Foundational research by CFA Institute aims to prompt the best minds in the asset management and asset owner communities to consider how to better consider climate risk. Institute chief executive Marg Franklin says governance, organisational design and systems thinking will be core elements of how the industry evolves its thinking and actions.

Entrenched systems and behaviours in the finance industry are hindering investors’ ability to adequately consider climate risk, says Marg Franklin chief executive of CFA Institute, which has just launched foundational research that examines practical ways for the industry to tackle climate risk.

Net Zero in the Balance: A Guide to Transformative Industry Thinking, a new paper by CFA Institute written by Roger Urwin, is the anchor for a series of research, qualifications and practical tools that the organisation will launch around climate risk.

“We will offer a portfolio that includes education, influence, research, and tools,” Franklin says. “You need qualified competent individuals, research and guidance to shape the thinking and influence the industry.”

The genesis for the paper, which also has contributions from many industry leaders, came from a monthly call between Urwin and Franklin where they discuss how the CFA can help untangle some of the entrenched systems, processes and behaviours that, like a bad relationship, don’t serve investors but are too difficult to see from the inside. The use of backward-looking data for investment analysis, attribution and prediction is one example.

“The industry is increasingly more creative, but it is still backward-looking, especially for valuation, and yet we recognise that net zero needs to be forward-looking,” she says. “We want to examine if some processes are fit for purpose and if not, how do we think about them going forward in the context of a rapidly changing environment.”

The paper stresses the importance of mindset shifts and transformative thinking, highlighting some strategies for success such as balanced scorecards, total portfolio thinking, universal ownership and stewardship.

A focus on systems thinking

It emphasises how investors can improve governance and organisational design including a focus on systems thinking which is not well understood in the industry.

“That gets you your frameworks to allow you to be effective and thoughtful in very complex systems and bring together people with investment and operating models,” Franklin tells Top1000funds.com in an interview.

She encourages fund managers and asset owners to be more creative and bolder in their thinking, including looking at signals from other parts of the finance ecosystem such as insurance.

“Increasingly we are looking at how asset-manager and asset-owner businesses compare to the rest of the financial system,” she says.

“Insurance is the canary in the coal mine, and managers could look at signals from other parts of finance.”

Franklin believes asset managers and owners aren’t as effective in assessing climate risk as players in other parts of the industry because benchmarks and incentives for performance measurement are not suitable.

“That starts to translate into how the system is set up and if it is fit for purpose, and you start to think it isn’t,” she says. “You can’t violate the risk and return equation, that is first. But then how do you incorporate climate into that and the levers that are available to have portfolios climate proofed or climate neutral or both, managing risk and capitalising on opportunities. That gets to portfolio construction, manager evaluation, and whether you have the governance and policies in place to make that happen.”

The data obstacle

Investors frequently cite common obstacles, data being the most obvious. It is well documented that data is often not robust or harmonised when it comes to climate risk analysis, but Franklin believes there’s also a behavioural aspect that is not as well debated.

“Are you big enough to be a leader?” she says. “Do you have a strong enough board to do something different to your peers? Can we explain things in different ways that are more complex than just a comparison to the S&P? Can you think about risk differently?”

The net zero paper is the foundational piece for a body of research work by the CFA including a deep dive into time horizons, incentives, benchmarks and systems thinking.

Franklin says the role of the CFA is to get the conversation with the industry started in a meaningful way that she hopes will be dynamic, and which could include some provocative suggestions on how the industry can change.

“I want people to square off, I want to put the greatest minds on it,” she says. “Hopefully we will be seen as very industry-oriented, and an intellectually robust public square or forum for this.”

Like CFA’s volume of work on diversity, equity and inclusion, the research, education and tools on climate risk will invite investors to think about the foundational infrastructure of the industry including questioning how risk is incorporated and managed, and how to structure and communicate with a lay board in a more complex world that keeps the focus on the beneficiary.

“It’s also important to consider right sizing for where you are,” Franklin says.

“And our offering is a variety of research, tools and education to help you think about what to actually do within your own system depending on where you are starting from.”

