Page 26 – Top1000funds.com

The $260 billion New York State Common Retirement Fund (CRF) will divest and restrict approximately $26.8 million of corporate bonds and actively traded public equities in eight integrated oil and gas companies, including ExxonMobil.

The fund has taken the step of divesting or restricting its investments in companies whose energy transition plans do not measure up to “minimum standards to assess transition readiness and climate-related investment risk”.

The fund’s most recent divestments and restrictions follow similar steps taken in 2023 in 50 companies which it also assessed as not being sufficiently prepared for the energy transition.

As a result of its latest review, the New York fund will restrict or sell down its holdings in Exxon, Guanghui Energy Company, Echo Energy, IOG, Oil and Natural Gas Corporation, Delek Group, Dana Gas, and Unit Corp.

Under New York Comptroller Thomas DiNapoli’s 2019 Climate Action Plan, the CRF aims to transition its investment portfolio to net-zero greenhouse gas emissions by 2040. (See NY State Common’s climate plan).

One of the fund’s core climate-change beliefs is that most of its investments are at some degree of climate change-related risk, but there is still time for those risks to be managed.

The fund plans to conduct analysis on companies in its portfolio that operate in sectors identified by the Taskforce on Climate Financial Disclosure as being high-impact; and on major US-based utilities which it believes are “among the highest emitters of greenhouse gases, but also potential leaders in developing climate solutions”.

The fund believes that some of the companies at greatest climate change risk are also among those best-placed to develop and offer climate change solutions. It says engagement with investee companies is a key component of how it identifies and addresses climate-related risks.

Alternatives build out

Strategy in the next few years will be most focused on growing the allocation to alternatives in line with a target to allocate 25 per cent of AUM to alternatives by 2025. The boosted strategy is a response to market volatility amid macroeconomic and geopolitical uncertainties, and a recognition that the benefits of diversifying between equities and fixed income are becoming less apparent. KIC had previously aimed to raise its alternatives target to 25 per cent by 2027.

KIC’s alternative allocations currently comprise private equity, real estate and infrastructure, and hedge funds. Five year returns in these portfolios came in at 13.5 per cent, 5.5 per cent and 5.7 per cent respectively. KIC will focus particularly on investment opportunities in private credit and will access opportunities both directly and through external fund managers. KIC began making direct private equity investments in 2010 and co-investments with GPs in 2011.

The decision follows other leaps forward in its approach to alternatives that include last year’s acquisition of private debt manager Golub Capital to supports the hunt for stable cash flows via loans to blue chip companies.

In another milestone, KIC opened its Mumbai office in January, its first local presence in emerging markets. The investor said the new office will become an integral part of its sustainable growth by capturing new investment opportunities in the world’s fastest growing economy, primarily in the private equity, venture capital, real estate and infrastructure markets.

Employees will be tasked with research, deal sourcing, and building and managing networks with investment managers in India.

KIC begun investing in hedge funds in 2010 and runs a diversified strategy using multiple approaches. In its latest annual report it states a renewed focus on absolute return strategies that take advantage of arbitrage opportunities such as equity L/S, event-driven and fixed-income arbitrage, seeking to tap the impact of rising interest rates, increased market volatility and other changes in the financial environment.

In 2019, KIC set up an Asset Allocation Forum, charged with adjusting asset class weights and companywide risk management. “We hold an asset allocation forum every quarter to integrate top-down and bottom-up views from various investment departments and formulate a house view to ensure a reliable asset allocation process,” states its annual report.

The equities team also runs a quota program to allocate to domestic securities firms with overseas stock trading orders as part of a continued effort to support growth in the domestic finance industry, a key goal at the fund.

KIC launched the International Finance Academy, an educational program that nurtures overseas investment specialists and supports the development of Korea’s finance industry. The fund has also revamped its compensation system “because we know that if KIC wants to grow excellent talent, they need excellent compensation.”

Responsible asset owners are preparing their portfolios for the climate transition, reducing holdings in companies with high emissions and pledging billions to climate investments. But climate proofing portfolios is proving one of the most arduous and complex challenges investors have ever faced.

Like concerns that many of the underlying companies in their portfolios haven’t meaningfully reduced their emissions; or the fact investors know they need to continue to provide capital to hard to abate sectors yet the financial rewards for doing so are still sketchy and jeopardize their own net zero targets. Success depends on time-consuming engagement with companies worried about change and governments loath to provide leadership. At one end of the spectrum, some US pension funds even face the risk of being sued if they divest from fossil fuels.

The problem with net zero

Net zero, where investors have focused much of their effort, provides a good window into the ups and downs of climate investment. Witness Sweden’s $46 billion AP4, out of the gate with a net zero strategy in 2012 since when it has cut emissions by 65 per cent, led by reductions in its $20 billion global and domestic equity allocation, the asset class where most emissions live.

AP4 uses fundamental analysis and a quant-based instrument to lower portfolio exposure to high emitting sectors which collectively account for 10 per cent of the portfolio but around 70 per cent of emissions.

Tobias Fransson (pictured), head of sustainability at the Stockholm-based fund, estimates nearly two thirds of that 65 per cent is a consequence of portfolio changes rather than underlying corporate change.

AP4’s progress reveals investors can lower their emissions by divestment and reducing their exposure or weighting to companies in an index, but it doesn’t mean the companies in the portfolio are reducing their emissions.

“We don’t’ want to get into a mindset of gaming the system and saying we are progressing but really just managing the numbers in a way that makes everything look like we are on the right path,” says Mirko Cardinale, head of investment strategy at UK pension fund Universities Superannuation Scheme.

