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The attempts by multiple Republican states to restrict where US pension funds can invest is symptomatic of bad governance. Top1000funds.com takes a deep dive into the quagmire of US state pension funds to assess the impact of partisan politics on the ability of CIOs to do their jobs. The analysis highlights the need for improved practices around delegated authority to prevent the politicisation of investments.

So much has been written about the rise and fall of ESG investing. But as an active participant in the global investment industry, and a non-American, it is extraordinary to observe the grandstanding efforts by US politicians, collapsing their vote-grabbing job functions with their roles as stewards of long-term capital.

The obvious and stark mismatch between the two-year political cycle and the long-term nature of pension investing is at the core of this problem, which also highlights the ignorance of the politically elected in managing pension assets. It’s no wonder best-practice pension management is complicated and difficult to attain.

The convoluted governance structures of US state pension funds, where elected officials are also trustees of the pension money and in some cases the sole trustee, is the complicating issue. And according to some governance experts, it’s the source of the problem.

The anti-ESG movement has been played out through comical headlines and quotes, one example being Montana’s Attorney General Austin Knudsen: “Montana’s a northern state. It gets really, really cold. We can’t heat our homes with rainbows and fairy dust.” But the impact is being felt by the investment staff whose jobs are to maximise the best financial outcomes for the beneficiaries of the pension funds whose money they manage.

The now-famous Montana letter, signed by 21 state Attorneys General and sent to 53 of America’s largest fund managers and financial institutions, argues that the investment industry is following liberal principles of woke capitalism for illegitimate reasons and contravention of fiduciary duty.

According to Roger Urwin, one of the world’s leading investment governance experts, their fundamental thesis is a strawman fallacy.

“It is the knocking down of an investment thesis that hasn’t been put forward in the first place,” he says. “But it is symptomatic of something we should respect in the investment industry that is that the politicisation of investments has become a systemic risk.”

The biggest risk is the legitimacy of the pension fund mission.

Shooting a moving target

The problem with the investment industry arguing either side of the ESG war is the fight is not about investments.

“My problem with the ESG wars is it’s like looking into the sun, that’s how stupid it is,” says David Wood, senior researcher at the Social Innovation and Change Initiative at Harvard Kennedy School, who has educated many pension fund trustees through the Initiative for Responsible Investment at the Kennedy School.

“My problem with the ESG wars is it’s like
looking into the sun, that’s how stupid it is.”

“What is the point of talking about the ESG wars as an investment style when it’s not what has motivated the attack?” Wood says.

It can be difficult to understand the arguments. One example of the complexities is in the state of Oklahoma which according to US Energy Secretary Jennifer Granholm is already the fourth-largest generator of renewable energy of all the 50 US states, with enough wind, solar, and energy storage capacity to power all of the state’s households, two times over. While it’s traditionally been a big fossil fuel state, clearly clean energy is a big part of its future.

And yet last month the state’s treasurer put together a list of 13 financial institutions that are prohibited from doing business with the state for engaging in “boycotts of fossil fuel companies” claiming the firms, including JP Morgan and BlackRock, were “beholden to social goals that override their fiduciary duties”. Both firms claimed the treasurer’s claims were baseless and their business practices were “not anti-free market” as claimed.

By nature, politics is short term and pension investment is long term. Investment professionals at the helm of pension investment management are managing 40+ year financial liabilities to an accuracy of three decimal points. Exploring the complexity of how these two competing time horizons intertwine is difficult and complex.

A Journal of Finance paper, Political representation and governance: evidence from the investment decisions of public pension funds, found that pension funds whose boards contain greater representation of state officials underperform. It explores three sources of poor decision-making by those state officials: control, corruption and confusion. Among other things, the paper says elected officials may be more inclined towards opportunistic behaviour arising from personal career concerns or the desire to attract political contributions.

This is certainly the observation from many investment professionals Top1000funds.com spoke to for this article, who noted that the behaviour of the political-elected trustees on their state pension fund boards did not even consider beneficiaries’ interests as an afterthought.

Many US public pension funds conduct their board meetings in public arenas. San Francisco City, for example, has public comment after every agenda item at its board meeting, and many public funds hire multiple lawyers just to deal with the Freedom of Information Act requests.

There are many problems with this structure, not least of which is focus. It opens the arena to people with objectives at odds with the beneficiaries and distracts trustee focus. When a trustee is also an elected official it can veer even more off course.