The next article in this series, with the CFA Institute, is an interview with Roger Urwin, chief author of the report “Net Zero in the Balance”.

The dominance of private-sector funding for research and development means large-scale foundational investment in biotechnology has not happened to the same extent that it did in information technology and other fields four or five decades ago, the Fiduciary Investors Symposium at Stanford University has heard. 

Private equity and venture capital investors invariably demand a return on capital over timeframes that are too short to commit to the kind of research that lays the groundwork for practical applications. For that reason, the almost unimaginable potential of synthetic biology remains largely unavailable as a general-purpose technology. 

The symposium has heard that few private sector investors have worked out how to profitably fund foundational research and development, and that private capital is unlikely to replace a national commitment to funding R&D.  

Stanford University Martin Family Fellow in Undergraduate Education for Bioengineering Drew Endy said that foundational research requires patient capital – such as the type stewarded by the global pension fund organisations attending the symposium. 

“When you have an emerging technology, there’s very early work in foundational engineering that I would argue private capital is not patient enough for, or not well suited for,” Endy said. 

Endy said in other fields, such as electronics and networking, it was public funding that “took the risk, and then things went differently”. 

“We just haven’t been doing that in this country, at least for biotech,” he said. 

Endy cited large language model (LLM) artificial intelligence systems that are being trained on genome sequences and are starting to show some promising results in designing new molecules. They may have potential in designing new genome sequences, but this has yet to be proven. 

“The bottleneck there is not the computational power to train the model, it’s the low throughput, high expense, building and testing of the biology itself to give feedback to the model,” Endy said. 

“I haven’t seen anybody organise an effort to scale that up. In my view, that should be something that in a high-functioning nation state we’d have national labs doing. We don’t have that.” 

For humanity to flourish

Endy said that although he and his colleagues are academics, “I don’t think of this topic as an academic”. 

“I think of this as a topic where I’d like to…get humanity to a flourishing planet by or before the year 2050, and what that means, among other things, is we have to deploy significant amounts of capital smartly, soon enough to matter,” he said. 

Endy said that he just happens to be working as a bioengineer “at a point in time where we’re putting the word ‘synthesis’ in front of the word ‘biology’, which means we’re working to compose biology”. 

“Anything we can encode in DNA, we can grow when and where we need to,” he said.

 “If we can pull that off, then we can get to flourishing. We’ve never had the sustained investments in the foundational research to unlock biology as a general-purpose technology.  

“I’d get lots of money to work on diseases, or fixing carbon, right now. But if you say, ‘I want to make a better operating system for a cell’, even my Dad goes, ‘what disease is that curing?’. I don’t know, Dad. [Then] it’s like, ‘No money for you!’.” 

Endy said the potential applications of synthetic biology are immense and wide-ranging, including, for example, creating novelty pot plants bioengineered to glow in the dark as night lights; reprogramming yeast so that instead of producing alcohol it produces specific medicines or drugs; growing modified mushrooms to create an alternative to leather; and “growing” computers. This last potential application sounds outlandish and is not currently technologically possible, Endy said, but serious research organisations are giving it thought and one, Semiconductor Research Corporation, has set out a five-step roadmap. 

Step one is to use DNA “not for biotechnology, but use it to store data, as if you’re an archivist”, Endy said. 

“Step two, figure out how to make energy efficient computation systems inspired by biology,” he said. 

“Step three, figure out how to connect cells and hardware. Step four, create electronic design automation.  

“And then finally, get to step five, we’re going to use biology to do bottom-up templating of inorganic materials as a type of living scaffold that then puts atoms where they need to be to make a piece of hardware.” 

All of this is “a pretty big leap”, Endy said, but “I love this roadmap because I can imagine it like it feels like it physically might just be barely possible”.  

“I also like it because technically, [it’s] totally impossible,” he said. 

“There’s no chance we can do this today. And the reason I love that is because it might be possible this star in the sky could motivate decades of investment in foundational engineering research that would unlock biology as a general-purpose technology.” 