“Investors would be fooling themselves if data shows lower carbon intensity of investment portfolios, but the corporate world isn’t actually decarbonising as expected.”

“Investors would be fooling themselves if data shows lower carbon intensity of investment portfolios, but the corporate world isn’t actually decarbonising as expected.”

Asset owners are developing tools to weed out false climate claims. For example, the giant Canadian investor, CPP Investments has developed a new Abatement Capacity Assessment that asks corporate boards and executives to report how they plan to reduce their emissions to hit promised targets.

Still, getting to net zero is much easier for investors if they avoid high emitting companies. Yet if investors sell a dirty asset, the chances are someone else will buy it less minded to persuade the company to clean up.

“Getting to net zero is much easier if you divest or reduce your exposure to high emitting companies but this doesn’t change global carbon emissions, and the most important thing is that underlying companies reduce their emissions,” says Fransson.

Indexes that encourage companies to step up to the plate to achieve inclusion are one tool. But staying invested in hard to abate sectors for a real-world impact is hardly an easy win.

Identifying opportunities in industrial decarbonization where companies are genuinely committed to the transition requires “a strong reliance on incentive setting, exposure to risk during the build out of new assets and retirement of old assets,” lists Anne-Maree O’Connor, head of responsible investment at $45.43 billion New Zealand Superannuation Fund which has introduced a Paris-aligned benchmark and also applies carbon targets to its externally managed multi-factor portfolios.

The strategy has successfully reduced exposure to climate risk and has had a neutral impact on investment returns.

Xavier Chollet, senior investment manager at Pictet Asset Management (Pictet AM) and specialist in unearthing opportunities from greening the power sector continues the theme that net zero targets don’t necessarily help real-world decarbonization. Speaking from the firm’s Geneva office, he notices that investors steer away from investing in hard to abate sectors because it’s easier to hit carbon targets by investing in companies with less emissions, like technology.

The way net zero focuses on numbers rather than nuance can also be unfair. Adam Matthews, Church of England Pensions Board’s chief responsible investment officer says emerging market corporates typically have a higher carbon footprint in a portfolio. Once again, reducing exposure is an easy win on the net zero road.

“Measuring local companies in emerging markets against globalised benchmarks doesn’t allow for these companies’ differentiation in-line with the Paris agreement,” he says, arguing current frameworks, including the Net Zero Asset Owner Framework, need enhancements to ensure they offer differentiated and fair pathways consistent with the science for these companies.

Progress at CalSTRS, the $325 billion Californian pension fund, in the process of allocating a meaningful 20 per cent of its total public equity book to a low carbon index reveals another important piece in the complex net zero jigsaw. CalSTRS chose a low carbon index because it minimizes active risk, but for large passive investors, the strategy still introduces tracking error.

“We really like to hug the benchmark,” says Kirsty Jenkinson, investment director for the sustainable investment and stewardship strategies at the pension fund.

Data Dilemma

Emissions targets also depend on emissions data, The next element of the challenge. The availability, consistency and quality of corporate emissions data continues to thwart asset owners’ ability to select investments and measure the extent to which portfolio companies are reducing their emissions.

Positively, data is getting better. O’Connor notices the percentage of actual versus estimated data is improving as is the degree of external assurance from companies on their own reporting. And Fransson says EU legislation is about to improve Scope 3 reporting.

Still, Scope 3 data, the largest source of emissions for most businesses, comprises 15 different categories, not all of which are reported or relevant. When investors try and bring a company’s Scope 1,2 and 3 emissions together, or when they try to portion emissions to different portfolios, particularly corporate and sovereign bonds which rely on different methodologies, double counting is ubiquitous.

To avoid this particular headache, in fixed income CalSTRS and USS have focused on measuring emissions in their corporate debt allocation – although USS has a large allocation to gilts.

AP4 has measured its net zero progress on an equity shareholder methodology. If it holds 1 per cent of a company, it reports on 1 per cent of that company’s emissions. Fransson is now immersed in the weighty task of recalculating the equity portfolio emissions based on enterprise value.

“We are not there yet,” he says, reflecting that equity value, outlined in TCFD disclosures and one of the two key emission counting metrics investors are converging around, has had implications on the emissions contribution of other assets classes in AP4’s portfolio like fixed income and credit.

Similarly, CalSTRS has run into challenges tracking the impact of emissions reduction at a company level to a total equity portfolio level.

“The data we get on emissions doesn’t pipe into the financial tools we use to govern the whole portfolio,” says Jenkinson.

Emissions data is also a backward-looking metric. Data from last year won’t help investors predict corporate behaviour in the future. An ambitious initiative at USS involves developing implied temperate change metrics that project a company’s future emissions based on stated targets. But limitations around the data have stalled progress integrating the numbers into portfolio construction.

“We will only get comfortable using forward looking metrics in our investment process, portfolio structuring and index design when the data gets better,” says Cardinale.

Other innovations include indexes like the FTSE TPI Climate Transition Index which embeds forward looking targets by assessing whether portfolio companies have delivered on previous targets and their likelihood of achieving future ones. The approach has offered a breakthrough in how the Church of England Pensions Board has differentiated between companies according to the pace of their transition. “Before this index, we couldn’t embed forward looking targets,” says Matthews.

Pictet AM’s stock picking team measures, reports, and needs to understand emissions in the portfolio. But they get around the data problem by focusing much more of their efforts on other metrics.

“Our analysis is not based on emissions or a company’s emissions trajectory,” says Chollet (pictured).

