France’s €41 billion civil service pension fund l’Établissement de Retraite additionnelle de la Fonction publique  (ERAFP) has just boosted its allocation to private credit, renewing and building out existing mandates in a €8 billion allocation begun in 2009 as it seeks to benefit from the higher cost of borrowing.

“The increase in interest rates over the last 18 months makes private credit particularly relevant for us given our liabilities,” says Bertrand Billé, head of credit investment who explains that the buy and hold mandates are mostly focused on investment in high-quality corporate bonds.

“The current absolute level of interest rates seems attractive to us. The aim is to ensure a good match between our assets and liabilities over the medium to long term,” he says.

However, within the mandate the managers also have the option to invest in certain complementary segments (like high-yield bonds and private debt, for example) in order to diversify the portfolio and improve the risk/return. The initial duration of the mandates is six years with the possibility for ERAFP to renew it for a period of two years.

ERAFP is one of the largest public pension funds in the world in terms of affiliates with nearly 4.5 million beneficiaries, 44,000 employers and nearly €2 billion  in contributions collected in 2022.

Manager selection takes time

As a public sector entity, ERAFP must comply with French public procurement rules when it comes to selecting its external asset managers. The process around public tenders has two distinct phases that make hunting for new managers a time-consuming process – RAPF launched this search in March 2022.

Phase one involves an “application” phase, through which RAFP assesses the overall professional, technical and economic capabilities of the candidates and their ability to meet its objectives in terms of exposure, performance, or ESG. This assessment mainly relies on “quantitative” data covering the asset manager’s expertise, track record on the strategy, access to resources like research and IT, and economic and financial soundness, adds Olivier Bonnet, head of asset manager selection at ERAFP.

Phase two, or the “offer” phase, involves asking pre-selected asset managers to answer a detailed questionnaire to “deeply understand” how they intend to implement ERAFP’s investment guidelines, he continues.

Responses to questions are gathered into three main buckets comprising the investment process and insights into the team that will be dedicated to the ERAFP account. A second bucket combines insights on manager’s trading, risk management and control, operations and legal prowess. Thirdly, responses focus on fees. “Based on this assessment, RAFP selects the best offers,” says Bonnet.

The latest mandates follows on the heels of other boosted allocations including European real estate, US dollar corporate bonds as well as an allocaiton to small and mid cap equites using a climate benchmark.

Managers’ ability to integrate ESG is another key element of the selection process. RAFP has its own ESG policy comprising an ESG rating framework detailing criteria against which managers are assessed. ESG integration includes contributing to the implementation of RAFP’s climate roadmap that it has committed to as part of its participation in the Net Zero Asset Owner Alliance (NZAOA).

“This ESG policy is part of our contractual documentation, so asset managers have to implement it on RAFP’s behalf,” says Bonnet.

ERAFP’s private credit managers are Amundi Asset Management, Ostrum Asset Management and HSBC Global Asset Management (France). Two stand-by mandates are attributed to Candriam and Groupama Asset Management. The five management mandates comprise three assets and two so-called stand-bys which means that ERAFP reserves the right to activate them, particularly for the sake of dispersing risks.

While the title of this thought piece might appear a little strange (“as small as possible please!”), my original (more accurate) title was even stranger: “When it comes to damage functions, are you a quadratic or logistic person?” All will become clear, very soon.

I have previously suggested that our breaching of various planetary boundaries is proof that we are increasing systemic risk. In this piece I aim to explore what might be the consequences of breaching planetary boundaries and triggering systemic risk. Specifically, I will focus on the carbon emissions boundary, because that is where most of the modelling is.

The phrase ‘damage functions’ is part of the jargon used within the modelling of climate risk. The damage function in a model relates the amount of predicted warming to an amount of predicted economic damage. The choice of damage function matters. They can be more, or less, aggressive. So, different models of climate risk will show a different amount of economic damage for the same amount of warming. It is therefore important to understand the damage function, and choose one that corresponds with your climate beliefs.

To illustrate this with examples, a really aggressive model (eg Burke et al 2015) would suggest a 23 per cent loss of GDP at 4C of warming. A less aggressive model (eg Khan et al 2019) would suggest a 7 per cent loss of GDP at 4.5C of warming. These answers are materially different, and we would expect different impacts on asset prices. However, both these models – and, in fact, the majority of models of climate risk – use what is known as a ‘quadratic’ damage function.

Our TAI paper Pay now or pay later? argued that the results above were substantial underestimates. And in a previous thought piece, Climate tipping points change everything, I argued that the wrong baseline was being used. Instead, I suggested a better baseline was to consider a 100% loss of GDP as currently measured due to unmanaged climate change and to work back from there.

