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Partnering for Impact: Institutional Investors and the Net-Zero Transition

Key Takeaways

China’s economic policy has shifted to growth, COVID-19 restrictions have been lifted, regulatory rhetoric has relaxed and the tone toward the property and private sectors has become more supportive.
While we expect China’s growth momentum to improve further in the coming months, a hard-hit property sector, aging demographics and geopolitics remain headwinds to China’s growth trajectory.
Long-term themes remain intact and a vast potential opportunity set exists across public and private markets. Investors should be ready to revise their approach to successfully navigate China’s next chapter.

China has reopened. The recovery of the world’s second-largest economy is underway after three years of some of the strictest public health measures globally. An earlier and faster-than-expected departure from zero-COVID policy began at the end of 2022 as major cities abolished mandatory mass testing requirements. Rules around domestic quarantine requirements and inbound travelers eased in January as China welcomed the Year of the Rabbit with Lunar New Year holiday celebrations. The reopening has occurred in tandem with a strong policy shift towards supporting growth by facilitating a consumption recovery and rebuilding consumer confidence, including measures to stabilize China’s property sector. This policy pivot led to a cyclical recovery between November 2022 and February 2023 as sentiment toward Chinese assets improved and fueled one of the best performing three-month periods on record for the MSCI China Index—albeit from a depressed starting point. A nine-day long policy event, the National People’s Congress (NPC), concluded on March 15 with policymakers re-emphasizing stability of growth as a key goal of the government and reassuring the private sector and international business community of Beijing’s pro-business stance. As many aspects of China’s economy and society normalize over the coming quarters, we expect China’s growth momentum to improve. While a cyclical recovery may continue to drive markets in the near term, successfully navigating China’s next chapter will also require public and private investors to refocus on a wide set of new opportunities—and new risks. These include long-term secular tailwinds and structural headwinds with the potential to affect asset class performance and investment portfolios in the years ahead.

Reopening and Recovery

The potential pace and magnitude of a consumption rebound in China this year remains firmly in focus among market participants. Chinese household consumption was ~7% below potential in 2022, implying significant room for recovery.¹ If the post-pandemic consumption pattern of other economies leaves any indication, China may see sharp rebounds in discretionary consumer goods and services spending, especially domestic tourism. During China’s Lunar New Year Golden Week (January 21-27), movie box office revenues, postal package delivery, and restaurant sales all exceeded 2019 levels. There was also a V-shaped recovery of domestic air traffic and booming hotel demand. Consistent with the mobility data, China has returned to work with a sense of urgency. Purchasing Managers’ Index (PMI) data came in above consensus expectations in February, with the Caixin Services PMI—the most sensitive part of the economy to a reopening—surging to 55.0 well above the historical mean of 53.7.² We believe China’s reopening has the potential to trigger a consumption revival in 2023 led by a release of pent-up demand, improvement in the labor market and incomes, and a broader recovery in consumer confidence. However, it is still too early to tell how robust and durable China’s economy will be, and three years of zero-COVID policy and eighteen months of property sector stress have left scars that could hinder a broad-based consumption recovery. For example, elevated unemployment rates among China’s 16-24-year-olds could weigh on the consumption capability of this cohort, even as the recent relaxation in various regulated areas, such as tech and education as well as the more recent recognition of platform companies as national champions and employment generators, provides some support for job prospects and income security. Meanwhile, cumulatively, from 2020 to 2022, excess savings in China—which we define as the amount of savings above what a “normal” pre-COVID savings rate would imply—appear to be relatively small in contrast to other economies such as the US, estimated at less than 3% of GDP or 6% of household disposable income at the peak during the pandemic, though in absolute terms this number exceeds RMB 3tn (~$435bn).³

Along with signs of a consumption rebound, we believe it will be vital for investors to closely monitor global spillover effects from China’s reopening on goods trade, international travel, and commodities. Increased domestic demand in China could boost goods exports from other economies, for example. We expect Asian economies—which account for more than 50% of China’s import demand—to be the key beneficiaries of this growth impulse, though results will vary at a country level. China is the largest export market for most economies in the region, absorbing 50% of exports from Taiwan and Australia, 30-40% from New Zealand, Korea, Malaysia, and the Philippines, and around 20% from the rest (with a notably smaller 7% for India). The distribution of benefits will also depend on which sectors in China experience the strongest growth. Taiwan accounts for a quarter of tech imports into mainland China, for example. Demand recovery in foreign services, particularly for international travel, would additionally provide a modest boost to global activity. Again, Asian economies and some developed markets are likely to benefit if international travel returns to pre-pandemic levels. Higher commodity demand and prices are another channel through which China’s reopening will affect other economies. China is the world’s largest commodity consumer and biggest oil importer, and we expect its reopening to be moderately inflationary due to higher commodity prices. Within China, the unique nature of the post-reopening recovery may result in a mixed inflation picture. Prices of pork, a staple in China, surged in 2022 but may be less of an issue as supply disruptions begin to ease. Durable goods such as autos, smartphones, and computers tend to have long and sophisticated supply chains and are likely to be affected differently by reopening.