Instead, analysis of the transition, or impact value, of a company is based on where companies are directing capex growth, homing in on corporates channelling at least 80 per cent of their capex into preparing for the transition. Other metrics include enterprise value analysis (a more forward looking metric than revenue) and an exclusion policy.

looking for Opportunities

Investors are beginning to put as much focus on finding the opportunities in the transition as they have on decarbonising their portfolios. NZ Super’s new benchmark has a higher exposure to climate solutions than its old one, supported by better climate risk analysis, including physical risk, and the potential for investment in renewables and other solutions.

CalSTRS’ investments in climate opportunities is focused on private markets. It has developed a $2 billion low carbon solutions portfolio across asset classes and the risk spectrum. The unconventional portfolio allows the team to invest in opportunities that fall between its strict asset class buckets and their associated internal rates of return and frees the pension fund from its long history of investing with partners in private markets, permitting investments in first time funds, unconventional structures, and organizations.

“We felt we needed to be open to building new structures with new players who understand the policy, technology and physics of the transition,” says Jenkinson.

We felt we needed to be open to building new structures with new players who understand the policy, technology and physics of the transition

At Pictet AM, opportunities are concentrated in what Chollet describes as the picks and shovels of the transition. The team invest in companies that are making the products that will upgrade the grid or produce the semiconductors and computer power needed to train AI that will guide the future. But competition for companies with strong tech, intellectual property, a high barrier to entry and positioned to benefit from the secular growth of the energy transition is fierce.

For the Church of England Pensions Board, one of the biggest opportunities is literally in picks and shovels.

“Estimates suggest that over the next decade overhauling electricity transmission will require the equivalent of all the world’s copper used to date,” says Matthews, an expert on the complexities of investing in a hard to abate sector essential to the transition but which he worries many risk-averse, pollution-wary investors may avoid.

Volatility in new solutions means trustees are wary

Investing in the transition isn’t straightforward. Most investors are focused on opportunities in renewables, preferring to carve out these safe assets rather than allow their capital to flow to other areas of the transition like developing new transport infrastructure, battery storage or changing the grid. There is space in a diversified portfolio to invest in climate solutions across the spectrum, but portfolios are carefully built around the risk appetite of trustees and beneficiaries and unproven technologies like carbon capture and storage, or hydrogen fuel cell innovation are too volatile for institutional investors.

Even the returns from established green assets are up and down. Wind assets have been hit by inflation and higher interest rates. Green bonds have the same credit risk as a conventional bond but have lower yields and lower liquidity. It leads Fransson to highlight another knotty issue inherent in climate investing. “We must take sustainability into account, but it mustn’t impact returns.”

Interviewees also flag that opportunities in the transition may only come to the fore with regulation or subsidies. It means investors are waiting on the sidelines for policy changes to create demand before they invest.

Adrian Mitchell, senior managing director, public equities at Canada’s HOOPP observes “the interaction of technological development with public policy” will lead to “an evolution in the opportunity set for green investments with returns that meet our requirements.”

NZ Super’s O’Connor puts it more more bluntly, arguing the absence of regulation forcing corporate change is a future opportunity cost for investors. “We could be benefiting now from allocating to solutions, including companies that require capex to transition.”

We could be benefiting now from allocating to solutions, including companies that require capex to transition.

But calls for stimulation and subsidies to create more opportunities are not universal. Most investors support a global carbon price that will make polluters pay for what they emit – Fransson calls for global carbon pricing “now”, Matthews says “it would be hugely helpful,” for example – but some worry wider incentives could backfire.

At USS, regulation has an important role steering investment and bringing new considerations into the investment process. The TCFD pushed the fund to consider wider factors, run stress tests and report on specific metrics, setting the investor on a new path to incorporate the energy transition into one of its big picture themes that will ultimately drive its SAA. Another welcome framework, ASCOR, will help investors look at emissions and engagement in their sovereign holdings.

But Cardinale doesn’t see the benefit of being told to invest in a certain way, or subject to regulation that steers allocations to particular assets. “The process of building a robust investment strategy is complex and can’t be a one size fits all,” he says.

And responsible investors protect their freedom to divest just as fiercely as they protect their ability to invest where they think best captures the winners and losers of the transition.

“You can’t force pension funds to hold onto assets they don’t think are attractive in the transition,” says Fransson.

“It was our fiduciary duty to take the decision we did,” says Matthews, recalling the Church of England Pensions Board decision to divest from oil and gas companies following sustained engagement.

Such is the messy state of global politics, Cardinale is also preparing for a transition that is not guided by regulation at all. He believes it is possible the private sector can develop solutions that become competitive in terms of pricing, allowing the world to reduce emissions without a big push from policy makers.

Pictet AM’s Chollet goes further still, arguing regulation is not fundamentally needed, investors don’t want to rely on unreliable governments, and its best viewed as a nice tailwind. New technology must be able to stand on its own and scale because it provides cost savings to customers.

“We can’t invest if something is only profitable because of subsidies. The energy transition will happen because clean energy will be economically competitive.”

We can’t invest if something is only profitable because of subsidies. The energy transition will happen because clean energy will be economically competitive.

It’s just that it’s not happening yet. Climate risk is not sufficiently reflected in asset values. An opportunity in the short-to-medium term perhaps, but from a systemic market perspective, a growing problem.

On one hand there are signs the tide is beginning to turn. Like a recent IMF report suggesting bond investors are starting to price in climate risks for sovereign borrowers more exposed to the physical risks of climate change. Research by economists from UEA and Cambridge University suggests that climate-induced sovereign downgrades could happen as early as 2030.