Now seems a good time to push harder on that idea. It is clear to me at least, that there is some level of warming at which all economic activity ceases. Sometime before that, it would appear reasonable to assert that humans will lose interest in measuring GDP or other conventional measures of growth because survival is more pressing. At what temperature might this occur? In the appendix of our Pay now or pay later? paper we listed physical damage as set out by the IPCC[1]. Among other effects, a temperature rise between 2.5 and 4.5C is expected to lead to the ‘widespread death of trees’ and ‘reduced provision of ecosystem services’. I will leave you to decide the level of warming associated with a 100 per cent loss of GDP – but it could be as low as 5C.

The question now is what shape of damage function should we draw between where we are[2] and a 100 per cent loss of GDP. It could be linear, but I would suggest a ‘logistic’ function (sigmoidal, or S-curve) is more realistic. Damage will accumulate slowly in the near term and then accelerate. How quickly it accelerates will depend on the temperature limit you chose above. But for any reasonable range of temperature limits, a logistic damage function will suggest a loss of GDP that is a multiple of the damage suggested by a quadratic function. In turn, this would suggest that the potential risk to asset prices is way, way higher than any modelling results you have seen to date.

So, what do you believe about climate? Do you believe the physical damage it will cause will rise at a faster rate (non-linear) as temperature rises? Do you believe that indoor work will be adversely affected, as well as outdoor work[3]? Do you believe that climate tipping points exist, and some could be triggered at low levels of warming? The more strongly you believe these, and similar aspects, the more I would suggest you consider a logistic damage function. Forewarned is forearmed.

[1] From the IPCC WGII Sixth Assessment Report’s Technical Summary

[2] Over the decade to 2020, annual climate damage was estimated to be around 0.2% of world GDP (Equity Investors Must Pay More Attention to Climate Change Physical Risk, IMF blog, May 29, 2020). This level of damage was associated with a level of warming rising from around +1C to +1.1C. A Grantham Institute policy publication dated 30 May 2022 estimated climate damage in the UK at 1.1% of GDP (What will climate change cost the UK? Risks, impacts and mitigation for the net-zero transition)

[3] Many models, and their damage functions, assume that 85-90% of GDP will be unaffected by warming because the activities are performed indoors

 

Tim Hodgson is co-founder of the Thinking Ahead Institute at WTW, an innovation network of asset owners and asset managers committed to mobilising capital for a sustainable future.

A consortium of APG, the asset manager for Dutch pension fund ABP, the UK’s Pension Protection Fund (PPF) and Australian superannuation fund UniSuper have just acquired one of the largest forestry operations in Australia, each owning a 33 per cent stake in the business.

The transaction, one of the largest single investments into Asia-Pacific’s forestry sector includes a land portfolio in Tasmania and one of the largest plantation forest estates in Australia. It combines a large-scale sustainable investment with compelling risk-adjusted returns, says Ben Avery, senior portfolio manager at APG.

The trio are the latest institutional investors to go after forestry assets. Nest, the United Kingdom’s £30 billion defined contribution scheme has begun the formal process of appointing one or more fund managers to help its 12 million members invest in timberland.

Timberland, says the pension fund, shows low correlation with traditional stocks and bonds and is resilient to shorter term-market dynamics – for example, timberland managers can delay harvesting times if wood prices are low. Returns from timberland also tend to have a strong correlation to long term inflation trends. Many other investors including Church Commissioners for England, New Zealand Super and the Swedish AP funds have been investing in timberland for years.

“We’ve been exploring ways to include natural capital investments into our portfolio as we continue to diversify our private markets allocation, take advantage of complex and scarce investment opportunities, and to decarbonise as we move closer to net zero targets. Timberland ticks all of these boxes,” says Stephen O’Neill, head of private markets at Nest. “The performance of timberland speaks for itself. It’s offered stable total returns underpinned by strong cash yields and should play a complementary role in our portfolio alongside our other illiquid investments.”

O’Neill says that a core element to procurement will be reassurance from bidders that they have a strong focus on sustainable forest management, as well as having enough scale for Nest to maintain a consistent portfolio allocation. The fast-growing pension fund takes in £500 million net contributions on a monthly basis.

AP2, the SEK 440 billion ($44.1 billion) Swedish buffer fund, is similarly mindful of sustainability in its extensive timberland investments, and has drawn up ten criteria for classifying its forestry assets as a climate investment. AP2 began investing in forestry back in 2010 and the  majority of its investments are in Australia and the US in forest assets that produce saw timber and pulpwood.

