For Marcus Frampton, CIO of the $81.8 billion Alaska Permanent Fund Corporation (APFC), a handful of issues are front of mind in the current investment climate.

Tight spreads for corporate bonds, despite the likelihood of a default cycle in fixed income, have been driven by the fall in corporate issuance as companies wait on the sidelines for rates to fall.

Fixed income accounts for 20 per cent of the fund, and Frampton’s current focus is on quality investments only, avoiding more risk in the asset class.

In public equity, APFC is hunting opportunities in areas like value over growth, an overweight to gold miners and in a more contrarian allocation, China. None of the plays are huge bets (there is a 2 per cent tracking error in equity) but he is looking for pockets that run counter to wider market sentiment.

Alaska is approximately 1 per cent overweight the MSCI World allocation to China A Shares via KraneShares and iShares ETFs using dedicated managers that can trade a mix of A and H shares. The allocation sits in a sleeve of the portfolio called tactical tilts where the fund leans into opportunities.

“Lots of people are shying away from China but our overweight has done well in recent weeks.”

Hedge Funds continue to deliver

Hedge funds aren’t transparent; they are expensive, rarely put on high returns in a bull market and can be a tough sell with trustees and stakeholders. But Frampton describes APFC’s 7  per cent allocation as one of the most exciting and valuable corners of the entire portfolio, delivering 8.13 per cent and 5.74 per cent over 3 and 5 years respectively.

The allocation has come into its own in an environment where stocks are expensive and corporate bond spreads tight, and in the last quarter the APFC has redeemed several funds to lock in profits and bring managers to the desired allocation. It has around 20 mangers on its books including names like Elliot and Millennium, invested in equity market neutral, growth and multi-strategy funds; commodities and  CTA trend following strategies.

“If you are backing high quality macro, equity market neutral and zero beta managers it’s possible to outperform a 60:40 portfolio with no correlation.”

Real estate shows the cracks

In contrast, APFC’s slightly above target 11.5 per cent allocation to commercial real estate is showing some cracks. It makes the portfolio a natural place to source funds for recent asset allocation tweaks – namely increasing the allocation to private equity.

Alaska’s proactive build-up of real estate in recent years has focused on life sciences developments; apartments and industrial. Billion-dollar deployments also include active lending to construction projects via two separate accounts.

“If they don’t pay off at maturity, they are properties we don’t mind owning,” he says.

Still, the portfolio has experienced some lumpy patches. Like stakes in downtown office buildings, often only 20 per cent let, which remain an enduring drag on performance. The challenge lies in the fact these buildings are not easy to reconfigure into apartments. There are no balconies, and turning the existing space into apartment blocks would leave some like “the worst cabin on a cruise ship,” he says.

Frampton suggests the costs of converting offices into apartments may require subsidies from cities and reflects that many downtown office investments – often in the best locations – have now shifted to become a land play.

“Someone, at some point, will demolish the building and build apartments, but right now interest rates and construction costs are putting investors off.”

Turning up the heat in Private equity

APFC has just turned up the heat on private equity, increasing its target exposure by 3 per cent to 18 per cent, a tweak that brings the portfolio in line with the current overweight of 18.3 per cent.

With the S&P 500 up, the relative case for private equity is stronger than it was a year ago and Frampton is reaping the rewards of cutting programme pacing in 2021. Hitting the breaks back then meant allocations fell from $2 billion a year to $1.6 billion in 2021 and 2022, and  $1 billion in 2023 and forecast for this year too.

“It caused us to pass on somethings which was hard, but at the time everyone felt it was important.”

More so now given that investors that hit the accelerator coming out of the pandemic are now struggling. Witness Kaiser Permanente, and LPs USS and Washington State, reportedly selling in the secondaries market at a discount.

“We are in a luxurious position because we didn’t deploy,” he says. “I think 2021 and 2022 will go down as the worst vintages for private equity and I think we are coming out of it, this is an attractive market now,” he says.

He says AFPC is finding opportunities in industrials and the old economy. And with a typical cheque-size of $30-$50 million the investor can be nimble, unlike larger funds with ticket sizes of $100 million.

The venture allocation, sitting within private equity, has also been reset. APFC has a mix of fund investments and directs, and Frampton is currently figuring out whether to re-up with existing managers or explore new allocations given venture with a bias to software and biotech, has been hit hard in recent years.