China’s reopening and recovery will be closely watched by many investors over the coming quarters. Data suggests hedge funds moved swiftly to rebuild China exposure from November to January. Active mutual funds globally re-risked to a lesser extent. However, by the end of February, Chinese equity funds had recorded steady year-to-date inflows of ~$3.6bn from global mutual fund investors.⁴ We see large pools of capital that do not have the level of holdings in China that they used to allocate. This implies that net foreign buying may continue in the months ahead, especially given the recent improvement in China’s fundamental outlook. Revenue normalization in areas that have been impacted the most by COVID restrictions may remain a tailwind and could drive further equity gains. The downside risk of maintaining underweight exposure to Chinese assets could therefore be high. We see public market strategies well placed to capture further upside in the near term. These strategies can take advantage of both improving fundamentals and tactical re-rating opportunities in areas where valuations are still suppressed relative to historical ranges, notwithstanding the recent rally. We expect China’s equity and fixed income complex to contain an abundance of alpha generating opportunities for bottom-up, active managers in 2023 and beyond. Many investors still include China as part of a broader allocation to Asia or emerging markets; however, China’s size and the breadth of its equity and fixed income markets could merit a standalone country or incremental regional allocation for investors considering Chinese equity and fixed income exposure. Both China’s A-share market and Chinese fixed income markets boast a strategic investment case for international investors underpinned by their size, liquidity, and diversification appeal.

Beyond Reopening

Despite optimism around China’s reopening and recovery in the near term, we expect headwinds to shape China’s growth trajectory and asset class performance in the years ahead. We examine three key issues in more detail: property sector stress, demographic shifts, and geopolitics.

First, China’s property market remains a key concern. The country’s real estate market stayed soft in 2022 amid continued liquidity and credit stress for developers, even as greater concerns over contagion risks stemming from Evergrande’s default began to abate. More recently, sentiment has further improved as policymakers’ tone towards the sector has turned decisively more dovish. Credit support to both high-quality developers and homeowners has been introduced and we expect more policy easing to come. We have since seen a recovery in both primary and secondary property transactions year-to-date. The long-term policy focus is likely to be on managing a multi-year property sector slowdown, rather than engineering an upcycle. Property developers’ debt-repayment problems have been among the biggest issues affecting Asia’s credit markets over the past two years. More recently, the asset class has experienced a forceful rebound. A recent rally of China property high yield bonds reflected a reduction of left tail risk for the stronger developers. We think stresses and defaults could continue to build and the near-term outlook remains challenging. Even so, we believe there is a potential opportunity for attractive total returns in the deleveraging of the Chinese property sector through active security selection, while recognizing that Asia’s credit markets represent a diverse opportunity set beyond China.

Second, China’s changing demographics will likely present long-term challenges to the country’s growth potential and alter the structure of its economy. China’s population started shrinking in 2022 for the first time in six decades.⁵ The demographic transformation has led to an increasingly top-heavy population pyramid. China’s old-age dependency ratio (the ratio of the population aged 65 and over to the population aged between 15 and 64) is expected to increase from 10% in 2000 to 41.5% by 2040, according to United Nations projections.⁶ Although China loosened its family planning restrictions in 2015 to address emerging demographic problems, birth rates have not improved following the implementation of the two-child policy. Even if China were to further relax its birth policies, fertility rates may not increase due to structural factors, including the fall in the number of women of childbearing age—a result of family planning that began in 1980; and improving living standards and education levels delaying marriages and childbirth, and the pressures and costs of parenting. Demographic headwinds are not unique to China. Many countries have increasingly aging populations, but China is already home to the largest population of older people in the world. Investors have opportunities to lean into areas of demographic change. Segments of China’s healthcare sector stand to benefit as aging consumers start to spend a higher proportion of their budget on medical services and less on tangible goods. At the same time, President Xi Jinping has put health and social care at the center of the government’s policy agenda. More broadly, lower labor force participation rates tend to raise labor costs and result in retirees drawing down savings. This may constrain the available supply of capital, potentially creating compelling opportunities for private investors seeking to put capital to work in China.

