social and environmental value in the
long term, making it prepared for the transition to a more sustainable economic model
(Dyllick and Muff 2016; Tirole 2017; Schoenmaker 2018). Unfortunately, current business
practices are still too narrowly focused on short-term financial returns, meaning that we
fail to achieve inclusive capitalism (e.g. Cort 2018). For decades, maximising profits has
been the leading objective in corporate finance. However, recent papers (Hart and
Zingales 2017) argue for a broader corporate objective than shareholder value in a
narrow sense.

CONTACT Willem Schramade [email protected] Rotterdam School of Management, Erasmus University, Postbus
1738, 3000 DR Rotterdam, The Netherlands
This article has been republished with minor changes. These changes do not impact the academic content of the article.
© 2019 The Author(s). Published by Informa UK Limited, trading as Taylor & Francis Group
This is an Open Access article distributed under the terms of the Creative Commons Attribution-NonCommercial-NoDerivatives License
(http://creativecommons.org/licenses/by-nc-nd/4.0/), which permits non-commercial re-use, distribution, and reproduction in any
medium, provided the original work is properly cited, and is not altered, transformed, or built upon in any way.
 JOURNAL OF SUSTAINABLE FINANCE & INVESTMENT 357

Hart and Zingales (2017) challenge the prevailing idea that externalities, like charity, can
be outsourced to the shareholders. They make a distinction between shareholder value,
which aims for maximisation of financial value only, and shareholder welfare, which incor-
porates social and environmental externalities. An important assumption in their model is
that these externalities are linked to a company’s operations. So, companies face a choice in
the degree of sustainability in their business model. The mechanism in Hart and Zingales
(2017) to guide that choice is voting by prosocial shareholders on corporate policy.
The internalisation of externalities is a dynamic process. That means that what is finan-
cially viable now can be loss making in the future (and vice versa). Some externalities are
already internalised through best business practices at companies, for example, energy and
material savings in the production process and cultivating an inspired work force. Further
externalities may be internalised in the future under pressure from government inter-
action, such as regulation and tax, societal pressure, and technological developments,
such as low cost solar and wind energy. Companies can anticipate and incorporate extern-
alities by connecting the relevant social and environmental dimensions to their business
model (Schramade 2016), making their business model transition prepared. That is in
line with the Hart-Zingales model, which assumes that the externalities are connected
to a company’s production process.
The materiality (or lack thereof) of the social and environmental dimensions is highly
context specific. It varies per industry, and also within industries, depending on the nature
of the industry, the specific company’s business model and local conditions. New evidence
indicates that there is a business case for full environmental, social and governance (ESG)
integration into investment. Companies that perform well on material ESG issues, also
show a superior financial performance (e.g. Clark, Feiner, and Viehs 2015; Khan, Serafeim,
and Yoon 2016). This is consistent with the idea that strong management of material ESG
issues brings a real competitive advantage.
Institutional investors are increasingly using ESG ratings to incorporate the social and
environmental dimensions in the investment process. But these external ratings rely on
scanty and sometimes conflicting data (Tirole 2017) and provide only limited information
on material ESG factors. Schramade (2016) argues that investing in sustainable companies
(defined as companies that optimise financial, social and environmental value in the long
term) requires doing fundamental analysis of the business model and the underlying value
drivers of investee companies. In that way, fundamental analysts can assess companies’
social and environmental value, next to their financial value. Unfortunately, very few
investors actually do this.
In this paper, we sketch the set of issues that make this problem so stubborn: the fact that
pricing, allocation and performance measurement are all versed in the language of efficient
markets; and that the other components of the current paradigm are skewed towards
optimisation within that same narrow financial risk-return framework. Long and compli-
cated investment chains -from the ultimate provider of capital to the ultimate user of
capital- mean that incentives are distorted, the horizon gets shorter with each extra party
in the chain and meaningful information is lost along the chain (Neal and Warren 2015).
We outline the contours of an alternative paradigm that is better able to pursue long
term value creation (summarised in Figure 1). It breaks away from efficient market think-
ing and assumes adaptive markets where the incorporation of sustainability information
into stock prices is an adaptive process, of which the success is dependent on the
358 D. SCHOENMAKER AND W. SCHRAMADE

Figure 1. Contours of an alternative paradigm. Note: EMH = Efficient Markets Hypothesis; AMH = Adap-
tive Markets Hypothesis; F = Financial; S = Social; E = Environmental.

number of fundamental analysts engage in transition preparedness analysis – and the

speed and quality of their learning; where investment chains are short, engagement is
deep. In such a setting, the financial system can fulfil its main task of allocating funding
to its most productive use, and achieving long term value creation.
Getting there requires a change of mindsets, which can be achieved by integrated sus-
tainable finance education and incentives from governance and regulation. This will take
time, but the first steps are being taken by advanced asset managers, asset owners, and
regulators.
This paper is organised as follows. Section 2 discusses how the current paradigm suffers
from an overreliance on market metrics and complicated investment chains. Section 3
then outlines what an alternative paradigm could look like and how it could be achieved.
Finally, Section 4 concludes.

2. The current investment paradigm and its (over) reliance on

market metrics
The efficient markets hypothesis and portfolio theory have been so influential over the past
five decades that they pervade the language and thinking of asset management. These the-
ories also established the separation of finance and ethics. Traditional finance is consistent
with the argument of Friedman (1970) that ‘the business of business is business’. In this
view, it is the task of the government to take care of social and environmental concerns.
This separation between finance and societal concerns seems especially true in the US
(Simon 2017) but it applies to the entire global financial system, which is dominated by
US asset managers and US investment banks. It is second nature for investors to think
and communicate in market benchmarks and market risks. This naturally affects the func-
tions of pricing, allocation and performance measurement in the investment process. It
also affects how sustainability is integrated; what investment approaches are favoured;
the complexity of investment chains; and the role of asset managers.

