Net zero requires transformational changes and significant investment. This guide aids industry leaders in implementing net-zero investing. It offers practical guidance that stresses the importance of mindset shifts and highlights strategies for success.
All recent net-zero research and policy insights can be found on the Net-Zero Investing topic page.
By Roger Urwin, FSIP
For investors with long careers in managing fixed income portfolios, 2022 was “a real shock”, according to APG Asset Management managing director of global fixed income Ann-Marie Griffith.
Griffith manages a €200 billion ($217 billion) fixed income portfolio, roughly 50 per cent in developed market government bonds, about 30 per cent in credit and the balance in emerging markets.
She told the Top1000funds.com Fiduciary Investors Symposium in Toronto that for a considerable period of time, treasuries were viewed as a natural hedge, but in 2022, “that hedge completely broke down and was probably one of the more significant loss drivers across fixed income portfolios”.
“The positive correlations caught many people offside in terms of the balanced portfolio 60/40 mix, but certainly within fixed income portfolios as well,” she said.
“And what I mean by hedges, generally, when you’re long credit risk, whether it’s corporate risk or structured credit risk, you can offset some of that risk with a bit of treasury hedges, because for a long period of time, they were quite negatively correlated,” Griffith said.
But the turnaround in 2022 has led to some rethinking inside Europe’s largest pension investor about “how long and how persistent the correlation between treasuries and underlying fixed income investments will remain positive”.
“And then the inverted yield curve obviously plays a little bit of a role here as well,” Griffith said.
“The cost of hedging across the yield curve can be quite different and also brings into question the traditional ways of looking at risk management within fixed income.”
Griffith told the symposium that “there’s quite a lot riding on when that positive correlation breaks down”.
“And if it’s intermittent, how agile can you be, how tactical can you be in adjusting your hedges so your hedges don’t undermine your actual investments in your portfolio?” she said.
“Hopefully, we’re not going from 5 to 10 per cent in terms of interest rates, but there is some question about how persistent these higher rates will be, and if in fact the Fed – it is actually the Fed and other central banks around the world – have done enough.
“You’ve seen the US economy be incredibly resilient in the face of these higher rates. One would expect that to have slowed things down quite drastically, but that was not the case. So there’s a lot of thinking going on a lot of challenging assumptions and again, making things more resilient and preparing for what, what might come.”
The bond rally of March 2020 was the kind of reaction to be expected in a period of crisis when risk assets sell off, said Maryland State Retirement and Pension System chief investment officer Andrew Palmer.
However, then “the bond market broke, and the Fed had to step in”, Palmer said. He believes from a structural perspective, that bonds still provide that hedge, but they may not provide it over short, intermediate periods of time”.
“And it may take extraordinary efforts by the Fed,” he said.
“So, I have got three Ss to talk about. Structure is the first; so the structure is different. The size is different, that’s the second S. And then the third one is sustainability.
“And my basic point is, I think we have to think differently than just looking in the rearview mirror and saying, ‘This is how they performed in the past’. Even if you go back to 1980, there was a positive correlation then. But I think you could think it has some different attributes to really pay attention to and try to incorporate into your portfolio construction going forward.”
Palmer said that the fund is currently rethinking how it approaches fixed income management.
“I’m thinking about things; doesn’t mean [I am] changing anything,” Palmer said.
“At the moment, we’re thinking [it] through. We have a one-year process we’re kicking off with our board on asset allocation. We’ve had a long duration portfolio, which has been sort of a pretty much of a drag over the last three years.
“I do believe that going forward, it’s actually got a lot more portfolio utility than it has had in the past. The cost of insurance is cheaper you’re getting it doesn’t cost you a lot to have it.
“I still believe in the role of it, I just think maybe for the implementation or through more stress testing and those types of things, I think we have to be a bit more dynamic in how we manage it.”
The symposium heard that paying attention to geographical diversification could become a more prominent aspect of fixed income management.
That’s one thing we’re going to look more closely at,” Palmer said.
“We’ve been very US focused. One, because it wasn’t very attractive to go elsewhere, with negative rates and much of the world, and our liabilities are all in dollar; but I do believe we’ll, we’ll be looking at non-dollar allocations to sort of build in some more diversification on the bond side.”
MFS Investment Management fixed income portfolio manager Ward Brown said if the post-2022 stock-bond correlation proves to be more than transient, “that has some big implications for portfolio construction”.
When interest rates are raised by central banks to curb inflation driven by demand, it generally indicates a growing underlying economy. But when rates are raised to tame inflation caused by supply constraints, the underlying economic fundamentals can be quite different.
