Policy makers in the UK are suggesting pension funds invest more at home to support economic growth, but investment executives at the funds say it’s not that simple.

The UK’s defined benefit funds, many in their end game as corporates prepare to shift their liabilities off balance sheet, aren’t positioned to tie up assets in illiquid investments. Moreover, many are still feeling the impact of the largely government induced LDI crisis. Elsewhere defined contribution schemes like Nest, although fast growing and already investing in illiquid assets in the UK, still lack the size to invest for economic growth on the same scale as the Australian DC model.

Policy makers have recently suggested that pension funds should invest more at home to support economic growth. But investment staff at the UK’s pension funds say it’s not that simple.

Nest, the UK’s £30 billion flagship DC fund, growing at around £400 million a month due to contributions from one in three working Britons, is just the type of investor the UK government has in its sights to invest more at home to fuel growth. Speaking on the side-lines of the annual pension association conference as part of advisory firm LCP’s Investment Uncut podcast, Nest CIO Liz Fernando, sounded a warning bell against investors being told where to invest by geography or asset class.

She said Nest already invests some 45 per cent of its assets in the UK and would resist any government compulsion on how it invests – an approach, she warned, that “always ends badly.” She also flagged that it takes time for Nest to put capital to work in infrastructure, where scaling up has been a little slower than imagined although managers are right to be picky on price and terms.

Investment Uncut interviewee Cliff Speed, CIO of £10.3 billion TPT Retirement Solutions, reflected that pension funds looking to the future can’t ignore the lessons of last year’s gilt crisis when the market froze over and it was impossible to trade.

Speed said that the unprecedented volatility in gilts has seen investors build new risk models into their portfolios that incorporate much bigger moves in gilts prices. This in turn has implications for how much they are prepared to invest in illiquid assets, running counter to the government push. Reflecting on the crisis he also noted the importance of diversity of thought and the value of people who think differently – everyone thought last year’s sharp movement in gilts was impossible.

Still, Speed noted that although DB schemes are looking to have less illiquid assets, DC schemes are wanting to build up exposure. “Is there a trade there?” he asked, adding that the barriers for DC schemes to invest in illiquid assets are starting to come down coupled with an awareness amongst participants of the benefits of “slow finance” – aka investing for the long term.

Investing more in the UK for growing LGPS and DC funds may make sense, said John Chilman, CEO of Railpen who said research shows that illiquid investments in DC improves member outcomes.  But he noted that Railpen, an open DB pension fund, already has significant UK holdings in infrastructure assets like windfarms and solar.

Investing more at home is also challenging when pension funds are worried about growth because of high inflation. For example, Fernando, who also had a 25-year stint at USS, said the fund targets CPI +3 per cent net of fees which in today’s high inflationary environment is a reach. Although higher interest rates have led to better nominal returns, most assets currently fail to meet Nest’s return target making a long-term view and diversification central to strategy.

She added that as inflation drops back, Nest will be able to deliver on its target return. Moreover, the fund now has the assets in its tool kit including private credit, infrastructure and renewables to diversify plus its huge monthly inflows help support a natural rebalancing.

The active equities team at CPP Investments has abandoned antiquated investment categorisations, such as style and size, and views companies through a more holistic “domain” interpretation. Amanda White spoke to the global head of active equities Frank Ieraci about the unique insights and organisational structure of the team; and the contributions it makes to the total fund, including capital efficiency, agility and pure alpha.

Frank Ieraci runs a giant hedge fund within CPP Investments. As global head of active equities, one of six investment teams at the C$570 billion Canadian pension fund, he has a mandate to deliver alpha in global public equities markets, and it’s done in one concentrated portfolio.

“We are a long-short, market-neutral strategy, and from that perspective we are very similar to hedge funds,” Ieraci says.

His team of 170 delivers a single C$69 billion portfolio driven by fundamental research, unique insights predicated on a long-time horizon and investment beliefs that have been empirically tested.

“We have a set of investment beliefs in active equities, that are not articles of faith, they are empirically tested facts. We have put the time in to think about what long-term fundamental investing looks like and empirically test what works and what doesn’t, and it’s that set of investment beliefs that really drive the way we structure ourselves and the way we make decisions,” he told Top1000funds.com in an interview.