2.1. ‘Efficient’ pricing makes blind

The efficient markets hypothesis assumes that all relevant information of a company is
incorporated in that company’s stock or market price (Fama 1970). So, investors
 JOURNAL OF SUSTAINABLE FINANCE & INVESTMENT 359

cannot systematically beat the market. The market is supposed to be so efficient that it
immediately incorporates all relevant new information, making it impossible for investors
to benefit from superior insights or information. While there are differences in risk-return
profiles across assets, these assets are assumed to be priced accordingly. Arbitrage makes
sure that prices stay correct: abnormally high return assets immediately attract more fund
flows, which drive up prices and reset expected returns back to the market rate. As a result,
in the world of efficient markets, all information is incorporated in stock prices.
However, there is plenty of evidence that markets are not always efficient. Whereas the
efficient markets hypothesis assumes perfectly rational investors, a vast body of behav-
ioural finance literature has shown since the 1970s that people (including investors) are
far from rational (e.g. the early work by Tversky and Kahneman (1973), the review
article by Barberis and Thaler (2003)). The efficiency of markets has also been questioned
by strong evidence on the momentum factor, which shows that stocks that have done well
over the past few months tend to continue to do well over the next several months (Jega-
deesh and Titman 1993). Behavioural finance indicates that such lack of rationality has
important implications for financial markets, which can be seriously overvalued or under-
valued for extended periods of time. More recently, these behavioural anomalies have been
supplemented by sustainability anomalies (e.g. Khan, Serafeim, and Yoon 2016). This
indicates that pricing is a far from perfect signal, which should not be followed blindly.

2.2. Allocation close to the market

The capital asset pricing model built on modern portfolio theory (Markowitz 1952) stres-
ses that risk is an inherent part of higher reward. Importantly, risk and return character-
istics should not be considered in isolation per security, but by how much the investment
affects the overall portfolio’s risk and return. One can construct an efficient frontier of
optimal portfolios that maximise expected return for a given level of risk, leading to an
efficient economic allocation (e.g. Elton et al. 2014). In the capital asset pricing model,
the only relevant variable to determine a stock’s return is its sensitivity to the market,
which is called systematic risk. The non-systematic or idiosyncratic risk is not priced.
In equilibrium, all investors hold the market portfolio, which is replicated in the market
index. It suffices to adopt a passive investment approach by investing in the market
index. That is a very strong idea indeed. And in practice most investors indeed seem to
be positioned close to the market. But the problem is the narrow view on financial risk
and return, ignoring the social and environmental dimensions. Even the measure of
financial risk is rather narrow, as it is based solely on the volatility of past stock
returns, which not necessarily captures future financial risk, let alone the fundamental
risks of the companies in the portfolio.

2.3. Narrow performance measurement

Performance measurement is also versed in the language of portfolio theory. The narrow
financial risk-return thinking has led to a strong focus on the stock price as central per-
formance measure for executive and investor performance. The traditional way of per-
formance measurement is the benchmarking of an investor’s returns to those of the
relevant market index, which is confined to the financial risk and return dimension.
360 D. SCHOENMAKER AND W. SCHRAMADE

Market benchmarks are indices, such as the MSCI World Index or the MSCI All Country
World Index, that consist of a basket of the largest companies by market capitalisation in a
certain market (i.e. the global stock market, a regional market like Developed Asia or a
sector like Real Estate). The underlying idea is that the index represents ‘the market’.
When assessing a fund manager’s performance, his or her performance will be measured
against such a benchmark (was it higher or lower over the past 5 years, 3 years, 1 year, 6
months, 1 month, and 1 day?), correcting for the amount of risk the fund manager took in
achieving that result.
Measures for such market risk-taking include beta, tracking error, information ratio
and Sharpe ratio (e.g. Elton et al. 2014). These performance measures relate a portfolio’s
return to the market return (or the risk free rate return), which is calculated in a financial
risk-return space. In this view, there is no need to analyse the companies in the portfolio
themselves; only the sensitivity of the portfolio’s return to the market. The social and
environmental dimensions are not included in these performance measures. And how
can markets maximise long term value if its major components are not measured?

2.4. ESG considerations as an overlay; and the limitations of ESG ratings

Several efforts have been made to supplement the market metrics with ESG ratings and
ESG indices. But they only help to some extent. Like Corporate Social Responsibility
(CSR) on the corporate side, they do not address the core of the issue. Rather, they con-
sider ESG as an add-on to financials and business models, instead of as a driver of business
models and financials. That is also how most investment professionals have been using
ESG ratings and ESG indices: as yet another indicator that may look good or bad, but
which hardly affects their investment decisions.
The advantage of these ESG ratings is that they provide investors with a quick approxi-
mation of a firm’s ESG quality, just like a price-earnings ratio provides investors with a
quick view on a firm’s valuation. However, just like valuation multiples, ESG ratings are
merely imprecise shortcuts and one should be vigilant of errors.
In fact, ESG ratings have a number of limitations by design. First, ratings want to be too
many things to too many people. They have little focus on material issues (i.e. issues that
are relevant to the investee companies), while it is crucial for investment purposes to focus
on material issues (Khan, Serafeim, and Yoon 2016). This means that a materially negative
(and potentially fatal) issue is easily cancelled out by high scores on immaterial items,
resulting in serious mistakes, which would have been spotted in a diagnosis by a seasoned
analyst. For example, the software fraud at Volkswagen was not very surprising given the
major governance issues at the firm, with fighting shareholders and the local government
pushing to maximise financial returns and employment at the expense of environmental
standards. Although these issues were well flagged, Volkswagen nevertheless got very high
ratings with most of the ESG rating agencies as it ticked many positive boxes on other
issues.
Second, the ratings are based on reported data and policies, which is only a fraction of
what is needed for a good assessment and sometimes even conflicting (Tirole 2017). More-
over, it creates biases in scores, for example, on size (as they favour large companies with
big sustainability staff departments) and region (higher scores for European companies).
Yet other firms, especially small ones, get low ratings since they do not put enough
 JOURNAL OF SUSTAINABLE FINANCE & INVESTMENT 361