“If you look at the private equity performance this year versus other state pensions, we’ve had a tougher time as venture has taken heavier market downs that buyout.”

He thinks the fund will reup with some venture managers but will also add new relationships in the more traditional buyout space.

Still, the team are quick to act when they see an investment they like. AFPC recently concluded a venture co-investment with a new manager for the first time.

“We know the manager well and we didn’t go into the first fund. But we looked at it and respect the team and made an exception.”

The £26 billion ($33 billion) People’s Pension, one of the largest master trust workplace pensions in the UK and forecast to reach £50 billion assets under management in the next five years, is modelling itself on Australia’s superannuation funds.

Dan Mikulskis, CIO of the People’s Partnership which oversees the pension fund, would like to set up an industry-owned asset manager modelled on Australia’s IFM Investors. He also likes the way Australia’s superfunds benchmark each other, and how they have built their own internal investment teams.

“We look outside the UK for our benchmark and the Australian superfunds are our closest cousins,” says Mikulskis who adds that the fund’s huge inflows will put it on a par with university scheme USS and NEST to become one of the biggest in the UK.

Since joining as CIO in September 2023, Mikulskis has spent most of his time developing the systems and processes behind the pension fund which was founded in 2012 off the back of auto-enrollment legislation. This has included building the team which now counts 900 staff working across the value chain in everything from customer service to administration.

Recently settled in new City of London offices close to the asset management community, he’s now turning his hand to investment strategy.

Most of the assets are invested in off the shelf index tracking funds, but Mikulskis has started to explore different products in a departure from a typical master trust. Around $15 billion (of the equity portfolio) was recently moved into climate indices, and now he is looking at how to move beyond index tracking to add value in fixed income and emerging markets.

“The huge choice of indexes means deciding which indexes to track is a strategic role. There are lots of choices we can make.”

Fixed income accounts for anything between 20-60 per cent of the (eight) different funds on offer and is focused on sovereign and investment grade global corporate bonds. He wants to push beyond standard products and approaches to include structuring bespoke mandates and leveraging the fund’s growing size and scale to shape a more adventurous approach to duration and credit, targeting parts of the market with more value for money.

“In fixed income, many of the products we use are higher quality and there isn’t much of a risk of defaults, but the returns are less.”

He says the delineation between active and passive has softened allowing a more creative approach. Strategies like buy and hold that involve more active decision making are now just part of a spectrum that includes custom indices and quant approaches.

He is also exploring different ways to access emerging markets which currently account for around 10 per cent of the equity allocation. Not only does he think emerging markets are cheap – “they were cheap a decade ago and have just got cheaper and cheaper” – he wants to carve out China where he says SOEs dominate. This could allow for increasing exposure to under-represented regions like the Middle East, South America and Africa.

“The term emerging markets is an early 80s label that doesn’t fit anymore. I’d like us to get more bullish on emerging markets and find a way of allocating that lets us unleash this. It’s difficult to get conviction in vanilla indices.”

The People’s Pension is still some way from developing an allocation to private markets, and one reason for Mikulskis’s caution is high investment management fees. The pension fund caps management fees at 50 basis points, and he doesn’t want to have to introduce a basket of investments with a higher fee. What he wants is a better split with alternative managers between economics and terms.

“In private markets, you can identify a good opportunity but end up paying a whole lot to the manager and it shouldn’t be the case. The end investors should benefit.”

Witness his decision not to join the Mansion House Compact. Names like Aviva, Scottish Widows, L&G, Nest, and Smart Pension have signed up to the endeavour by the UK government to get pension funds to invest at least 5 per cent of their assets under management in unlisted UK equities by 2030, but Mikulskis wasn’t keen.

“It is our choice where we invest, and we want to do it right. We want to dictate the terms and will allocate when the terms suit us and when the market is right,” he says.

He thinks the fund’s first foray into private markets will be in infrastructure, or possibly real estate, because these two asset classes are the most aligned around collaboration on fees, external co-investments and fund structures. “Open ever green structures are more prevalent in infrastructure than closed end funds which I don’t like.”