“Politics and investment don’t mix,” says Craig Slaughter, CEO and CIO of the $19 billion West Virginia Investment Management Board (IMB), a position he has held for three decades.

He believes recent legislation introduced by West Virginia’s Republican administration to claw back direct control of the fund’s proxy vote marks the tip of an iceberg. Political interference in investment decision-making threatens the fiduciary independence of the retirement plan, he says. [See: West Virginia CIO fears anti-ESG campaign threatens fiduciary duty]

The new legislation, coming into force in the next 15 months, will increase the level of scrutiny and impose potentially costly processes and hurdles in the proxy voting process. However, Slaughter’s main concern is that this legislation marks the first step on a road that could see the legislature tell the pension fund how to invest its assets.

One day that could mean ordering divestment of fossil fuels by those that oppose investing in them, but right now he is more concerned the anti-ESG movement led by West Virginia’s cultural Republicans could start to dictate investment strategy that could include forcing investment in West Virginia’s fossil fuel industry.

“At the IMB we don’t favour or disfavour fossil fuels, we just buy them if they are a good investment and if not, we don’t; but that may no longer be good enough. Whether pro-ESG or anti-ESG, the idea of using other peoples’ money to achieve a political purpose is offensive to me.”

“Whether pro-ESG or anti-ESG, the idea of using other peoples’ money to achieve a political purpose is offensive to me.”

The political hurly-burly is impacting state pension fund CIOs’ day jobs in a meaningful way.

“From an investment perspective I’m trying to use every tool I can to make better investment decisions – any other CIO will say the same thing,” says Andrew Palmer, CIO of the $63 billion Maryland State Retirement and Pension System. “Politicians are taking the ESG bat and hitting each other with it. And that has made the life of people trying to make investment decisions more difficult.”

“It turns out good risk management is important for banks; that is a governance thing. If you don’t have good safety for petroleum companies, there can be multiple-year impediments for that company. Every fundamental investor I know looks at these issues to make better decisions. That’s ESG. If CIOs think they can make more money by looking at ESG factors they will look at it,” he says.

Chris Ailman, the long-time CIO of CalSTRS has been dealing with external pressures on investments for more than 25 years.

“The average teacher works for 30 years and lives for another 30 after that so this money has a 30- to 60-year time horizon. When you think that long-term you think of all sorts of things beyond the balance sheet. You need a lot more information,” he says. “Whatever initials you want to use, these are long-term risks, and they should be disclosed by companies so we can make investment decisions. End of discussion. This is not about political outlook it’s an investment decision. I’ve never thought of them as political, and still don’t. But I am saddened by fact that people characterise words and suddenly make them good or bad.”

Indeed, Willis Towers Watson’s Roger Urwin says asset owners worldwide are trying to solve a financial equation, not solve something more pro-social or pro-environmental. And yet it’s become a political issue.

The governance conundrum

To understand best practice pension governance, it’s necessary to go back to 1980s Canada, where independence from the United Kingdom was fresh and KD Lang’s career was going gangbusters.

In 1986, Keith Ambachtsheer was on a taskforce set up by the then-Treasurer of Ontario, Bob Nixon, to reform pension organisations. The resulting report “In whose interest?” recommended two ways public sector pension management could be improved: first, ensure pension deals were intergenerationally fair; and second, that arm’s-length pension organisations should be governed and managed as effective financial intermediaries with fiduciary mindsets.

“If you are going to create a great pension system there has to be legitimacy and value for money. Governance is critical to both. You have to understand what arm’s-length means, and you have to understand good business to be effective,” Ambachtsheer says, adding clear delegated investment authority is a key feature.

The outcome of the report, and the implementation of the governance principles it outlined, was the formation of Ontario Teachers’ Pension Plan which has returned more than 10 per cent a year since inception.

“It can be done right,” Ambachtsheer, a Canadian himself, says. “I look south of the border and shake my head. There are a few US states that have people who understand the principles around what Peter Drucker said and create outcomes that are kind of OK, but they are a [clear] minority. The issue is at odds with the original principles of legitimacy and effectiveness.”

Similarly, Willis Towers Watson’s Roger Urwin has spent his career advising asset owners on governance and organisational issues – notably Australia’s Future Fund and New Zealand Super, both recognised for their organisational acumen.