information on their policies in the public domain; or they get misclassified and compared
with the wrong kind of firms.
Third, scores are ‘industry neutral’ and based mainly on operations, while hardly taking
into account the products of the companies in question. This can result in ratings that are
intuitively wrong, as the least bad companies in very unsustainable industries (say coal or
tobacco) still get very high scores and can be named sustainability leaders.
Finally, there are too many stocks (as many as 70) covered per analyst, which also
makes an in-depth assessment unlikely. While the ESG ratings agencies do aim to
address these design limitations, they seem trapped in their own frameworks, which
they are reluctant to change because they want to maintain consistency in their data.
Hence, it is not surprising to see a lack of correlation in scores between ratings agencies.
Across 1600 stocks in the MSCI World benchmark, Howard (2016) finds a correlation of
26% between the scores assigned by the two largest rating agencies. Based on survey data,
Mooij (2017a) concludes that ‘reporting fatigue, a lack of convergence and the (some-
times) poor quality and transparency have made the ESG rating industry more vice
than virtue in the adoption of responsible investment’.
In sum, ESG ratings need to get better. Investors should not accept them as the con-
clusion on a company’s sustainability quality, but rather as a starting point for analysis.
What is more, they should reconsider some of their core assumptions to really embed
ESG in their investment process.

2.5. Passive as the favoured investment approach

The pervasiveness of efficient markets thinking also affects the choice of investment
approaches. Since all information is supposedly incorporated in stock prices, one could
argue that everyone should do passive investing, as there are no benefits from active
investing. The industry has increasingly been buying this argument, also since passive
investing minimises visible costs (i.e. fees) as well as career risks for investors and consult-
ants. And indeed, why would one buy the more expensive active approach if it fails to
deliver what it should, namely better long-term value creation and returns?
Some even argue that passive is inherently more sustainable as holding periods are
much longer. That argument is flawed though, as long-termism is not about long
holding periods but about long-term views on the economic viability of your investments.
This should drive decisions – which can imply that you sell a stock now as you do not
believe in its long-term survival.
The real strength of passive investing is that it involves huge amounts of capital that can
be moved across types of passive investing, i.e. across asset classes, and potentially also
from unsustainable to sustainable companies. However, its allocational role is ultimately
limited as it cannot really distinguish between sustainable and unsustainable business
models. Indices based on ratings (and their abovementioned problems) cannot do that.
Sustainable indices with exclusions of say tobacco have been an important step forward,
as they at least allow investors to avoid allocating capital to the worst models. But they
still do not select for opportunities, let alone long term value creation. Over time this
should get better, especially if voting and engagement on passive holdings becomes
linked to fundamental analysis of the underlying holdings. Active and passive investments
can then reinforce each other.
362 D. SCHOENMAKER AND W. SCHRAMADE

2.6. Long and complex investment chains

Long investment chains exacerbate the reliance on market metrics, as each party wants to
monitor the investment performance of the next party in the chain. Along the chain, a lot
of valuable information is lost. In institutional investment, there is a long and complicated
chain of parties that sit between the ultimate provider of capital (typically someone invest-
ing for his or her retirement) and the ultimate user of capital (typically a company or
project). In their simplest form, such investment chains look like Figure 2. But in practice,
such chains are much more complicated than suggested by Figure 2, because beneficiaries
have investments with multiple asset owners (pension funds of current and past employ-
ment; several insurance products) and multiple asset managers. In an investment chain,
there is a principal-agent relationship between the parties at each link, with implications
for allocation and performance. The investment performance of the asset manager is, for
example, measured against a clearly articulated market benchmark.
Investment decisions are often made across multi-layered asset owner organisations
supported by multiple consultants and ratings agencies. A pension fund, for example, typi-
cally has a long internal chain:

. Beneficiaries (pensioners and future pensioners);

. Governing board;
. CEO and/or CIO;
. Asset class heads;
. Supporting functions like finance, accounting, legal, and compliance;
. External and internal asset managers.

Delegated investment management – with multiple parties in the investment chain –

causes agency problems between the asset owner or principal on the one hand and the del-
egated asset manager or agent responsible for making investment decisions on the other
hand. Investment objectives, risk appetite, incentives, horizons and knowledge are

Figure 2. A stylised investment chain.

 JOURNAL OF SUSTAINABLE FINANCE & INVESTMENT 363

typically not fully aligned, neither across nor within organisations. These problems are
exacerbated when investing for the long term, where the payoff is distant and often
highly uncertain (Neal and Warren 2015). The human reflex is to battle such uncertainty
by focusing on short-term metrics that can be measured.
Problems arise from differences in investment horizons, a tendency to evaluate and
reward based on short-term results and a failure to commit. While an institutional inves-
tor might wish to pursue a long-term investment strategy for its beneficiaries, it might also
use a quarterly benchmark to evaluate its asset managers internally. Next, an institutional
investor might appoint internal and external gatekeepers to benchmark them against each
other. In such a setting, it is very difficult to avoid tactical investment decisions aimed at
short-term investment gains.