As the global fight against climate change shows signs of slowing down, some large asset owners are taking a more pragmatic approach to investment returns from the transition by focusing on more targeted engagement in order to drive more lasting impact.

In a discussion at the Fiduciary Investors Symposium at Stanford University, PGB chief investment officer Peter Kolthof gave the example of the Dutch pension fund industry, which has made sustainability an explicit objective by framing its ambition to provide a decent return for all its pensioners, but also to do so in a world they find valuable living in.

Kolthof says the $35 billion fund follows a three-stage approach to climate targets: exclusion, engagement and intentionality.

“First, we look at things that we absolutely don’t want to have any exposure to, and we exclude that – cluster munitions, or the tobacco industry, for example,” he said.

In the next stage, the fund looks to put some influence in its portfolio, either by trying to change the companies themselves through engagement, or by adopting a best-in-class approach to gain exposure to the good things related to water, waste and climate.  Finally, it uses impact investing to also pick businesses that show pure intention to contribute to energy transition or sustainability.

Kolthof said PGB does not try to exclude fossil fuel investments, stemming from the belief that it should actually contribute to a better world, rather than leaving the damaged goods for somebody else to solve.

“I’d rather go for a best-in-class approach for those because there’s also the belief that these will be significant contributors to the energy transition, and we’re going to have fossil fuels for quite some time, so somebody needs to produce them and export and exploit them in a sustainable way,” he said.

Positive Change

A slightly different approach is followed by Yuko Takano, who runs the Positive Change portfolio at Pictet Asset Management.

“In a nutshell, we invest in the transition, and that can be anything from climate transition to social transition, but engagement is a core part of our strategy,” she said.

“We believe one of the main areas that we can differentiate is through that active engagement with managements.”

One of the successful engagements the team has had is with global auto giant Toyota. The Pictet fund saw a valuation opportunity in the company because while the markets largely deemed Toyota as not having any concrete battery EV strategy, it had taken a multi-pronged approach and was a front runner in terms of hybrid and plug in hybrids.

Takano said when Pictet approached the company and asked it to disclose more of its ex-China EV opportunities, it was pretty reluctant to engage. But there was a step change when Toyota announced its new CEO last year, and the company started taking in recommendations from investors.

It eventually came out with a concrete and more enhanced battery EV target, boosting its share price.

Sustainable Investments

While the $350 billion California State Teachers’ Retirement System has a net zero objective as a strategic priority, the giant fund also has a $6.5 billion sustainable investments portfolio within that focused on public and private markets.

Nick Abel, who co-manages CalSTRS sustainable investments portfolio, said that when large asset owners talk about targeted engagement, they really only need to focus on 250 companies that make up 75 per cent of the emissions profile of ACWI MSCI.

“When you start shortlisting down that, there’s only about 45 companies that CalSTRS can meaningfully focus on to start moving the needle when it comes from emission reductions in decarbonisation, while focusing on positive shareholder value creation,” he said,

Abel said it was relevant asking companies about climate exposure and how it affects their strategy, at one point of time, but public markets have since evolved.

“That was appropriate at one point in time, but now we’re starting to get into an implementation phase where it’s a lot more meaningful for our stewardship team to have conversations with CFOs about marginal cost abatement for carbon and how they can improve shareholder value,” he said.

On the private markets side, it is investing in companies that are creating unique technologies with the potential to scale, such as those that use AI and robots to sort municipal solid waste and upcycle recycling capabilities, or closed loop battery recycling businesses.

Investors have long moved beyond the realm of exploring hypotheticals with artificial intelligence, with those who have appropriately integrated the technology into their workflows now reaping benefits.

The Fiduciary Investors Symposium at Stanford University heard how pension and endowment funds based in the US, Canada and Australia have set barometers for success when it comes to AI usage in their respective organisations.

For Mohan Balachandran, senior managing director of multi-asset strategies group at Teacher Retirement System of Texas (TRS), one straightforward metric is performance. He oversees TRS’ quant equity and quant macro programs, with the former being a $21 billion long-short portfolio and the latter being effectively an internal hedge fund focused on cross assets in commodities, FX and bonds.