“What’s critical for thinking about this positive correlation is whether or not those demand shocks are going to continue driving inflation, or whether it’s going to be something else,” he said.
“What else could cause inflation to be higher and move inflation around? Well, one obvious answer is supply shocks.
“That’s a situation where inflation goes higher, but growth doesn’t move. In fact, growth might go lower. So in that circumstance, you’re going to get this positive correlation.”
But growth isn’t responding, Brown said.
“And so equities and any long-duration asset is going to be very sensitive to interest rates,” he said.
“They’ve got two things driving those assets: growth and the discount rate. If growth isn’t doing anything, then they’re just going to respond to the discount rate. No higher growth, but central banks are raising rates. That’s how you get this positive correlation: raising rates, bond yields go down, and long-duration assets go down as well.
“That’s important to think about when you’re saying, Well, we’re going to get persistence, because one argument that we’re going to have this positive correlation persisting is that we’re going to have continued supply shocks in the future, and they’re going to dominate over demand shocks.”
Brown said investors also need to consider whether central banks around the world might move away from inflation-targeting strategies, which he said grew out of the supply shocks of the 1970s (the OPEC oil crisis) but also when the Fed moved away from the Gold Standard.
“When people say, well, we’re going to be in this high inflationary environment that’s not going to be correlated with growth’, they have some sense that we’re going back to the 1970s,” he said.
“But I think that’s not very likely, as long as these inflation-targeting regimes stay in place. And whether they stay in place is a is a political prediction.”
Brown said he predicts that the positive correlation between stocks and bonds “probably does not persist in the way people are thinking of the 1970s”.
“It may be more incremented, because we may have large supply shocks going forward for a number of reasons,” he said.
“But they are probably going to be transitory, and we’ll go back between positive and negatively correlated regimes.”
The stars aligned in the 2010s when a series of structural conditions stacked up favourably for global investors. Coming out of a decade defined by two major crises – the dotcom bubble and the GFC – the 2010s saw cheap valuations and a depressed economy needing to heal.
Low inflation, increasing globalisation, pro-business policy and steady economic growth have together helped the average 70/30 developed world stock-bond portfolio to return 8.5 per cent in 2010s, outperforming the previous five decades, according to analysis by Bridgewater Associates.
However, co-chief investment officer of the world’s largest hedge fund, Karen Karniol-Tambour, warned that these perfect conditions will be hard to replicate in the 2020s, and it’s high time that investors start building portfolio resilience.
“I think, for any CIO sitting with the allocation that they have, what you definitely can’t do is be confident that you will get the 2010s again,” she told the Fiduciary Investors Symposium at the University of Toronto earlier this week.
“[They need to think] ‘I don’t want to have a portfolio that is reliant on getting the amazing 2010s to repeat itself – what I want is something that’s a little more resilient to a range of options, knowing that the world has shifted in a way where a range of options might occur.”
Resiliency can be defined with several characteristics, she said, including narrower range of outcomes, lower tail-risk outcomes, less likelihood of sustained period of underperformance and higher average return across the environments.
In practice, Karniol-Tambour said investors can use “incremental decisions” such as shifting existing asset allocation, the types of exposures they hold within a particular asset class, or allocating to strategies that can hedge the tail risks.
However, the biggest challenge in building resilience, she said, is for investors to remember that a part of their portfolio will need to be explicitly assessed relative to how the rest of the portfolio performed, rather than as standalone performance.
It matters a lot to make it clear to that resilience-building part of the investment team that the plan is for them “to have a more consistent return or to only perform well when things are going poorly” in the rest of the portfolio, she said.
“You’re not telling the person [responsible] that ‘you did a bad job’. You’re saying that was the plan.
“If you don’t govern it that way, then the person who manages that bottom asset is going to say ‘wait a minute, we just had a great growth year, and I had this very low return relative to the rest of the portfolio, I better change my strategy to not have that happen to me again’.”
Chief investment officer of the C$25 billion ($18 billion) pension OPTrust, James Davis, echoed the sentiment and said it’s governance can be a huge challenge when the objective is building resilience.
“Resilience is not about avoiding risks, it’s about understanding them, and it’s about managing them,” he said.
“We define risk not as volatility or return. We define it in terms of the probability of becoming under-funded. The reality is that the risk-free rate is not high enough that we could just invest in risk free assets and earn the returns we need to pay pensions, so we have to take risks.
“We’re not trying to grow that funded status, just try to keep it stable.
“We do rigorous due diligence in all of our deals, and in our fund and direct investing. We treat risk as a scarce resource. We don’t incentivise excessive risk-taking.”
