A foundation stone of the transition to renewable energy is paradoxically a major contributor to the problem it’s helping to solve. How asset owners think about investing in a solution that is also part of the problem is a challenging and complex task.

Semiconductors are integral to the transition to renewable energy and the development of AI. But investors face a paradox when semiconductor production itself has such a large environmental footprint.

The energy transition and the growth of AI is inconceivable without semiconductors, Pictet Asset Management senior portfolio manager Luciano Diana told the Top1000funds.com Fiduciary Investors Symposium at Stanford University.

Diana said the question facing investors is whether semiconductors are a very simple enabler of the energy transition, or whether they a growing environmental problem, “and the answer is both, actually”.

“We do have a paradox, because they are crucial for the green transition,” he said.

“They enable electrification, decarbonisation and energy efficiency. At the same time, they have an environmental footprint which is growing very rapidly in-line with our data economy.”

That footprint includes the use of large quantities of water, and (perhaps ironically) energy consumption.

“Should an investor like me, a responsible investor, allocate capital to this important and growing industry? Should I avoid it altogether? It’s a very complex topic,” Diana said.

Diana said calculating the footprint of semiconductor manufacturing is complex and bedevilled by incomplete data and, in any case, only tells part of the total story. But the energy transition can’t happen without increased semiconductor production so Pictet applies two conceptual frameworks to its investment decisions. The first is the concept of planetary boundaries, originally developed by the Stockholm Resilience Centre.

“It comprises nine dimensions [including] climate change, biodiversity, freshwater, chemical pollution,” Diana said.

“These are all interconnected, it’s really crucial to understand this. And each dimension has a boundary that shouldn’t be crossed if we want to avoid nonlinear and irreversible change.”

(The Stockholm Resilience Centre reported earlier this month the six of the nine boundaries have already been crossed.)

The second conceptual framework is lifecycle analysis, which is an estimate of energy, water and raw material-related emissions that are associated with a product’s lifecycle. And the lifecycle analysis gives rise to the concept of a company’s “handprint”.

Diana said a company generates a handprint when it offers its customers a solution that has a lower footprint than business as usual. It is a positive environmental measure, and the bigger the better, and there’s theoretically no limit to a company’s handprint.

“This is the opposite concept to that of the footprint, where with the footprint we want to reduce it down to zero as much as possible,” he said.

“Here, we want to maximize it. And because it’s a difference between a baseline and a counterfactual scenario, measuring a handprint inherently is complex and cannot be done very precisely.”

This approach can, and does, give rise to scenarios whre an investor commits capital to a company it knows has a large and often growing environmental footprint, but for the sake of the role the company plays in reducing the footprints of others.

Diana says the aim is to identify and invest in companies that “only want to minimize their own footprint, but they also at the same time want to maximize their handprint on the rest of the economy”.

Semiconductors are a good example of this approach, and there are others. And while there’s been significant focus on the production of semiconductors, particularly as a result of heightened public interest in renewable energy and AI, Diana says it’s important to keep the environmental issues in perspective for two reasons.

“The first reason is that the emissions from semiconductor manufacturing alone are around 100 million tons of CO2 equivalent per year,” Diana said.

“That’s 0.2 per cent of the global total. But more importantly, this footprint of an industry doesn’t tell the whole story about the environmental impact that it has on the rest of the economy. It’s important and essential I should say to also look at the handprint.”

After a slow and steady research and development phase, the “big bang” moment of last year’s ChatGPT launch will kick off a slew of innovations that could rival the internet for their profitable application to investible businesses, says tech equity analyst Owen Hyde of Jennison Associates.

After a slow and steady research and development phase, Owen Hyde of Jennison Associates expected a slew of investible artificial intelligence innovations to come to market.

The New York-based tech equity analyst told the Fiduciary Investors Symposium at Stanford University on Wednesday that the launch of Microsoft-backed OpenAI’s ChatGPT tool in November last year was a “big bang” moment for institutional capital to begin flowing to artificial intelligence ventures.

“The question is how fast we go from R&D to production,” Hyde said. “I think it can be as big [as the internet] because it’s a new platform, in the same way the internet was a new platform you can build on top of.

“There’s fundamentally new capabilities that you can have when you’re able to generate text or generate images, and I’m not smart enough to be able to guess what all those applications are going to be. But I know we’ve seen some interesting stuff early on.”