2.7. A limited role for asset management

In the current setting, the role of asset management firms seems limited to providing
efficiency and aggregation, especially as the belief in their alpha generating capabilities
has faded. With efficient market thinking, people seem to have forgotten about their
social function. However, a much bigger role for asset management looms in a paradigm
aimed at long-term value creation, as its success depends on services that need to be pro-
vided by asset managers, most notably analysing companies’ transition preparedness (see
section 3.4).

3. Contours of a new paradigm

This section proposes the elements of a new paradigm that is geared towards long term
value creation. The backbone of such a paradigm is an active investment approach
aimed at assessing companies’ transition preparedness. The aim is to uncover and
realise companies’ social and environmental value next to their financial value.
However, such an approach needs to be fostered in a context of proper governance, incen-
tives and structures. That includes the other dimensions, like performance measurement,
allocation and pricing beyond near-term financials. The incorporation of ESG information
into stock prices then becomes an adaptive process, dependent on the number of funda-
mental analysts, how they have their decisions determined by ESG factors, and the quality
of their learning. The remainder of this section considers the same dimensions as in
Section 2, but through the lens of their proper functioning in such a new investment
paradigm.

3.1. Pricing: from EMH to AMH

The adaptive markets hypothesis (AMH) provides an alternative description of markets
(Lo 2017). Contrary to the neoclassical view that individuals maximise expected utility
and have rational expectations, an evolutionary perspective makes considerably more
modest claims. The degree of market efficiency depends on an evolutionary model of indi-
viduals adapting to a changing environment. Prices reflect as much information as dic-
tated by the combination of environmental conditions and the number and nature of
distinct groups of market participants, each behaving in a common manner and having
364 D. SCHOENMAKER AND W. SCHRAMADE

a common investment horizon. For example, retail investors, institutional investors,

market makers and hedge fund managers can be seen as distinct groups with differing
investment horizons. If multiple groups (or the members of a single highly populous
group) are competing within a single market, that market is likely to be highly efficient.
If, on the other hand, a small number of groups are active in a given market, that
market will be less efficient. The adaptive markets hypothesis can explain how new
risks, such as environmental risks, are not yet fully priced in, as not enough investors
are examining these new risks. Indeed, Andersson, Bolton, and Samama (2016) find
that carbon risk is hardly priced by markets, which they attribute to limited awareness
of carbon risk among (institutional) investors. Hong, Li, and Xu (2016) find that
markets that are inexperienced with climate change tend to underreact to risks brought
on or exacerbated by climate change.

3.2. Allocation: from factors to investing for long-term value creation

However smart factor models and indices may be, they offer poor proxies of what we truly
want: long-term value creation. Indices are an attempt to insert ESG considerations, and
they are a moderate success in that they at least shift away capital from some of the worst
industries and companies. There is potential in dynamic indices that adapt portfolios
according to pre-set rules, but their effectiveness too depends on the availability of
better data, for which we need better performance management (section 3.3), deeper
ESG integration (section 3.4) and stronger signals from active management – the back-
bone of investing for long term value creation (section 3.5).
Private equity partly shows the way: private equity investors look into companies and
analyse future prospects (which could include transition preparedness), while taking a step
away from financial markets, short-term metrics and portfolios. It means deviating much
more from benchmarks. This is a path taken not just by sustainability investors, but also by
several investors looking for better ‘alpha opportunities’ in less well-known companies
that are not covered by several sell-side analysts. Cremers and Pareek (2016) show that
investing away from the benchmark (with high active share, as they call it) combined
with a patient investment strategy (with holding duration of over two years) generates
on average an outperformance of over 2% per year.
Governance plays an important role here, not just as a major consideration when asses-
sing potential investee companies,2 but also at the investors themselves. There, long-term
value creation should be the main objective and enshrined in fiduciary duty, prospectuses,
employee incentives and performance measurement.

3.3. Performance measurement: from short-term financial to long-term financial

and extrafinancial
3.3.1. Alternative measures of financial performance
Investors face an information problem when judging the performance of their fund
manager. One way of mitigating that problem is by benchmarking fund performance,
either to others in the industry or to an industry-wide index. That is an important
reason why relative return benchmarking and index-tracking is commonplace (Haldane
2014). The resulting problem is that funds are reduced to a few simple backward
 JOURNAL OF SUSTAINABLE FINANCE & INVESTMENT 365

looking metrics, which gives incentives for taking shortcuts, without real accountability.
Still, those metrics are not entirely without merit. So what to do with them? A possible
solution lies in using those same metrics in a more flexible, slightly adapted way, while
being cognisant of their limitations (e.g. only measuring the financial dimension).
For example, instead of measuring performance against a single benchmark, one
could use:

. A range of indices instead of a single one;

. A peer group of comparable competitor funds;
. An absolute return target, possibly corrected for an absolute risk metric.

An absolute return target is appealing as it is often more closely aligned with the goals
of the beneficiaries, which are typically in the realm of building capital over the long run
rather than beating indices. Jordà et al. (2017) find a long-term average return on equity of
about 7% in a cross-country study. An absolute return target could, for example, be 7%
over 5 year cycles. An absolute return target is not the holy grail of performance measure-
ment, but simply switching perspective and putting performance in a wider context is
valuable.

3.3.2. Extrafinancial performance

It is crucial to also have non-financial performance measurement, as we aim for optimis-
ation of the financial, social and environmental dimensions given risk. Ways to do that
include:

(1) Performance on specific key performance indicators (KPIs);

(2) Contribution to global sustainability goals.