Getting the board to understand this objective can take rigorous communications sometimes, Davis said, but that needs to be done.
“It’s amazing how our board gets distracted by returns, and the media feeds into that.
“At the end of the day, we can have a very good stable, potentially even improving funded status and have a negative rate of return. Think bonds that hedge your liabilities, then bonds have a bad year and yields went up.
“Then our board is like ‘well, you say you did good, but did you really do good?’
“Boards in general, our board as well, are line item focused. This is one of the things you try to overcome by going to a total portfolio approach, but it’s hard to break that habit.”
Karniol-Tambour said that at the end of the day, the first step to building resilience is to create shared understanding of the investment end goal within an organisation and its investment team.
“Being able to really have that shared understanding of why over the long-term resilience is so valuable, especially be able to demonstrate mathematically how damaging it is to have ups and downs [in returns].
“People who think themselves as long term investors – given that we have requirements along the way to make payments – not being able to compound and having big ups and downs makes a big difference.
“So creating that shared understanding, and then being able to have that understanding pushed through to the actual activities people are doing, to the actual choices they’re making [is important].”
The investment path to net zero may not always be clear for asset owners. With the lack of a dedicated asset class and shifting risk profiles for energy transition-critical assets, the Fiduciary Investors Symposium in Toronto heard that investors need to be flexible and ready to creatively make room in their portfolios when the right opportunities arise.
For example, even infrastructure can be perceived as a riskier asset class when it is tied to new energy technologies, said Rossitsa Stoyanova, investment chief of Canada’s Investment Management Corporation of Ontario (IMCO). The fund invests C$77.5 billion on behalf of its public sector clients.
“We’re used to looking at infrastructure as clipping the coupon – there’s assets, they have a contract, and they just throw cash,” she told the symposium in Toronto.
“And the infrastructure of the future is not that, because it doesn’t exist yet – like renewables, batteries or green data centres, you have to build them.
“It might be perceived as taking higher risk, because we’re developing new infrastructure that eventually will become the infrastructure that is clipping coupons – for now, it’s not. But I think that’s the only way to do it.”
IMCO doesn’t have a specific allocation to sustainable investments, but Stoyanova said it has the expectation that “every asset class in the portfolio will be sustainable at some point”.
In cases where a sustainable asset doesn’t fit neatly into traditional asset classes, Stoyanova said IMCO is usually able to leverage its broad mandate and do things like splitting the investment into two sub portfolios.
For example, the fund’s investment in electric vehicle battery company Northvolt draws from the EV expertise of the infrastructure team, as well as on structuring and pre-IPO knowledge from the public equities team, Stoyanova said. It can take some explaining to the board, but the result is worth it.
“Sustainability brings the teams together. They work together, they find opportunities, and then we’ve committed to find a place for those opportunities,” she said.
“They’re not easy to approve, especially sometimes [these investments] are a challenge for boards to understand. I mean we’ve gotten there, but it’s not a cakewalk.”
Chief strategy officer of global infrastructure asset manager IFM Investors, Luba Nikulina, told investors not to lose sight of the fact that “net zero is not really an investment target, it’s an emission target”.
“The reality is, if you own assets that are critical for the functioning of the society, and these assets are really difficult to decarbonise, then net zero target becomes, in some instances, impossible,” she said.
“So what do you do in this context? I think actually, in the whole industry, my observation is that we are on a learning curve.
“Instead of just being the slaves to this target on carbon emissions, and say ‘I will do anything possible to reduce carbon intensity’, they [our team] start thinking about transition planning.
“This is where you really step into it as an investor, rather than an ecologist and ask ‘do I have the technology to decarbonise?’.”
Answering that question can require some creative thinking. For example, IFM Investors has partnered with several research universities in Italy to study a wireless technology that will allow EVs to be charged on the road as they drive, hence addressing EVs’ range problem and toll road assets’ decarbonisation.
Peter Martin Larsen, senior managing director and head of private markets in Canada’s University Pension Plan also spoke of the inclination and need to transform existing assets into more sustainable operations over time.
“Touching on the long-term view here, if I buy a data centre today, I would rather sell a green data centre in 15 years than a data centre that is not green,” he said.
“Coming from Denmark, we invested directly in offshore wind 15 years ago. ESG was not even a term [then], but it was a good commercial investment.
“For us, it’s really fundamentally believing that sustainability is commercially the right thing to do, so it’s 100% about risk return.”
The global head of sustainable investing at Canada’s Ontario Teachers’ Pension Plan (OTPP), Anna Murray, said she had finally come to terms with the anti-ESG sentiment that is floating around in certain investment circles.