Hyde, who was previously an analyst at JPMorgan, said the AI sector was on the cusp of a major innovation as “multimodal” applications – i.e. tools that can take multiple inputs and generate multiple outputs – begin to launch to the public, possibly before the end of 2023.

“Right now, we can see a handful of pretty clear opportunities in the app space but we think we’re also going to find out that there’s stuff that we haven’t thought of yet. And that’s where I am getting really excited because there’s opportunities.”

He anticipated that enterprise-facing AI applications would be the first serious investible proposition, singling out existing software providers who are able to help clients boost productivity by harnessing AI technology would be obvious early winners. But he said there were also plausible consumer use cases in the near to medium term, including personal assistants who might answer questions or assist with administrative tasks such as booking travel, although he added there may be a “behavioral” hurdle to consumer take-up of AI tools.

However he said the sector faced considerable regulatory risk, given its nascent status and government concerns about AI-generated misinformation or “hallucinations”.

“I worry about something happening that creates an issue for the whole industry and gives it a bad name,” he said. “And that regulation has to come in after the fact and goes over the top.”

He dismissed concerns that AI may replace many human jobs, which may create populist obstacles to its rollout, saying any serious discussion of replacement technologies for existing parts of the workforce were at least five years’ away.

And, even if it were to replace some menial tasks, Hyde suggested some economists and investors may welcome that development anyway.

“Employment growth may slow … but that’s somewhat healthy,” he said. “That might be a deflationary force in what has been a very inflationary environment.”

Breakthroughs in understanding the function of the brain have opened up a host of possibilities for expanding humanity’s perception of the world around us – and investable commercial opportunities are following the Fiduciary Investors Symposium at Stanford heard.

Humanity is on the cusp of being able to choose how it interacts with the physical world, raising the possibility that science can creating new senses for humans that will radically change how we perceive our cosmos.

Neuroscientist David Eagleman, adjunct professor in the Pysch/Public Mental Health and Population Sciences department of Stanford University, says every living organism has what’s known as “umwelt” – or the way in which it perceives the world around it.

Eagleman told the Top1000funds.com Fiduciary Investors Symposium at Stanford on Tuesday  that our interaction with the physical world is constrained by our biology. Our eyes, for example, convert photons into electrical signals, and the biology of the eye means it is receptive to only a small portion of the light spectrum. Eagleman says the colors we can perceive are only about one ten-trillionth of the available spectrum – which includes, microwaves, radio waves, x-rays, and gamma rays.

Eagleman’s insight is that the human brain is fundamentally a receptor of electrical signals, and that it doesn’t matter where the brain gets its those signals from, it will always be able to process them into something that enables us to interact with the physical world. But even though we think we see or hear the world around us, “the whole secret is you your brain is not directly hearing or seeing [anything]”, Eagleman says.

“Your brain is locked in silence and darkness inside the vault of your skull and all your brain ever experiences are electrochemical signals running around in the dark,” he says.

“And that it turns out the brain is really good at this, at figuring out patterns and extracting information this way, and eventually building your entire subjective cosmos out of that.

“The key point I want to make is that your brain doesn’t know and doesn’t care where the data come from, because whether that’s photons getting captured in these spheres in your skull, or air compression waves getting picked up on your vibrating eardrum, or pressure or temperature on your fingertips, it all gets converted to spikes – just these little electrical signals that are running around. And it all looks the same in the brain.”

Eagleman says the brain is an extremely good “general purpose computing device” – even though it is the most complex thing we have so far found in the universe, and still well beyond our capability to fully understand it.

“Whatever information comes in, just figures out what it’s going to do with it,” he says.

Eagleman says once the brain is understood in this way, it’s then possible to regard organs such as eyes or ears or the tongue as peripheral devices that convert interactions with the physical world into data inputs for the brain. And it’s a short leap from there to realise that other peripherals can then be created, which exploit the brain’s ability to make sense of the signals it receives.

These insights have already been commercialised, and there is more to come. For example, Eagleman created a jacket that could be worn by hearing impaired people, with converts sounds in their environment into vibrations they feel though their skin. It took a surprisingly short period of time – measured in mere hours – for an individual’s brain to start interpreting those vibrations as other people would interpret signals received from the ears. Smaller devices, such as wristbands, have now been created that do similar things. And Eagleman says the cost of producing a device that helps a deaf person “hear” is a fraction of alternatives such as cochlear implants.