Third, geopolitical risk remains a significant overhang on Chinese assets. The Russia-Ukraine war raised investor concerns around geopolitical issues, including China-Taiwan tensions and US-China trade and technology frictions. Diplomatic tensions with the US increased at the start of 2023 as the US shot down a suspected surveillance balloon and Secretary of State Blinken postponed his planned trip to Beijing. Strained relations between the US and China appear to have encouraged both to strive for more self-sufficiency in key industries. This may lead to more centralized economic policies where state intervention plays an important role, either directly or indirectly, through incentives and disincentives to decision makers and businesses. The US move to ban the transfer of advanced semiconductor technology to China may prompt Chinese leaders to ramp up state-directed investment in domestic chip producers and bolster onshore manufacturing. This could intensify the race between the two countries for dominance in the tech sector. Elsewhere, Beijing and Washington have also been at odds over access to audit papers of Chinese companies. Since 2021, Chinese offshore initial public offerings (IPOs) in the US have almost ground to a halt. However, February saw the first Chinese company to raise more than $100 million in the US in 15 months as China’s securities regulator eased curbs on overseas IPOs, sparking hopes that Chinese companies will restart their ambitions to list in major markets such as New York.

Geopolitical headwinds and new alliances ultimately create a more uncertain environment that weighs on consumer and corporate confidence. Governments’ fiscal spending priorities may also change, with increased spending on defense and/or more support for domestic industries. Private capital may be advantaged by its ability to provide long-term, patient capital that can respond to long-term shifts, while reacting less to near-term geopolitical gyrations. Private capital can also provide investors with access to a broader selection of industries given the stops and starts in the IPO market. From an FX perspective, global instability is also leading to a desire for greater currency diversification and could give rise to more institutional investor allocations and central bank reserves potentially shifting to RMB and EUR, alongside the dollar. That said, there are still material barriers to a wholesale shift into RMB. For example, foreign ownership of Chinese Government Bonds (CGBs) remains low at around 12%, although we think CGBs continue to offer investors diversification benefits given their low correlation with other assets.⁷ We also expect structural inflows as a result of increasing weights of CGBs in major bond indices to be supportive for the asset class over the long term.

Secular Trends

Every new cycle has new winners, and in China, picking the right themes and sectors in the right cycle has demonstrated to be highly rewarding. As China enters a new chapter, we believe it will be critical for investors to align their portfolios with long-term secular trends. This may include opportunities that are essential building blocks to—or at least well-synced with—initiatives set to guide China’s economic growth orientation in the decades ahead. China’s Common Prosperity vision, for example, is a concept which we believe represents a growth reorientation where policy support could pivot towards industries that carry long-term strategic value to China, including areas of technology, healthcare, and decarbonization.

Prosperity heavily depends on the ability for China to grow its economy in a high-quality, efficient, and sustainable manner. We believe China will have to develop its internal production capabilities in foundational technologies, specialized equipment and essential materials along key supply chains, such as semiconductors and enterprise software, if it is to improve its global competitiveness and self-sufficiency—especially against a backdrop of elevated US-China tensions. Building out digital infrastructure will also be essential to enable China to reach its long-term growth targets. Digitization will touch most areas of China’s economy, but we believe it could have the greatest impact on the enterprise technology and financial sectors.

Core technology aside, energy security is another necessary condition for sustained growth. While China is the largest producer of rare earth elements critical for energy transition, it is also the largest energy consumer in the world, representing 14% of oil and 52% of coal demand globally. About 73% of its oil consumption and 8% of coal is sourced externally, underscoring China’s heavy dependence on energy imports in areas that could expose the country to national security concerns.⁸ The word “ecology” has also received significant mentions in many official Common Prosperity reports, and reducing energy pollution is a core component of sustainable development. We believe China’s pledge to reach peak CO₂ emissions by 2030 and carbon neutrality by 2060 will continue to underpin its quest for less-polluting energy supplies and enhancing energy efficiency. This could usher in secular investment opportunities centering on renewables (e.g. solar, wind, hydrogen) and environmentally-friendly energy applications, notably electric vehicles and related supply-chain components (e.g. battery technology and charging piles). Policymakers are also increasingly focused on alleviating water scarcity and reducing water pollution.