In the power sector, Chollet says utilities switching their asset base to renewables are worth more than those relying on fossil fuels, a bellwether for a green premium in other sectors like transport ahead. “These companies are accelerating their growth profile and investors are prepared to pay for it,” he says.

Cardinale agrees a comparison of price multiples in the energy sector versus other sectors shows the market is beginning to price in climate risk and says the cost of capital is creeping higher for fossil fuel projects. But he is reluctant to be drawn on whether it is transition risk changing these valuations.

“So many different factors feed into P:E ratios that decide the valuations of an energy company. It could be the trajectory of the oil price linked to supply and demand; slower growth in China impacting demand or the transition, but we can’t be sure.”

Meanwhile concerns that transition risk isn’t valued by the market is a growing theme at CalSTRS as it strays from the benchmark in its global equity allocation.

“I do worry about this,” says Jenkinson. “Because there is no visibility on how the market is pricing risk, we have to assume it may respond at the last moment, when the crisis happens.”

A reference to a sudden correction in asset values flagged by experts in the field like Carbon Tracker think-tank founder Mark Campanale and Oxford University’s Cameron Hepburn.

Because there is no visibility on how the market is pricing risk, we have to assume it may respond at the last moment, when the crisis happens.

The CalSTRS’ risk team is now trying to understand the interplay between risk, return and emissions. From this they hope to be able to calculate what risk they are prepared to take versus the market.

“We are very used to understanding where, say, inflation is going, but the market has no way to calibrate emissions. We don’t have a clear way of saying emissions are doing this and physical risk is doing this and therefore we need to be aware of this,” she says.

Alarm bells that the market isn’t doing its job are starting to ring louder. Like from the Financial Stability Board warning that the scenarios used to assess risks to the financial system may understate climate vulnerability. The UK Pensions Regulator recently flagged concerns that scenario impacts “seem relatively benign” and are at odds with “established science.”

Meanwhile, the number of investors talking about aligning with science (rather than the market) when it comes to climate investment seems to be growing. Singapore’s GIC called in specialists Cambridge Econometrics and Ortec Finance to model how a portfolio composed of 60 per cent global equities and 40 per cent bonds would fare under varying climate scenarios.

The sense of looming change is difficult to ignore.

Long-term, responsible investors have always known they would be at the sharp end of preparing for climate change. They are doing all they can to catch the wave before it breaks.

It’s just that so many different things need to happen for a successful transition.

At a global population level, the pure genetic component of intelligence has been estimated to have declined over the last 100 years. This was offset, for decades, by improved education allowing average intelligence ability scores (measured by the well-known IQ test) to rise across generations.

Unfortunately, a number of recent large-cohort studies suggest the education component peaked a while ago, and so individual intelligence scores started falling from the mid-1970s. It would appear that we are getting dumber – just when we most need an intelligence boost amidst an unprecedented climate emergency.

This provocative and overly simplistic snapshot simply aims to be a gateway to a thought: we need to learn to harvest the benefits of collective intelligence.

Global governance is the way forward, but it doesn’t exist

When we think of climate change, we desire global collective action and governance. It is such a complex and interconnected problem that “we” thinking is intuitively more appealing and more powerful than “me” thinking.

With the exception of the 2015 Paris Agreement, governments do not appear to behave as predicted by the collective action framework (we thinking). Rather their climate policies are as much, if not more, influenced by their national politics and various interest groups (eg businesses, politicians, activists, etc).

For example, the recent US Inflation Reduction Act is expected to bring higher employment, green subsidy benefits, and emissions reduction. This breakthrough climate policy has successfully passed via pleasing powerful domestic interests – note that the name of the legislation gives no clue as to its climate credentials. Things seem to be working better at a local level than at a global level.

Building the case for distributed leadership

We should therefore think about distributed leadership, or shared management, which is arguably a more natural fit in a complex network-based system like ours. Systems leaders must understand and solve the real local issues. When they do so they leave traces of good practice.

One good example can be seen in the insect world. When a foraging ant in a colony discovers a rich food source, it leaves a trail of pheromones as it returns to the nest. Other ants follow and reinforce the pheromone trail, making it stronger and more attractive, leading even more ants to the food source.

Using this as an analogy, we can explain the human love of case studies. A case study is effectively a pheromone trail – “I went here, and did this; you may want to copy me”. This allows for more instinctive and indirect behaviours of followership and emulation.

Last summer, Ecuadorians voted to halt oil drilling in one of the most biodiverse regions on the planet, the Amazon. One of their indigenous leaders and environmental champions seems to echo this leadership model: “It took us thousands of years to get to know the Amazon rainforest. To understand her ways, her secrets, to learn how to survive and thrive with her. […] we are the closest to the land, and the first to hear her cries.”

With the decision and action to stop oil drilling, local traces of best practices have now been left. What needs to be built now is a trail behind them.

What it means for investors?

For investors, it’s time to harvest the benefits of collective intelligence. I see three ways for this to happen:

Think of the portfolio as a form of collective intelligence. This involves a shift in thinking from individual successes to the success of the collective portfolio. For example, the prophylactic use of antibiotics in animals may boost the profits of company X, but anti-microbial resistance would threaten the profits of all other portfolio companies (this is universal ownership, or shareholder commons)
Greater co-operation with other investors. This is the laying of new trails and the give-and-get of learning from and with others. Investor-ants exploring local opportunities (eg biodiversity conservation or restoration) must act as first movers, reducing the cost of action for others to follow. The pay-back is being able to emulate others
Greater collaboration. This is systemic stewardship, as exemplified by the Ecuadorian indigenous leaders. For investors, this involves acting together to bring systemic change that improves rather than destroys long-term value creation. It will also build stronger networks and ultimately collective intelligence.