In the world’s most important capital market, the US, responsible investment has become a politically charged topic. The nation’s market regulator, the Securities and Exchange Commission (SEC), last month stayed the implementation of its climate-related disclosures by public companies in the face of multiple legal challenges from attorneys general of several Republican-led states.
Speaking just across the border at the Fiduciary Investors Symposium held at the University of Toronto this week, Murray conceded that she has spent the last number of years feeling “defensive” against the anti-ESG sentiment, but now, she “very much welcomes it”.
“I think it’s a blessing in disguise, in that it’s made all of us very focused on removing the labels and [recognising] what we’re really talking about [around sustainability] as a set of growing and material risks that is just fundamental to our fiduciary duty,” she told the symposium.
“One of the challenges I think that we are experiencing – if I could call us collectively as an industry – is around emissions intensity, and the absolute focus on that as the sole measure of progress.
“While it’s a very important measure, of course, I think we can all recognize that perhaps it’s an imperfect measure, it is backward looking.
“[I am] hoping to see the discussion starts to evolve more to include the ability to identify and capture these investment opportunities, as opposed to just focusing on the emissions portfolio reduction.”
It is a sentiment echoed by Hendrik du Toit, founder and chief executive of international asset manager Ninety One, who said that ESG considerations have become an integral part of modern investing.
“[The ESG team] are not the people in the corner next to the compliance team. They’re actually embedded in the investment teams, and they are in the leaderships of the firm,” du Toit said.
Despite all the negative narratives around ESG, du Toit said the area is still witnessing an unprecedented level of international collaboration.
“It’s very significant that the US government and the Chinese government, which don’t really talk a lot, have their climate channel absolutely open… which is not often publicized,” he said.
“There are things happening that we should celebrate as well.”
However, not one to mince words, du Toit said the asset management industry has done “a pretty abysmal” job in quantifying the transition risk, and it’s disappointing to see the world’s inability to even mobilise 1 per cent of its capital per annum to finance the transition.
“We as an industry are collectively incredibly stupid sometimes,” he said. “We had a decade or five years of literally free money – what did we do with that? We threw it at tech we don’t really need to use.
“What can we do as asset managers, besides pricing securities, is we can actually mobilise capital to invest behind the most important investment opportunity of our generation.
“All we try to do is encourage the companies we invest in to maximise their value by recognising the transition risk – ie developing real world plans to protect the equity value, and contribute to a world which is livable. It’s really as simple as that.”
With C$750 billion in assets under management, BNP Paribas Asset Management has committed 50 per cent of them to 10 net zero objectives, spanning across equity and credit corporate investments and some private assets.
The firm’s global head of sustainability Jane Ambachtsheer said the anti-ESG move is evidence of impact.
“A lot of the pushback we’re seeing today in the market is actually… because we’re pushing in uncomfortable places,” she said.
“I think a lot of people are waiting for rates to come down and then we’ll see clean energy investment deployment pick up and become more attractive.”
While pension and sovereign funds have positioned themselves well in private markets to harvest clean energy opportunities, Ambachtsheer said “the big question will be on the public [market] side”. And the performance there hasn’t really been glowing, as the S&P Clean Energy index was down 15.63 per cent on an annualised total return basis in the past three years.
“A lot of people are looking at that and pointing to that as a proof point that sustainable investing has had its run the last three or four years, and now we’re moving on to something else,” Ambachtsheer said.
“That’s not our perspective. Investing in clean technology and renewables is one piece of an overall broad diversified approach to thinking about the transition, and looking for the right kind of pricing and opportunities is an important element of that.
“On the stewardship side, we voted against 1000 management resolutions last year because we weren’t happy with what the companies were reporting on climate.
“So there are certain things that you can just measure year over year and report on, and I think understanding what investors want to achieve around net zero and helping them align with that is really a big part of our commitment.”
The $96 billion New Jersey Division of Investment is expanding its emerging manager programme beyond private equity to include real estate and private credit.
Investments with minority and women-owned private equity fund managers already comprise 18.7 per cent of the total market value of the pension fund’s $11 billion private equity programme.
Now New Jersey will allocate more to experienced spinout teams and return-generating seed investments, in line with its commitment to improve DEI in America’s $70 trillion asset management industry of which only 1 per cent is managed by people from under-represented groups.
“The chance to build long term relationships, and being there at the beginning, investing in the first fund and seeing how the team evolves, is really rewarding,” says Dana Johns, New Jersey’s head of private equity and chair of the Private Equity Women Investor Network, a passionate advocate of next generation investment managers who has spent much of her career understanding the risks and opportunity of the sector.