“An investment in forests is not automatically beneficial to the climate and needs to live up to certain criteria in order to be classified as climate investment,” says AP2 chief executive, Eva Halvarsson.

The ten criteria to which managers must adhere include a comprehensive and externally published policy for responsible investments; that timberland assets must be managed in a sustainable manner that is verified by a third party through certification, and that all managers integrate TCFD in their reporting.

The benefits of vertical integration

APG, UniSuper and the PPF’s investment brings access to a leading forestry management platform and commodity exposure. Another compelling element of the investment includes vertically integrated assets and operations, says Avery.

The business owns and operates assets along the entire supply chain including some of Australia’s largest tree nurseries, 90,000 hectares of commercial hardwood and softwood plantation forests and significant infrastructure assets, including two large processing mills and facilities with port access for full supply chain integration from seed to ship. “Vertical integration provides greater control over each step of the supply chain,” he says.

Allocating money to forestry projects also offsets emissions from other investments and will deliver attractive returns as the price of carbon rises to reflect the increasing costs of pollution.

“The investment also brings positive exposure to carbon sequestration capacity. The forests sequestered 123 million tonnes of carbon in 2022,” says Avery. By way of comparison, the Netherlands’ total emissions in 2021 was the equivalent of roughly 168 million tonnes.

“To make another comparison, the carbon balance stored in these forests in 2022 is equivalent to the annual emissions of roughly eight million people in the United States, or taking 27 million vehicles off the road annually,” he continues.

A large part of the acquired estate is native forests which the investors will manage for biodiversity conservation.

“Production forests are typically the primary focus of our investment strategy, however when we considered the whole envelope of sustainability across all of the environmental assets managed by Forico, we recognised a unique opportunity to acquire and become stewards of significant natural infrastructure with assets such as trees, soil, air and water all essential to a wide range of services important to society,” he concludes.

Restructuring its internal processes has reshaped ADIA’s investment approach and highlights opportunities in active investment ahead.

ADIA, Abu Dhabi’s sovereign wealth fund with an estimated $700 billion under management, has spent much of the last year honing internal processes. A key element has included strengthening its core investment and support activities through the creation of two complementary and interlinked departments – the core portfolio department (CPD) and the central investment services department (CISD).

Together CPD and CISD enable ADIA’s management of the total portfolio, particularly supporting agile implementation, says the fund in its recently published Annual Review. CPD is responsible for implementing the fund’s benchmark exposures, managing its treasury-related activities and executing equity, fixed income, money market and currency trades.

The department has also built its internal quantitative capabilities, seeking to extract higher returns from a single core portfolio of public equities and fixed income assets. As internal teams take on more responsibility, about half of ADIA’s assets under management are now externally managed. In 2009, 80 per cent of the portfolio was externally managed.

CISD, meanwhile, seeks to strengthen the investment processes by enhanced operational support activities, data services and total portfolio support activities. The team also play an integral role in harmonizing ADIA’s technology systems, while acting as a key source of visibility and intelligence on its overarching portfolio exposures and correlations.

This operational flexibility allowed the fund to make swift portfolio adjustments as market conditions evolved through 2022. It also positioned the fund to capture pockets of absolute return across asset classes bringing the benefits of its diverse portfolio to the fore in a year when bonds and equities correlated.

As ADIA has improved its internal efficiency, it has reduced the headcount in support functions. This has been offset in part by active recruitment in investment areas, particularly in private markets and technology-driven specialisations – ADIA’s famously diverse headcount (from 64 countries) is currently 1,380.

Tech prowess can be seen in its purest form in the Quantitative Research & Development team. Comprising a multidisciplinary group of more than 50 experts, the team uses complex models to analyse data, generate investable ideas and put them into production, organised as a problem-solving machine. In 2022, the division implemented its first investment strategies and is continuing to recruit globally-respected experts in diverse areas such as machine learning, strategy development and portfolio construction.

Another example can be found in ADIA’s fixed income department, which has sought to diversify its sources of return with quantitative strategies, building out its internal team of specialists and implementing robust risk-management processes. The real estate department is also harnessing the power of data and cutting-edge quantitative methodologies for portfolio strategy, optimisation, and risk management.

In its annual review, ADIA signposts higher inflation and borrowing costs will impact asset valuations, future earnings and growth prospects with challenges and opportunities. This environment will also complicate diversification strategies and erode the real value of assets with fixed returns, such as cash or bonds. However, equities – both public and private – should continue to find support, especially if profitability remains resilient despite lingering tensions in supply chains and the availability of labour.

