At Brightwell, which manages the assets of the £47 billion ($62 billion) British Telecom Pension Scheme (BTPS) one of the largest private sector DB schemes in the UK, liability-driven investment (LDI) is managed in-house, but cashflow-driven investment (CDI) for client funds is managed externally.

In contrast to many other UK pension schemes or asset managers, Brightwell believes that the credit collateralisation of LDI exposures and cashflow management is possible without all the relevant assets sitting with the same manager.

The two-pronged approach requires a sophisticated set up, technology and position level data sharing, says Wyn Francis, executive director and CIO in Brightwell’s latest newsletter.

“It is a received wisdom in the industry to combine LDI and credit under one roof for credit collateralisation and holistic cashflow management,” Francis says.

“However, this can result in manager concentration as the majority of a scheme’s portfolio sits with a single investment manager. The usual argument is that this is the only way to use credit as collateral for LDI and manage the operational requirements of cashflow management. At Brightwell, we strongly disagree with this approach.”

LDI and CDI

LDI is best described as a fancy name for a structured set of derivatives exposed to, in this case, the price of gilts. The idea is that pension funds buy these derivatives to protect them against yields going down, as this leads their liabilities to go up – when their liabilities are going up, they also have an asset that is posting them collateral. When yields fall, LDI funds receive margin but in the reverse scenario when yields rise (like they did in the UK’s gilt crisis in 2022) pension funds must post more collateral in-line with calls from their investment banks.

CDI, in contrast, matches fund income to scheme cashflows as they fall due and is an alternative to a traditional growth-and-matching investment strategy.

Since the LDI crisis, many pension funds have run their LDI and CDI allocations with one manager in a combined portfolio. The approach, Francis says, is a consequence of pension funds struggling to manage their collateral (bonds) during the LDI crisis because it was not easily accessible for their LDI managers. Some funds were unable to get cash fast enough to meet increasingly urgent collateral demands.

“One of the issues was that managing collateral was very difficult because their collateral pools were not in the same place, or the place that LDI managers needed it to be. Communication between LDI and CDI managers was challenged,” says Francis, who adds that under Brightwell’s approach, the internal team also have full cashflow visibility of the CDI assets.

Splitting up the allocation between in house and external managers brings a range of benefits. For example, the strategy allows pension fund clients to benefit by exposure to their preferred credit manager, gaining exposure to niche or best in class managers. Clients also retain the flexibility to change managers if performance drops or their requirements change.

It also avoids manager concentration, another problem during the LDI crisis when some investment managers were unable to service all their clients equally. Brightwell argues its approach reduces pension funds’ reliance on a single manager, often running many mandates to similar objectives, potentially creating operational and market risks.

Francis says Brightwell likes to build long-term relationships with managers, treating them as trusted advisors. But it also seeks to limit the number of managers it works with, to ensure a diversity in approach and portfolios.

“We like [managers] to be able to move across from public to private credit and make that value decision for us,” Francis says.

“It is unlikely that a good LDI manager is also the best-in-class credit manager. Managing LDI and credit under one roof to deliver CDI not only means potentially forgoing the returns that a credit specialist could offer and, as such, a loss of value, but also the loss of future flexibility.”

Putting the plumbing in place

Francis explains that the strategy has involved working closely with asset managers and custodians to make sure “the plumbing is in place”, including daily data on the bonds managers hold, and which ones are ring-fenced for collateral purposes.

“It requires communication with managers and the custodian whereby managers inform us of any bonds they want to sell out of, and new bonds coming into the portfolio,” Francis says.

He says Brightwell has built and uses a hybrid platform that allows it to manage LDI and CDI as one portfolio without directly managing corporate bonds.

“We believe that we are uniquely positioned as a fiduciary manager who only manages LDI, overlays and longevity risk in-house,” he says.

“We do not have proprietary funds or strategies to allocate to and as such do not compete with other asset managers. Other asset managers see us as investors and there is a mutual desire to co-operate. Close collaboration between all parties is vital for managing LDI and CDI under separate roofs.”

AP4, the SEK533.3 billion ($51 billion) Swedish buffer fund, is integrating Scope 3 emissions into its systematic equity allocation in the latest bid to improve risk and return at the pension fund, globally recognised as a role model in sustainability.

