System-level investing ideas from a European investor tour

When Bill Burckart and I created The handbook of system-level investing, we did so with a simple goal. We wanted to show how institutional investors are already acting to improve the health of the systems on which capital markets ultimately depend. Why do they do that? They understand that 75-94% of the variability in their returns is related to the general price levels of the market, and that it, in turn, is dependent on the health of the economy and the social, environmental, and financial systems. By demonstrating how they act –what tools they apply and how – we hoped to make it easier for other investors to consider how to mitigate systemic risks.

So when a group of European institutional investors and investing organisations invited me to discuss system-level investing with them, I accepted. The result was a packed week of conversations, including leading Dutch pension investors APG and PGGM, about 100 other investors in two book launch events in London together with Bill, and at a two-day TransCap Initiative workshop with another 40 asset owners, managers, and market participants. Plus, of course, in numerous private discussions. Collectively, the participants with whom I spoke represented well over $2trn (€1.7trn) in assets.

The operative word in the previous paragraph is with — as in talking with investors, not at them.

Those investors recognise that systemic risks are already degrading portfolio returns and, left unchecked, threaten to become materially worse over time. They also see substantial investment opportunities in funding solutions to those risks.

Beyond theory

What struck me most, however, was that they were past the discussions about systems-level investing theory. They wanted practical tools. What are other institutional investors actually doing? What processes are emerging? Which approaches are proving useful in day-to-day investment decision-making?

Perfect. That is why we wrote The Handbook, and many mentioned that the practicality of The Handbook is what resonated with them. But they wanted more. As a result, our discussions surfaced five additional ideas for asset owners. Some are incremental extensions of current practice; others represent a significant shift from where most institutional investors are today. Some remain largely untested while others have already been piloted by a handful of sophisticated institutions.

All are worth considering.

1. Move from disclosure advocacy to substantive policy engagement

Several investors argued that institutional investors need to engage more directly on substantive policy issues, not merely on disclosure frameworks.

The problem is that stewardship and engagement professionals are often outmatched in the policy arena. Most investment organisations simply are not structured or trained to influence government effectively. Which raises an obvious question: Should institutional investors hire actual lobbyists?

Some investor associations already employ policy professionals, but it remains rare for asset owners themselves to do so. Some asset managers do lobby, but those efforts are usually directed toward advancing the firm’s commercial interests rather than addressing the systemic risks affecting beneficial owners and long-term portfolio returns.

Pension funds and other large asset owners do possess one lobbying advantage: the tens of thousands – and sometimes millions – of beneficiaries whose financial futures are directly tied to the resilience of these systems. That is a constituency few other policy advocates can match.

Of course, such engagement should remain grounded in the economic interests of beneficiaries and beneficial owners, rather than partisan politics. Thankfully, The Handbook details a four-part legitimacy test for determining which systemic risks properly fall within investor concern.

2. Put policy expectations into investment management agreements

Two stewardship professionals at different asset managers independently suggested another idea: asset owners should explicitly address policy engagement expectations in investment management agreements (IMAs).

Investment managers are extensively evaluated on portfolio construction, risk management, reporting, and stewardship activities. Yet policy engagement — despite its importance to long-term systemic outcomes — is rarely incorporated into formal mandates. Explicitly including expectations around policy engagement could change incentives and priorities. The fact that this recommendation came from two stewardship professionals from two different asset managers at two different events suggests that asset managers are being asked to engage with policy makers informally, but that the executives in those firms are pushing back, saying it’s not in the IMAs. That’s easily fixed.

3. Use RFPs and due diligence to normalise systemic-risk analysis

A third proposal also focused on IMAs and RFPs.

Asset owners should ask managers how they think about systemic risk – both in terms of how systemic risks affect portfolio performance and how portfolio holdings either exacerbate or mitigate those risks.

The goal is to normalise the idea that investment managers should think about the health of the systems in which markets operate, rather than merely trying to extract relative returns from markets exposed to deteriorating systemic conditions.

One particularly intriguing suggestion: ask managers to provide a system map showing the relationships between relevant systemic drivers, portfolio exposures, and potential interventions.

4. Hold “partner meetings” with managers

Most asset owners already conduct regular due diligence meetings with investment managers. One participant suggested adding something different: hold a dedicated “partner meeting” and ask about systemic risk.

These discussions would move beyond traditional manager reporting/oversight into a more collaborative exploration of shared systemic exposures.

Afterwards, asset owners could aggregate the insights across managers to identify gaps in their own understanding of the systemic risks embedded in their portfolios. In effect, the process could become a distributed intelligence exercise drawing on multiple perspectives across the investment ecosystem.

5. Ask actuaries harder questions about systemic risk assumptions

For pension funds, insurers, and other liability-driven institutions, another important suggestion emerged: ask actuaries how systemic risks — particularly climate risk — are incorporated into their models.

Too often, institutions rigorously debate investment assumptions while accepting actuarial Monte Carlo similations assumptions as technocratic. Yet actuarial models can embed powerful implicit judgments about economic growth, policy effectiveness, inflation, migration, mortality, and environmental disruption. Those assumptions deserve scrutiny.

Each of the individual ideas above generated considerable discussion. But, in the end, the most important takeaway from the trip was something broader: asset owners increasingly understand that systemic risk is not a niche sustainability issue. It is an investment issue. And investing has to evolve more tools to deal with it.

Jon Lukomnik is managing partner of Sinclair Capital, a strategic consultancy to institutional investors, and teaches system-level investing at Columbia University in New York. He is the former deputy comptroller for pensions in charge of investments for New York City’s pension systems and co-founded the International Corporate Governance Network (ICGN) and GovernanceMetrics International (now part of MSCI). He co-authored the book ‘Moving Beyond Modern Portfolio Theory’ and, more recently, edited ‘The Handbook of System-Level Investing’ with William Burckart, who also teaches at Columbia and is CEO of The Investment Integration Project (TIIP).