He is working with USS and Sweden’s AP funds, and although he did some work with the CalPERS’ board some years ago setting up their investment beliefs, he has done limited recent work with US funds. Urwin, whose work with Oxford’s Gordon Clark demonstrated there is a 100 to 200 basis points a year return attributable to good governance, says there are three universal rules of governance: pension funds are fiduciaries; they should be independent; and they should be run as professional organisations.

“Those three principles take you a long way,” Urwin says. “It looks on the surface in the US as if both the fiduciary and independence principles are being challenged in some funds.

“The fiduciary-duty principle has always started with a financial-first orientation, but essentially sustainability is one of the instruments to secure the financial mandate,” Urwin says. “Sustainability is instrumental to financial outcome. But not everything in sustainability is supportive to financial outcomes. Understanding where those things are inter-related is important.”

In the US there are some examples of good governance and Utah’s John Skjervem, for example, cites the fund’s governance model as a critical support for his team’s decision making.

Specifically, the URS board addresses investment matters in executive sessions which limit the “political grandstanding and virtue signalling” that Skjervem says is commonplace at many US public-plan board meetings.

Skjervem says the URS governance shields the entire program from politics and “non-fiduciary” influences, allowing the team to focus exclusively on hunting for the best risk-adjusted returns without interruption or interference. He believes this combination of delegated investment authority and multi-level fiduciary oversight is the program’s “secret sauce” and manifests as excellence in both portfolio construction and team culture. [See: Utah Retirement Systems: Why ESG is a waste of time]

But Utah is a rare case, and for the most part the governance of the state pension funds is complicated at best, embroiled in the political sphere.

“Politicians shouldn’t get involved in the investment policies in pension plans that are properly set up at all,” says Amabachtsheer. “As soon as they put their fingers in, they are offside. One of the big breakthroughs in the Canadian model was that politicians are deathly afraid to meddle – and they should be.”

“Politicians shouldn’t get involved in the investment policies in pension plans that are properly set up at all.”

According to Ambachtsheer, turning retirement savings into wealth-producing capital is the narrative that is central to pension fund management.

“The whole question should be what is the best way for pension funds to do that transformation process?” he says. “OTPP got that straight away. It forces a long horizon, and you understand the businesses you are investing in. If you are a knowledgeable investor, then of course you can call up those companies and ask them about what they are doing. It comes naturally if you have the right narrative. In the US there are some cases where funds have gone off road on that central narrative to a laughable extent.”

If getting the foundational governance right wasn’t hard enough, now investment practice is moving from 2D investing with a focus on risk and return, to 3D which also incorporates real world impact.

“It’s going to get more messy,” Urwin says.

The Thinking Ahead Institute, which Urwin co-founded, encourages investors to look through a systemic lens incorporating social, technological, economic, environmental, political, legal and ethical issues which all have influences on the system in which investments operate.

“The new phenomenon is the increased connectedness of these things which is speeding up change as well as increasing complexity,” Urwin says.

Rob Bauer, Professor of Finance at Maastricht University has been studying ESG considerations for more than 20 years and agrees where societal issues and financial institutions there is complexity. He believes a lack of authenticity from product providers has added to the polarisation and politicisation of ESG issues in the US.

“I needed 20 years to understand what we are talking about here, every day a piece of the puzzle is added,” he says. “Then suddenly these marketing organisations come through overnight and say they are experts on ESG.”

“I needed 20 years to understand what we are talking about here, every day a piece of the puzzle is added. Then suddenly these marketing organisations come through overnight and say they are experts on ESG.”

The most complicated governance relationships according to Bauer are where the boards delegate their proxy voting to firms such as BlackRock and Vanguard.

“These organisations have commercial incentives, that are often conflicting. On one hand BlackRock is saying divest, but on the other hand Texas oil companies are clients of BlackRock. This says it all. How can these organisations engage when they have two different stances?”

For Maastricht’s Bauer, who also advises many Dutch funds on ESG-related issues, it again comes back to governance.

“Pension organisations set up investment beliefs and hire organisations to implement. But it’s more like they are wishing for an outcome so they set up beliefs consistent with that. But they have to test the beliefs regularly,” he says. “ESG is a container so broad and complicated, how do you measure preferences?”