We believe finding and executing public and private investments in areas that benefit from structural tailwinds will prove rewarding. The make-up of China’s newly born unicorns—privately held start-ups with valuations over $1 billion—is increasingly concentrated in industries that are more aligned with China’s national development goals. In 2022, 70% came from four fields: clean technology, renewable energy, healthcare and smart logistics.⁹ Economies of scale and industry consolidation have historically been winning formulas in China. Going forward, a focus from policymakers on regulating anti-monopoly behaviors, discouraging cross-sector capital expansion for platform operators, and offering targeted support to emerging companies may strengthen the competitive positioning of small and medium sized enterprises. ‘Little Giants’—emerging companies handpicked by China’s authorities for explicit policy support—are particularly aligned with strategic policy goals. These small/mid-caps are mostly found in capital goods, new materials, technology hardware and semiconductors. These sectors are critical to Chinese national security, growth sustainability, and the Common Prosperity initiative.

New China Playbooks

China remains a large, growing market with a vast opportunity set. But as China reopens and its economy recovers, the country’s next chapter is set to look a lot different than the last. This means investors cannot rely on their existing game plan. As the long-term trends in China shift, it is important to see the change, understand the change, and continue to look forward. We believe investors will need to take a more nuanced view of public market exposures and add thoughtful idiosyncratic exposure to private markets with managers able to identify and execute in thematic areas with structural tailwinds. This could make portfolios more resilient as China enters its next chapter.

Important information

¹Goldman Sachs Global Investment Research. China post-reopening consumption recovery: Large potential, lingering scars. As of January 18, 2023.

²Goldman Sachs Global Investment Research. As of March 1, 2023.

³Goldman Sachs Global Investment Research. China Data Insights. As of February 7, 2023.

⁴EPFR, Morningstar, MSCI, FactSet, Goldman Sachs Global Investment Research. As of February 28, 2023. Morningstar data includes flows across China Equity and China A-Share Equity categories. Past performance does not guarantee future results, which may vary.

⁵National Bureau of Statistics of China. As of January 18, 2023.

⁶Goldman Sachs Global Investment Research. Population Aging, Pension System, and Individual Retirement Savings in China. As of February 10, 2023.

⁷Source: IMF, Goldman Sachs Global Investment Research, Goldman Sachs Investment Strategy Group, and Goldman Sachs Asset Management. As of January 29, 2023.

⁸Goldman Sachs Global Investment Research. Finding the “Common” paths to “Prosperity”. As of October 25, 2021.

⁹South China Morning Post (SCMP). China added 74 unicorns in 2022, maintaining steady pace of growth despite fundraising crunch. As of February 3, 2023.

Glossary

Alpha refers to returns in excess of the benchmark return.

Bps refers to basis points or 1/100th of 1%

Correlation is a measure of the amount to which two investments vary relative to each other.

Dovish refers to more accommodative monetary policy, the opposite of Hawkish

FX is foreign exchange market.

GDP is Gross Domestic Product

Left-tail risk refers to the risk of unlikely yet extremely negative portfolio outcomes.

PBOC is People’s Bank of China

Risk Considerations

All investing involves risk, including loss of principal.

International securities may be more volatile and less liquid and are subject to the risks of adverse economic or political developments. International securities are subject to greater risk of loss as a result of, but not limited to, the following: inadequate regulations, volatile securities markets, adverse exchange rates, and social, political, military, regulatory, economic or environmental developments, or natural disasters.

Private equity investments are speculative, highly illiquid, involve a high degree of risk, have high fees and expenses that could reduce returns, and subject to the possibility of partial or total loss of fund capital; they are, therefore, intended for experienced and sophisticated long-term investors who can accept such risks.

Alternative Investments often engage in leverage and other investment practices that are extremely speculative and involve a high degree of risk. Such practices may increase the volatility of performance and the risk of investment loss, including the loss of the entire amount that is invested. There may be conflicts of interest relating to the Alternative Investment and its service providers, including Goldman Sachs and its affiliates. Similarly, interests in an Alternative Investment are highly illiquid and generally are not transferable without the consent of the sponsor, and applicable securities and tax laws will limit transfers.