The biggest use of AI in Balachandran’s team is decision trees for picking up signals, he said.

“In the equity portfolios, it used to take a long time to update your models, because people would do univariate regressions and things like that,” he said.

“But once we started using this, it’s just become a very quick and fast turnaround, so much so that now instead of global models, we’re more focused on sector models and country models.”

Another plus is that the models are usually open source, Balachandran said, which means the fund’s cost is limited to the data side.

Leading the pack

TRS tracks its internal quant equity program’s information ratio against those of the hedge funds it invests in, and as of February 2024 its internal program has outperformed seven out of ten external funds.

“If we update this for the end of June, we’re leading this pack, actually,” Balachandran added.

“I have 12 people in my team who built this [portfolio] out, whereas if you compare it to any of those hedge funds there, you can add another zero to the number of people working on those products.

“There’s lots of knowledge workers [in financial services], and there’s lots of data, but what I find is that we can do a lot of that in-house with a lot fewer people [with AI].”

Australia’s HESTA also has a quant strategy team utilising AI models overseen by head of portfolio design, Dianne Sandoval. She said its success, like everything else the fund does, comes down to the nexus of three things: performance, cost and suitability for members.

HESTA’s signals are slower with an 18-month horizon, she said, and aim for a CPI plus 3 per cent goal over the long-term.

“This program has added 83 basis points of alpha, and has been very successful,” Sandoval said.

“The thing I think that has made it so successful is that it tends to be counter cyclical, so we’re essentially diversifying some of the active return streams that our active managers are doing.

“Through equity drawdowns, this this program has actually added alpha.”

The two types of models HESTA’s quant program has been building out is the neural network, used for equity forecasts, and advanced statistical tools to explain the behaviours of those models. Sandoval said the latter is crucial for a fund operating out of the competitive and highly regulated Australian pension industry.

“We have to be really careful about ensuring that we have KPIs and audits,” she said.

“It’s really important that we can be really clear as to what the model is telling us, why the model is behaving the way it’s behaving, and that – if we get audited or the regulator comes in – we can explain the behaviour of that model and it’s not a black box.”

More of an internal focus

CPP Investment’s Judy Wade has more of an internal focus when she considers AI’s success metric. Wade heads up the fund’s San Francisco office and is head of strategy execution and relationship management, and as a part of her broad remit led the development of a generative AI knowledge platform in the fund.

On the so-called “first mile of investing”, Wade said successful technology integration should be able to drive efficiency and access to do research or respond to investments.

“On the last mile investing, we’re just starting to do some experiments that can really help investors. For example, trying to predict and looking at sentiment analysis more quickly,” she said.

“Taking the fact that we have ingested all of our fund’s PE managers’ materials, and our venture growth materials – if you’re now in the public markets, can you find disruption risk that you wouldn’t otherwise.”

On the spectrum of being a “taker, maker or shaper” of technology, Wade said CPP is somewhere in the middle.

“[We] imagine it as both a navigator and a workbench for an investor,” she said.

“We do fundamentally believe that it is our data combined with large language models that provides us with the proprietary insights – that is our data and our partners’ data.

“As part of that, we really fundamentally believe in attribution, we really believe that if you get something back from our platform, you should be able to see the exact sources…and our partners care about that too.”

WK Kellogg Foundation senior manager of asset allocation and risk management Matthew Shellenberger echoed AI’s role in administrative excellence but said its impact is more acutely felt on a smaller team, such as the foundation’s.

The foundation has more than 100 manager relationships and Shellenberger said it is utilising machine learning tools to scrape data, summarise documents and support its accounting system.

“We’re 11 [team members] overall, but being able to digest materials from over, let’s say, 100 relationships, and actually be able to cultivate our own portfolio and our own tilts, I’d say those three components are quite valuable for us.”

“The one other part of this [AI]…is it allows us to do what we really love. Most of us got into the field because we love investing, and we’re infatuated with that idea.