3.3.2.1. Performance on specific KPIs. Investors increasingly consider company perform-

ance on specific KPIs pertaining to components of E, S and G. For example, on E, many
companies now report their scope 1, 2, and 3 CO2 emissions following to the Greenhouse
Gas Protocol (WRI 2015), and these data are fed into the Bloomberg data system available
to a large part of the institutional investment community (Bloomberg 2013). To a lesser
extent, this also applies to water and waste data (Bloomberg 2015). On S, there is increas-
ing reporting of data points like employee attrition, percentage women on the workforce,
job creation and safety data, like lost time injury frequency rates (LTIFR).3 On G, there is,
for example, the number of independent directors, gender balance and voting rules to
consider.
It is encouraging to see such data increasingly becoming available and indeed analysed.
But there are also limitations to analysing the performance on specific KPIs. First, each one
of the KPIs is too narrow individually. As they pertain to specific components of perform-
ance, their meaning on a standalone basis is inherently insufficient to obtain a holistic view
of sustainability performance. Second, sustainability is highly context specific, making
KPIs very hard to compare across companies and industries. The ‘normal’ values of
these KPIs are very much affected by the nature of a firm’s activities, and also by where
the boundaries of the firm are drawn. For example, safety issues are much more of a
366 D. SCHOENMAKER AND W. SCHRAMADE

concern for metals and mining companies than for financial institutions. Pryshlakivsky
and Searcy (2017) provide a list of types of such contingencies. Third, the KPIs in question
may not measure all that should be measured. Fourth, it is not clear if performance on
certain KPIs means a sufficient contribution to achieving a more sustainable model. As
Pryshlakivsky and Searcy (2017) find, these indicators tend to be self-referential rather
than context-based. In fact, when investigating the sustainability reports issued by sustain-
ability leader companies in Canada, they found none of the 463 environmental indicators
identified to be context-based.
In sum, reporting on sustainability KPIs is still in its infancy. Too often, companies
produce sustainability reports with data on immaterial issues that happen to be measur-
able. A dramatic improvement in reporting is needed and this should be a focus point in
company engagement. Such improved reporting should be context-based and show to
what extent a company harms or helps global and local sustainability goals.

3.3.2.2. Contribution to local and global sustainability goals (context-based). As men-

tioned above, a problem with specific KPIs is that it is often not clear what performance
is good enough. However, the planetary boundaries and the 17 UN Sustainable Develop-
ment Goals (SDGs) are global sustainability goals that provide a context for assessing just
that. They do require a translation to the meso level of specific industries and the micro
level of the individual corporation though. What is the current contribution of a particular
company right now? And what should its contribution be? Is it doing enough? And is its
business model fit for the transition to a more sustainable economic model? Frameworks
like Future-Fit (2018) and Reporting 3.0 (2018) give valuable guidance on how to answer
those questions and report on them. But even the most advanced sustainability reporting
companies have only just begun to explore these frameworks. Danish pharmaceutical
company Novo Nordisk is a pioneer as it has recently completed a Future-Fit assessment
and will report on it.

3.4. ESG considerations: from ESG as an overlay to assessing transition

preparedness
In Section 3.2, we argue for active management in concentrated portfolios, aimed at
assessing transition preparedness. In this section we expand on what transition
preparedness is, how to assess it, and how to achieve the change in methods and thinking
that is required for it.

3.4.1. What is transition preparedness?

Transition prepared means that a company’s business model is either already fit for, or
sufficiently flexible to successfully adapt to, a more sustainable economy. A typical
example of a transition prepared company is Novozymes. This enzyme maker helps its
clients to save energy and avoid 80 million tons of CO2. It currently gets paid for the
energy savings, but will be paid even better in case of a considerably high CO2 price
(Schoenmaker and Schramade 2019). By contrast, most airlines are not transition pre-
pared. They will suffer massive losses in case of a significant CO2 price and seem to
lack the options to avoid such a scenario (see the Air France-KLM case study with scenario
analysis, Schramade 2019). Other cases are less obvious. The typical fast food chain is not
 JOURNAL OF SUSTAINABLE FINANCE & INVESTMENT 367

ready for a world with high sugar and salt prices (due to taxes on them to reduce intake).
But it might be experimenting with food that is tasty, affordable and healthy - thereby
creating the option to survive such a scenario, and turn out to be transition prepared
after all.

3.4.2. Assessing transition preparedness and implications for methods

Assessing a company’s transition preparedness is not easy. The traditional tools are still
needed, but do not suffice. Investors have to look at companies through a different lens,
and go beyond traditional financial statement analysis and inserting some ESG ratings.
It requires an investment analyst to investigate a company’s externalities and their likeli-
hood of internalisation; the materiality of a company’s ESG issues and how well the
company manages these ESG issues; what issues are in or outside of management’s
control; what scenarios might occur with what implications and what probabilities. The
ultimate question is: can and will the company’s business model be adapted to a sustain-
able economy? This can be assessed at the company level but hitherto only in a diagnostic
way (Schramade 2016). This means that one needs an expert, like a fundamental analyst,
to make a judgement call as to a company’s preparedness. As we lack objective and scalable
metrics for preparedness, it is very challenging to make an assessment at the portfolio or
market level. Improved metrics and classifications are needed.
Figure 3 provides a simplified illustration of ESG analysis at the company and industry
level. An analyst starts by identifying the company’s material ESG issues, and subsequently
assesses those issues in both qualitative and quantitative ways to arrive at their financial
impact. While this analysis still falls short of full transition preparedness analysis, it
does show that quantification is not a mechanical process that can easily be put into a
formula.
Transition preparedness analysis is impossible with a passive investment approach and
nearly impossible with a quant approach. There are several reasons for this. First, ratings
are of limited use, as argued before. Second, there is a lack of universally relevant indi-
cators. For quant and passive approaches to be meaningful in assessing transition