But for now he is prepared to wait it out. As the People’s Pension grows in scale, it will grow easier to swing fees in the fund’s favour and leave more of the return in the hands of members. He is also using the time to explore the possibility of setting up an industry-owned asset manager modelled on Australia’s IFM Investors, owned by a collective of 17 pension funds.

“This is one way to access private markets. We are talking to people about this, and trying to start the conversation.”

Despite the sizeable staff, there are only 20 people in the investment team. He says this will grow alongside AUM.

“We will get to 25 by the end of the year. It’s rule of thumb that you have one person per one-billion AUM, getting towards that.”

Once again, he is turning to Australia to see how to build internal teams and when to bring allocation inhouse. He also likes the Aussie comparison model that promotes competition in the sector via league tables, and has lead to underperforming funds merging with the most successful.

“The superfunds have a well-known and mature approach to compare performance.”

As he approaches his first year in the job, Mikulskis says his leadership will focus on cutting through short term noise and focusing on what the pension fund can realistically achieve. For example, introducing climate tracker funds will meaningfully reduce emissions in the portfolio and also chime with the fund’s competitive advantage, expertise and low cost priorities.

He wants to avoid being distracted by talk of uncertainty and risk, both of which are inherent to investment.  “We could walk in tomorrow, and our assets could be down by £2 billion. This will happen at some point and it is part and parcel of what we do.”

His approach is to shift his gaze upwards and draw on evidence of the past to see how asset classes will behave and have faith in the fact that in the long run stock markets go up.

“I like to start with the last five years, and focus on that number. Drop off those columns and rows that are short term and diving in too deep.”

 

 

The investment committee at the $94 billion State Teachers Retirement System of Ohio (STRS Ohio) has narrowly voted to block bonuses to investment staff.

The decision to stop at least $8.5 million earmarked for performance-based bonuses marks the latest turmoil at the pension fund. The 11-member main board has a 6-5 majority in favour of reform-minded trustees who have publicly supported moving the fund to index strategies and downsizing the 108-member investment team.

They also have the backing of a noisy beneficiary group, Ohio Retirement Teachers Association, ORTA, which has used the board election process (7 members are elected) to push reform-minded candidates onto the board.

In-house investment and costly alternative allocations have become a lightning rod for anger amongst ORTA members who never received an adequate annual cost-of-living allowance (COLA) given to retired teachers.

The previous board cut the standard 3 per cent COLA and then eliminated it for five years to help stabilise the system’s finances. Retirees got a 3 per cent adjustment in 2023 and 1 per cent in 2024, not nearly what they wanted.

Meanwhile, other forces are trying to pull Ohio STRS in the opposite direction. The state’s Republican attorney general is suing to remove two board members, claiming they have breached their fiduciary duties following an anonymous memo – reportedly from the investment team – flagging board misconduct. The board, the memo said, was lobbying to mandate 70 per cent of the fund’s assets to an investment firm touting an untested AI-driven trading strategy.

This hotchpotch of grievances made for a fraught June investment committee meeting where discussion included the annual review of performance compensation for the investment team. The testy back and forth, peppered with applause from current and retired teachers assembled in the audience, shows what happens when the investment team are drawn into politics and face public participation.

One board member argued that recent returns showed the fund was doing well without needing to pay higher compensation. “If we can get top performance and not pay as much, what’s wrong with this?” the board member asked. STRS’s net total fund performance is in the top 10 per cent of  sponsor peer group analysis over the long term.

A reference to the disconnect between asset performance and the COLA was greeted with angry shouts. Elsewhere, concerns from one board member that not paying the investment team performance compensation risked staff leaving, met with calls from the gallery to “let them walk.”

It fell to Lynn Hoover, acting executive director, to lay out the risks of not rewarding investment performance. Sixty-nine members of Ohio STRS 108 investment staff are eligible for incentive pay and current levels sit below peer funds, she warned. Competitive pay is crucial to the fund’s ability to attract and retain staff  at a time an increasing number of staff members are approaching retirement.

Over the last five years, 200 staff have retired or left the organisation, and between 90 and 95 current employees who have been at Ohio STRS for the past 25 years will also retire soon.

“Ninety four billion dollars in assets – that does not manage itself,” Hoover said.

Hoover added that investment performance is a key source of funding for benefits. She said internal management is a strategic advantage at the pension fund and provides low-cost access to both active and passive strategies. Outsourcing internal management would increase costs by an estimated $130 million annually.