Today, breaking down the collective action problem into shared leadership building blocks is a powerful tool in the hands of investors to tackle global challenges like climate change and make the overall system more resilient.

Andrea Caloisi is a researcher in the Thinking Ahead Institute at WTW.

One of Denmark’s largest pension funds, the DKK 712 billion ($103 billion) ATP, is introducing two new overlay strategies in its investment portfolio to better manage unwelcome correlations between bonds and equities that have had a disastrous impact on its risk parity strategy in the past.

New overlays, mostly developed since 2022, will be rolled out through 2024.

“We have been preparing for the equity bond correlation spikes to happen again. It’s important to prepare for a war during peacetime, and this is what we have done,” Christian Kjær, senior vice president and ATP’s head of liquid markets, told Top1000Funds.

Of the two overlays, ATP’s ‘correlation overlay’ draws signals from the market that warn the investment team correlations are changing and ATP risks losing money on both equity and interest rates.

“It sends us a signal to take risk off,” said Kjær. “The overlay flags the beginning of losses in the portfolio, particularly the interest rate portfolio, combined with shifting correlations.” The correlations are measured with intra-day data across different markets so the team can detect correlation shifts as quickly as possible.

The process that combines two key elements, he continues. Firstly, it warns the team about any spike in volatility – which directly increases the risk. Secondly, it highlights any move in the correlations that also changes the risk –aka sending warning bells that any assumption it will get back on equities what it loses in bonds is now in doubt.

“In 2022 the volatility came up and the negative equity and bond correlation which is usually our saviour, disappeared. This negative correlation is important for all investors, but for a risk balanced investor like us, it is more important.”

Another, second overlay, will tilt the portfolio when it sees changes in correlations in general. Unlike its sister overlay, which Kjær describes as “a zero-one strategy,” the second approach is more continuous. It involves constantly trying to manoeuvre and position to adjust for the changes in correlations.

Neither of the new overlays have a large risk budget.

“ATP is humble in its ability to beat the market,” he says.

Kjær acknowledges the new overlays add to the complexity of a portfolio that already relies on pulling multiple levers, and has been criticised for not receiving sufficient compensation for this higher level of risk.

But he argues the small risk budget portioned to the latest strategy tweak doesn’t really change the appearance of the portfolio: the risk level – which is what primarily draws attention to the investment portfolio – is unchanged and the hedge portfolio ensures pensions are safe.

Still, he does stress the overlay strategies require robust digital infrastructure, particularly tools to draw on the right data and the trading ability to handle the orders.

ATP’s complex portfolio comprises the investment portfolio (20 per cent of AUM) and a large hedging programme that guarantees pensions for ATP’s 5 million beneficiaries.

This internal loan from the hedging portfolio gives the investment team more funds to invest while a large part of the interest hedging consists of interest rate swaps which do not tie down liquidity.

Latest performance

The investor has just announced its 2023 numbers, posting a 5.5 per cent return in the investment portfolio, boosted by government and mortgage bonds and listed equities. Returns from inflation related instruments – namely breakevens and commodities which have fallen or traded sideways since the Covid-fuelled inflation boom – and the illiquid allocation, which didn’t keep pace with liquid markets in 2023, were negative.

The latest numbers were also affected by ATP diversifying equity risk in a global portfolio across geographies and companies. In recent years, any diversification away from market capitalization-weighted U.S. stock indices that have done exceptionally well has punished investors.

Still, ATP’s positive results are a marked change from 2022 when torrid markets – and the correlation between bonds and equities – resulted in the investment portfolio shedding -40.9 per cent, equivalent to 54.5 billion kroner ($7 billion).

The return-seeking fund, run on a risk-parity basis since 2005, introduced four risk factors in 2016 based on equity, interest rates, inflation and other risk factors – namely illiquid risk factors and an allocation to long/short hedge funds or alternative risk premiums. The strategy has always sold itself on an ability to function well in almost any market environment due to its perfect balance between different asset classes.

Kjær says ATP will remain overweight equities in 2024.

Levels published at the end of 2021 marked market equity factor at 47 per cent, interest rate factor at 32 per cent, inflation factor at 14 per cent and other factors at 7 per cent.

Despite the challenges of the risk parity allocation, Kjær says ATP is sticking to the approach which continues to work well. “We still like balancing equity and interest rate risk on average. We are a bit different to others, and the risk balance works well keeping our funding ratio relatively stable.”

Some investors lost faith with risk parity when interest rates started to climb. Arguing that the strategy can open the door to hidden interest rate risk seeping into other allocations and upsetting the balance.

For example, high interest rates can convert into lower equities. Rising inflation is another source of disruption because of its impact on interest rate risk. In short, the different factors may end up throwing off the same cashflows and stack up the same exposures. It can leave risk parity investors struggling to diversify and reduce risk – or running more risk than they thought they had.

Tough and volatile investment environments, pressure on costs and competition for jobs are creating pressure on investment teams to perform better. At the same time investment professionals need to jettison some antiquated approaches to decision making to keep pace with social norms. Cognitive diversity in teams has been hailed as a saviour.

“Cognitive diversity” describes the way individuals receive, process and respond to information or changing circumstances. It describes a way of thinking, not how much an individual knows about something.