Figure 3. Financial impact of qualitative and quantitative ESG information. Note: The first step is iden-
tifying the company’s material ESG issues. The second step is assessing those issues in both qualitative
and quantitative ways to arrive at their financial impact (the final step). Source: NN Investment Partners.
368 D. SCHOENMAKER AND W. SCHRAMADE

preparedness, they require indicators that ‘work’ at the market level, i.e. are relevant across
companies and sectors. But so far, these indicators are rare because materiality is industry
or even company specific. Where quant ESG is successful, it is mostly at tracking short-
term ESG momentum (Kaiser 2017) often without a theoretical model or clear thought
behind it, let alone a view on transitions. However, it can be very useful in a complemen-
tary role to fundamental analysis.

3.4.3. Achieving a change in mindsets and methods

While transition preparedness analysis is possible with an active approach, unfortunately
only very few do it (Cappucci 2017; Mooij 2017b). Ironically, part of the reason is that the
low relevance of ratings has made many analysts overly sceptical of ESG. Unfortunately,
that scepticism does not stimulate them to dig deeper themselves. So, a change of mindsets
is needed, which can be achieved by integrated sustainable finance education and incen-
tives from governance and regulation.
Finance courses at business schools and universities are still mostly taught from an
EMH perspective, with little reference to sustainability or even behavioural insights. It
would be a major step forward if (both regular and executive) students were taught in
the spirit of this article in at least one of their finance courses – and with plenty of real
life company examples for students to apply the new approach in practice.
Most corporate governance frameworks, corporate incentives and financial regulations
are squarely aimed at financial performance and financial stability. It would be most
helpful if regulators’ goals were widened to include the prosperity and survival of the
societies whose financial stability they are supposed to protect. This would be prudent
as financial stability cannot exist in a failing society. Similarly, the financial industry
should have a wider concept of fiduciary duty. This is a powerful tool as institutions
tend to stick very strictly to their fiduciary duty. Indeed, the High Level Expert Group
on Sustainable Finance (2018) recommends incorporating sustainability in the fiduciary
duty of institutional investors (and their asset managers) towards their beneficiaries and
clients.
On the reporting side, companies should be required to at least report on their material
ESG issues, allowing analysts to better assess their transition preparedness. Eventually,
companies should report on their full societal value, ideally providing an integrated
P&L and an integrated balance sheet. That road is long, but sustainable accounting initiat-
ives like SASB and IIRC are helpful. However, given the importance of context, it is prob-
ably wise not to standardise too early, as it would stifle creativity and innovation in
reporting. Rather, regulators are advised to require companies to answer a short list of
simple but tough questions.
All this needs to change and it will take time, but partly the change process will take care
of itself. The fact that very few do transition preparedness analysis, and that quants cannot
do it, is also an opportunity for very good financial performance (alpha generation in
Figure 4) – just like any use of valuable additional tools and data that most other
market participants do not use. This is adaptation at work. Over time, quant and even
passive will get better at it, as ratings are expected to improve. Figure 4 provides a
dynamic picture of the availability of qualitative and quantitative ESG data. The lack of
available data is very large now, but should diminish over time in line with the adaptive
 JOURNAL OF SUSTAINABLE FINANCE & INVESTMENT 369

Figure 4. The increasing availability of ESG data.

markets hypothesis (Lo 2017), with pockets of poorly used (and poorly available) data as
inefficiencies and opportunities to be exploited.
ESG integration can be complemented by engagement with investee companies (see
Section 3.5 below) to reap the full benefits of ESG research. However, for that to
happen, we need a change of governance and incentives in the investment chain, which
is overly long and complicated.

3.5. Favoured approach: from passive to active management in concentrated

portfolios with deep engagement
Compared to passive investing, active management has superior potential for achieving
long term value creation. Unfortunately, that potential is often not realised in practice,
as most active managers are still stuck in the current paradigm. Those active managers
that do realise that potential can still differ from each other in terms of say culture and
investment strategies. But two elements seem needed for achieving long term value cre-
ation: concentrated portfolios and deep engagement.

3.5.1. Concentrated portfolios

By its nature, thorough fundamental ESG analysis can be done for a limited number of com-
panies only, resulting in more concentrated portfolios. In a large cross-country study of hold-
ings of institutional investors, Choi et al. (2017) find that concentrated investment strategies in
international markets result in positive risk-adjusted returns, conditional on an information
advantage. Institutional investors concentrate holdings in their home market and selected
foreign markets and industries as if they possess an information advantage. Institutional
370 D. SCHOENMAKER AND W. SCHRAMADE

