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.” 

 

Norges Bank Investment Management, asset manager of Norway’s Government Pension Fund Global, has spent much of the last year increasing transparency, convinced that sharing its actions and progress, providing more information on its investments, participating in more consultations and engaging in more dialogue with companies and stakeholders, is key to building the trust needed to achieve the energy transition.

“We hope that this transparency and visibility can contribute to companies, investors and policy makers pulling in the same direction, and that, in this way, we can achieve more than we would on our own. But we also hope that our transparency in this report can increase the public’s understanding of and engagement with our work. Engagement, discussions, and input help us to improve and to continue to be a leading responsible investor,” says Carine Smith Ihenacho, chief governance and compliance officer at NBIM, encouraged that the investor’s work is helping support the rise in sustainability-related shareholder proposals.

Her comments accompany the publication of NBIM’s latest Responsible Investment Report that showcases key milestones over a year when the investor was also recognized as the most transparent fund in the Global Pension Transparency Benchmark, next published in October 2024.

Pressure on companies

The report highlights how NBIM has put increasing pressure on the companies in its portfolio to transition to reach net zero by 2050.

“Long-term targets are no longer sufficient, they must be underpinned by detailed transition plans with interim targets and updates on their progress,” it states.

“We expect large emitters to set net zero targets with urgency and all companies to set targets by 2040.”

NBIM as rolled out an ‘engage-to-change’ approach with many more companies through 2023. Although NBIM says it is still early to evaluate results, it observes encouraging changes.

It states 2,385 portfolio companies had set science-based net zero 2050 targets at the end of 2023, a rise of 790 on 2022, meaning 68 per cent of its financed emissions are now covered by net zero 2050 targets, a key metric defined in the plan.

Engaging with regulators and frameworks

NBIM spent much of the year engaging with regulators and contributing to shared frameworks. Last year marked the finalisation of several long-awaited standards and outcomes, and the adoption of mandatory reporting regimes across several of the markets NBIM invests.

The most important milestone was the publication of the International Sustainability Standards Board (ISSB) standard for climate-specific disclosures.

Looking ahead, NBIM will increase its focus on engaging with regulators and frameworks in emerging markets particularly India and Brazil where it has responded to consultations and met local standard setters including securities regulators and stock exchanges.

Divestment

NBIM has also measured the impact of its investment decisions, including risk-based divestments, on its returns. The impact on the equity portfolio from the risk-based divestments was 0.07 per cent in 2023.

Since 2012, risk-based divestments have increased the cumulative return on equity management by 0.44 per cent, or 0.02 per cent annually.

Risk-based divestments linked to climate change and human rights have increased the cumulative return on equity management by 0.23 and 0.09 per cent respectively.

Funding research

Last year, NBIM begun funding research for the first time. Like its exploration into CEO incentives where it aims to better understand what optimal executive incentives look like for a diversified investor seeking to promote long-term returns. NBIM is partnering with the National Bureau of Economic Research (NBER) in the US to encourage further academic research by top scholars on the area.

In another initiative, it is seeking answers on the relationship between climate change and natural resource availability. Working with the University of Minnesota it seeks to estimate the future economic impact of changes to natural resources on countries and industry sectors, seeking a more complete picture of how changes to natural resources might affect the fund’s investments, particularly in areas such as food production, infrastructure, and renewable energy, as well as in countries whose economies depend significantly on natural capital.

Insights from another research project have just come to light. Since January 2021, NBIM has disclosed how it intends to vote prior to annual shareholder meetings. The latest analysis of whether pre-disclosure transparency has any effect on other shareholders’ voting decisions suggest that voting pre-disclosure influences other shareholders’ voting decisions.

“Market participants seem to find our pre-disclosure valuable and, more generally, it shows how voting pre-disclosure can be an effective ownership tool for us.”

Innovation

In 2023 NBIM developed a portfolio-specific governance dashboard and expanded the use of an investment simulator, a decision-support framework which highlights strengths and weaknesses in portfolio managers’ investment decisions. Elsewhere, a forensic accounting team has developed a screening tool looking at more than 100 accounting ratios to help us identify companies where sources of revenue or cash flow may be unsustainable.