The systematic equity portfolio sits alongside a fundamental allocation which already integrates Scope 3 and supply chain risk in its deep fundamental processes. It means the latest innovation will complete Scope 3 integration across the entire SEK165 billion ($16 billion) equity portfolio apart from a (SEK 29 billion ) $2 billion allocation to emerging markets.

“We aim to be exposed to as little systematic risk as possible and want to find the green leaders of the future,” says Julia Ripa a senior analyst in the listed equities portfolio tasked with building sustainable equity strategies. “Because Scope 3 can be a large part of a company’s emissions, it is very important to integrate this risk into the portfolio and we can’t wait for ever to integrate Scope 3 – the danger of being exposed to the systematic risk of climate change is growing all the time.”

AP4 aims to achieve net zero emissions in its portfolio by 2040 and has cut emissions by 65 per cent since 2012 when it was one of the first pension funds out of the gate with the strategy. In 2023, the portfolio’s carbon dioxide emissions decreased by a further 11 per cent.

Although Scope 3 emission data is still frequently based on inaccurate estimates (in contrast to reported Scope 1 and 2 data) Ripa says the tide is turning, and the decision to integrate Scope 3 is a response to the steady improvement in emissions data from companies’ complex up- and downstream processes.

It is also born from AP4’s belief that new European reporting standards will yield better data going forward, despite fears amongst some investors that the regulatory focus on reporting could end up hindering genuine corporate change.

“EU regulation is really helping because we need reported data to improve data quality and availability. Once companies report their Scope 3 data it makes it much easier for us to select the best companies from the worst companies,” she says.

In the systematic portfolio the team continuously optimises the parameters that govern the algorithms used to select the sustainable winners of the future. If the data is poor quality, it yields noise and is often volatile; it holds too many inaccurate estimations that don’t correlate enough to reveal significant trends. “The team can end up just targeting companies on the basis of luck,” she warns.

Feeding Scope 3 data into the systematic portfolio won’t necessarily lead multiple companies falling out of the index.

“We won’t exclude all companies with high Scope 3 emissions,” she says.

Instead, the team aims to use the data to increase AP4’s weighting to the winners in each sector in the sector neutral strategy. They believe this will reflect the transition risk that the team is trying to capture more accurately compared to simply excluding the worst sectors. It is this, she says, that will ultimately lead to higher risk-adjusted returns.

“We are convinced sustainable investment will yield excess returns going forward, both by minimising sustainability risks but also by identifying winners,” she says. “In the long run, companies that are producing sustainable products and have sustainable business relationships, will be the future winners and yield excess returns.”

Ripa acknowledges that in some ways integrating Scope 3 data might not reveal significant corporate change. High emitting companies under Scope 1 and 2 like energy and utilities will still be high emitting under Scope 3.

However, she does say integrating Scope 3 will give a more holistic view of the carbon footprint of a company, something that will potentially change the way a corporate is viewed through a sustainability lens. It is possible that corporates that were clean under Scope 1 and 2 emissions will become brown when their Scope 3 data is revealed. “We will be able to fully understand company risk,” she says.

Car manufacturers which don’t have high emissions in their own manufacturing processes and have fallen out of Scope 1 and 2, but which produce a product that does have high emissions will be picked up in Scope 3, are a case in point.

Although the data from financials still has gaps, she says that Scope 3 data will also cast banks and insurance groups in a new light. For example, it can expose banks’ corporate lending book, particularly those financing fossil fuels.

“Banks have the opportunity of playing a large role within the climate transition, and we will finally be able to track their activity,” she says.

When it comes to high emitting sectors, AP4 combines Ripa’s team’s quantitative skills with the experience of the fundamental portfolio managers so that fundamental analysis is integrated into the systematic strategies.

The lack of quality, forward-looking data makes it challenging to pinpoint future leaders in these sectors, she says. A fundamental, qualitative approach is better suited to look deeply into individual companies and create a sustainability profile based on a corporate’s ability to transition and become a green leader of the future.

AP4 has continued to invest in the energy sector and in select fossil fuel companies in accordance with a belief that fossil fuels are essential for a successful transition. However, the investor has divested from thermal coal and oil groups it doesn’t believe are on a transition path.