“It is important for eligible associates to understand performance goals and expectations before the fiscal year begins,” Hoover said. The bonuses would be applicable for July 1 to June 30, 2025. Although the board agreed to explore alternative plans for employee performance incentives at a meeting in July, they did not set an exact date.

The meeting also exposed the challenge for pension funds when members of the board lack investment expertise. Witness one board member’s rapprochement of the investment team during presentations on asset class performance for using investment terms like tranches, credit and pre-payment risk. Calling for better explanations and clarity, and more information presented in a simple way, he said:  “It’s not helpful making decisions if you don’t have a good grasp of the information.”

Others countered it was incumbent on board members to take an active role by asking questions, and suggested focusing board scrutiny on the competency of investment staff in managing the fund and making investment decisions. Members of the investment team responded that they seek to find a balance between clear explanations and not dumbing down or patronizing the intelligence of the board.

Such discussions will surely grow more heated as the year progresses. Decision-making will now focus on a new asset liability study requiring board decisions on implementation and the asset liability mix.

The $127 billion Ontario Municipal Employees Retirement System (OMERS) has just written off its entire 31.7 per cent stake in troubled UK water utility Thames Water. Valued at £990m at the end of 2021, that fell to £321m by the end of last year, until trickling away altogether.

OMERS losses mirror write downs at other investors in the utility which are split over four continents. Like £75 billion British Universities Superannuation Scheme (USS) which wrote down its 20 per stake. According to financial statements published at the end of last year, USS valued its investment at £364.4 million. A 62 per cent write down from £955.8 million the year before.

Other investors include British Columbia Investment Management Corporation and  PGGM the Dutch asset manager for €237.8 billion PFZW, the healthcare pension fund.

Write downs and write offs won’t have much of a financial impact on the pension funds. But Tim Whittaker, research director at the EDHEC Infrastructure Institute in Singapore where he is also head of data collection, argues the losses illustrate that managing infrastructure assets is complex and has brought reputational damage to the investors.

“Not every organization has the skills to be able to do it well,” he tells Top1000funds.com.

What went wrong?

Whittaker says that Thames Water epitomised the stable and predictable cash flows that investors are attracted to in infrastructure. Yet the company’s previous owners (Australia’s Macquarie Group which owned the utility until 2017) took cash out of the business and increased the leverage “and the new owners failed to see this before it was too late.”

Despite abrupt and unexpected losses revealed at the end of 2022, just nine months earlier, some investors were still increasing the valuations of their stakes.

“For a large water utility to lose so much value so fast, the investment must in fact have been mispriced for several years leading up to the impairment,” writes Whittaker in an EDHEC paper “Low Tide” co-authored with Frédéric Blanc-Brude and Abhishek Gupta.

Now, faced with a choice between putting more money into the utility and recapitalising, or cutting their losses, investors have baulked. A key issue, says Whittaker, has been demands from Britain’s regulatory authority, OfWat, that investors cut their returns below the cost of capital.

“After more than a year of negotiations with the regulator, Ofwat has not been prepared to provide the necessary regulatory support for a business plan which ultimately addresses the issues that Thames Water faces. As a result, shareholders are not in a position to provide further funding to Thames Water,” wrote the shareholders in a statement published in March.

Lessons Learnt

Whittaker argues it is possible to learn important lessons from recent events. Firstly he says  “OfWat should recognize that not all water companies are the same and recalibrate the allowed return calculations to properly take into account the risk associated with these companies.”

This would require a change in the methodology for estimating the allowed returns (WACC) for water utilities, as the current method does not work.  “OfWat employs a long-discredited methodology to set returns. If market returns were employed, then investors would more likely to be willing to provide the funds needed to both invest in the network and reduce debt.”

He also warns that balance sheet arbitrage which allows companies to borrow more debt to pay more equity returns should not be allowed.

“A significant number of water utilities have done and are still doing this. It is only recently with the ban on dividends that OfWat brought in last year that we’re seeing these businesses recapitalize and reduce debt,” he says.

It leads him to reflect that previous owners of the water utility had short investment horizons and acted more like private equity investors than infrastructure investors. Having better scrutiny of the investors and incentivizing long-term asset management over short-term profit taking “should be the focus if the assets are to remain in private hands.”