Anger over proxy votes

To get a sense of the level of grievance red-state investors feel about the misuse of their proxy vote, we spoke to to South Carolina State Treasurer Curtis Loftis, beginning his fourth term as sole trustee of the state’s $65 billion fund, the bulk of which is invested in a $41 billion portfolio and separate from the state’s $38.2 billion pension fund which is managed by the Retirement System Investment Commission (RSIC). Loftis insists asset managers fired the opening shots in the now-raging ESG war by misusing institutional investors proxy votes in the first place.

Most of his anger is directed towards BlackRock, which was mandated to run a passive equity allocation in the state’s portfolio until Loftis began removing BlackRock mandates, most recently re-allocating a final $200 million tranche to Vanguard.

BlackRock was using South Carolina’s proxy to mandate dramatic changes in energy use, employment practices and looking after stakeholder rather than shareholder interests and that didn’t represent the beliefs of the people of South Carolina, he says.

“We’ve eradicated them from our portfolio,” he told Top1000funds.com. “BlackRock was voting contrary to our wishes. It’s as if I couldn’t vote and asked my best friend to vote Republican for me, but he voted Democrat, sealed it up and mailed it.”

Loftis, who was retired for 10 years before he returned to work to take up the role as South Carolina’s banker, managing, investing, and retaining custody of the state’s assets, continues. “This is what happened on a massive scale and it’s appalling, and it fuels the conundrum we are now in today. It’s about getting these asset managers to vote the investment dollars we’ve given them in accordance with the beliefs of the people who own them.”

“It’s as if I couldn’t vote and asked my best friend to vote Republican for me, but he voted Democrat.”

Talking to Loftis reveals that taking back control of the proxy voting process is being driven by a deeper grievance than just a belief that the vote was being used contrary to South Carolina’s Republican taxpayers’ beliefs. He believes ESG-minded proxy voting has infiltrated corporate America and is now triggering fundamental change for the worse. Take the gradual move away from shareholder to stakeholder primacy for example. In today’s new world of stakeholder capitalism, companies are beholden to their community, consumers, and special interest groups not just shareholders, yet he believes these groups shouldn’t be a company’s responsibility. “We have governments to keep stakeholders happy,” he says. “It’s tipping the financial house of America on its head in a process that hasn’t been sanctioned at the ballot box.”

Loftis says the capital markets used to work well. Now a business wanting to raise money must comply with ESG and other non financial stipulations laid down by ratings agencies and banks that insist on a swathe of rules that do not represent conservative ideas.

“It is difficult to raise capital if you don’t have a high ESG score,” he says, describing a new landscape where corporate America, a reliable conservative partner, is now in the grip of “a hard left ideology”.

Perhaps the fact that ESG isn’t the result of a democratic process – and wouldn’t, he says, pass through Congress if presented – angers him most.

“ESG is changing a country and culture but without having the government permission to do so,” he says. “It’s created a veneer of governance that we don’t think is even legal.”

The guardians of South Carolina’s pension assets managed by RSIC are also preparing for change. The ESG Pension Protection Act, passing through South Carolina’s legislative process and which Loftis expects to be ratified either this year or next, would require the retirement system consider only “pecuniary factors” when making investment decisions. Although this is consistent with the perspective RSIC currently takes when managing the portfolio, the bill also requires the state’s retirement system to exercise shareholder proxy rights for shares that are owned directly or indirectly on behalf of the system.

Negotiations over the bill have required substantial involvement by chief executive of RSIC Michael Hitchcock.

“I’ve spent a significant portion of my time over the past year working with the legislators on ESG legislation,” he says.

A process during which, like other CIOs interviewed by Top1000funds.com, he articulated his biggest fear is an outcome that decreases the availability of investment opportunities in a way that impacts returns and leads to increased contributions. HIs goal has been to keep the focus on RSIC’s obligation to earn an investment return that helps fund benefit payments for the retirement system’s 600,000 beneficiaries.

“We are not woke, or anti-woke,” he says. “We are anti-broke.” 

CIOS hitting back

Florida’s Republican Governor and US Presidential hopeful Ron DeSantis, the anti-ESG camp’s biggest hitter, has signed into law a bill that prohibits and seeks to punish all ESG considerations in the state’s investment decision-making, spanning all state treasury and retirement plan funds. It requires Florida State Board of Administration, guardian of $232.5 billion including the $181 billion Florida Retirement System, to only make investments on pecuniary factors and prohibits, amongst a raft of other restrictions, banks integrating ESG factors into their lending criteria.