Both the fundamental and systematic allocation seek out transitioning companies. Both portfolios also incorporate forward looking metrics, analysing how aligned companies are to the Paris Agreement and how exposed they are to rising carbon prices.

AP4’s allocation to emerging markets doesn’t sit within either the fundamental or systematic allocation, and is managed by external managers. Here the investor also aims to reduce emissions in the index, but hasn’t begun to integrate Scope 3 – although Ripa says it’s in the pipeline.

“Our approach when investing in emerging market equities is just the same. It’s about finding companies willing to transition and trying to improve, but doing so is more challenging in emerging markets. Data quality, reporting and to some extent awareness haven’t come as far as in developed market. In the end, it’s the same approach, just a few steps behind.”

The AI boom is nearing its end, according to Thijs Knaap, chief economist at APG, the Dutch asset manager overseeing €577 billion ($640 billion) on behalf of 4.6 million participants across a range of different pension funds. He warns that every innovation, including AI, experiences a peak of inflation expectations which are not fully realised.

“My sense is that we are nearing the end of that peak, and AI may not be as big as we think,” he says.

Knaap explains that Nvidia, the chipmaker producing the technology that will support large AI systems, is a bellwether for the boom, coming to dominate the US stock market during a rally that has pushed its share price up 160 per cent year to date and given the company a market capitalisation of $3 trillion. The company’s growth has driven more than a quarter of the gains on the S&P 500 over the last year.

Insight into what lies ahead can be gleaned from analysis of Nvidia’s price-to-earnings ratio (the stock has a price that’s over seventy times the earnings) rather than the company’s sky-high share price, says Knaap.

“This means that investors expect the company’s revenue and profit to grow even further. The big question… is what the profit growth will be. It’s great that the company is so successful now, but will this trend continue?”

He says the risk of another company appearing on the horizon able to produce a cheaper alternative to Nvidia’s chips could topple the company from its unassailable position as the “lead prince” in the AI carnival.

“This could be very challenging for the chipmaker to maintain this growth.”

With Nvidia’s annual turnover predicted to near $100 billion, Knaap observes “that’s an increase of more than 100 per cent.” He says the company’s profit alone is roughly equivalent to the GDP of the Dutch province of Overijssel which has a population of 1.2 million people. In comparison, Nvidia employs around 30,000 people.

Earlier this month, a delay to its next generation of chips, known as Blackwell, posed a potential barrier to Nvidia’s continuing to grow at pace. In recent results, the company’s year-on-year growth drove another record quarter but it was less than the 262 per cent jump in revenue it had reported in the previous quarter.

APG does not disclose its total position on individual stocks within its public equity allocation. The asset manager with vast in-house expertise manages approximately 75 per cent of assets internally. The equity portfolio is divided between developed markets, fundamental and quant strategies and developed markets small cap and emerging markets.

Prepare for a US rate cut in September

Knaap continues that the Federal Reserve is likely to cut interest rates in its September meeting given growing concerns regarding rising unemployment. He said inflation seems to be under control and the Fed is now switching to focus on the other element of its dual mandate – labor market figures.

“There are particular concern about rising unemployment. At 4.3 percent, it’s still on the low side, but it’s a full percentage point higher than a year and a half ago, and that rise seems to be accelerating,” says Knaap

He voices his surprise that American statisticians seem to struggle with tracking the number of jobs following a recent unexpected downward revision. “In the Netherlands, we’re used to everything being perfectly administered, and we know exactly how many jobs there are, but in the U.S., it’s much less precise.”

He said any cut in US interest rates is designed to ward off recession and the ensuing impact of layoffs and people spending less money. But he says a recession still feels far off.

“The Fed wants to get ahead of that dynamic, which is why they are now starting to lower interest rates, even though unemployment is still on the low side. They’re playing it safe and will probably start with a small cut.”

The impact of climate change on investing presents a big challenge. Learn how investors are tackling the risk.

When people envisage the impacts of climate change risk, they tend to picture the physical risks: soaring temperatures, rising seas, failing crops, species loss, hunger and strife.