For investment teams, in particular, subject-matter and financial expertise is taken as a given, and it is about finding ways of taking different routes to arrive at conclusions and to make decisions. Bringing more than one way of thinking about something helps teams test, challenge or indeed avoid assumptions and biases than could affect the process if everyone thinks the same way.

For investors facing increasingly complex, inter-related and volatile investment markets, diversity of thinking is a tool to make better investment decisions – both what to invest in, and what not to.

Former chair of the C$158 billion ($118 billion) Alberta Investment Management Corporation (AIMCo) Mark Wiseman says cognitive diversity should reduce investment mistakes.

Wiseman says investors are typically prone to making two types of errors: Type One errors, or “errors of commission” – that is, investing in things that perform poorly; and Type Two errors, or “errors of omission” – that is, actively deciding to not invest in something that goes on to perform well.

Wiseman, who is also former president and CEO of the (now) $437 billion Canada Pension Plan Investment Board (CPPIB) and former global head of active equities at Blackrock, says investors generally are good at recognising and adjusting for Type One errors but are significantly less good at recognising and adjusting for Type Two errors. He contends that cognitive diversity and diversity of thinking on investment teams has the potential to mitigate errors by opening the team’s thinking to the possibility of novel or unusual ideas.

“To me, investing is ultimately about reducing both Type One and Type Two errors,” Wiseman says. “The way you do it has to be that having a greater degree of cognitive diversity… should lead to a reduction in both Type One and Type Two errors.”

“Having a greater degree of cognitive diversity…should lead to a reduction in both Type One and Type Two errors.”

Either type of error can occur when the inputs into a process miss important things, are based on assumptions that are accepted by a whole team and not challenged, or where the route to making a decision is too narrow.

Wiseman, who stepped down from AIMCo at the end of 2023, says that compared to boards and investment teams of the past, which tended to be homogenously white and male, “you’re more likely to get diversity of thought when you have teams that have other forms of diversity, be they gender diversity, ethnic diversity, geographic diversity, et cetera”.

“But it’s not a given,” Wiseman says, and it usually doesn’t get you far enough.

Unhelpful proxies

Chief executive of the £40.3 billion ($51.1 billion) Border to Coast Pensions Partnership, Rachel Elwell, says gender, background or physical characteristics sometimes are used as proxies for cognitive diversity – men are assumed to think differently always and inevitably from women, for example – but “if you all went to the same school and the same university, you’re probably not, really diverse”, Elwell says.

“Being a female leader in financial services, something that you grow up being aware of is I think we sometimes use physical characteristics to try to second guess the cognitive side,” she says.

That’s not to say that diversity based on gender, ethnicity and other factors is not important – it is, critically, for a range of well-established reasons. But it also means you cannot look at a team and necessarily use visual cues to determine its inherent cognitive diversity.

CalPERS’ chief diversity, equity and inclusion officer Marlene Timberlake D’Adamo, says every organisation is looking to hire the best people they can find to strengthen teams and improve organisational performance. Cognitive diversity is a lens that can be used to support that.

“When we think about cognitive diversity, we think about folks that actually think a little bit differently, or maybe even a lot different,” Timberlake D’Adamo says.

“When we think about cognitive diversity, we think about folks that actually think a little bit differently, or maybe even a lot different.”

“It’s not specifically about subgroups of people. I think a lot of times when we think about DEI or maybe even, say, the early versions of DEI, it’s really thinking about subgroups, like parts of the whole.

“What I like is that this definition is really focused on the people part, because it really is about people, and it’s not about specific, identifiable subgroups.”

CFA Institute global senior head of diversity, equity and inclusion Sarah Maynard says cognitive diversity tends to be “a bit of a huge bucket into which people put multiple different types of diversity”.

“And it’s not altogether wrong, but it’s not altogether, right,” she says. “Comparisons within groups or between groups, if they’re done on that, frankly, sort of visual [basis] – OK, I’ve got one of those, one of those, one of those – it’s going to be way too superficial,” Maynard says.

“Ultimately, you’re trying to get to understanding the humans that you’ve employed, in many diverse ways, because that makes for better management.”

Maynard says not all organisations will harness benefits of cognitive diversity, perhaps because they simply do not perceive the benefits, or they don’t have the resources to do it effectively.

“In a majority of cases, I would say it’s [because of] not necessarily really understanding more deeply as to what we might mean by that cognitive diversity, certainly from a neuroscience point of view,” Maynard says.

Neuroscience and interacting with the physical world

From a neuroscience perspective, we’re all wired to process information and to interact with the physical world differently. Stanford University neuroscientist and author David Eagleman says how individuals respond to challenges, solve problems and make decisions is shaped by their “life trajectory”, and we all have different trajectories.

“We all believe our internal models are the truth, which is to say, whatever your thin trajectory of space and time has been, your brain has constructed a model of how the world works,” Eagleman says. “Despite the fact that the internal models are always quite poor, we have this illusion of explanatory depth, which is we think we know everything in a much deeper way than we do.”

“We have this illusion of explanatory depth, which is we think we know everything in a much deeper way than we do.”

Eagleman says there’s a risk for investment professionals that without being challenged on established ideas and without thinking carefully about how they reach conclusions, “assuming you don’t screw up an investment totally, and you make some amount, then you think you’re really good”.

Eagleman, who also hosts the Inner Cosmos podcast, which explores the way the human brain interacts with the physical world, says it can be beneficial to expand the cognitive capabilities of an investment team to include, for example, individuals schooled in the scientific method.

“Having subject matter experts is one thing,” Eagleman says, but “from an investment point of view, I’mbecoming good at just speaking the language of science”.