The importance of a comparative view in infrastructure investment

Worrying, Whittaker believes there is every chance of it happening again. The report flags the authors concerns that infrastructure investors often see their investment in the context of one asset, not the wider market or peer investments.

“This narrow vision can obscure the big picture and the role played by market dynamics. When compared with its peers, Thames/Kemble Water showed some significant risks that were not accounted for when viewing the utility in isolation – as its investors apparently did when assessing the asset.”

Instead of concentrating their attention on just the one asset in isolation, investors would have done better to take a comparative view of Thames/Kemble Water with other assets in the UK and around the world, states the report. This would have helped to identify the red flags sooner and allowed for a better assessment of the risks involved in investing.

Published in partnership with Pictet Asset Management

The energy transition is happening; the only real question is the pace at which it takes place. The long-term direction appears set, but it is likely the path will not be smooth and will continue to present challenges to solve and questions to answer as asset owners work through an investment theme that touches all parts of the economy and all parts of society in one way or another.

To grasp the challenges and the opportunities of investing in the transition, it helps to break this very big, all-encompassing issue down into smaller, more digestible chunks.

The energy transition will touch all parts of the economy and all parts of society in one way or another. It’s a transition that will not be linear in progression, but one which Pictet Asset Management (Pictet AM) senior investment manager, active thematic equities, Manuel Losa says is inevitable.

“There are several risks, but they would only serve to potentially delay or slow down the transition, not stop it, Losa says.

Losa says it’s basic economics.

“Renewables have become drastically cheaper over the past decade, and they will continue to see cost decreases going forward,” he says.

“On the other hand, coal power plants or nuclear power plants are getting more expensive. The competitive economics have turned in favour of renewables and nothing will stop this trend.”

That said, investing successfully in the transition isn’t a given without an understanding of what’s really happening across economies, across industries and across businesses.

It’s not just investing in renewable energy – it’s far broader and deeper than that. And so, it’s not a trivial task.

All industries, many geographies

California State Teachers’ Retirement System (CalSTRS) portfolio manager Nick Abel says that “when you think about a multi-decade investment opportunity and trend, such as the energy transition, the transition to a net-zero global economy, this touches nearly all industries and spans many geographies”.

“How you allocate across the [capital] stack, whether it’s public [or] private equity or debt, really depends on your investment policy and your cost of capital…predicated on the focus on cost-efficient, commercially viable technologies to help decarbonise the way we produce goods and services.”

CalSTRS’ Sustainable Investment and Stewardship Strategy (SISS), which Abel co-manages, had about $2 billion invested at the end of 2023.

Abel says that in some respects, large investors hold an advantage over small investors because “you need deal teams willing to innovate or organisations willing to give flexible capital, not concessionary capital but flexible capital, to take advantage of nascent but rapidly scaling opportunity sets”.

“This portfolio that I help co-manage is a public and, growing, private portfolio that is unconstrained and has the flexibility to invest across various stages of company growth in venture growth, equity buyouts, private credit, real assets, and then all the way into public equities,” Abel says.

“When we think about our investment opportunity set, it really is an unconstrained investment portfolio focused on where there’s relative value across industry sectors and the capital stack of companies, and then ensuring that we get, or are likely to achieve, a commensurate risk-adjusted return for the risk that we’re taking with those investments.”

Holistic approach

Pictet AM’s Losa says “if we really think about what the energy transition entails, what it requires in a very holistic sense is also just as much about electrification as transitioning the existing energy supply” from fossil fuels to renewables.

He says the transition will rest on three main pillars.

The first one is about transitioning existing power generation sources away from fossil fuels such as coal and gas towards cleaner energy production, such as renewable energy, wind and solar.

The second pillar is what Losa describes as electrification.

“It’s about the various sub-industries and sectors that are also transitioning away from direct combustion of fossil fuels towards electrified alternatives because it’s more energy efficient, cleaner and also becoming more cost-competitive,” he says.

“And the reason for this is because if you can transfer direct combustion towards electrified alternatives, and then supply that electricity, with cleaner, cheaper power generation from wind and solar, etc, that is a true energy transition.”

Losa says said the first two pillars relate to energy generation and supply and the transition of industries to adapt to the new supply sources.