“By having these tools that basically allow you either during a meeting to focus more on the active conversation…or distilling notes over the course of a year into a nice executive summary for your reporting structure – whether it be your IC or board – it allows you to be the investor that you grew up wanting to be.”

The spotlight on artificial intelligence has already fuelled astonishing valuations for companies like Nvidia, but long-term tech investors expect an abundance of investment opportunities in the sector in coming years as innovations appear on the horizon.

The biggest paradigm shifts in technology history – the internet and cloud computing – both had common characteristics, in that there was initially a cycle of investment in infrastructure before the applications were delivered to consumers, according to John Donnelly, managing director at Jennison Associates.

“We don’t think AI is going to be any different,” he told the Fiduciary Investors Symposium at Stanford University. “There’s going to be an infrastructure cycle that is going to create great investment opportunities, and there’s going to be an application cycle that also does that.”

Donnelly says chipmaker Nvidia and ChatGPT founder OpenAI have been instrumental in the current infrastructure phase. But while graphics processing units such as the ones developed by Nvidia have increased speeds 50 times in the past couple years, data centre speeds haven’t been able to keep up, creating a real bottleneck, and creating potential investment opportunities.

“The risk is that the rest of the supply chain can’t keep up, and so we have to really watch companies evolve, because the technology transformation is happening so rapidly,” Donnelly said.

“Nvidia is way ahead on the computing side, but networking and storage need a lot of work, so there’s going to be some great companies that will solve problems in those areas.”

Market challenge

Nvidia has seen its share price surge since 2022 to its current valuation of around $3 trillion, making it the third-most valuable company in the world.

The challenge for public market investors, though, is that there are not a lot of opportunities, says Angus Botterell, senior managing director at Canada’s $77 billion Investment Management Corporation of Ontario.

“There’s Nvidia, and then there are some smaller companies that have exposure, but they’re not pure plays on AI,” he said.

“And I’m not sure we actually know how AI is going to play out. We don’t know who the winner is going to be.”

IMCO has chosen to play the sector through a hybrid investment strategy where it holds data centre investments in its infrastructure group, and also owns a stake in company called CoreWeave, which does actual computing.

“You’re going to start with investing in the infrastructure, and ultimately there will be consumer facing applications,” Botterell said.

“Given that consumers are two-thirds of all the economy, that’s where the real money will be made.”

It’s a sentiment shared by Prabhu Palani, an investment industry veteran who is currently chief investment officer at the City of San Jose, part of the Silicon Valley.

He said that while the hype is real, because many of these early AI companies are doing transformational work investors don’t want to be caught up in the hype in terms of valuation.

Palani pointed out that startup funding has fallen off a cliff since equity markets saw the tech-wreck phase in 2022, with AI now dominating funding.

“But I have to say we have been slow in deployment,” he said.

“You want to be careful. You want to be cautious and and the way to access these companies is through funds. We rarely make direct investments.”

Consumer Transformation

The rapid pace of development in artificial intelligence and the shift towards consumer applications means it is difficult to pick winners from the Magnificent Seven technology stocks that currently dominate equity markets.

“The incumbents don’t usually win in any major paradigm shift,” Jennison’s Donnelly said.

“And so the new companies probably haven’t even been founded yet. The infrastructure companies probably have, but the consumer companies probably haven’t.

“Secondly, consumer is the biggest AI market it’s going to be, and we haven’t even started yet.”

On the question of whether the development of AI will result in loss of employment in parts of the economy, Palani said many positives will also come out of it and it’s better to not put barriers on the development of technology. Instead, the focus should be on developing safeguards around it.

“With any technology, once it’s unleashed, there’s no way to put it back in the bottle. And so the consequences will be the consequences, hard to predict those although that does worry me,” he said.

IMCO’s Botterell said one of the issues with the evolving sector is the potential for market concentration, given that data is the foundation of AI, and the more data you have, the better your AI is, resulting in kind of virtuous circle.

“We’re trying to be cognizant that, if you pick a winner now, it might end up being the ‘one app to rule them all’ sort of thing in the future,” he said.