He says that this means being trained to challenge conventional wisdom, and to ask the right questions about what’s being placed in front of you.

“It means when the founders [of a potential investee company] show you some data, just being facile with the questions: OK, did you have a control group? How did you do the statistics here? You know, is it statistically significant in the first place?”

Joining the dots

Cognitive diversity does not automatically arise in a team just because it has a range of subject-matter experts. And sometimes it’s a diversity of cognitive skills that allows specific subject-matter expertise to be linked together in new and productive ways.

PRI chief executive David Atkin says he himself is a case study in diversity of thinking – he’s an historian by education and qualification and holds a master’s degree in history.

“You would not want me making investment decisions for you,” Atkin says. “But I’ve been running pension funds [and as] an historian one of the things you do is look across various areas of domain expertise and join the dots and create, analyse.

“I was analysing why do societies change? What are the factors that see change occur? You have to be across a whole range of areas to be able to draw that all together.

“I just use my own experience: I come into rooms where I have lots of different people who are just super smart – super, super smart, and super deep in their expertise. But they’ll think like this [narrowly and deeply]. And I’ll think like that [broadly].”

Atkin says the investment world is throwing up new challenges for investors and creating a new set of complexities that asset owners “need to join the dots on”.

“There’s a challenge for the whole industry because there’s a capability piece that needs to be built out for, which is beginning to happen,” he says. “And that requires different skill sets, different expertise, different cognitive abilities, to better problem-solve and join the dots of these connected issues.”

“And that requires different skill sets, different expertise,different cognitive abilities, to better problem-solve and join the dots of these connected issues.”

Despite the neuroscience element to cognitive diversity, it is not, in practice, an exact science. And it should not be pursued at the expense of creating a high-functioning team focused on serving the interests of beneficiaries as well as possible.

An evolutionary process

Willis Tower Watson Thinking Ahead Institute co-head Marissa Hall says cognitive diversity in an investment team can’t easily be achieved in a single, big-bang moment, it has to “happen in a real-world context”.

“There’s diversity on paper, which can be well, if I had 100 people I would probably optimise it – if all those people were aligned with my goals, caveat. But the real context is I’ve got three spaces to fill, and I need to think about it as incremental, not necessarily transformational.”

Hall says it is much harder now than it used to be for organisations to ignore the benefits of cognitive diversity and say that it’s too difficult, or because the “right” people can’t be found.

“You still have to show best endeavours,” Hall says. “Are you going into schools? Are you working with targeted recruitment firms? Are you maybe thinking about your entrance criteria, so you’re not just looking for graduates, you’re looking for people from different backgrounds, all of that sort of stuff?”

Boarder to Coast’s Elwell says cognitive diversity in organisations is “something that’s really close to my heart”.

Elwell says that “particularly in financial services, there are a lot of opportunities for people with neurodiverse characteristics”. She says her intention is to “create an environment where all colleagues can thrive and be themselves”.

“As a leader understanding the different challenges people face helps you to really think about how to create that environment where you can get the best out of everybody, and that they can work together and they understand the differences,” she says. “That’s something I’ve been really thoughtful about.”

Elwell says Border to Coast has processes formally built into its recruitment and induction that “try to bring that to life in different ways”.

“At the executive level, when I’m recruiting into my executive team, when we get towards the end of the process an executive coach gets involved to do some analysis, run a coaching session with the [final] candidates,” she says. “They’re not going to share personal things that happened in those conversations. But [it is] to get an indication from that coach about how those people might add to the team dynamic at an executive level, to set the expectation that this is something that’s important.

“Then for me to have a think about how do I run that team, and how do I get the best out of the individual, and the individual’s contribution to the team, is formally part of it.

“That is very much looking at cognitive diversity because you’re using psychometrics and actual time with an executive coach to explore what those mean.”

“That is very much looking at cognitive diversity because you’re using psychometrics and actual time with an executive coach to explore what those mean, not just using the output of a questionnaire.

“But that is a lot of investment, both for candidates and for us, because obviously there’s a cost associated with that, and time.”

STRENGTH IN DIVERSITY

Eva Halvarsson, chief executive officer of Swedish buffer fund AP2, says exposing individuals to other people’s ways of thinking about and solving problems strengthens a team overall, by demonstrating there’s more than one way to make decisions and no single approach is automatically always the right one.

She says the challenge for asset owners is to create an environment where diverse thinking is recognised and valued. This means organisational leaders are being challenged to “really try to get to know your staff or your colleagues, and to talk, finding ways to address your [different] reaction in a way that is not threatening”.

“And that’s the reason it’s very good to go away for an offsite to do some Myers-Briggs training, or whatever, to find common words so it’s not challenging,” Halvarsson says.

The SEK425 billion ($40.7 billion) organisation is currently restructuring its investment teams and some team members will be exposed to ways of thinking and investing that are new to them, or different from how they’ve done it previously. For example, its head of equities will also work with a team of quantitative investment managers and analysts.

“He has not before worked with quants, only had them as colleagues in a different team,” Halvarsson says. “On the contrary, he has often been challenging their investment style. And now he will be heading those guys and women. I am sure that both he and the team will learn a lot from each other and find new ways to work to make good use of the all the different skills that exist in the new team.”

Asset owners rarely, if ever, have the luxury of creating a new investment team from scratch and setting recruitment parameters that incorporate cognitive diversity factors from day one. But they can still benefit from accommodating teams of individuals who do think differently from each other.

Halvarsson says her own preferred approach to making decisions is to take her time and to be considered.