This backdrop may also increase the appeal of physical assets and alternative approaches that are better suited to managing inflation risk. One positive consequence of this trend may be greater alignment between investment and impact, particular in infrastructure. Advanced computing technologies such as artificial intelligence, machine learning, and data analytics will be the biggest opportunities.

Active strategies opening up

ADIA also believes opportunities are opening up for active strategies. It’s equities department (EQD) continues to concentrate its active management capabilities in areas with structural advantages and strong prospects for future relative growth. In 2022, EQD complemented its existing risk exposures in preferred markets by allocating additional capital to high turnover strategies with low volatility. It also added several high conviction strategies with higher volatility profiles.

The more favourable environment for active managers. This contrasts with the “beta trade” of recent years, in which a rising economic tide carried most growth stocks higher, while punishing investors who sought to differentiate companies by relative valuation, among other factors.

In 2022, the fixed income department (FID) continued to capitalise on its fully active mandate, having transferred its passive investments to ADIA’s CPD a year earlier. FID’s inbuilt flexibility enabled it to navigate the complex market conditions by targeting return-enhancing opportunities across the full spectrum of fixed income assets.

In mid-2022, this team began to deploy capital in targeted strategies, with positive returns, and they plan to develop this further in the year ahead. As a result, FID is structured to pursue diversified outperformance from three core teams: Internal, External, and Quantitative.

Private equity opportunities

In private equity, ADIA’s commitment of new capital in 2022 was divided roughly equally between direct investments and funds, alongside an increased allocation to secondaries. In total, the department completed 24 direct investments of more than $150 million across its core regions and sectors of specialisation, in line with 2021. Meanwhile, it was able to take advantage of the market’s capital scarcity to support and invest in new secondaries and direct lending platforms.

ADIA continues to expand its operating advisors network, useful in an unsettled economic backdrop, in due diligence, portfolio management activities and digital transformation. Looking ahead, the team is positioning for the continued growth of private equity markets including private credit as an increasingly important alternative to traditional bank lending.

Escalating diplomatic “disillusionment” surrounding the US-China relationship has made investors think twice about exposure to the world’s second-largest economy. Geopolitics expert Professor Stephen Kotkin said China, and other emerging markets, may still be attractive to asset owners, as long as they understand the complexities of domestic Chinese politics – and ensure they are paid a hefty risk premium. 

Tensions between the US and China have escalated significantly after the Trump Administration introduced new tariffs and China’s zero-COVID policy heavily disrupted trade and travel between the world’s two largest economies. They have continued to clash since over Taiwan, human rights, microchips and rare earths.

Stephen Kotkin, a geopolitics expert at Stanford University’s Hoover Institution, said officials in Washington DC and Beijing are “disillusioned” about the relationship after decades of efforts to transform China into a liberal, open society have fallen flat.

And they’re not the only ones. Institutional investors, many of whom had been beneficiaries or champions of what Kotkin called the “Pygmalion” approach to engagement with China – a reference to the classical Roman poem in which a sculptor creates a statue of his idealised version of womanhood – are also now feeling disillusioned as the Chinese market is submitted to rising state intervention and a reversal of once-lucrative partnerships with the global financial system.

Some investors call this dynamic “geopolitical risk”. But Kotkin said it should more accurately be seen as simply a re-pricing of the inherent risk attached to investing in the developing world – a risk he says some have clearly underestimated.

“What many people are calling geopolitical risk is just investing in places where the governance is not the same as in your home country, where rule of law is not the same (if it exists at all) and, where transparency is lacking [or] opacity is extreme,” Kotkin told the Fiduciary Investors Symposium held at Stanford last month.

“And for some reason, it was considered normal practice, to invest in those places, and to assume a great deal of risk for which you didn’t get rewarded. But you did do it. And it was known as emerging markets. This never seemed to me a properly understood idea.”

The thesis that emerging markets could yield similar or better returns to developed world markets – without sufficient attention being paid to inferior governance or institutional structures of these countries – was flawed, Kotkin said.

“You were not getting a sufficient premium in my view,” Kotkin told delegates, speaking rhetorically to the broader institutional investor community. “And you maybe were not aware of the scale of the risks that you were undertaking. And now it’s become more obvious and we’re having the repricing.

“Investing in places beyond North America, Europe, Japan, Australia, we’re not advising against that – we don’t give advice on investment. But it’s just how you price those investments previously, but especially going forward.”