Building on this accounting database, the team is developing an AI tool which seeks to identify companies where it should scale back on its investment. Last year NBIM also launched a net zero target tracker. It stores information on all corporate net zero targets published in its portfolio companies, including short- and medium-term targets. It shows that the highest increase in companies setting targets in 2023 was in the Pacific region.

Moreover, the research indicates that targets matter for corporate emissions. “We are seeing increased emissions in companies that have not set any targets, whereas companies with science-based targets have decreased their emissions since 2015.”

Risk

NBIM has developed a screening methodology for assessing ESG risks across all companies in the equity portfolio and benchmark index on a quarterly basis. The purpose is to assess the potential financial impact of ESG risks on companies, as well as the companies’ potential and actual adverse impacts on the environment and society.

The screening feeds into its sustainability due diligence processes. In 2023, NBIM identified 166 companies with heightened ESG risk through its screening method. Following additional analysis, it decided to monitor developments in 49 cases, initiate dialogue in 28 cases and divest in 4 cases.

Both divestment and re-inclusion decisions are made within the overall limit for deviation from the benchmark index. The use of this tool is typically chosen for selected small investments where it has uncovered systematic mis-management of ESG risks, and where engaging with the company has failed or is unlikely to succeed.

Engagement

NBIM also revealed progress around its strategic board dialogues.

Dialogue is based around net zero dialogues, where it engages with the highest emitters in the portfolio and supports and challenges them on their pathway to net zero emissions. Thematic dialogues involve engagement with companies on specific sustainability matters and incident-based dialogues involve working with companies because of poor risk management.

Chris Ailman, chief investment officer of $317.8 billion CalSTRS, spent much of his childhood surfing on America’s west coast and dreamt of becoming a lifeguard until he discovered the world of investment. Fittingly, he tends to describe seismic events as waves, and an investor’s job to time and ride them.

Reflecting on his tenure as he prepares to pack up his desk after 23 years in his Sacramento office (a process, he jokes, that could take some time given the junk accumulated) he says the pension fund has been dragged under twice.

First losing $15 billion when the tech bubble burst 18 months into his leadership – he took the CIO job in October 2000. Then, much worse, when $55 billion disappeared from the portfolio over a period of 120 days during the GFC. A traumatic time that led to a long-term collapse in CalSTRS’ funded status and an experience he still calls the most difficult time in his career (See Top1000funds.com’s interview with him in 2009 Back to basics as CalSTRS rethinks active/passive mix).

Now that wave is the energy transition, stirring and building in the deep and which Ailman says must hit the shore by 2030 if the world is to have any chance of preventing devastating climate change. CalSTRS’ investment team is paddling hard, mindful of both timing it right to not get crushed, but also that the waters will get very choppy if the world doesn’t transition as one.

“If CalSTRS achieves net zero alone, it doesn’t do anything. We need everyone around us to change behaviour. By 2030 we need to be looking out of the window and see a very different life, otherwise we will be in real trouble,” he says.

Top1000funds.com has followed the evolution of sustainability at CalSTRS including how Ailman questioned the morality of  divesting non-US coal assets back in 2016; why the fund hired ESG-specific equity managers and more recently, CalSTRS’ net zero path and engagement wins, like its driving support of Engine No.1, the activist hedge fund that campaigned for directors with climate experience at oil giant Exxon.

But it’s the role of investors when it comes to financing the transition where much of Ailman’s thinking currently focuses.

He says it’s expensive cleaning up dirty industries, and the world needs and should welcome people who see the economic benefit from a green premium down the road. Building this new cohort of investors involves encouraging people like CalSTRS’ one million members (who he describes as “long-term, reasonable people,” a nod, perhaps, to the politicisation of ESG) to invest in greening industries.

It involves carving a middle ground between climate “zealots” who insist on divestment and boycotts, and a more unscrupulous bunch who continue to invest in high emitting sectors but won’t improve them.

“We still have investors who are willing to hold and buy coal,” he despairs.

Emerging risks

Ailman says he leaves his long tenure at CalSTRS as other risks also gather on the horizon, playing to his tendency for pessimism despite buoyant economic statistics like strong US GDP and historically low unemployment.