“We can demonstrate empirically that markets are less efficient when you start to extend the forecast horizon. At approximately the one-year mark you start to see a big difference in both how information is priced in and the speed at which it is reflected in market prices . At about that one year mark it breaks down, publicly available information is not uniformly or ubiquitously priced in, and that trend continues to break down as you push out the horizon. The drivers of returns over the long run are company specific fundamentals. So for individuals who can think and act as long-term fundamental investors there is opportunity to generate alpha.”

He believes the ability to exploit those market inefficiencies is predicated on unique insights, and it’s the proprietary company specific fundamental research that yields a collection of high-conviction, single-company investments that are assembled into a highly concentrated long/short, market-neutral portfolio. An optimization process removes unintended factor exposures.

The active equities team is organised around regions and ‘loosely’ around sectors, that internally are labelled as domains. Unique to its approach is redefining the ecosystems within which businesses operate either through the lens of a theme business model, or value chain.

“It’s not enough to just have fundamental insights, those insights need to be unique,” Ieraci says.

“It’s not enough to just have fundamental insights, those insights need to be unique”

It means approaching investments with a holistic, broader view of business operations and drivers of success and not through the lens of pre-constructed investment criteria such as capitalisation or factors and styles.

“When I was early on in my career I struggled to label whether I was a value investor or some other description,” Ieraci says. “Over the years I have just got to better understand what active security selection, and more specifically fundamental investing, meant. Increasingly we are seeing there is not that much difference between say factors and small cap or mid cap, so why have those distinctions? It’s tough to appreciate why that exists today.”

How to get unique insights

It’s this domain expertise that defines the analysts in the active equities team.

“We believe that domain expertise is necessary, we don’t think about a generalist model. At the same time we don’t need marketing-driven labels such as value or momentum, they have been created to market to clients and it’s not how we think about the world,” he says.

Instead a more inclusive and universal view of a company means they are viewed through mini eco-systems that operate in larger systems.

“We need to understand the business model of each company and the competitive dynamics that exist within the systems within which they operate and become an expert in that to really understand what will be the long-term drivers of success for these businesses,” he says.

That domain expertise is how the analysts are organised. Eco-systems are identified around emerging themes, business models, value chains, and in some cases a more traditional industry definition.

“It could be any of those, and it is any of those. We look at building expertise in that space and from there our fundamental, and in some cases data-driven, research comes in to produce those fundamental unique insights.”

By way of example he says AT&T or Verizon might be traditionally covered by a telecommunications analyst, but at CPP it’s not so narrowly defined.

“You need to understand the parts of the value chain that go left and right of that. For example the handset makers, the tower companies, software, the equipment providers and how that is changing how consumers use their devices, you need to understand the unique partnerships attracting customers. All of these things are part of the value chain, but the traditional analyst is just set up to look at that company in the telcos lens.”

Ieraci says there is a culture at CPP of collaboration and knowledge sharing as an important part “of the way we apprentice our analysts and how we build investors”. But to some extent the need to share knowledge misses the point of how the team is organised and researches companies.

“In the traditional sense you would need to be collaborate across industry analysts to get the full 360 view. But our analyst already looks across industries. We handpick the companies in those domains to create these structures. It’s one person that does all of that. At first blush you might say that seems hard. But I think it’s the opposite. I actually think it is impossible to fully understand A&T and Verizon without understanding the other parts of the business. So when you are separated you actually hinder people from truly understanding the ecosystem and developing those more unique insights that they could develop.”

Portfolio optimisation

The active equities portfolio has a three-to-five year horizon, although it can be longer. Turnover is about 20-25 per cent with a holding period of about four years. One position has been in the portfolio for 11 years.

Consistent with a long/short approach investments can be opportunistic and as a market-neutral approach it is by definition not tilted.

“We do think opportunistically, agility is the important piece of that,” Ieraci says. “We want to operate in areas where there is an alpha opportunity we can exploit through our fundamental research and if we have a unique insight then we will deploy capital there. For example on the long side of the portfolio we could have a big position in India or more in tech than industrials, but that changes frequently because we operating opportunistically.”

The short is used where a company is in structural decline and there’s a view that hasn’t been priced in, or to mitigate the exposures it doesn’t have a view on.

The portfolio optimisation process has three layers that gradually brings the view of risk down from 30,000 feet.