Emerging markets investments may be less liquid and are subject to greater risk than developed market investments as a result of, but not limited to, the following: inadequate regulations, volatile securities markets, adverse exchange rates, and social, political, military, regulatory, economic or environmental developments, or natural disasters.

Equity investments are subject to market risk, which means that the value of the securities in which it invests may go up or down in response to the prospects of individual companies, particular sectors and/or general economic conditions. Different investment styles (e.g., “growth” and “value”) tend to shift in and out of favor, and, at times, the strategy may underperform other strategies that invest in similar asset classes. The market capitalization of a company may also involve greater risks (e.g. “small” or “mid” cap companies) than those associated with larger, more established companies and may be subject to more abrupt or erratic price movements, in addition to lower liquidity.

Investors should also consider some of the potential risks of alternative investments:

Alternative Strategies. Alternative strategies often engage in leverage and other investment practices that are speculative and involve a high degree of risk. Such practices may increase the volatility of performance and the risk of investment loss, including the entire amount that is invested.

Manager experience. Manager risk includes those that exist within a manager’s organization, investment process or supporting systems and infrastructure. There is also a potential for fund-level risks that arise from the way in which a manager constructs and manages the fund.

Leverage. Leverage increases a fund’s sensitivity to market movements. Funds that use leverage can be expected to be more “volatile” than other funds that do not use leverage. This means if the investments a fund buys decrease in market value, the value of the fund’s shares will decrease by even more.

Counterparty risk. Alternative strategies often make significant use of over- the- counter (OTC) derivatives and therefore are subject to the risk that counterparties will not perform their obligations under such contracts.

Liquidity risk. Alternatives strategies may make investments that are illiquid or that may become less liquid in response to market developments. At times, a fund may be unable to sell certain of its illiquid investments without a substantial drop in price, if at all.

Valuation risk. There is risk that the values used by alternative strategies to price investments may be different from those used by other investors to price the same investments.

Infrastructure investments are susceptible to various factors that may negatively impact their businesses or operations, including regulatory compliance, rising interest costs in connection with capital construction, governmental constraints that impact publicly funded projects, the effects of general economic conditions, increased competition, commodity costs, energy policies, unfavorable tax laws or accounting policies and high leverage.

Alternative Investments – Hedge funds and other private investment funds (collectively, “Alternative Investments”) are subject to less regulation than other types of pooled investment vehicles such as mutual funds. Alternative Investments may impose significant fees, including incentive fees that are based upon a percentage of the realized and unrealized gains and an individual’s net returns may differ significantly from actual returns. Such fees may offset all or a significant portion of such Alternative Investment’s trading profits. Alternative Investments are not required to provide periodic pricing or valuation information. Investors may have limited rights with respect to their investments, including limited voting rights and participation in the management of such Alternative Investments.

Investments in real estate companies, including REITs or similar structures are subject to volatility and additional risk, including loss in value due to poor management, lowered credit ratings and other factors.

Alternative investments are suitable only for sophisticated investors for whom such investments do not constitute a complete investment program and who fully understand and are willing to assume the risks involved in Alternative Investments. Alternative Investments by their nature, involve a substantial degree of risk, including the risk of total loss of an investor’s capital.

The above are not an exhaustive list of potential risks. There may be additional risks that are not currently foreseen or considered.

Conflicts of Interest

There may be conflicts of interest relating to the Alternative Investment and its service providers, including Goldman Sachs and its affiliates. These activities and interests include potential multiple advisory, transactional and other interests in securities and instruments that may be purchased or sold by the Alternative Investment. These are considerations of which investors should be aware and additional information relating to these conflicts is set forth in the offering materials for the Alternative Investment.

General Disclosures

Diversification does not protect an investor from market risk and does not ensure a profit.

The views expressed herein are as March 28, 2023 and subject to change in the future. Individual portfolio management teams for Goldman Sachs Asset Management may have views and opinions and/or make investment decisions that, in certain instances, may not always be consistent with the views and opinions expressed herein.

Views and opinions expressed are for informational purposes only and do not constitute a recommendation by Goldman Sachs Asset Management to buy, sell, or hold any security, they should not be construed as investment advice.

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Examples are for illustrative purposes only and are not actual results. If any assumptions used do not prove to be true, results may vary substantially.