DeSantis said the legislation would protect “hard working pensioners” against “woke” asset managers and “joyriding ideology” and said he believes Florida’s legislation, which follows on from Florida State Board of Administration divesting the state’s pension investments from BlackRock, will act as a blueprint for other states opposed to ESG, in a multi-state effort.

“This governor is leading the fight and 20 other states are following his lead into battle,” says Florida’s chief financial officer Jimmy Patronis, who sits on the SBA board alongside DeSantis and Attorney General Ashley Moody as the three government-elected trustees.

But the idea that Florida’s sweeping legislation, backed by the campaign’s biggest beasts, signposts the rollout of similar legislation at other pension funds is not necessarily the case. CIOs are also hitting back.

Like Alan Conroy executive director of $24.3 billion Kansas Public Employees Retirement System, whose testimony highlighting the potential impact on the pension fund contributed to legislators reducing the scope of Kansas’ Protection of Pensions and Businesses Against Ideological Interference Act. The final legislation still restricts ESG but addresses all concerns Conroy raised in testimony. Like the fact forced divestment from ESG-minded managers, restructuring the portfolio and hiring new managers could cost $3.6 billion over the next decade, impacting the already underfunded pension system. He warned that KPERS’s funded ratio could be lowered by 10 per cent due to the combined impact of lost assets due to divestment and increased liabilities due to lower future investment.

Forced divestment from ESG-minded managers, restructuring the portfolio and hiring new managers could cost $3.6 billion over the next decade,

Other CIOs also complain if anti-ESG legislation in their states went through in its original format it would have a huge adverse impact on their investment organisations, including needing to fire managers, build bigger internal organisations or go passive – all of which have cost, resource and return implications.

CIOs are also arguing that new proxy rules create an unnecessary layer of administrative complexity in structures that are already highly bureaucratic compared to global peers, that will make them less competitive with private market investments.

“These requirements could also prevent the system from using commingled investment accounts that often provide a more efficient, low-cost way of investing trust fund assets,” KPERS’ Conroy told legislators. He also sounded a warning bell on new complexities around the term “fiduciary”.

It’s a similar story in Nebraska, where Michael Walden-Newman, CIO at $40 billion Nebraska Investment Council has resisted an attempt by Nebraska state legislator to introduce legislation banning ESG investment that directly interfered with fiduciary duty.

“I explained to legislators that Nebraska already states that the investment council is prohibited from making any investment if its primary purpose is for social or economic development benefit,” said Walden-Newman. “Also, that the members of the investment council board and I, as CIO, are fiduciaries under the law, and are bound by that fiduciary responsibility to ensure investments are made for the benefit of the members of the various retirement plans and the general taxpayers of Nebraska. The Legislature chose to not act on the legislation.”

In Texas, where an anti-ESG bill went through the legislative process earlier this year but was not passed because it missed a key deadline, Amy Bishop the executive director of the $45 billion Texas County & District Retirement System (TCDRS) raised similar concerns with the Senate State Affairs Committee. She warned the proposed bill would impact the organisation’s “ability to maximize returns and have a financial impact on employers” adding the bill would keep the fund from “partnering with some of the best investment managers in the world”. She warned that adjusting the asset allocation could cost more than $6 billion over the next 10 years, causing employer contributions to double.

How do you right the ship?

The governance structures of US public plans were set up in the 1970s and are due for modernisation.

55 per cent of the board members of US public sector pension funds are either appointed through some kind of election process or through ‘ex-officio’ status, requiring board membership by state or local officials. The number in Canadian and European pension funds is zero per cent.

The important distinction, according to CalSTRS’ Ailman, is that these organisations are trusts set up for a specific benefit.

“These are trust funds and they needed to be treated that way. We don’t use that word enough and that’s why we’ve lost sight of it,” he says.

“Seeing trust funds being attacked by both sides of the aisle may be enough of a catalyst for us to make some change. These retirement plans are for multiple generations. I have 20-year-old teachers starting this fall and it’s their pension too. Elected officials want to make a statement and so why not use somebody else’s money? It’s too easy for them.” CIOs and their investment teams are money managers trapped inside the business model of a government entity.

“These are trust funds and they needed to be treated that way. We don’t use that word enough and that’s why we’ve lost sight of it.”

“That is costing us money,” Ailman says. “But even that is not enough to make people want to change the governance, because the people who will change it are the ones using it for personal gain. I can’t put my finger on what will cause it to change, but when it does it will spread like wildfire across the country.”

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.