Nobel Prize-winning economist Myron Scholes says changing how investors look at risk can improve the way it is managed, and can help boost returns.

He told the Fiduciary Investors Symposium at Stanford University that the focus of asset owners needs to shift from thinking of risk as a constant to considering how risks are changing. Then, the two important things in investment that would have to be included are time and risks changing.

“Most of what we’ve done in the past is concentrate on cash flows and trying to estimate cash flows. In my view, we also have to think about how discount rates change,” Scholes said.

“How the discount rates change affects our portfolios, and risk is really discount rates and thinking about how they change over time.”

The discount rate is low during times when risks are low, and when when risks are high, the discount rate is high.  So the important part is really the phase transition, or how we get from low to high and high to low.

“It’s really trying to understand how to get information when risks are changing, not just the level of risk. And then if we concentrate on risks changing, we can then increase our return,” Scholes said.

For example, if asset owners know that risks are going to increase in the future, they would want to reduce their risk and have more powder dry, than when risk goes the other way. So they can reallocate.

“Even if you’re in a long run horizon, phase transitions are very important in risk. And what the data shows is that’s what we should be looking at. Not necessarily the level of risk today, but how it is changing. How to get information about changing risk to enhance our rates of return.”

Time Value

Scholes says asset owners typically think of risk management in four different ways.

One is the idea of holding inventory, so deciding on what risk to hold. That could be in the form of either a strategic allocation, or even tactical tilts such as more equities, less bonds and vice versa. Another way is turning over inventory to make money or generating alpha, whether through short term plays or by thinking about themes. But that is quite difficult.

The third way is to look at what the constraints of others are, and when they’re willing to transfer risk and pay people to take their risks, or periods such as liquidity crises when people want to liquidate portfolios quickly and dramatically.

“Because the risk changed, the price changed, the risk premium changed, the required rates of return changed, and you can make money by stepping in,” he says.

The fourth way to manage risk is to smooth the discount rate over forward in time, such as when you’re a long horizon equity holder, have no interim cash flows to worry about, and can hold for a very long time. Basically, a buy and hold strategy, or the strategy behind passive investments.

“The problem with that is it doesn’t take account of time. And the interesting thing in time is that even though it averages out, the volatility hurts you because compound return is what we should be interested in,” Scholes said.

Risk has multiple dimensions that we have to consider, so every period counts, and that is an advantage, because in compound return, everything multiplies.

“As every period matters, then we have to think about how to get information, not about what’s going to happen five years or three years from now, what’s going to happen next quarter or the quarter after that, if we’re managing money.”

The increasing willingness on the part of regulators such as the Federal Reserve to bail out investors at times of crises is reducing the competitive environment in which banks and financial institutions operate, the Fiduciary investors Symposium at Stanford University has heard.

Ross Levine, the Booth Derbas Family/Edward Lazear Senior Fellow at the Hoover Institution, said the Fed’s practice of insuring the liability holders of financial institutions was encouraging more risky behaviour and creating a fragile system in the longer run.

“This means those financial institutions are likely to take excessive risk, because the people with the money on the line don’t have their money on the line, because the government will bail them out.”

“Without those entities providing governance over the financial institutions, the degree to which they are going to allocate capital effectively to the people with the best entrepreneurial ideas is diminished,” he added.

Levine, who is also a research associate at the US National Bureau of Economic Research, has previously criticised the Fed’s perceived lack of regulatory power through the global financial crisis and other banking crisis in the US. He has also criticised the high incentives of financial services executives.

The question I always asks regulators when a major bank fails in the US: what decision maker at that institution loses their house? And the answer is either silence or murders of ‘nobody’, he said.

“If you have a financial system in which the decision makers don’t share in the downside, this simply cannot be sustained for the long run, and so that incentive is what scares me.”

He says the Fed has essentially insured all liability holders in financial institutions, except for shareholders, even though by regulation, a large bank in the US cannot have a shareholder that controls more than 5% of the equity.

That means all liability holders who are supposed to provide governance are insured, so the only entity that can really be in a position to monitor excessive risk taking, are the regulators.

“I think the Fed is caught within the context of a political and social expectations in the US. We don’t interfere with free markets, but at the same time, we don’t want people to lose money, so we’re going to provide this insurance for liability holders,” Levine said.

“You can’t have both of those. You can’t have insurance of the liability holders, which encourages excessive risk taking, without the regulation that constrains the excessive risk taking, and philosophically, the US doesn’t seem to be able to resolve this.”

Reliable Indicator

Levine says his research has shown that the financial sector has been fundamentally important for promoting economic prosperity across the US states and across the world more generally.

It is also one of the most reliable indicators about how an economy is going to perform in the long run.