“We start with off-the-shelf risk models we refine for our needs, they have factor exposures including sector, geography, beta, momentum, value etc and that allows us to structure portfolios to neutralise standard factors. Those risk models will get from 30,000 to 10,000,” Ieraci explains. “At the next level we think carefully about the nature of the company and specific exposures that may not be captured in off the shelf factor models. For example there could be an exposure we have where regulation may change the outcome of the company and we want to neutralise it.”

The third layer, he explains is the toughest to get right and a constant area of improvement, looks at emerging correlations.

“It’s where we are trying to identify those situations where there is a lurking correlation that will only present itself when something goes wrong. Covid showed us there were some companies where there was no historical correlation but post-Covid there was. These were out of model risks.  We’re looking to see if there are any early correlations where we can examine them through a fundamental lens. We are experimenting with new data and analytical techniques to identify emerging correlations.”

Research clarity

It’s possible for active equities to manage as one portfolio, because it has a platform that allows the team to think and operate as a long-term investor with scale, certainty of capital, and a sophisticated internal team.

“We know what will matter the most and over what horizon, so we can laser in on those,” he says. “Others are having to consume vast amounts of information and trying to process that in a mosaic, which is impossible to do. I don’t think humans are very good at doing this.”

“We know what will matter the most and over what horizon, so we can laser in on those”

Because of how hard that is people end up taking short cuts like reading other peoples’ research without validating it. “Other peoples’ research has an element of postulating and is not really evidence-based or data driven” he says.

CPP’s active equities research has clarity with the team identifying one or two questions to focus on and get right over the next three to five years.

“We focus solely on that and bring as much evidence as we can to those questions, and don’t rely on other peoples’ research, we do it ourselves. We read it but because we’re not tasked with doing what others do, and having to know everything about a stock at any given time, we can actually can do the work that we think is the most relevant.”

The research process is protracted and detailed with specific research being identified and bought, which in some cases has taken months to negotiate and evaluate.

“Once we have identified the key question we can take the time to do the research and find the evidence and data that can support that,” he says.

The questions being posed are always company specific.

“We are very clear about what specific performance we are investigating. Earnings don’t matter to every company. For some revenue or operating margins or investment capital might matter more. We identify what matters for each company and then we are laser focused on those questions that will drive that fundamental outcome,” he says.

Serving the total portfolio

At CPP, teams are broken into six groups: total fund management, active equities, credit investments, capital markets and factor investing, real assets and private equity.

Like any of the groups active equities delivers alpha, so at the most basic level its commercial imperative is to deliver outperformance to the fund. But as a long short portfolio it doesn’t deliver any other factor exposure.

“We don’t deliver any public market beta, just alpha,” says Ieraci. “So as a result how we contribute to the fund tends to be a bit more simplified in terms of the factor exposure but in other dimensions we can do things that other long-only strategies can’t.”

This means the contributions to the total fund are more than just alpha. The long short positions mean it is a very capital efficient portfolio, using less dollars to deliver the same alpha; and the liquidity of the fund means it is very agile.

“We deliver an agile strategy that can expand and contract very quickly if we need to move capital from a relative value perspective to other parts of the organisation,” he says.

While it doesn’t happen very frequently, Ieraci says the conversations are constant.

“Our CIO, Ed Cass, in partnership with each investment department head, is constantly trying to identify where the best relative value opportunities are , and how would we tactically allocate capital to them. That conversation happens regularly given our size we need to constantly be thinking about how to set ourselves up at any point in time for the next two to three years,” he says.”

The net-zero investing journey passed a milestone this May, having already ticked one third of the way towards 2030 goals and one twelfth of the way to 2050 goals. Roger Urwin, co-founder of the Thinking Ahead Institute, enquires how investors and the real economy are really doing.

Asset owner net-zero progress

On the plus side of the ledger the asset owners, and the asset managers, have come a long way in their net-zero mindsets and skillsets. Net-zero ambition involves writing a completely new investment chapter. And the response of the industry has been to mobilise a lot of new thinking in a short space of time to do so. The amount of effort and innovation applied has been exceptional.

We are seeing the fruits of this in the industry’s deeper understanding of scenarios and alternative pathways with the TCFD process an important catalyst.