Geopolitical uncertainty and two regional wars concern him. And he believes November’s US election will see unprecedented levels of AI and deepfake from “bad actors” peddling misinformation to create instability and cynicism amongst an already weary voter population. “We need to be more sceptical about what we read and where it comes from,” he says.

The irony that America’s tech giants and the (worryingly few) companies leading the digital revolution are facilitating so much instability but have also provided some of the best returns for US equity investors isn’t lost on him.

Describing himself as “not generally a fan of regulation” he says the US urgently needs to draw up rules around AI and the internet, a Wild West that now poses an existential threat. “This is an area where we need regulation. If you think back to all types of communication in the past from postal services to TV and radio, the government had regulatory authority.”

Ailman may be calling for government action in one area, in another he is increasingly mindful of the risk ahead from policy maker largesse.

He predicts the cost of servicing US debt and financing the deficit in a climate of higher rates will be one of the biggest risks for the next President, whoever it is. “The cost of US debt will be the biggest budget line item by far.”

The risk (and opportunity) for investors will come with a new level of volatility in fixed income. Investors will face Treasury tails, the reaction from bond markets if auctions go badly and the government is forced to pay more to issue and service debt, for the first time in decades. “Ordinary people know what it is to go to the bank; ask for money, and the bank won’t give it,” he says. “We are just beginning to see the US struggle to finance its deficit.”

Riding the career wave

It’s not surprising that Ailman also compares his own career to riding a wave. In this case the growth of institutional investment off the back of pension fund reform in the 1980s before which CalSTRS was still part of CalPERS and run by around 40 people, hidden from view. “No one knew they existed!” he says.

He spent the 1980s as CIO of Sacramento County Employees Retirement System and joined the then $100 billion CalSTRS as CIO in 2000 after a four-year stint at Washington State Investment Board. Climbing up the ladder from financial analyst to investment officer, and ultimately CIO, in lock step with the growth of the industry and pension funds’ assets under management. “My job never changed. I got lucky, and caught a wave.”

Over the years, he was tempted to work for the sell side and join a Wall Street firm. But he says institutional investment always pulled him back, primarily because working at a pension fund in California best suited his family. The members of which pepper the conversation from his three-year old grandson to the influence his wife has played on his career. Or hearing how his sister and daughter, who both had careers in teaching, hold him to account over a crowded table. “I never wanted to move or meet demands that would have an impact on my family,” he says.

But his motivation has been purpose as well as personal. Namely his connection with CalSTRS’ beneficiaries and the fulfilment he derives from knowing they will be supported.

“Teachers spend their career on a modest income, and I love the fact we can provide a lifetime guaranteed income to help them in that trade off they’ve made.”

It was also CalSTRS’ beneficiaries who he credits with getting the investment team through some of the toughest days in the aftermath of the GFC, a connection that helped them all, him included, take ownership of what had happened and rebuild for the future.

Overseeing the growth of the investment team and championing them at any opportunity is, perhaps, his most important legacy.

“They are recognised as one of the best money managers in the world,” he says.

Grown from 35 when he joined to 230 today (and 70 per cent are women) they are responsible for managing $150 billion in house. The strategy has helped save more than $1.6 billion in costs since 2017 and CalSTRS currently targets an additional saving of $200 to $300 million a year over the next five years, a cost saving that is also supported by getting tough on asset managers about fees. He told Top1000funds in 2015 there was no need for the pension fund “to be friends with its asset managers.”

Ailman downplays his influence on the team’s success or his role in developing an investment mix that includes new portfolios introduced over the years like total portfolio management (begun during the GFC to bring asset class heads together to locate mortgage exposures and liquidity pockets), inflation sensitive and risk mitigating strategies. Insisting instead – in another glimpse of his light touch – that he just “hired the right people, gave them the right tools, pointed them in right direction and got out of their way.”

Typically, he spent much of the recent January board meeting when his retirement was made public celebrating the tenure of another CalSTRS employee. But he does allow himself one boast.

CalSTRS’ previous CIO lasted just three years in the role and at Ailman’s 2000 interview he promised the board he’d try and stay longer.

“I’ve smashed it,” he says.

Brunel Pension Partnership chief investment officer David Vickers recently flagged the risk of today’s “Goldilocks” economic scenario not delivering for investors. Although recession risk is receding; markets have priced in three rate cuts in the US and the inflation dragon appears slain, the reality might be different.