investors with higher learning capacity (i.e. skilled investors) form more concentrated portfo-
lios. These results suggest, in contrast to traditional asset pricing theory and in support of
information advantage theory, that concentrated investment strategies can be optimal.
Statman (2004) shows that a well-diversified stock portfolio needs to include just 50–
100 stocks to eliminate idiosyncratic or unsystematic variance of stock returns. There are
smaller benefits of diversification beyond those 100 stocks, but they are exhausted when
the number of stocks surpasses 300 stocks (see Figure 5). Risk management should
monitor that the stocks are not overly correlated (reducing their diversification potential)
and are spread over sectors and countries. Moreover, diversification gains are mainly
driven by a well-balanced allocation over different asset classes, like equities, bonds and
alternative investments (i.e. real estate, private equity, hedge funds, commodities and
infrastructure) (see for example Jacobs, Müller, and Weber 2014). Thus, for diversification
it is more important to have a concentrated portfolio in each asset class than to have a very
diversified portfolio (beyond 100 securities) in a single asset class.
Moreover, diversification comes at a cost, which might cancel out the low fee costs of
passive investing. First, diversification reduces selectiveness, which disappears almost
completely in passive strategies. In passive investing, it is not yet possible to invest only
in the sub-set of companies that are able and willing to transform towards sustainable
business models. However, it is possible to build passive investments on ESG adjusted
indices that exclude the worst industries, such as coal and tobacco. This negative screening
is a rather crude measure, but does steer investment away from the worst companies. And
over time such indices should become more sophisticated.
Second, the larger the number of stocks owned, the harder it becomes to have sufficient
knowledge about, and really engage with, multiple companies in the portfolio. Third, on
an aggregated level, widely diversified portfolios result in inadequate monitoring of cor-
porate management teams. A free-rider problem arises as small percentage stakes mean
that few investors have sufficient incentives to monitor management.

3.5.2. Engagement
Another element of an active investment approach is effective engagement with investee
companies on the long-term, both behind the scenes by meeting with companies and in

Figure 5. Diminishing benefits from diversification. Source: Statman (2004).

 JOURNAL OF SUSTAINABLE FINANCE & INVESTMENT 371

the annual general meeting by voting (McCahery, Sautner, and Starks 2016). Investors and
companies can exchange not only funds, but also ideas on how best to put these funds to
work. Even the companies that are already on a journey to become more sustainable still
need help in developing the most useful and cost-effective disclosure practices. And while
lots of investors want companies to provide more and better disclosure of their ESG
exposures, they tend to shy away from giving explicit recommendations. So, investors
need to become more active in communicating their demands and preferences for infor-
mation (Higgins et al. 2017).
However, such engagement is costly. It requires human resources, expertise and time of
the asset managers, ideally delivered in cooperation between portfolio managers, invest-
ment analysts and sustainability specialists. This is only feasible in a concentrated and
actively managed portfolio: 100 stocks can be followed and engaged by a small team of
people who work closely together. Engagement needs to be actively managed to allow
the investment case knowledge of portfolio managers and investment analysts to be inte-
grated into the engagement.
In practice, this happens at very few financial firms. Rather, engagement is typically
done at the group level for a small percentage of the holdings and by a team of engagement
specialists that lack knowledge of the firms’ investment cases and hence miss important
points, resulting in engagement on matters that are often not material. As passive portfo-
lios typically have thousands of stocks, the best a passive asset owner can do in practice is
to vote for all those companies along the guidelines of a proxy advisor and do engagement
with a few dozen companies.
Large (passive) asset managers could have a strong impact on promoting sustainable
business practices by their size. However, US evidence on proxy voting (Bolton et al.
2019) indicates that mutual funds, including the large passive asset managers (Black-
Rock, Vanguard and State Street), are more narrowly ‘money conscious’ investors that
often vote with management, while pensions funds support a more social and environ-
ment-friendly orientation of the firm. Moreover, Bebchuk and Hirst (2019) show that
mutual funds have an incentive to under-invest in stewardship, as they bear the full
cost but only get a tiny part of the benefit.4 For Europe, Dimson, Karakaş, and Li
(2018) find that institutional investors, in particular pension funds, are active in coordi-
nated engagement to influence firms on environmental and social issues. The large US
mutual funds, which also have a large presence in Europe, are absent in these coordi-
nated engagements.

3.5.3. Investment strategies: channelling capital to sustainability leaders or to

laggards that are set to improve?
One can employ a multitude of strategies to invest for long term value creation. And a
major question is whether it is better to invest in companies that already do well or in lag-
gards that look set to improve. On the one hand, investing in the leaders likely implies that
the capital will be used in a sustainable way, that risk is lower, and that good behaviour is
rewarded. On the other hand, investing in the laggards means that the invested capital
could make more of a difference. Moreover, the latter strategy may also be more profitable:
the European Centre for Corporate Engagement (ECCE 2016) finds that companies with
improving sustainability ratings outperform the stock market, while companies with
already high ratings do not outperform it (with the caveat of the flaws of ratings). Of
372 D. SCHOENMAKER AND W. SCHRAMADE

course, the answer does not need to be binary, as one could also invest in a mix of leaders
and improving laggards.
Investing in the laggards does raise additional questions. First, how to determine the
size and likelihood of the improvement? Second, will that improvement be good
enough to be consistent with global sustainability development goals or is it perhaps
better if the company perishes? Hence, where is the demarcation between laggards that
really want to (and will) improve significantly and the laggards that are beyond salvation?

3.6. Investment chains: from long & complex to short & simple
Building on our stylised investment chain in Figure 2, Figure 6 contrasts the ideal and the
current investment chain. The middle column illustrates the ideal investment chain from a

Figure 6. Ideal versus actual investment chains and their components. Note: IV = Integrated Value; FV
= Financial Value; SV = Social Value; EV = Environmental Value.
 JOURNAL OF SUSTAINABLE FINANCE & INVESTMENT 373

sustainable finance perspective. The asset owner (e.g. a pension fund or a retail client) is a
long-term investor, who cares about financial, social and environmental returns. If it has
sufficient scale, the asset owner can do its asset management in house. If not, the asset
owner appoints an asset manager, who invests on his or her behalf. The asset owner
asks the asset manager to report on financial and ESG returns, including carbon-related
financial disclosures of the invested companies. The asset manager also actively engages
with the company to promote sustainable business practices.
The final party in the investment chain is the company, which ideally has a board that
has adopted a sustainable business model, and applies integrated reporting. Closing the
circle, the integrated report provides the necessary information on financial, social and
environmental values to the asset manager, who can report back to the asset owner. All
parts of the chain are expected to understand the important aspects of sustainable
finance and its nuances.
This ideal investment chain does not exist in practice, and the right column of Figure 6
is a more realistic representation of current investment chains. First, there are multiple
parties in the chain: both within each nexus of the chain and across multiple nexuses
(an asset manager may delegate the investment to another asset manager and so on).
An example of the latter is an asset manager for a pension fund, who invests in a hedge
fund or private equity. There may be so many delegates that monitoring becomes very
hard. Second, performance metrics tend to be narrow. For example, the performance of
the asset manager is often measured against a clearly articulated benchmark. Third, incen-
tives are shorter term than desirable given fiduciary duty and investment goals.