And there are credible investment strategies emerging with bigger allocations to climate solutions in combination with deeper engagement with companies, within the industry and in public policy. At the same time, there has been correspondingly and appropriately little appetite for divestment.

Inevitably there have been some setbacks, including recent performance challenges with low-carbon allocations being whip-sawed by the consequences of concerns about energy security. There are no easy answers in how to deal with these performance issues, and greenwashing temptations, which are further complicated by politics – particularly in the US. These issues illustrate the difficult balancing acts ahead for investors in staying true to their beliefs and principles.

Fiduciary duty, with its heavy presumption of financial pre-eminence, hasn’t helped the net-zero challenge. Asset owners face a tough hurdle when it comes to deploying the requisite capital in climate-solution areas, where long time horizons and policy risk are front of mind and which can be roadblocks to faster change.

On the minus side of the ledger, all these new circumstances are introducing clunkiness and disjointedness into governance arrangements, which is feeling the strain under the grip of massive complexity. This has produced a pile-up problem: too much fragmented reporting and not enough joined-up action. We all notice the grind of new technical stuff, onerous regulations, the talking over each other, and the conversations not landing. The governance pathway will involve normalising and standardising our practices, as well as mastering a new language – this will all take time.

So how do we mark the card at this early, but critical point? We can only give a ballpark answer – such is the peasouper fog that we are working in. But it is reasonable to suggest we are doing as well as can be expected in the difficult circumstances and asset owners are building some muscle and savvy for the challenges ahead. But at this check-in point we are nothing like on track for the climate outcomes sought[1]. In the net-zero pathway, let’s be clear, we have a lot of ground to make up.

Net-zero progress in the real economy

To still achieve the 1.5C pathway, in the real-world, we will need a dramatic reengineering of our energy system across multiple technologies and every conceivable geography. Challenges don’t come bigger.

The massive reengineering required has solar and wind key to the mix; hydro, bioenergy and nuclear in the mix; coal, oil, and gas out of the mix; and carbon capture and storage, battery technology and a streamlined decarbonised grid playing a developing role.

But here’s the rub. We haven’t got the capacity to do all these things to the extent we need because of the frictions[2] that are holding us back and need some fixing.

In the energy transition, it’s not that much about costs holding us back. We now have renewables looking attractively priced and we can absorb somewhat the energy-transition costs arising from new capital deployment. What we can’t seem to do is deploy capital at the speed needed; with less than half the rate of deployment required of solar and wind being the most obvious example.

This lack of speed is because of the frictions involved: capital allocation decisions with fiduciary duty issues; benchmark and time-horizon issues; planning and policy bottlenecks; capacity issues for enabling infrastructure; political infighting around priorities; and aligning the incentives to support the transition.

Understanding these quandaries is not helping us fix them because they are too deeply embedded. Can governments get us back on track? There are few signals that they have the convictions and mechanisms to do this. Jean-Claude Juncker, in his EC President role, very honestly said: “I know the policies we need, but they are not ones that will keep us in power.”.

So how do we mark this scorecard? Again, it’s a ballpark answer but we are not doing well and nothing like on track to align with the climate outcomes sought. And there will be dire climatic consequences to mismanaging the Paris agreed global carbon budget.

What next?

We have written previously about the 4321[3] pin-code. The next phase needs to be about all units of power being aligned to the net-zero challenge and reaching agreement on policy levers and wider incentives. For the investment industry, this is using its democratised power to engage broad societal support and applying its corporate muscle to engage with the private sector to reduce the destructive effects of business externalities. And, in tandem, using its soft power on government to make progress on the key policy measures like a price on carbon, clarity on energy priorities and taxation consistencies. It is through this soft power on others where the investment industry’s pin-code multiplier effect can be most effective to catalyse change. This is about the investment industry taking a systems-leadership position to ensure the system can support the future returns needed. You could call it enlightened self-interest.

We can do this. But we are still looking like we are in the starting blocks. We now really need the power of ‘and’ in thinking and action that is systemic and holistic. And stronger leadership that is joined-up, agile and relentless. And recognising the critical ethos that when we’re in it together we’re stronger together. And we are truly in this together.