The third pillar of the transition is related to energy consumption, and “how we use energy efficiently; how we use our electricity; and things like demand-response solutions that help us to bring down our overall energy-slash-electricity consumption”.

That objective is to create “a much smarter, much more responsive energy system that is ready for how that future energy system will look”, he says.

How investors define the energy-transition opportunity set is linked to how broad a view they take of the transition, how far they look past simply renewables and clean energy supply to consider everything that needs to be in place to make those three pillars happen: electrification, energy efficiency, infrastructure, grid networks, and other issues besides.

Breaking it down

Again, to understand the potential opportunities, it helps to break down that big-picture view into smaller chunks.

“If you think about it from a supply-to-demand perspective, obviously the first segment is pretty intuitive: it’s really about renewable energy,” Losa says. He notes that this doesn’t mean only investing in renewable energy generation, but can also mean investing in traditional, fossil-fuel-powered generators that themselves will transition their supply to renewable sources.

“The next segment is what we call enabling infrastructure,” Losa says.

“Here, examples would be companies owning and operating electric grid infrastructure, or smart grid technology solutions, or any other types of infrastructure related to energy transition such as EV charging, et cetera.”

The third segment is what Losa describes as energy efficiency, “related to the demand side of the equation”. And here there are three subsets: efficient industry and manufacturing; green buildings; and smart transportation.

“And then the final segment is what we call enabling technologies,” he says.

“This segment consists of what we call the enablers of electrification, the enablers of the clean energy transition, which consists of the semiconductor value chain as well as energy storage or battery technologies.”

A driver of investment

The transition to a low-carbon energy and more climate-resilient world is an important driver of investment in a range of sectors, including infrastructure, real estate, growth equity and venture capital, says New Zealand Superannuation head of external investments and partnerships Del Hart.

Hart says investment opportunities in the energy transition are constantly evolving and NZ Super’s approach will “evolve as best practice evolves and better data is available”.

“For example, we are considering how to invest in carbon intensive businesses that are rapidly transitioning to sustainable solutions,” she says. And it’s also important to stay in touch with developments in the investment industry through formal and informal swapping of ideas and information.

“We regularly exchange knowledge with peers and external managers we consider to be leaders,” Hart says.

“We attend industry events to keep abreast of the moving landscape and evaluate how these insights impact our portfolio and/or strategy. The fund is also involved in several global target-based initiatives including Climate Disclosure Project, Investor Group on Climate Change, Climate Action 100+, [and] Net Zero Asset Owners Alliance (NZAOA).”

Local Pensions Investment Partners (LPPI) chief investment officer Richard Tomlinson says the energy transition is “easy to talk about, much harder to do and be practical” about.

“From an allocator and investment manager perspective, you’ve got three horizons,” Tomlinson says.

“There’s the short horizon, mid horizon, long horizon. The long horizon, think 10, 15, 20 years, it’s secular stuff. The short horizon, one or two [years].

“The long horizon stuff, I think, is quite well understood. There’s a direction of travel you’re going in, and people are saying that net zero by 2050, we’re going to decarbonise, you kind of know that.

“In the short horizon you’re really in the compliance and reporting-type stuff. It’s standards, it’s how do I get the data and all that good stuff. It’s the mid-horizon stuff that’s really challenging because that’s then actionable around how to execute. That’s the bit that’s hardest to define and most nebulous.”

While investing in energy-transition opportunities might seem like it naturally lends itself best to an active approach, it’s also possible for investors who adopt a passive approach to fine-tune their approach.

NZ Super’s Hart says the fund has changed the equity indexes it tracks for its passive strategies to indices that incorporate the Taskforce on Climate-Related Financial Disclosures (TCFD) recommendations, and which are “designed to exceed the minimum standards of the EU Paris-Aligned Benchmark, and [incorporated] equivalent ESG criteria into our multi-factor equity mandates”.

As a result, “more than 40 per cent of the fund’s net asset value shifted to a portfolio that is net-zero aligned”, Hart says.

Not without risk

While a broad energy-transition trend may be in place and, in Losa’s view, unstoppable, investing in an area that is technology-dependent and can be subject to regulatory disruption is not without its risks.

Losa – whose background is in aeronautical engineering – says some risks can be mitigated by focusing on investing in mature technologies.