New Jersey launched its emerging manager programme in private equity in 2022, kicking off in the asset class with the largest universe of emerging managers, most new fund creation, and more managers with a historic track record. Alongside deepening DEI in the portfolio, the programme has supported diversification by enhancing exposure to lower middle market opportunities which have historically outperformed relative to larger funds.
Rolling the programme out to other asset classes will allow the fund to enhance exposure to unique and niche opportunities from which it is typically excluded because of size, track record, and assets under management constraints.
Emerging managers seeking a place in New Jersey’s portfolio need more than a deep understanding of their investment strategy and an experienced track record of exits and distributions. Some of the most probing questions Johns asks centre around how new managers are building and running their business.
Finding a partner, raising, and deploying capital (often raising for a second fund as soon as the first has closed) and building a team is an arduous task.
Johns likes to know if the team spun out together or if they have come together for the first time to launch a fund. The latter, she says, poses more of a risk.
“If two individuals are coming together for the first time, institutional investors need to understand their prior investment experience and how they came together. LPs elevate business risk when underwriting a first time fund manager. Sometimes emerging managers ability to manage the business is more of a risk for LPs than the investment strategy itself,” she says.
Johns says the skills set and deep level of experience she looks for make the term emerging manager inappropriate. “I prefer the term Next Generation rather than emerging managers because these are investment professionals who have been doing the job for a long time but have decided to go it on their own.”
New Jersey’s program is centred around a platform of Separately Managed Accounts that allows the investor to target small investment sizes. Emerging manager fund sizes are typically between $100 million to $1 billion and New Jersey prefers not to account for more than 20 per cent of any one fund. “We write cheques of upto $25 million that overtime will grow to 12-14 commitments to these managers.”
Size is also an issue around graduation. She says managers will only graduate to the main portfolio if, and when, they can scale to absorb larger cheques of between $100 million to $200 million. “Not all managers will move into the larger portfolio because some of them might not be able to scale,” Johns says.
A $200 million fund is not the right fit for a large LP seeking to allocate $1-2 billion a year, she continues. “These managers need to be smart about who they talk to and smart about building their network, “she advises. “They should approach the LPs that are the right size and a better fit for smaller managers. This is why we built our platform.”
New managers can expect close contact with her team. New Jersey is closely involved with the managers on its platform, particularly via the LPAC seat. Mentorship, advice and “direct impact” will include sharing broad industry knowledge; whether to use credit lines, or how new managers should diversify the LP base for their next fund.
“We can introduce emerging managers to other LPs focused on building their emerging manager programme,” she says.
Johns treads a sensitive line when it comes to negotiating fees and counsels against “going in and pushing new managers down.” They have invariably sunk all their resources, including their own net worth, into their new fund. She says for many of these managers, every 2:20 is vital to long-term success.
But that is not to say it’s not possible to draw other LP benefits from taking the risk of supporting new partners build their portfolio. This could include first refusal on opportunities to upscale commitments, access rights to financial statements, or opportunities to build a co-investment sleeve where there are zero fees, zero carry, and size fee breaks.
“There are different ways to approach fees, and it is important managers are set up for success. We take the opportunity to minimise fees as much as possible while not putting the manager in a situation that could be detrimental to the fund.”
Unlike some asset owners that are overweight private markets New Jersey was under allocated across most private markets. It means the fund has been able to allocate capital to emerging managers “at a full pace” across venture, growth and buyout within private equity.
But she acknowledges that today’s challenging market is making it harder for emerging managers. It has triggered a flight to quality with fewer, large funds absorbing a bigger portion of available private equity allocations and increased competition for investment dollars.
“There is a big knot in the system right now where LPs are constrained. They need dollars back before they can reallocate to new opportunities.”
In other trends, LPs are seeking to consolidate the number of general partner relationships to reduce risk and keep portfolios efficient.
But Johns also notices that ever-larger GPs could serve to increase the number of experienced spin outs and opportunity for LPs with an emerging manager programme.
And New Jersey has previously voiced concerns at the ever-growing size of external manager private equity and debt funds, flagging the risk of allocating to asset gatherers, where managers harvest lucrative management fees but are slow to invest because they are hampered by executing and deploying billions of dollars.
Despite her oftentimes pessimism at the level of DEI in the asset management industry, Johns passion remains undimmed. The satisfaction of seeing a new manager roll out successive funds and generate success for themselves and their LPs drives her on.
New Jersey is holding an emerging managers virtual symposium on June 26.