[1]In the MSCI Net-Zero Tracker for May 2023 Scope 1 emissions for equities in the MSCI ACWI IMI index are estimated at 11.2 Gt CO2e and have gone sideways since 2019. Only 19% of listed companies are aligned to a 1.5°C pathway while 51% of listed companies align with warming equal to or below 2°C.

[2]Focusing too much on the fuel of change (the supporting science, the technology, the costs) we can lose sight of the principal reason for change failure as not addressing the human frictions implied in change: the inertia, effort and emotional cost attached. With net-zero progress this is most seen in process blocks, disincentives and limits in resources.

[3]The 4-3-2-1 pin-code is a reminder of the sources of power in the ecosystem to effect change where roughly four units of power reside with public policy, three with corporations, two with the investment industry and one with civil society. The critical need is for these four sources of power to connect in an effective combination where the product is far more than the sum of the parts. And the investment industry has the biggest reach, over other sectors, to achieve this.

 

Roger Urwin 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.   

Recent high profile investor losses under score the importance of due diligence. As Compenswiss looks to mandate new private debt managers, chief investment strategist Frank Juliano talks through the importance of the due diligence processes at the Swiss pension fund.

Recent high-profile pension and sovereign wealth fund losses in collapsed crypto exchange FTX, or when Silicon Valley Bank suddenly hit the wall, have cast a spotlight on due diligence.

Whether competition for returns, more investments flowing into less regulated private markets and the speed investors are required to commit capital, or just a prolonged period of relative calm in financial markets since the GFC lulling investors into undervaluing its importance, hands-on due diligence is in danger of being replaced by a tick the box exercise. So warns Frank Juliano, chief investment strategist and member of the executive committee at Switzerland’s CHF39 billion ($43 billion) Compenswiss.

As the fund prepares to bring new asset managers on-line in a boosted allocation to private debt, the process of checking that a new cohort of external mangers will deliver all they promise and the bone fide credentials of the team behind the strategy is front of mind.

“A simple questionnaire sent to managers is a recipe for disaster,” explains Juliano, who says the fund’s manager relationships (it has around 44 mandates with 27 managers) are partnerships not friendships, and for whom the value of due diligence is engrained from previous roles as head of portfolio management at Merrill Lynch and heading up hedge funds at Lomboard Odier.

The process

Compenswiss will only select managers with proven experience and expertise in a process that begins with reviewing all documents and references. The team get to know the firm and the people, especially the portfolio managers; the firm’s capabilities surrounding the investment and their risk management operation.

Once the strongest contenders have been selected (typically between 12-15 are shortlisted) each manager has a three-hour video conference with Juliano’s team. From this, between four to six go onto the next stage, an in-person visit and another 3-4 hours of onsite due diligence.

Of course, in person meetings don’t always flush out red flags. Famously, when executives at Sequoia Capital met FTX founder Sam Bankman-Fried in person he was playing video games and the firm still sunk $214 million into the exchange.

But it is this part of the process that Juliano feels is particularly crucial. Recalling a recent experience, he says on-site visits sometimes lead compenswiss to rethink manager selection.

“We thought we’d selected the final candidate but when we visited them, we decided to go with another. We discovered aspects to their strategy that were well described, but in reality, the manager was no doing what they said.”

Not being able to visit managers in-person meant compenswiss didn’t onboard any new managers during Covid.

A time it was also impossible to visit the managers it had in place and monitor strategies. Following selection, compenswiss meets managers at least quarterly – twice remotely, once at its Geneva headquarters and once on the manager’s own turf. Not being able to meet face-to-face was an increasing source of angst, he recalls. “I grew concerned about the pension fund’s ability to effectively monitor managers remotely.”

“We have strong partnerships with our managers, but they are not our friends,” he continues. “We are a good partner but at the same time we have to be bold enough so that when things don’t go well, we can take a tough stance and sort the issues.”

That could include a portfolio manager unexpectedly leaving the firm. In this case, compenswiss would immediately place the manager on watch. “When a manager changes course like this, a firm will quickly reassure and minimize the materiality of the departure. But for the next six months we make sure there is continuity, and we monitor them closely.”

Private debt

Juliano says that approval of the first wave of shortlisted private debt managers is currently in the investment committee process, awaiting sign off. compenswiss will likely relaunch an RFP in the next two years to increase the private debt segment again with a focus on diversifying across vintages and pushing the allocation to 3 per cent of assets under management over the next 3-5 years.