“And by mature, what I mean is they are already commercially scalable without requiring subsidies,” he says.

“So, we are talking about solar PV, we are talking about onshore wind, where subsidies and policy support can act as an additional growth accelerator but in reality, they are already cost-competitive compared to other power production technologies without needing subsidies.”

Newer technologies continue to require subsidisation to be competitive investments.

“So that’s reason number one. Reason number two is from a regulatory perspective,” Losa says.

“Here, I’m not talking about subsidies, but rather other challenges for clean energy projects such as permitting.”

“Building renewables requires a relatively lengthy development process which includes gaining the required permits for wind farms or solar PV farms, or even new transmission or distribution grids. So, when these processes are delayed, they represent a risk to the project, causing bottlenecks at some point in time.

A third macro-issue is interest rates, but again, the impact is more to delay the transition in the near-term rather than derail it.

“One thing to bear in mind is renewables requires high capex, but low opex. You need an upfront investment, and then what you want to have is breakeven during the useful life of that asset,” Losa says.

“So the higher the interest rates, because you have the capex upfront, the less attractive it is for renewables at that point in time.

“On the flip side, the lower the interest rates, the more supportive the environment will be for renewables at that point in time. What we have seen right now with interest rates going up, was that the valuation for renewables might be going down.”

CalSTRS’ Abel says a major risk of investing in energy transition is that organisations lacking the “cross disciplinary and nuanced view on cost structures and business models and how technologies are maturing and how different industries are likely to decarbonise” may simply fail to capitalise adequately on the opportunities available.

“A generalist approach that largely buckets the clean energy transition into wind and solar underestimates the need to specialise, to find and achieved commensurate risk adjusted returns.

“It’s much bigger than just renewables, solar and wind story.  It really does require that cross disciplinary view thinking about technologies. And so I think that’s one big risk because traditionally, not all investors have devoted time to in-housing engineers or very nuanced technical experts beyond the investment team.”

In addition to  the risk that may arise from a lack of specialisation, NZ Super’s Hart says risks come from “all directions: regulatory risk, transition risk, physical risk, technology risk, changing market expectations”.

“We are very aware of the risk of greenwashing and mitigate this risk through thorough due diligence,” she says. “Thankfully, data quality is getting better.”

Return versus environmental impact

One of the challenges that arises reasonably regularly for investors grappling with the transition is the conflict between identifying an investment opportunity that stacks up on a risk and return basis, but which doesn’t measure up on immediate environmental or climate considerations.

LPPI’s Tomlinson says this issue is “very much an active conversation that we’re teasing out”. He says the discussion is being framed in an environment where investing in high-carbon assets isn’t frowned upon as greatly as in relatively recent years, provided there’s a credible transition pathway for the asset in question.

“We were debating if someone came to us with a coal fired power plant, or a business, which was essentially a coal-fired power plant, but they said they’re going to decommission it and here’s the transition plan and it’s going be green within five years, how would we feel about that?” he says.

Tomlinson says buying a coal-fired power plant today, for example, would understandably be “a challenging conversation” with some of LPPI’s stakeholders. He says earlier in the energy transition the investment approach was “exclusion: we just don’t want to own anything that’s kind of fossil fuels”.

“The reality is the world’s going to need fossil fuels for a long, long time. And not only that, you’ve got to power, provide energy, to build infrastructure for the transition,” he says.

“We’ve moved on to a much more thoughtful conversation now. And the more important piece to me it’s the forward looking pathway, credible pathway, to decarbonisation supporting that. That is the big one. The here-and-now and whether your carbon profile is a bit high or not [is] second order in many ways, even though that was the primary focus a few years ago. Just selling stuff isn’t necessarily the solution.”

Losa says Pictet AM prefers to describe the risks facing the energy transition as “headwinds”, and adds that they won’t last forever.

“It’s not a risk in the sense that none of this is going to happen anymore,” he says.

“It’s more like, okay, there’s challenges or bumps along the road, the growth might take a bit longer,” he says.

“That’s what thematic investing is about. It’s about investing in the megatrends of the future, where we focus on long-term, secular themes such as the clean energy transition.”

A significant part of the investor’s task is just figuring out where the winners and losers from the energy transition will emerge, and when. It won’t affect all companies or industries to the same extent, and they won’t all be affected at the same time.