A similar approach has been taken for people with sight impairments, and to help people who have had, for example, a leg amputation, to walk again more quickly by providing sensory feedback to them from an artificial leg.

“So those are some of the clinical things we’re doing, but what I’m interested in is how can we use a technology like this to add a completely new kind of sense to expand the human umwelt?

“For example, could we feed somebody real-time data from the internet and have them actually come to understand and have that become a direct perceptual experience for them?”

Eagleman says he has conducted experiments in which a subject feels a real-time feed of data from the internet for five seconds, and then two buttons appear on a screen.

“He has to make a choice…and he gets feedback a couple of seconds later, either frowny face or smiley face”, Eagleman says.

“And what he doesn’t know is that we’re feeding in real-time data from the stock market, and he’s making buy and sell decisions. We’re seeing if he can develop a direct perception of the economic movements of this planet.”

Eagleman has already commercialised some of his research, establishing a company called Neosensory to produce a wristband, used to address hearing loss and tinnitus.

“Neosensory spun out of my lab a while ago,” he says.

“We’re on wrists all over the world now. It’s been really exciting.”

The chief investment officers of three global pension schemes have told the 2023 Fiduciary Investors Symposium at Stanford University they are re-evaluating or reducing their exposure to the world’s second largest economy as tensions between the US and China escalate. But they are resisting total divestment to a country that still dominates emerging markets benchmarks. 

The chief investment officers of three global pension schemes say they are re-evaluating or reducing their exposure to China as tensions between the world’s largest and second-largest economies escalates.

Alison Romano, CEO and CIO of the San Francisco Employees’ Retirement System, told the Fiduciary Investors Symposium at Stanford University on Tuesday that exposure to the Chinese market had been a meaningful contributor to performance over recent years.

“When I joined [SFERS in June last year] the performance was very strong, based on a number of strategic bets,” she told the symposium, hosted by Top1000funds.com.

“We leaned into growth, we leaned into innovation, we leaned into China.”

But she said increased geopolitical risk attached to the market meant she is now re-assessing that portfolio exposure, which she described as overweight.

“Let me be very clear – we’re not throwing in the towel. But we are evaluating our risk-reward basis, there is increased risk,” Romano said. “We want to be very careful who they partner with to invest there, that they have on the ground knowledge or connections.”

She said analysts, experts and industry peers held a wide range of views on China, which made it difficult to come to a position on the appropriateness of its inclusion and weight in a well diversified portfolio.

The comments come amid heightened tensions between Washington and Beijing, with reports of diplomatic communications having faltered between the two world powers and conflict over maritime disputes and alleged espionage, most notably the incident of a suspected Chinese spy balloon over US territory earlier this year.

Mark Walker, CIO of the UK’s Coal Pension Trustees, told the symposium the fund had reduced its Chinese exposure from 15 per cent to 10 per cent of its public equities portfolio, under “pressure” from trustees and concerns about geopolitical risk. He said it would likely also reduce its private equity exposure to China going forward, but added that the country was too big to ignore or divest entirely.

He said he and his team were considering how to remain a neutral position in the escalating US-China tension, while also looking to burgeoning Southeast Asian economies that have large or growing populations and can provide alternative emerging markets exposure.

“We’ve absolutely not eliminated it, but we have downplayed,” said Walker, whose fund represents UK-based mining sector workers.

James Davis, CIO of $25 billion Canadian fund OPTrust, said the China challenge was symptomatic of a broader concern around pricing geopolitical risk, especially in developing economies.

“I am not sure I am being adequately rewarded for being exposed to China,” Davis said. But he said he had resisted eliminating the fund’s exposure to China because it still accounts for at least a third of most emerging market benchmarks.

He said divesting China would be difficult for that reason, arguing the case showed some of the flaws of an index-hugging approach to emerging markets investment. “Benchmarks are constraining; I personally don’t like them,” he said. “We follow the total portfolio approach, so we try to avoid getting caught in the benchmark trap.”

Table discussions of delegates to the symposium centred on geopolitical risk, with some attendees questioning whether China should be split out from other emerging markets when making asset allocation decisions.