The move is a consequence of a combination of factors, he explains.

On one hand, building out the allocation to illiquid assets is due to compelling opportunities in private debt as fixed income as a whole becomes more attractive. After years in the doldrums, yield to maturities are more attractive and investment grade corporate bonds offer decent returns. A conservative risk profile means the fund has a large, diversified, fixed income allocation of 56 per cent. Equity accounts for 26 per cent of AUM, real assets 15 per cent and gold 3 per cent.

On the other, the move is due to an unexpected swelling of assets under management at the pension fund because of social security reforms. From 2017, assets under management were expected to steadily decrease as compenswiss entered run off mode. Now assets are expected to increase over the next 5-6 years by around $10 billion before they decrease again, offering a window to invest more in illiquid markets.

“The liquidation of assets has been significantly postponed and we can invest more in private assets to capture that illiquidity premium,” says Juliano.

As to what other illiquid assets will be added to the allocation remains under wraps. “We are exploring how comfortable we feel [with more illiquid assets] and determining what contributes more to the portfolio. There is room to go up more.”

Gold

Gold, an allocation that now replaces a broader commodities portfolio, has given the portfolio a recent sheen.  Juliano likes gold because it is “anti-fragile” so that when inflation spikes it lends support.  “Gold is a really good diversifier from a portfolio construction perspective,” he says, explaining that gold does best just after inflation has spiked and just before central banks start to hike rates. “When inflation surprises, the first reaction on gold is usually good.”

Over his tenure, Juliano has steadily increased internal investment capability at compenswiss with around half the portfolio run internally including most of the fixed income and local equity allocation. An 18-person team comprises eleven portfolio managers, and smaller teams involved in portfolio construction, ESG and manager selection.

The focus on internal management has driven costs lower. But in a counterbalance, onboarding costly strategies in private markets will see costs creep higher. Not only are private assets more expensive, due diligence requires that external managers have a strong commitment to resources, efficiency and good risk adjusted performance.

“People won’t work for us for free. You have to pay for what you get.”

The asset allocation of the $63 billion Maryland State Retirement and Pension System is “better than a 60:40” protecting the fund on the downside. But now CIO Andrew Palmer is looking at the allocation in the context of cash rates persistently at 4 per cent, what that means for various asset classes and how the fund should be allocating accordingly.

The asset allocation of the $63 billion Maryland State Retirement and Pension System “is working” according to its chief investment officer Andrew Palmer with the fund producing a relatively good year of returns despite the market conditions.

The fund’s asset allocation is “better than a 60:40” according to Palmer with the asset mix specifically protecting the fund on the downside.

The long-term strategic asset allocation is 34 per cent public equities, 21 per cent rate sensitive assets, 16 per cent private equity, 8 per cent credit/debt strategies, 15 per cent real assets, and 6 per cent absolute return, designed to produce greater protection during short-term market volatility.

In fiscal year 2022 the portfolio returned -2.97 per cent, net of fees, which was well below the 6.80 per cent assumed actuarial return rate but ahead of the plan’s policy benchmark of -3.48 per cent.

“Returns relative to risks are very good. That’s what we are aiming for. We can always get higher returns by taking more risk,” says Palmer in an interview with Top1000funds.com.

“The high allocation to private markets has worked well over the past year, although with recovering public markets it’s holding us back a bit this year.”

The fund continues to tweak its allocations and is making some changes around the edges, including winding back allocations to emerging markets and bond protection over the next year or so.

Emerging markets has made up about 7.5 per cent of the total public equities allocation, and an asset allocation discussion in February specifically focused on China.

“When we made our move into emerging markets, China was a small part of that allocation now China is 40 per cent of EM equities,” Palmer says, adding that after an evaluation of the return expectations the fund has decided to wind back emerging markets and a lot of that is due to the outlook for China.

“Among EM we think China will have a lower return expectation than the rest of emerging market and developed market stocks and we think we should have a premium for investing in China equities,” he says.

The adjustment over the next two years will rebalance towards US equities (6-10 per cent).

“We think returns are broadly higher respectively in public markets now, so we can move back to less risky stocks,” Palmer says.

Biggest risks in the portfolio

While Palmer is clear that any investment decisions are based on risk /return assessments and not politics, he is aware of the geopolitical risks to the portfolio.