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Date of First Use: April 20, 2023. 310270-OTU-1771097

Key Takeaways

Unpredictable markets and elevated economic uncertainty may call for a more deliberate approach to portfolio construction.
A stronger tilt toward dynamic active strategies may help deliver alpha on a more consistent basis.
Allocations that mix traditional public equities and fixed income with hedge funds and private alternatives such as infrastructure, real estate and private credit may boost portfolio performance while hedging some risk through diversification of returns.

The last decade was generally one of plain sailing for investors. A mix of very low inflation and interest rates following the 2008 Global Financial Crisis (GFC) cut the cost of capital for companies and pushed equity and bond prices sharply and steadily higher. This set off an extended secular bull market during which nearly all financial assets appreciated from low starting valuations. As a whole, active fund managers investing in US large cap equities beat their benchmarks in just two calendar years between 2008 and 2022. In nautical terms, a rising tide of easy monetary conditions and low inflation, coupled with relative geopolitical stability, lifted all boats, no matter whether there was a captain at the helm or not.

In these conditions, passive benchmark-oriented strategies delivered robust returns—often outpacing those delivered by many actively managed strategies. But as Franklin D. Roosevelt once said, “a smooth sea never made a skilled sailor.” Last year’s stormy markets made it clear that what might have appeared to be investor acumen in the years after the GFC was, in many cases, probably just market beta. Indeed, by 2021 passively managed index funds had overtaken active funds’ ownership of the US stock market for the first time.¹ This suggests the marginal buyer in most public asset classes was more likely to be an open-ended index fund than a portfolio manager making decisions rooted in research and corporate engagement.

In today’s markets, characterized by higher interest rates and elevated volatility, we believe investors will likely have to be more selective. Profitability and indebtedness will matter more, and tighter financial conditions, increased economic and geopolitical uncertainty and increased return dispersion may offer greater opportunities for managers to generate alpha. We began to see this outperformance in 2022, when 57% of active US large-cap core equity managers outpaced their benchmarks, the highest percentage in over a decade.² Over a longer period, data suggests more challenging markets characterized by lower total returns tend to correlate with better relative returns for active managers.

We believe building durable investment portfolios in a world of higher volatility, changing correlations and what we consider a new macroeconomic reality requires a stronger tilt toward active strategies with the potential to deliver alpha through nimble portfolio management and original research. The most effective way to do this, in our view, involves an integrated approach that combines traditional public assets such as equities and fixed income with hedge funds and private alternatives. Private real assets, including real estate and infrastructure, have low correlation with public assets, which can provide attractive diversification opportunities. Private equity and credit correlations are largely driven by pricing lags, as these assets are less liquid than their public counterparts. But they have the potential to enhance overall returns, which can complement a portfolio’s beta component. First, though, a closer look at the shortcomings and risks of a passive-only strategy may help illustrate why we believe the time is right for investors to rethink their approach to asset allocation and portfolio construction.

A Closer Look at Benchmarks

Passive investment strategies, in our view, do not put capital to work in the most effective way possible. Most allocate according to size (market capitalization), with the largest amount of capital flowing to securities with the largest weight in an index. That has meant index investors were heavily exposed to a small group of securities in recent years. As of December 2021, the five largest US companies accounted for nearly 25% of the market capitalization of the S&P 500 and 37% of the Russell 2000 Growth—most of them long-duration growth stocks. This may have seemed like a good problem to have during the post-GFC bull market, when these companies were driving market appreciation and investor returns. The situation looked quite different, though, when the market turned in 2022.

Other benchmarks also overweight certain stocks or sectors. The MSCI World Index is heavily skewed toward US stocks in general and technology stocks in particular. Roughly 40% of the small-cap companies in the Russell 2000 Index were unprofitable by the end of 2022, as measured by negative 12-month trailing earnings per share (EPS), up from just 15% in 1995.³ Investors with passive benchmark exposure must own attractive and unattractive stocks. And in smaller, less efficient markets such as small cap and emerging market equities, tracking error can be high. That amounts to unintentional—and uncompensated—risk.

In passive bond benchmarks, issuer weights are often determined by market value of outstanding debt rather than fundamentals, and index inclusion does not include considerations such as bond liquidity or transaction costs. But this weighting schema also means that the benchmarks are tilted towards the sectors and companies with the most debt. In addition, they tend to be backward-looking: index composition is based on credit ratings that are revised after, rather than before, a change in fundamentals.