 

CalSTRS has recognised the unique opportunity presented by the energy transition needs a unique response and its Sustainable Investment and Stewardship Strategies (SISS) portfolio has been specifically positioned to invest in opportunities that fall between private equity and infrastructure asset class buckets.

The SISS private portfolio which has made $1.4 billion in commitments since it was set up in March 2021, aims to take advantage of material sustainability-related economic and financial shifts. It targets three risk-return allocations across opportunistic climate infrastructure; venture capital/growth equity low carbon solutions; and hybrid/innovative climate solutions.

Setting up that fund structure a few years ago has allowed the fund to make the most of opportunities as they developed, according to Scott Chan, deputy chief investment officer of the $317 billion fund.

“If we hadn’t done that three years ago years ago with this approach, we probably would have missed out on opportunities we have now committed to,” he says.

The SISS portfolio is set to grow over the next few years to about $3 billion and is the beneficiary of a recent asset allocation change where 4 per cent from global equities was reallocated to direct lending, private equity and inflation-sensitive assets.

“We are finding opportunities in the transition are falling between risk and reward in private equity and infrastructure,” Chan says. “We have intentionally made a portfolio to navigate that so we can be flexible financiers. That is key to our success in the energy transition, we have built a team focused on the opportunities and have been pursuing that for the last couple of years, and we want to further that.”

Chan says the opportunities presented by the energy transition don’t necessarily fit neatly into existing asset class buckets or risk/return profiles.

“This could be significant as the energy transition evolves so we are lining it up. We are trying to own stakes and as it matures getting in position and creating the right structures,” he says. “It’s part of the playbook of the collaborative model… We’ve seen this story before and we are lining up our opportunities to capture it if it is very large and significant.”

The evolution of the portfolio is expected to follow a similar arc to the maturation of the real estate and infrastructure portfolios which has evolved to now be accentuated by direct lending and unique partnerships.

In real estate the fund directly owns operating companies evolving from original investment via funds through joint ventures (JV) and then direct ownership.

“This is heading the same way. Now we are in funds but we are trying to take general partner stakes with the best operators in the energy transition,” Chan says. “Eventually we will be so close to the partners as the industry evolves we will JV with operators and may end up owning directly. We want to create the right portfolio partnerships for being able to capitalise if that happens.”

Within the SISS private portfolio about 50 per cent is allocated to opportunistic climate infrastructure with a primary focus on clean energy and decarbonisation. It looks at sectors with existing commercial operating models but where capital is required to scale solutions. The sustainability real assets investments have structured downside protection and stable cashflows.

A further 30 per cent is in the hybrid/innovative climate solutions bucket with unique structures which might not fit into the other asset classes. It’s a blend of company investments and real assets that intentionally decarbonise heavy emitting sectors and are made up of a mix of growth equity and structured downside protection.

The remaining 20 per cent looks at venture capital and growth equity and technology-enabled low carbon solutions. Here the focus is on solutions not contingent on binary policy outcomes or subsidies and sectors with large emission profiles where end-users seek cost-effective solutions to reduce emissions.

The SISS portfolio, managed by Kirsty Jenkinson, sits in the “innovative strategies” bucket as part of the total portfolio asset allocation.

That portfolio returned 9.3 per cent over the year to June 2023, against a custom benchmark of 0.8 per cent. The three-year return is 11.3 per cent.

 

Railpen has combined its fiduciary and risk management roles enhancing the fiduciary element across investment strategy and developing a risk model that fits better with the long-term thinking of a pension fund.

In July, Railpen, the £34 billion multi-employer pension fund for the UK rail industry, combined its fiduciary and risk management roles, putting them under the same umbrella. The new approach introduces another pillar to its fiduciary duty to ensure the pensions it manages are safe and prevail, and staff members don’t have to pay more in contributions.

One way the new structure manifests is via an enhanced fiduciary element across investment strategy, explains Mads Gosvig, Railpen’s chief officer, fiduciary and investment management.

His role includes responsibility for overseeing Railpen’s investment strategy on behalf of the trustees representing the 107 sections, or small pension schemes, Railpen invests on behalf of – and who are in turn responsible for setting the strategy that best fits their section. Gosvig now chairs a monthly eight-member investment and risk committee meeting, equally split between representatives from the investment and fiduciary teams.