3.7. Long-term investing in practice

Institutional investors are finding out that they can realise long-term investment returns
by investing in and engaging with companies that are capable of adding value over the
long-term, thereby having a positive effect on the value of their portfolios and on society.
In addition, asset owners can reduce the complexity of their investment chains by relying
less (or not at all) on external asset managers and consultants. For example, many Canadian
pension funds have insourced much of their asset management, achieving better returns and
lower overall costs. Their higher salary costs are more than compensated by lower external
fees, which is also known as the Canada effect (Ambachtsheer 2016).
A nice example of how long-term investing can be done in practice is provided by
Alecta (Schoenmaker and Schramade 2019). This large Swedish pension fund (€81
billion assets under management in 2016) has an investment strategy squarely aimed at
long-term value creation. The pension fund adopts a 15–20 year perspective on the
asset side and applies ESG integration in its investment process.
Active management of a limited number of shareholdings (104 listed shareholdings in
2016) is central to Alecta’s asset management model. This active management is done
through independent in-house analysis, focusing on the absolute return and risks of
investments using a 5-year average. This has significant advantages compared with
index management. Each investment decision is preceded by a sustainability review of
the company being considered. When Alecta invests in a company, it often becomes
one of the largest shareholders, which enables it to engage in a close dialogue and
influence the company in the desired direction.
374 D. SCHOENMAKER AND W. SCHRAMADE

Alecta’s total management costs are 0.09% of assets under management, of which
investment management costs are 0.02%. Alecta can keep its operating costs very low,
because it has cut out external asset managers and consultants. While a large pension
fund like Alecta has sufficient scale to do this, it might be more challenging for smaller
pension funds to do this. Such smaller players as well as retail investors will have to
rely on asset managers.

3.8. Role for asset management: truly performing the social function of finance
A new paradigm has serious implications for the role of asset management. The industry
can add a lot of value and build trust by offering active management aimed at long term
value creation, truly performing the social function of finance. However, for that potential
to be met, the industry needs to step up its efforts in terms of the depth and breadth of
transition preparedness analysis, its engagement, and the concentration of its portfolios.
Ideally, this feeds into passive products as well, making the two types of investment
mutually reinforcing.
In addition, asset managers will have to make products available to the public that not
only do the above, but also do it in a way that is credible and verifiable, which is quite a
challenge indeed as even professionals are confused by the current state of the field. This
task is not merely hypothetical since client demand for sustainable and impact investing
products is strongly on the rise. The younger members of wealth families seem particularly
eager to invest their capital in ways that make the world a better place.

4. Conclusions
The financial system is instrumental in achieving the transition to a sustainable
economy. To fulfil that societal role, investors have to move from a focus on short-
term financials, towards long term value creation. This requires doing fundamental
research into the investee companies. While several financial institutions aim to
move to investing for long-term value creation, traditional investment approaches
are still built and run on the concepts of efficient markets and portfolio theory. More-
over, long and complicated investment chains exacerbate the reliance on market
metrics.
This article identifies the contours of an alternative investment paradigm, aimed at
investing for long-term value creation. Its ingredients are adaptive markets thinking,
short investment chains, and active management in concentrated portfolios, with deep
engagement aimed at assessing transition preparedness.
These alternative ways are available, but not yet widely used. Some are showing the way,
but the asset management industry has yet to deliver its added value. Achieving paradigm
change requires a change of mindsets. For this, integrated sustainable finance education
and incentives from governance and regulation are needed. Finance education at univer-
sities is not much different from what it was two decades ago. That needs to change. We
need students that are trained in assessing transition preparedness; who are able to look
beyond both the numbers and the fuss. That requires examples, training and sharing of
best practices. And we need an evolution in governance, incentives and regulation that
stimulates long-term value creation.
 JOURNAL OF SUSTAINABLE FINANCE & INVESTMENT 375

Notes
1. Chunka Mui, ‘PG&E is just the first of many climate change bankruptcies’, Forbes, January 2019.
2. Indeed, Shrivastava and Addas (2014) find that strong governance can engender high per-
formance on E and S.
3. The lost time injury frequency rate measures the number of lost time injuries occurring in a
workplace per 1 million hours worked. An LTIFR of 7, for example, shows that 7 lost time
injuries occur on a jobsite every 1 million work hours.
4. While an asset owner receives a proportional increase in value of a company due to engage-
ment, the asset manager (which charges a small fee on assets under management) only
receives a tiny amount (the fee times the proportional increase in company value).

Acknowledgement
The authors are grateful to Magnus Billing, Mathijs van Dijk, Han van der Hoorn, Rob Lake and
Marno Verbeek, two anonymous reviewers and seminar participants at the University of Zurich
and Vienna University for very useful comments.

Disclosure statement
No potential conflict of interest was reported by the authors.

ORCID
Willem Schramade http://orcid.org/0000-0003-2004-4409

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