(more…)

Measuring the value add of technology deployment is a question pension executives should be asking, says chief operating officer of CPP Investments Jon Webster. Amanda White double clicks on CPP’s technology strategy exploring a new user-centric focus on modular design so technology can evolve alongside investments; how in the not-too-distant future teams will include “non human” intelligence; and how to answer the question of value added.

CPP turned 25 years old this year with C$632 billion in assets, and its rapid growth is expected to continue with a projected AUM of C$3.6 trillion by 2050. This growth, combined with the fund’s complexity – it invests in 56 countries across public and private investments and has 328 global investment partners – means evolution is important across the organisation’s people, processes, thinking and investment implementation.

Jon Webster joined CPP in February 2023 to lead the fund’s technology, data, investment operations, security and corporate services functions, and describes his role as bringing together an integrated platform that serves colleagues with experiences they need to do their job well for CPP’s mandate. Those experiences are often technology-enabled and need to be safe and secure, and created through strategy execution capabilities.

CPP’s technology strategy is characterised by two differentiating factors. The fund is deliberately shifting to modular architecture and trying to be user centric.

Having technology that can evolve is one of the fund’s underlying design principles and one of the reasons a modular, or Lego brick, approach to technology is appropriate. The fund is very diverse in its approach to investments across teams, sectors, asset classes and geographies, so using different technology systems allows each investment area “degrees of freedom” to develop at its own pace and meet different needs.

“Evolvability means you can replace bits of it relatively quickly and effectively to respond to changing circumstance,” Webster says in an interview with Top1000funds.com.

“It’s one of the reasons we have chosen the modular approach, so we can very deliberately evolve the architecture in the spaces we need to.”

For example, Webster points how the different ways of looking at the world might evolve and so how scenario analysis around investment performance also needs to be a distinct module to evolve over time to meet the specific needs of its users.

In addition to having separate, modular, systems there also needs to be some organisational standard way to use the information. Webster says this comes in the form of an overlay of data products on the top of the tech systems, and it is what allows the fund to “liberate” the data and operate in an integrated way across the organisation where it is needed.

“How we record our positions is not going to change dramatically, it will still be an electronic ledger, there isn’t a lot of competitive advantage directly in a ledger,” he says.

“So for performance attribution, we are making it modular so we can replace and evolve. The most important thing with the ledger is they are simply integrated and the data sets that they make available in a consistent way across the organisation and accessible to everyone that needs it. In those cases, we are using a higher level of modularity and the idea of a data product that can be made available to the organisation for a variety of uses.”

The broad philosophy, Webster says, is that what CPP does is pretty stable over time, but how it does it changes. The modularity and the data products are the two mechanisms to reflect that.

The technology strategy is also focused on being very user centric. It’s where Webster, whose background is in digital transformation, is bringing in his experience working in consumer markets particularly banking where the architecture is far more responsive.

“I have a deep belief that the most important thing you can do with technology is to put it into the hands of people who can create some value with it,” Webster says. “You really do need to focus on user-centricity, testing and learning with users, experimenting what works and what will get adopted.”

He says the technology industry has developed an idea of product management, which is to treat technology like products to sell to users and meet the deep need of the user.

“It is something we are pushing heavily on, a product-oriented technology model,” he says.

“We have product owners in the investment departments which are directly integrated with the technology team, and [those individuals] are part of the technology department so we are consistent in how we build software; the security standards we apply; the design patterns we try to apply to software; and that has resulted in giving the right degrees of freedom to the users but that we are also building enterprise capabilities.”

To be useful technology has to be used

As elementary as it sounds, for technology to be useful it has to be used. For CPP, users are colleagues across all departments and Webster emphasises the need to develop technology that means something valuable to them day to day.

“Enterprise capability is super important,” he says.

“We are one fund and one integrated organisation. But what is important about the user perspective…is you have to take that overall enterprise perspective, and you do have to make sure your teams are connected to the everyday users, you need to be tapped into the users on the ground, where the work happens, and the local context of what they do.”

Webster says there are around 20 to 30 capabilities that are critical to make modular, including performance attribution, research management, knowledge management, integrated fund reporting and integrated risk reporting.

“I have found people in institutional investment to be hungry users of information, it’s a very data, information, knowledge-oriented culture,” he says.