It’s also important to understand that passive investing isn’t as passive as one may think. Benchmarks are built by investment committees that make decisions based on a specific methodology. The S&P 500 is not the index of the biggest 500 companies in the United States. It comprises 500 companies that meet certain qualifications set by the committee. Consider that it took years for the S&P to add Tesla to the index because the company was unprofitable. During this time, it was among the top performing US stocks. Since being added in late 2020, Tesla stock has lost value.⁴

Dispersion

In an actively managed portfolio, a manager makes decisions about which securities to purchase and attempts to add value through fundamental analysis of those securities and, at times, buying those that she deems undervalued or short selling those that appear overvalued. This is important, because we believe that successful investing is heavily rooted in investor skill. Applying that skill requires opportunity, and opportunity grows when markets are volatile and returns varied. If we were writing a mathematical equation to express this interconnected relationship, it might be done like so: alpha = manager skill * dispersion.

In the last cycle, a wave of liquidity and a decline in borrowing costs boosted most asset prices, limiting performance dispersion. Over the last year, return dispersion across strategies and asset classes has increased sharply. The current pace of interest rate increases and broader financial tightening will eventually slow. But it is difficult to overstate how historically low interest rates and bond yields have been over past decades. We believe it is unlikely that they will retreat to those levels any time soon. Going forward, we expect conditions to become more micro-driven, focused on how companies adapt to the post-pandemic realities of higher inflation, higher rates and emerging secular trends, including deglobalization, decarbonization and demographics.

Instead, a market environment of increased idiosyncratic risk and a higher corresponding dispersion of returns seems likely to persist. The chart showing the High-Quality Spread Universe illustrates how this applies to high-quality fixed income spread sectors including investment grade corporate credit and AAA-rated securitized sectors. As illustrated by the bottom left corner of the chart, ample liquidity and record low interest rates in the last cycle lifted all assets with limited performance dispersion. For instance, corporate bonds in a given sector generally performed in line with each other despite differences in balance sheet positions. We expect that to change in a higher-for-longer rate and inflation environment, and that will provide opportunities to generate alpha through active security selection. An investor with detailed knowledge of a company’s ability to afford higher borrowing costs will be more valuable in today’s environment to add alpha—and avoid losses—than in the post-GFC era when low rates obscured the differences in corporate finances.

The possibility of greater intra-sector dispersion also suggests the potential for wider dispersion in specific company returns. This creates more opportunity for managers to generate alpha based on other key factors such as cost of capital and profitability. The end of the record low-rate, low-inflation era suggests that company-specific—or micro—factors may have greater influence on individual stock returns in the years ahead. The 2022 surge in interest rates may have delayed the onset of a more micro-driven market. But as investors adjusted to a higher-rate environment and resilient US economic data pointed to reduced recession risk, the share of S&P 500 stock returns explained by micro factors has increased, driven by high single-stock volatility and low stock correlation.⁵ We expect dispersion to increase in this environment, making security-specific factors more important.

21st Century Risks

Climate change and the transition to a low-carbon economy and other environmental, social and governance (ESG) factors are widely recognized as investment considerations. In our view, active managers are better equipped to analyze and verify corporate sustainability practices because they can directly engage with company management. Green bonds have made fixed income a particularly important source of financing for the technologies and policies that can help the shift to cleaner energy sources and other projects with the potential for positive environmental impact. An active manager who engages regularly with bond issuers to understand their sustainability strategies can more readily identify ESG leaders and laggards and develop a better sense of their commitment to ESG.

The Role of Private Assets

Private markets might best be characterized as the realm of “deep active.” Managers do not manage to a specific benchmark. Benchmarks reflect aggregate performance of managers, rather than something to track. But adding private market investments to an allocation that also includes public assets can provide greater diversification. Private ownership structures and deal terms typically give investors the ability to have more influence over company operations. These markets can also provide the opportunity to invest in assets that are best positioned to adapt to key long-term structural trends, including a partial pullback from globalization and a shift toward green energy. We see potential opportunities to capitalize on these and other trends in corporate and real assets and across the capital stack, from debt to equity.

Private investments require more patience than public ones, as well as the ability to sacrifice near-term liquidity for longer-term gains. But we believe they are also likely to offer higher excess return per unit of risk relative to beta-driven investment options.