“The other big questions we’re asking ourselves is regulatory pushback, regulatory issues as well as data privacy. Those are sort of the big things on our radar screen as we’re thinking about it going forward.”

The changing nature of volatility in financial markets and a more client-centric approach that allows allocations to be tailored is helping more institutions adopt a total portfolio approach (TPA) to investment management.

In a discussion at the Fiduciary Investors Symposium at Stanford University,  a number of large asset owners outlined their efforts and the challenges they are tackling to achieve a comprehensive total portfolio view amid an evolving investment landscape.

“What we have figured out is that volatility is changing and you have to be more dynamic,” said Pedro Guazo, the CEO for investment management at the US$95 billion United Nations Joint Staff Pension Fund (UNJSPF). “You have to adapt your portfolio, still respecting a disciplined approach, but also understanding your total risk in the total portfolio.”

Guazo says the fund is aiming to have a convergence of both systems, by starting with the total portfolio approach information, then using it for tactical deviations to the strategic asset allocation (SAA).

He says the comprehensive approach has excited his investment team, because they will have more flexibility for deviations or take more risks, while the risk management people are also big defendants because the approach is a good model to start bottom-up and include responsible investment factors that they consider important for portfolio creation.

AIMCo’s director of investment strategy research Jean David Tremblay-Frenette says the US$170 billion Canadian pension fund’s client centric approach required the move towards TPA because it allows tailoring of allocations for clients on the basis of liquidity, maturity profiles, and other specific considerations

“The TPA approach is the way to go, to be able to have that unified view of all those risks and different factors on a client by client basis,” he said.

Unified Approach

The total portfolio approach involves taking a unified view of all the risks and returns of the entireportfolio. The approach focuses on the fund’s absolute return goals, in contrast to the strategic asset allocation, which seeks to outperform benchmarks.

TPA does not use a specific model, but instead comprises a range of approaches that can be tailored to each asset owner’s long term investment thesis.

A recent global study by the Thinking Ahead Institute found TPA can add between 50 and 150 basis points of return above the SAA. Its exponents emphasise that the two portfolio allocation approaches are targeted at different problems.

The study found the trend towards TPA is continuing, with 20 of the 26 funds survey stating they were either at their maximum TPA or moving more towards TPA. The approach has also been successfully deployed for years by both Australia’s sovereign wealth fund, the $272 billion Future Fund, as well as Kiwi sovereign fund New Zealand Super.

James Wingo, the head of the quantitative analytics at the US$46.7 billion pension fund, South Carolina Retirement System Investment Commission, says its important to ensure a unified view through TPA is by focusing on regular interactions between the risk and investment teams.

“One of the big things as we move beyond the basics, is really creating that culture and fostering a common language between investment and risk teams in order to have good conversations around risk and around TPA and understanding what risks in different parts of the portfolio are impacting others.”

Governance, technology challenge

 The biggest challenge that fund manager’s struggle with in implementing a total portfolio approach is adapting the institutions culture and governance, as well as the use of technology.

AIMCo’s Tremblay-Frenette said as an asset manager, he is targeting consistency, swiftness and accuracy to ensure capital allocation across both public and private assets, but that has been difficult from a cultural standpoint, because of different operational teams or even investment teams.

“This becomes a real challenge, because everyone has their own little version of what the total portfolio, or even the portfolio component they’re responsible for is looking like,” he said.  

“We’d want to really veer away from that state of the world towards a place where we feel we can truly come up with insights on the total portfolio, because the whole package is really what matters here.”

 Allen Zimmerman, the head for Americas at technology provider SimCorp., says part of the governance problem is the data problem, taking the example of an institution running a private book completely separate from where it runs a public book, meaning it struggles to confirm in real time that all investment guidelines are being adhered to.

“Absolutely correlations are important from that total portfolio perspective, because oftentimes people think that they’re making an investment and it’s a diversifier. Sometimes they don’t recognize that it’s actually an amplifier. Sometimes you take a specific bet and you don’t realize that it’s primarily a FX risk,” he said.

“The only way to do this is to start bringing things together, whether this be because I’m looking at correlations or, how risks are always changing.”