“The last mile of investing for us sits in the hands of our investors but empowering them to make the decisions well and with the right quality of information is what the technology strategy is all about.”

Measuring the value add from technology

It is important but difficult to measure the value added by a technology deployment. For Webster, whose career is specialising in technology enabled transformations, it’s a question executives should be asking.

“Coming to the value question is very important,” he says.

He says that as AI grows and becomes more embedded into organisational decision making, it will start facing questions about the value it adds. For pension funds, that could be answered by the fundamental metric of basis points.

“AI is fascinating, it will restructure how thinking gets done, how work gets done, and organisational set ups,” Webster says.

“That will cause that question to be asked more pointedly. For some of these capabilities you have to boost them in a way to compound the advantage and need to give them sufficient space to demonstrate efficacy.”

For example, if knowledge management can be available at an investor’s fingertips, how do you put a price on that? But he suggests perhaps a more valuable measure is the compounding effect of that over time.

“Bootstrap it for a period of time then ask if you are seeing the compounding effect of it, and then [ask] how do we value it?” he says. It could be a returns-based value, but it could also be a decision quality, or decision throughput measurement.

The transformational power of AI

At the moment consumers are mostly using one-dimensional technology, like search engines, asking questions and producing results.

But Webster believes that this will develop and shift to “designing for dialogue”.

In other words, technology that enables a conversation with a different type of intelligence will become another useful agent in a topic that matters to the organisation.

“Getting people familiar and fluent with that is really important,” he says, stressing the importance of everyone in the organisation using tools like Copilot and versions of ChatGPT.

“This is legitimately useful in the five- to 50-minute tasks and the nature of how you do your work. It’s building the fluency of designing for dialogue.”

Like many investors with large complex allocations, CPP receives a vast number of documents from partners, in various formats, particularly in private investments where data is less standardised.

Historically, reading something about private equity funds felt different to reading an external portfolio management documentation. Enter ChatGPT with the origin of a general-purpose transformer which is basically about the translation of languages.

“We are starting to see that change,” he says. “Because the tech is language-agnostic, problems can be more solvable in things like investment operations because it understands the dialects of business and the languages of investment.”

Future uses of AI

Webster says with the use of AI there will be a “levelling up” of what people couldn’t do before, forcing people to be clear on their edge and value add.

“The bar will go up and up,” he says, adding that investors need to take a broader perspective and understand that all professional services where thinking is one of the primary products will be disrupted in the sense of how work gets done.

“There is already a diverse set of agents bringing together a diverse set of skills,” Webster says.

“In the future they will be non-human and human working together. We are just early in the cycle. Any of us interact with Google, but how we interact is simple. We don’t say ‘hey Google I’m thinking about this complicated world puzzle and can you help me in how to approach that?’, and then have a dialogue. That is not a thing yet embedded in the interaction.”

Webster says that in the near term, say one to two years, your job could be replaced by someone using AI effectively. He says there is already a set of people who are more effective because they have embraced the idea of dialoguing with the current technology, and they set aside the notion it can make mistakes because they are in a dialogue with it.

“They see the technology as a smart apprentice that makes mistakes,” Webster says.

“Beyond that, we move into prediction territory, but it will probably be different to that in the future, and more likely to be another set of intelligent agents in a broader dialogue. Things like AI will be an additional team member on your team.”

Connecting the purpose of the organisation and the ability to legitimately make a difference is one of the reasons Webster says he likes working at CPP.

“We have a real sense here, a direct connection between what we were set up to do and the impact on the lives of 22 million Canadians, that is very motivating for our colleagues,” he says.

Also, he says, because institutional investors are not huge organisations there is the ability to make real progress.

“You are only two to three steps from where the work gets done, and can understand the context and frictions better, and what it means for the platform,” he says.

“There is a connection between building a platform for people to do their best work, and the impact of that platform then on them.”

Because the world is becoming more complex, organisations need to bring together diverse expertise to solve problems, with employees needing to step outside of their silos. That is not straightforward for organisations to do.

“In investments, cross-sectional teams have always been there, and it’s a great platform for building that,” Webster says.

“This plays back to the AI point. In the future those cross functional teams won’t just be humans, but other forms of intelligence being involved in the decision.”