“It’s a great question [but] it’s also a little bit of an unfair question – it’s a bit like asking in the 90s who’s going to benefit from the internet revolution in the next few decades?” CalSTRS’ Nick Abel says.

“The reality is, it’s such a massive and pervasive theme that’s obviously situation-specific on where there’s great investment opportunities, but it’s going to touch all parts of the global economy.”

Identifying best practice in pension asset management is not a straightforward task. As much as asset allocators may want there to be a definitive answer, differences in size, mandate and resources between different pension funds means an investment approach that works for one may not work for others.    

At the recent Fiduciary Investors Symposium in Toronto, defined contribution and defined benefits pension funds from four different countries came together to discuss 30 years’ worth of governance, cost and performance insights collected by CEM Benchmarking, and it was clear that investors are still split on key issues such as the benefits of active management and scale. 

CEM data shows that active management has on average added 22 basis points of net value and 75 basis points of gross value per annum between 1992 and 2022 for asset owners. In public markets, the highest active risk and average one-year gross value added has been achieved in US small-cap equities strategies. 

It’s clear that there are benefits to active management in public markets, but South Carolina Retirement System Investment Commission is one fund that still decided to shift its entire public equities portfolio to passive, and chief executive officer Michael Hitchcock said it is not regretting the decision. 

“We had a significant amount of active management in the public equity portfolio – we had active managers, we had enhanced passive, we had GTAA [global tactical asset allocation], which was kind of a mix of public equity and bonds,” Hitchcock said. 

“And we really realised…out of humility that we’re really not that good at this. Because what we found is that we were underperforming the benchmark, at about the same amount that we were paying in fees. 

“We were able to shift to all passive, but we were able to do it in a way where through the structures that we have with our external partners [we can] pretty much lock in about a 30 to 40 basis point spread above the performance of the index, because of the efficiencies that these large managers have when it comes to securities lending, and the tax recaptured.” 

Hence, the fund is now outperforming by about the same amount that it was underperforming in the same part of the portfolio, Hitchcock said, and shifting to passive allowed the fund to utilise its resources better.  

“We decided that we really needed to put that energy into the private market asset classes, where we really felt like we would have the opportunity to outperform,” he said. 

However, UK’s Railpen doesn’t consider active management fees as a big issue. The fund has internalised two-thirds of its investment management. 

“On the public market side, we’ve got to about 50 per cent in equities; of that 50 per cent, we’ve got about 60 per cent in quantitative strategies and 40 per cent in fundamental portfolios,” said director of real assets and private markets Anna Rule. 

“Given I’ve seen their performance – yes, passive is cheap – but my fundamental team would argue that they’re both cheap. 

“They’ve been running that internal strategy for about the last eight years and have had about an outperformance versus ACWI of about 130 basis points.” 

The question of scale

When it comes to the scale discussion, the sentiment among funds is weighted heavily in favour of having greater scale, due to the potential access to deals, influence and cost structure benefits it may bring. CEM Benchmarking head of research Chris Flynn said the firm has not found evidence of diseconomies of scale so far. 

PSP Investments chief investment officer Eduard van Gelderen said being big has brought the fund many perks. 

“What I see happening in practice is that we are invited for specific deals, and there are only a handful of investors around the table [and] because we’re sitting at a table, we also dictate the terms of those deals,” he said.  

“Is there a limit to this? Well, we all know Norges Investment Bank, they’re so big that they have to basically invest passively all over the world. 

“I can only say for us there is a limitation on the public side, because I am not convinced that every active strategy we pursue actually has the capacity to do it. On the private side, at this point…there is no limit.” 

This view is echoed by Australian Retirement Trust, which gained massive scale in a short period of time from the merger of two Queensland-based pension funds, Sunsuper and QSuper. 

“Having spent the last couple of years on integration, we found that we really needed to focus on things that we’re going to be able to do well consistently – strategies that we won’t outgrow,” said the fund’s senior portfolio manager of investment strategy, Anne Blayney.  

“On the public market side, perhaps there will be some diseconomies of scale in that… as you get bigger and bigger, it’s going to be harder and harder to harness that alpha in some asset classes or some strategies.  

“But we haven’t we haven’t seen it as yet.”