Fiduciary scrutiny of the committee process involves making sure investments are fit for purpose and the risk team works through the numbers behind an investment, as well as risk advisory. The approach is particularly visible in Railpen’s illiquid investments.

“Every time we invest in private markets, the fiduciary team are now part of this process. They sit alongside the investment management team and produce a risk opinion – it creates a very strong dialogue,” says Gosvig.

Gosvig believes combining fiduciary and risk management is an example of how fiduciary duty continues to change in line with its evolution from a concept to becoming a legal obligation. At Railpen, fiduciary duty has expanded in line with the asset manager bringing around two thirds of investments in house over the course of the last decade.

The new structure also shines the spotlight on an area of fiduciary responsibility he finds most challenging – explaining complex investment strategies, rationale and risk to trustees so that they are informed enough to choose the right strategy.

“Our trustees are not investment specialists – they are railway specialists who are responsible for delivering and overseeing pension provision on behalf of 350,000 members. To support and deliver on their fiduciary duty, they need to be able to explain the purpose of our investment strategy in a simple and effective way for members.”

Alongside providing guidance on risk and return in private markets, other investment strategies are also shaping that conversation.  The sections invest in pooled funds and most of them remain open to new entrants, but the landscape is beginning to change as some sections grow more mature and require different risk management.

“Just a couple of years ago, most of the sections were immature. Now a few more are starting to consider their end point and discuss buyouts. We are closely working with our clients to tailor investment strategies in light of improvements in funding levels,” he says.

To date, Railpen has only used liability-driven investing (LDI) in specific areas. One consideration currently under discussion is whether to introduce LDI into its broad framework of investment strategies.

“So far discussions have included explanations around last year’s LDI event and ensuring that trustees understand how the strategy aligns with their overall objectives,” he says. “My focus is about trying to solve the problems that we have, rather than saying we can’t do anything about this. It is about trying to simplify what is special for each individual section, and making sure we look at them in a different way.”

Elsewhere the fiduciary team is working on a new framework that approaches mean reversion through a different lens.

The classic approach to investment risk is short-term on the basis of solvency, volatility and the variation of the surplus, Gosvig says.

“If a pension fund loses money, the surplus falls and they look to de-risk. In other words, when markets are down, investors tend to sell. At Railpen, we have been working on a new framework that uses other long-term metrics that keeps the risk on when markets are down. In this way risk stays on the books, so when there is a mean reversion, we are in good shape.”

“We are developing a risk model that fits better with the long-term thinking of a pension fund with a sponsor, instead of a short- term focus more like a bank or insurer tied to the surplus,” he continues. Every three years Railpen carries out an actuarial valuation where it sets the funding and investment strategy for each of the sections and Gosvig says he hopes to apply this new framework to each of the schemes.

We are developing a risk model that fits better with the long-term thinking of a pension fund

Managing ESG risk is also a central element of risk oversight and involves working with the ESG team in an integrated analysis. “Twice a year we have a training session with trustees around specific ESG issues. Managing and acting upon ESG factors is a significant and integrated driver of investment outcome and part of our fiduciary duty to protect and grow assets.”

ESG risk analysis involves scrutinising reputational risk or exploring how getting out of one exposure could impact the rest of the portfolio. Analysis isn’t just approached through an exclusion lens – engagement is increasingly a part of strategy.

Still, Gosvig notes that ESG risk is easier for Railpen’s trustees to integrate into their decision making given they are already familiar with the climate impact on rail infrastructure or the importance of health and safety in the industry.

Fiduciary management in practice.

Gosvig sees fiduciary duty as ensuring trustees are well informed and communication flows easily. However the task is complicated by the fact trustees are not involved in the day-to-day running of the pension scheme and Railpen manages over 100 small schemes. “There is a lot of reporting and structure behind that communication.”

Railpen’s trustees are particularly focused on risk and return because all contributions are shared between members and employers, he continues. If returns fall short, employees of the railway must also contribute more to meet defined benefit promises. The continued affordability of pension contributions for individual members is an essential pillar safeguarding against members choosing to opt out of the scheme.

He says a failure of fiduciary duty could manifest in a scheme becoming severely underfunded to the extent that it can’t invest long term. It could manifest in unsuitable exposures, or failure to deliver on legal requirements.

“It is about running modern portfolio theory in a smart way that doesn’t leave money on the table and runs an efficient business for our members,” he concludes.

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