“The biggest thing we should be advocating for is China and the US to figure out their differences,” he says. “Biden and McCarthy need to figure out the debt negotiations and then China and the US need to respect each others’ sovereignty and look at the bigger things they can work together on, such as climate change, and partner together to be more impactful. This will take a reset.”

As part of a recent risk assessment of the portfolio by a large investment bank, scenario analysis looked at the impact of an invasion of Taiwan by China and the possible US reaction to that.

“With a Ukraine-like reaction by the US we would see a fall in the portfolio of 8 per cent immediately,” Palmer says. “If we reduce our exposure to China from 10 to 5 per cent then we can reduce that to a 7.5 per cent loss. There is so much interconnectivity because of the impact on global growth and inflation, the interruption to global trade is orders of magnitude bigger than Russia.”

Scenario analysis of various risks is a contributor to asset allocation changes for the fund and Palmer also points to climate risk analysis as a driver of the decrease in the absolute returns portfolio and an increase in infrastructure and natural resources a few years ago.

In 2015 when Palmer joined the fund as CIO the absolute returns allocation was 16 per cent, now it’s down to 6 per cent.

“A couple of years ago we shifted the absolute returns portfolio from 8 to 6 per cent and moved it into natural resources and infrastructure. The return scheme is diversifying but not sensitive to inflation and we wanted to add inflation sensitivity,” he says, adding he is still worried about inflation.

“After the financial crisis the central banks were fighting against deflation and fiscal stimulus that ended up driving the inflationary impulse. We are going to have a similar problem on the other side, to get inflation back down. It will be hard for them to get it materially lower,” he says. “The Fed has done a fair amount and needs to let it work a little bit. They were late to this, they should have been tightening when the government was stimulating.”

Recognising that all asset class teams do things differently when it comes to climate risk, one of the key projects at the fund is to coordinate efforts across asset classes to drive more effective practice.

Using the Alladin risk system to evaluate risks and build functionality to identify, reduce, and hedge climate risks Maryland is also incorporating an engagement program by first identifying the most effective places to engage.

“The focus for the next year or so is to build that out,” Palmer says.

Looking forward from a top-down perspective, the team is assessing the performance of non-zero cash rates and what that means for the portfolio.

“We are trying to earn 6.8 per cent and if you can earn 4 per cent on cash what does it mean for other asset classes and what should our return hurdles be for those,” Palmer says. “If an infrastructure manager is earning 2 per cent over cash and the money is locked up why is that exciting for us?”

Palmer still sees a lot of value in the private world and a differentiation of investments that can’t be replicated in the public space. But he wants to make sure the tradeoff is clear.

“It really depends on how permanent this non zero cash rate of 3-4 per cent will be,” he says.

Like many large pension funds, British Columbia Investment Management Corporation, BCI, the $211.1 billion asset manager for around 30 Canadian pension funds and insurers, has steadily internalised asset management over the years.

Now BCI’s reduced reliance on external managers requires a similar in-house approach to ESG and sustainability that is also bespoke, expert, consistent and controlled. Enter Jennifer Coulson, BCI’s first global head of ESG, recently promoted to the new position.

Coulson joined BCI eleven years ago as part of the public equity team, back when ESG strategy was primarily focused on voting, engagement and public policy, and BCI had little in-house management.

Today a total portfolio programme built on four pillars (invest, integrate, insight and influence) seeks to capture ESG opportunities and manage risks in a nuanced and fast-changing environment where the benefits of internal management are manifold. “As our assets have been internalised, our focus has shifted to ESG integration through a comprehensive corporate-wide programme,” she says.

For example, managing assets internally has allowed BCI to integrate ESG at the ground level across all asset classes, bringing complete control of the process.

“We really love the flexibility of being able to design something that is a fit for us,” says Coulson. “It is about the flexibility of doing it internally and doing it how we want. We don’t have to continually go back to an external manager, who will have several clients that they need to accommodate, with our expectations.”

Working with global frameworks like SASB and ISSB provides essential tools for the team. But BCI also takes pride in pursuing and developing its own, bespoke processes. For example, it has created an ESG risk and opportunity framework that involves comprehensive scenario planning for systemic issues like climate change across different sectors, revealing how an asset will behave based on BCI’s own underlying assumptions.