Japan’s Noritz Pension Fund, the 25.4 billion yen ($0.17 billion) corporate fund for employees of the manufacturer of gas appliances will continue to prioritise active management. Chief executive and chief investment officer, Kyoshi Iwashina, believes the current environment of high interest rates and inflation will continue to create volatility and opportunities in bonds and equity. He has shaped a strategy with a large allocation to overseas markets and outsized allocation to cash, ready to snap up opportunities.

“I may reduce passively managed products and increase actively managed products that can be considered excellent alpha creators in both fixed income and equities,” he says.

Iwashina is also considering increasing the allocation to short hedge fund strategies and reducing the weighting of the multi-asset portfolio, especially quant type products which he says have been built around data from the low-interest-rate, low-inflation era that means the models are less effective in an environment of higher rates.

Almost all (around 80 per cent) of the portfolio is actively managed, overseen by three staff members and targeting a 3 per cent return. The portfolio is divided between foreign bonds (28.2 per cent) foreign stocks (18.5 per cent) cash (20 per cent) hedge funds (14.4 per cent) multi asset (7.2 per cent) domestic bonds (5.9 per cent) general account, a unique product offered to pension funds by the insurance industry (4.1 per cent) and domestic stocks (1.7 per cent)

In another seam, he is mindful that opportunities in secondary and distressed funds in private assets will begin to emerge over the next few years. Although he remains on the sidelines for now, he believes the massive inflow of money into these private assets has been disappointing for investors. “Due to subsequent changes in financial and economic conditions, neither investment nor dividends seem to be progressing.”

He predicts that concerned LPs will gradually accelerate the process of disposing their interests, creating opportunities – especially when the latest round of dry powder is allocated.

“In another year or two will be a very good time to invest, as the buying power of primary funds will be reduced and the number of existing investors, LPs, will find themselves forced to let go at really big discounts, will increase.”

The small pension fund partners with 18 gatekeepers (an advisory role) and 50 investment management companies. Iwashina says a key requirement is asset manager support to ensure the portfolio is properly diversified. “Our goal is to minimize the amount we invest in any one investment product.”

Although he has 30 years of experience in investment management he says corporate pension fund CIOs in Japan often encounter prejudice and assumptions from the asset management community. Asset managers are particularly quick to attribute poor performance to pension fund CIOs, he says.

“In general, investors with small asset sizes are often assumed to be less financially literate and to have no investment management expertise,” he says. “I would like to request the financial industry to understand this point, as more and more people of my origins are moving out to corporate pension plans in Japan.”

It is not his only criticism of the asset management industry. He says asset managers are not putting enough pressure on corporate Japan on behalf of institutional investors and regulators to improve governance. Since the introduction of Japan’s Corporate Governance Code in 2015 the country has been trying to modernize corporate boards, long dominated by in-house executives. The Tokyo Stock Exchange is also pushing for stronger governance to improve underperforming companies, lift valuations and improve capital efficiency.

“I believe that many companies are taking this issue more seriously than before and are taking measures to deal with it. The problem, however, is that many Japanese managers lack financial knowledge, and in many cases, the true needs of investors are not taken seriously in their management. In this sense, I think it will still take some time to change to a level comparable to Europe and the United States.”

Iwashina’s call for stronger governance amongst Japanese corporates doesn’t extend to a wider enthusiasm for companies or investors to integrate ESG, however.  Something he believes will only add to costs and impact returns in a culture wholly focused on return numbers and fund performance.

“We are not convinced that ESG is a source of excess returns on our investments, so we do not actively incorporate it into our investments. ESG means starting to do things we haven’t done before, which all contribute to higher costs, and in my opinion, will be a factor in the decline of corporate earnings.”

He is also critical of the government’s initiative to get companies to disclose the returns of their corporate pension funds. Part of a wider effort to improve pension fund investment in the country by introducing transparency and competition and includes topics like ways to attract talent into the sector and highlights the benefits of mergers between smaller funds.

“Since corporate pension funds vary in terms of the attributes of their members and the size of their assets, disclosing their performance may draw too much attention to their performance alone. I think it is utter nonsense to force disclosure that may encourage this form of comparison.”