“From that perspective, or that example, I can say, well, you know me,” she says.

“So you have to find a common language to address these issues. I think it’s the way forward.”

A critical characteristic

AIMCo’s former chair Wiseman says not all investment teams have true diversity of thought, but it’s a really critical characteristic.

“Investing is ultimately about predicting the future, which, in spite of all the work we have on AI and quant analysis, is exceptionally hard to do,” Wiseman says. “But what we know is that the future outcome is going to be multivariate in terms of what causes the outcome.”

It that’s true, then it stands to reason that cognitive inputs to investment decision-making should also be multivariate.

And PRI’s Atkin says there is a real need for different skills sets because of the new and evolving challenges of investing.

From his current vantage point, Atkins says he’s seeing how institutional investors are responding to being asked to address increasingly complex issues, such as sustainability.

“We are reimagining the way in which we think about the balance sheet, and the way in which we think about value,” Atkin says. “And we’ve understood more and more that there are these externalities that are hitting the balance sheet, either now or in the future, which require different ways of understanding the problem and different ways of diagnosing risk and opportunity.

“When it comes to the issue around, for example, climate change and investment teams seeking to achieve net zero targets, there are a lot of challenges. There’s information challenges, but there’s a whole lot of technical challenges that are in front of teams, because investment teams are being asked to solve problems that they have not been trained for.”

CFA Institute’s Maynard says an asset owner that “does the deeper work will, I think, be able to generate a different kind of organisation, different kind of team interactions”.

“[Who] does the deeper work will, I think, be able to generate a different kind of organisation, different kind of team interactions.”

“There is a wealth of experience and understanding to come from that. But of course…it’s tough work. It’s not simple and straightforward. I definitely think there’s a huge opportunity there, and there are some very encouraging signs. But it’s certainly not going to be industry-wide.”

Maynard says one thing that can be “super helpful” to building cognitively diverse teams is to ensure that “when it comes to interviewing, selecting, you have a really consistent approach”.

“You don’t just say somebody gave a great answer to this question,” she says.

“You do a numerical score, there’s a degree of anonymizing of CVs and the like – there are things that can help with debiasing the process – and also being much clearer about if you want to appoint somebody, why you’ve done so.

“Things even as simple as, whether you’re doing an internal promotion or you’re recruiting from outside, you ask all the candidates the same questions. It would seem to be blindingly obvious that would happen, but you’d be amazed how few organizations have that as an accepted practice.”

A means to an end

Thinking Ahead Institute’s Hall says diversity, in any form, isn’t an end in itself, but rather, is a means to an end.

“I don’t think organisations think of that as the end goal,” she says. “That wouldn’t make any sense. The end goal is how do we invest and deliver outcomes for our end savers; or how do we achieve the goals of the organisation. And so diversity, just like culture, just like good governance, just like technology, these are the enablers to be able to achieve that.”

Hall says achieving cognitive diversity will generally always be a work in progress.

“You will always be on a journey, you will always be on a path to doing it, you will always tweak it, just like how you always tweak your investment portfolio – you never keep the same strategy in changing conditions,” she says.

“You will always be on a journey, you will always be on a path to doing it, you will always tweak it, just like how you always tweak your investment portfolio”

“Making it aligned with the investment portfolio narrative, and the sustainability journey that we’ve all been on, why would we treat our human capital narrative any differently?

“If we almost look beyond diversity, and it’s like we are trying to find the best humans, regardless of where they come from, regardless of their background, regardless of what they look like, and we have a mindset that talent can come from anywhere, then you’re more on the right track.”

CalPERS’ Timberlake D’Adamo says managers and people who lead teams within the business need to see diversity of thinking as a strength of a team, not as a challenge to them as a leader, nor as insubordination on the part of the individual.

“It really is trying to make space for those people…to do what they do, to think the way that they think, and not feel like they have to tamp that down, or not be able to raise their hand and say, hey, I’ve got a different take on this, or, you know, I don’t really see it that way,” Timberlake D’Adamo says.

“I always value the people that have the ability to do that. Why? Because it takes a lot of courage to be able, in a roomful of people who are nodding their heads, to say, I see it a little bit different; or gee, I’m just not quite there yet.

“The natural inclination of some people is to think of that as like a challenge, or threat or insubordination, or somebody who’s not just going along with the program and throwing a wrench in it.

“It takes a lot in terms of checking ourselves, to be able to say, okay, you know, this person has a different take, let’s hear it.”

Timberlake D’Adamo says the $483.7 billion CalPERS doesn’t formally assess individuals to try to determine or identify their cognitive capabilities but she says the organisation spends a lot of time considering the sorts of individuals it needs to bring in.

“There’s no sit-down test where you’re checking boxes or doing things like that,” Timberlake D’Adamo says.

“Like a lot of things when trying to find, call it, that square peg in the round hole…a lot of times this type of work around people is, I was going to say hard but I don’t mean hard in terms of difficult. It requires you to be thoughtful and intentional, and it’s step-by-step.

“I was going to say [it’s] hard, but I don’t mean hard in terms of difficult. It requires you to be thoughtful and intentional, and it’s step-by-step.”

“It’s on an individual-by-individual basis. It is assessing what you have, and then figuring out what you’re missing and then trying to find people that bring that other element to what it is that you think that you’re missing.

“But I want to be clear in saying that when you think about what you have, you actually have to do that very thoughtfully. You have to really have thought this through because if you just knee-jerk say what you think you have, and you’ve not interrogated your own views, perspectives, results, data measures, then you might not end up with what you think you need.”

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