“How an economy’s financial sector is performing, how open it is for competition, is its regulatory system one that promotes competition?. These sets of analysis are a very useful way to understand and predict which countries are going to succeed.”

Responding to a question about using growth as an accurate measure for the health of an economy, Levine said that GDP growth, over long decades, is a pretty good summary statistic for how the economy is doing. It’s not perfect, but there are no good alternatives.

That is because GDP growth, if measured correctly, is not just about more stuff but also about better stuff.  “I’m thinking about that as a proxy for a better standard of living on average, not just, you know, more TVs per capita.”

Levine criticised both major political parties in the US for moving away from a focus on growth, and considering the economy as a zero sum game. That has meant people are worried about the relative slice that they’re getting, and less about increasing the size of the economic pie.

The reduced focus on growth feeds into the fact that the US is in the midst of a major fiscal crisis, with the overall debt to GDP ratio somewhere between four and five times as great as it was after World War II.

“That’s a gigantic problem and and very difficult decisions are going to have to be made. Those decisions are going to be easier and less severe if the economy is growing,” he said.

The transition to net zero is well underway, but it won’t be a smooth path and getting there will pose significant risks for investors. These are the conclusions of a new report by Pictet Asset Management and the Institute of International Finance. It will require higher levels of borrowing by the companies they invest in; the risk of transition-related “greenflation”, along with increases in unemployment; and the possibility of creating asset-price bubbles as a vast amount of capital chases a relatively constrained supply of assets.

To avoid these pitfalls and others, investors must take a measured approach to assessing opportunities as they arise, including assessing the extent to which markets have already priced-in the “greenness” of companies, and what implications that has for alpha generation. And that requires deep research and confidence in available data – which in some cases continues to be patchy.

Pictet Asset Management senior investment manager Yuko Takano, managing investment director, sustainable investments at CalPERS Peter Cashion and Institute of International Finance director Emre Tiftik discuss the opportunities and risks investors need to understand to maximise returns as the energy transition progresses.

In conversation with Top1000funds.com editor Amanda White, they discuss how it’s possible to generate outperformance by investing in climate solutions; and how investors should think about the associated risk and alpha opportunities.

An allocation to climate solutions and the ability to generate alpha from that across asset classes are what will define the future “California model”, according to CalPERS managing director of sustainable investment, Peter Cashion.

At the Fiduciary Investors Symposium at Stanford University, Cashion invited other Californian pension and endowment funds to together create an enabling environment for sustainable investment considering that the state is a “global leader when it comes to climate policy initiatives”.

“It’s [the California model] a working process, we haven’t trademarked it yet,” he quipped.

“We’re starting to work more closely together, particularly with CalSTRS, and doing things jointly.

“We can even draw some parallels with what California, and specifically Silicon Valley, has done as a global leader in technology.

“I think there’s an opportunity now for California to also lead in the climate transition, and actually technology will be a critical driver in that.”

CalPERS is the biggest asset owner in the United States and the fund has committed $100 billion to be invested in climate solutions in 2030. Cashion added that close to $50 billion of that mandate has already been deployed.

But on a state level, there is still plenty of capital to deploy as all of the major Californian pension and endowment funds collectively have more than $1 trillion assets under management – CalPERS alone has two million beneficiaries.

“We’re in a unique position. We have the assets, we have the aspiration and the desire, and it’s really grounded in we’re doing this to generate outperformance because that’s fundamental as part of our fiduciary duty,” he said.

Although generating alpha from climate and transition allocations is often easier said than done, Cashion said CalPERS has a few reasons to back its conviction.

Firstly, the sheer size and scale of the transition means it’s bound to throw out some good opportunities, Cashion said.

“In 2023, $1.7 trillion was spent on transition, up from $900 billion in 2019, so there’s really been a considerable increase, and that’s only going to grow,” he said.

“The second element is the importance of resource efficiency…so whether that’s water, power, energy efficiency – just inputs in general – that’s going to translate into lower costs, higher profitability and higher valuations.

“We’ve really seen, particularly in public equity, those strategies have really outperformed over the last years that are resource-specific measures.”

The third reason is CalPERS’ belief that it is beneficial to work with companies which are more aware of the climate and transition risks and act upon that information.

“At the end of the day, it’s really about information asymmetry and knowing something that the market either isn’t fully aware of or hasn’t fully priced in,” he said.

“If we think that the market…isn’t fully pricing in, correctly pricing in, something that will take six [or] seven years to play out, we’re okay to invest now and wait.”

Another advantage of being situated in close proximity to Silicon Valley is that there is a “strong cohort” of venture capital funds in the area, and CalPERS has good exposure to those and growth funds in private equity, Cashion said.