Cold war the best of bad options

Notwithstanding the disillusionment felt by diplomats and analysts, Kotkin said geopolitical tensions between world powers was not new and that investors should be realistic that a cold war scenario between the US and China has not only commenced – but is preferable to the alternative scenarios.

“People are against cold war, they say that would be terrible if we went into a cold war with China … [but] you only have a handful of options in geopolitical competition … What are the other options that you would prefer? How about hot war? Would you prefer hot war? I would not prefer hot war. That would be maximal geopolitical risk. I want to avoid hot war,” he said, adding that nobody wins a war given the losses on all sides.

That leaves two options, Kotkin said: appeasement, which he described as “capitulation” and dismissed as “not a good idea” and the “Pygmalion” option favoured by former US Trade Representative Bob Zoellick. Attempting to reform China through engagement and co-operation was well-intentioned but “not going to work”.

“I study geopolitical competition and history, and cold war to me looks like a really good option, because it’s better than all the other options that I know from history,” he said. “So, just learn how to compete, keep it from becoming hot war, don’t capitulate and don’t have illusions about Pygmalion. This is not rocket science.”

He said some analysts and historians had ignored that during the Cold War between the US and Soviet Union there was a “tremendous amount of scientific cooperation”. The standoff was not based on miscommunication or misunderstanding, but a fundamental clash of strategic interests and values which cannot be reconciled. Cold war is the most feasible way to mitigate that tension without escalating to catastrophic conflict, he said.

At the same time, he said China’s success in lifting around 700 million people out of poverty had been built on the back of access to the US economy and consumer. He said there may yet be opportunity for investors in the Chinese market.

But as well as ensuring they are generating sufficient risk premia, he added they face another challenge.

“From an investment point of view, your problem is … understanding Chinese domestic politics. If you’ve made investments there, or if you’ve made investments that are influenced by China, because they’re elsewhere in Asia, or they’re in Germany, or wherever, there are second-order effects from … Chinese domestic politics. Good luck with that proposition. I think it’s possible, but it’s not simple.”

 

APG is considering licensing its new bespoke ESG real estate index to the broader industry, with CRREM compliance a driving factor of broadening its availability.

APG launched a new cost-effective ESG-focused real estate index strategy for pension funds last month and APG head of global real estate investment strategy Rutger van der Lubbe says following the launch the organisation has received many inbound requests about licencing the index.

“This was not originally in our scope but we are contemplating it,” he says.

The index was developed in conjunction with STOXX and includes data from providers including RepRisk, Sustainalytics and CRREM (Carbon Risk Real Estate Monitor).

Van der Lubbe says one of the benefits of licencing would be to increase recognition across the broader industry that CRREM compliance is important, driving compliance and ultimately improving energy use in the property industry.

APG has been involved in other innovative ideas that have been made available to the broader industry, including the SDI initiative, which was an asset owner collaboration with PGGM, BCI and AustralianSuper.

The real estate index strategy built by APG combines data providers and the fund’s own unique proprietary views.

“We wanted to leverage various data providers for the best fit for what we want to achieve,” van der Lubbe says.

“We created our own index with those filters as we believe what clients are after is not available in the public domain at this point in time. We are not aware of an index solution that looks at the criteria like we do, to really embed responsible investment criteria for a passive strategy. We aim to deliver something standout from the market perspective and our own RI leadership.”

The strategy is built on a proprietary process that filters via APG’s exclusion policy, inclusion policy, solid reputation, good governance and CRREM, with van der Lubbe emphasising the CRREM compliance as a unique element.

“It prescribes carbon transition pathways and energy pathways,” van der Lubbe says, adding the guidelines for energy emission and consumption for buildings applies to the present and the years up to 2050.

In its strategy APG reweights securities so it is factor-neutral on a currency, regional and sector basis, to avoid individual tilts that could arise from the five criteria.

The index also uniquely includes APG’s bespoke inclusion policy and whether specific assets meet transition pathways.

APG has about €55 billion ($57 billion) in global real estate assets, the majority of that is actively managed for ABP.

The bulk of the real estate assets are in a globally integrated investment strategy that invests in both public and private assets.

“It is a function of what is out there,” van der Lubbe says.

“The US has a very well developed public real estate market so we have greater share of public there, in Europe it is orientated towards private exposures, in APAC more balanced.

“We are known for an active approach so look for a typical share of control to drive the strategy of the entities we invest and to drive ESG matters.”

This new index strategy will be aimed at smaller clients and is the equivalent to the equities index strategy launched in 2021.

There is consideration of further initiatives to be launched in other asset classes in the future.

“We hope it will drive the industry towards further carbon reduction,” van der Lubbe says.