Vickers, who joined  as CIO in 2021 to oversee around £40 billion in assets at one of the eight LGPS pools, warned that conflict in Ukraine and the Middle East, and weakening economic data pose substantial investor risks. He said equity is, on aggregate, more expensive and warned that investor compensation for investing in debt markets is low. “It is plausible we get a Goldilocks scenario, but [investor] disappointment if we don’t will be keenly felt.”

Brunel Pension Partnership goes into 2024 with a raft of ambitions but also facing challenges, states the asset manager’s recently published Annual Review. One of the biggest unknowns is UK government plans for the LGPS pools. Following a consultation on the future of the LGPS, policy makers laid out ambitions for pools to transition all assets by March 2025, a process some local authority pension funds like West Yorkshire, part of Northern LGPS, have been slow to complete.

The government also targets further consolidation, suggesting pools reach £200 billion by 2040. Brunel says it has appointed “a third party to enable us to consider options for consolidation.”

Pools also face government pressure to invest more in unlisted assets and venture. In its 2023 Autumn Statement the government said it will revise guidance that the LGPS double its allocation to private equity to 10 per cent.

Brunel has also stated new commitments to raise manager reporting duties. In its latest climate policy, which updates an original policy first published in 2020,  the investor promises to “turn the screws” on managers and its holdings via increased RI expectations, seeking to drive whole-economy change for the long term  and “not simply buff our portfolios.”

Brunel was one of the first out of the gates regarding pooling assets and integrating sustainability. In 2018 it was the first UK pool to sign up to TCFD reporting and the first to launch its own RI policy. One year later, it had transitioned 50 per cent of client assets. In 2021, it formally committed to net zero, co-launched new Paris-aligned benchmarks and had introduced a suite of 17 multi-client portfolios – adding a local impact portfolio in 2022. Last year it introduced a fourth cycle of private markets portfolios and began developing a new RI priority – biodiversity.

The investor will spend much of this year beginning to integrate nature risk having committed to adopt Taskforce on Nature-related Financial Disclosures (TNFD) reporting metrics that detail nature dependencies, impacts, risks and opportunities in the financial year 2025-6, one of 320 organisations from 46 countries that signed up as early adopters in Davos.

Brunel’s TNFD commitment builds on earlier biodiversity initiatives. Last year it conducted a pilot project with S&P Global to assess nature risk across its listed equity and fixed income portfolios. Working with S&P Global enabled Brunel to delve into complex themes, like identify companies whose assets overlap with existing protected areas and key biodiversity areas. “Less than a third of Europe’s biggest companies have set biodiversity targets,” it states.

In it’s latest review, Brunel reports that absolute performance was strong across all listed market categories, in a reversal of 2022. Within private markets, whilst performance data is lagged, the last audited NAVs show that portfolios performed well.

Active management struggled, specifically in global equity mandates, given the concentration of returns. Indeed, the global equity index looks likely to have beaten the vast majority of active managers. Brunel’s least constrained fund, global high alpha, kept pace.

Other 2023 milestones include successfully trialing AI internally and strengthening access to data by drawing a clearer line between data managers and data owners.

The Global Pension Transparency Benchmark, a collaboration between Top1000funds.com and CEM Benchmarking, ranking pension funds globally on their transparency of disclosures, will make a number of process improvements to the 2024 survey.

For the first time since the benchmark’s launch in 2020, the survey will be updated this year including removing or improving overly interpretative questions; updating the responsible investment survey; and aligning the cost survey questions with reporting best practice as set out by CEM’s Global Reporting Principles.

Consistent with the benchmark’s approach to be inclusive of the industry to drive better performance, a consultation period on the new survey will be open from February 1 to March 1, 2024. [Click here]

The benchmark scores the five largest organisations in 15 countries on the transparency of their public disclosures across four factors: performance, cost, governance, and responsible investing. This year the five largest funds in each country will be re-assessed, and there is an exploration for ways that organisations outside the top five can participate.

The benchmark will be published in October, 2024.

For last year’s results, including the overall top fund (Norges Bank Investment Management), the winners in each category and the biggest improvers, click here.