“We were a participant in Clean Tech 1.0 and unfortunately, it ended up where it did,” Cashion said, lamenting the early commercialisation efforts of climate technology and the bubble created by VC investors between 2006 and 2011.

“There were reasons for that, and we’ve studied those, and we feel confident we’re in a very different position today. We’ve done a few site visits, actually, just to portfolio companies here which are really at the cutting edge.

“Whether it’s because of institutions like Stanford or National Labs, there is just a whole ecosystem that promotes and supports [climate tech in California].

“And I think frankly, they like to have in their LP list an institution like CalPERS, which is also a local player.”

Five years after signing up to net zero, climate-conscious asset owners have a message for governments: act now, or risk global prosperity. As policymakers, investors and climate action advocates ascend on NYC for Climate Week chair of the Net-Zero Asset Owner Alliance, Günther Thallinger, reflects on the progress.

Policymakers and climate action advocates are arriving in New York for the city’s annual Climate Week on the back of yet more record summer temperatures and the growing probability of the world overshooting warming of 1.5°C above pre-industrial levels, the most ambitious goal agreed by governments under the 2015 Paris Agreement.

Against this backdrop, some of the world’s largest investors are calling on governments to intensify their efforts to slash global emissions. This robust intervention comes from the UN-convened Net-Zero Asset Owner Alliance whose 88 members control $9.5 trillion in assets under management.

This is not investors indulging in climate alarmism, nor playing at environmental activism. New scientific research presents compelling evidence that crucial climate ‘tipping points’, such as the melting of the polar icecaps, could be imminent. The chain reaction arising from such an event will bring about huge economic instability, and thus poses a substantial risk to our portfolios.

Closing our eyes to this reality will not make it go away. The data is ever clearer, and ever harder to ignore. Annual economic losses from natural disaster events already hover at around $400 billion, while the estimated losses from a climate-driven shock to global food systems could easily reach $5 trillion annually. In short, if only to uphold our fiduciary duty, it’s imperative to act.

On the flipside, ambitious climate action promises to give rise to economically viable new asset classes. Just look at the clean energy tech sector, which has seen its total value already reach a staggering $790 billion. This aligns with our own research, which indicates that demand for innovative clean technologies, products and services could result in investment opportunities worth $136-275 trillion by 2050. This underscores the importance of the commitment by Alliance members in 2019 to balance the greenhouse gas emissions of our investments by mid-century, in line with the landmark Paris Agreement.

In what is considered to be the decisive decade for climate action, nearly all members (98%) have individually set intermediate climate targets as guided by the Alliance’s robust Target-Setting Protocol. As a direct consequence, financed emissions dropping by at least 6% on average annually, in line with requirements set by 1.5°C pathways, while $555 billion has been directed by members into climate solutions.

From the outset, however, our net-zero commitment came with a proviso that governments must set the pace and confirm the direction of travel. Why? Because without a clear political steer, businesses lack the confidence to shift their strategies accordingly. The lack of regulatory action stymies changes and leaves emissions creeping ever upwards.

For asset owners with clear climate investment targets, such as those in the Alliance, the failure of the real economy to decarbonise shrinks our investable universe. This not only reduces investment returns, but also restricts the quantity of transition finance. In short, a lose-lose for everyone.

Yet the wait for decisive government action continues. Glimpses have been seen. The pledge at last year’s UN climate summit in Dubai to transition away from fossil fuels was welcome, for instance. But far more urgent and ambitious measures are required if businesses are to shift track at the scale and pace required.

So, what can policymakers do? Most immediately, it’s essential to tackle the root cause of the problem. That means slashing demand for oil and gas, be it through regulatory measures such as a carbon tax or policy incentives for fossil fuel alternatives, while ensuring an economically and socially just transition. Similarly, governments should take firm steps to phase out all unabated existing coal-fired electricity generation.

Second, identify the best low-carbon solutions out there and work to bring them to scale. An obvious place to start is accelerating alternative energy supply through innovative market and non-market mechanisms. Similarly, governments should waste no time in setting up equitable carbon-pricing mechanisms in line with their Paris Agreement commitments.

Critics argue that the pursuit of net zero represents a drag on economic growth. Such thinking is short-sighted. Its climate change itself that is impinging growth, not efforts to stop it. Every day of delay in bringing about a rapid low-carbon transition, the costs of global warming go up – as does the unlikelihood of a stable, prosperous society for all.

Fortunately, with all signatories to the Paris Agreement obliged to submit progress reports before the end of 2025, policymakers have a last window in which to act. By doing so and duly meeting their Paris obligations (known as Nationally Determined Contributions), governments can send a powerful signal ahead of UN climate talks in Baku, Azerbaijan, this November.