These internal models provide full granularity, she continues. “It helps us at a total portfolio level to see if we are getting too much exposure in one area and not enough in another.”

Elsewhere, BCI has partnered with Dutch investors PGGM and APG, as well as AustralianSuper, to develop the AI-powered Sustainable Development Investments Asset Owner Platform, SDI AOP.

total portfolio approach

As BCI grows its internal ESG expertise, how to structure integration has been front of mind. In a total portfolio approach, ESG professionals are embedded into each asset class across the fund, fully aligned with asset class teams and investment committee members making decisions.

This approach replaces a previous system she describes as “de-centralised” whereby members of the different asset class teams would call on the ESG team for expertise.

“Now the ESG perspective is within the asset class,” she says, describing one of her roles as providing an overarching consistency, bringing the 16-person team of which she has 5 direct reports together to function as a cohesive unit.

Another part of the role involves ensuring that ESG is treated differently in different asset classes. ESG due diligence on an infrastructure asset, that the fund might own for 30 years and is vulnerable to physical climate change, will differ from analysis of a liquid asset that is easy to sell.

“ESG integration looks different in fixed income than infrastructure or equities given the varying investment horizons and the physical nature of the asset,” she explains. “We are trying to create something that provides consistency, but which is also sensitive to the realities of the asset class.”

Private market nuance

ESG also looks different in private markets. And because most of her expertise lies in public markets, managing ESG integration in BCI’s private markets, where the investor still uses external partners, has been a new experience.

She is particularly focused on working with GPs and portfolio companies to ensure they understand BCI’s expectations in a joint effort between her team and people in those asset classes looking after the relationships.

She is also focused on bringing real consistency to manager selection in private markets. Strategies include careful assessment prior to onboarding and regular monitoring as well as tracking managers committed to the Principles of Responsible Investment – around 80 per cent of BCI’s managers in private markets have signed the PRI.

She notes that in many cases, engagement in private markets is quicker.

“As an owner in private markets, you can get into a room together and present a case; show how it would add value, and implement it, pretty much right away.”

That compared to public markets where it takes time for investors to build relationships with the company, ensure they understand the business and where (because these companies are accountable to more shareholders and stakeholders) discussions never comprise just one conversation.

BCI’s engagement program is run around KPIs where it uses specific indicators to measure corporate performance around, say, climate or diversity and can chart the change in the numbers over time. “We are aware that engagement takes time. It is not a silver bullet; it takes time and persistence to do it well and it means we have to put actions behind our words and really invest in engagement.”

Increasingly her focus is turning to policy engagement too.

“When you advocate at the policy level you are lifting all boats. If you go straight to the regulator, you can achieve widespread change and we are spending more time on this,” she says. “We will continue to push on the regulatory front to try to ensure governments hit the appropriate targets and push companies to innovate and invest in research and development. The transition involves everyone, but governments must set the tone.”

In one high profile example, BCI is currently engaging with Ontario Securities Commission (OSC) and other regulators to improve corporate disclosure, requesting companies on the exchange publish diversity statistics of their board members beyond just gender.

The investor can’t implement its proxy guidelines and enforce expectations if it doesn’t have this disclosure from companies, explains Coulson. “We can’t judge if a director is from a minority or not; it needs to come from the company.”

BCI has contributed to an ongoing consultation process around better disclosure at an Ontario, BC, and federal level. Progress to date includes new regulations like the Canada Business Corporations Act now demanding better corporate disclosure, although only for a subset of companies.

Will that be extended? “I am hopeful we will get greater disclosure,” she says. “It is hard for them not to do something in this space. It is just a question of how specific it will be, but we are going to push for specificity.”

Hard won, slow victories amount to big rewards in the role, but she reflects that although some elements of ESG have got easier over the years (like the availability of data for larger and private companies) it is still fraught with complexity. Like the constant evolution of tools and methodologies that don’t always make ESG easier. “Keeping up with the pace [of change] is very challenging,” she says.

“For me, ESG is just part of the investment process,” she concludes. “We are not here trying to take on a specific issue; we are doing everything in the best interest of our clients from a financial standpoint. In terms of managing risk and capturing opportunities, ESG is still financially material and not looking in this area would be imprudent.”