Portfolio Construction: The Best of Both Worlds

A public-private mix may give investors—whether pension funds, insurance companies or individuals—a stronger chance of increasing alpha potential. The optimal mix of assets will vary from investor to investor. What may be appropriate for an endowment or insurance company may be different than what makes sense for an individual investor. The right place to land for some investors may be a combination of active and passive strategies. Such a hybrid asset allocation can allow investors to optimize their potential performance depending on variables such as risk tolerance, fear of underperforming and controlling costs. In an active-passive mix, investors may want to consider concentrating active exposure in the least efficient markets (e.g., emerging-market equities, which include a high concentration of state-owned enterprises, small-cap equities, emerging-market and high-yield credit, real assets) and taking a more passive approach in larger, more efficient markets such as large-cap equities.

Another option might be to concentrate the passive portion of an allocation in passive strategies rooted in a more rules-based methodology. For example, a rules-based fixed income strategy would seek to define a liquid investable universe, which is then refined by fundamentals and rebalanced periodically. We believe this can result in a smarter passive strategy with improved risk-adjusted return potential over a market cycle. On the active side, it’s important that investors consider where it makes the most sense to pay for alpha. For example, private market funds and hedge funds come with higher fees, but we believe they offer more potential to generate alpha.

However, in a world where economic conditions may change more rapidly than in decades gone by, investors should be ready to revise their approach to portfolio construction. Passive exposure, for example, might be concentrated in a “main” market portfolio that benefits during market upswings and helps to control costs, while active exposure might act as an adjustable hedge against risk. This could involve a public active portfolio that provides short-term, dynamic hedges and a private market portfolio that supplies a longer-term hedge against structural changes. Such a structure may make portfolios more resilient as conditions and risks change—something that we expect to happen more frequently in an era of elevated inflation, increased geopolitical risk and accelerated secular transitions.

For active managers, volatility and uncertainty can be an opportunity. We believe having the ability to take advantage of that in a diversified portfolio can make a significant difference to total return, particularly in a less predictable investing environment.

Important information

¹Investment Company Institute data. As of December 31, 2021.

²Factset, Goldman Sachs Global Investment Research, as of February 17, 2023. Past performance does not guarantee future results, which may vary.

³Goldman Sachs Global Investment Research. As of March 14, 2023

⁴Refinitiv. As of March 30, 2023

⁵Goldman Sachs Investment Research. As of January 10, 2023.

Glossary

Alpha is excess returns versus a benchmark index.

Beta refers to the tendency of a security’s returns to respond to swings in the markets.

Collateralized loan obligation (CLO) is a single security backed by multiple loans.

Correlation is a measure of the amount to which two investments vary relative to each other. Past correlations are not indicative of future correlations, which may vary.

Duration is a measure of the sensitivity of the price of a fixed income investment to a change in interest rates. The longer the duration the greater the sensitivity to changes in interest rates.

Earnings per share (EPS) is the portion of a company’s profit allocated to each outstanding share of common stock. Earnings per share serves as an indicator of a company’s profitability.

Greenwashing is the practice of making overstated or misleading claims about the environmental ambition of a project, asset, or activity.

Gross Domestic Product (GDP) is the value of finished goods and services produced within a country’s borders over one year.

Volatility is a measure for variation of price of a financial instrument over time.

MSCI World Index is a free-float weighted equity index that includes developed world markets and does not include emerging markets.

Russell 2000 Index measures the performance of the small-cap segment of the US equity universe. The Russell 2000 Index is a subset of the Russell 3000 Index representing approximately 10% of the total market capitalization of that index. It includes approximately 2000 of the smallest securities based on a combination of their market cap and current index membership.

Risk Considerations

All investing involves risk, including loss of principal.

High-yield, lower-rated securities involve greater price volatility and present greater credit risks than higher-rated fixed income securities.

Investments in fixed income securities are subject to the risks associated with debt securities generally, including credit, liquidity, interest rate, prepayment and extension risk. Bond prices fluctuate inversely to changes in interest rates. Therefore, a general rise in interest rates can result in the decline in the bond’s price. The value of securities with variable and floating interest rates are generally less sensitive to interest rate changes than securities with fixed interest rates. Variable and floating rate securities may decline in value if interest rates do not move as expected. Conversely, variable and floating rate securities will not generally rise in value if market interest rates decline. Credit risk is the risk that an issuer will default on payments of interest and principal. Credit risk is higher when investing in high yield bonds, also known as junk bonds. Prepayment risk is the risk that the issuer of a security may pay off principal more quickly than originally anticipated. Extension risk is the risk that the issuer of a security may pay off principal more slowly than originally anticipated. All fixed income investments may be worth less than their original cost upon redemption or maturity.

Private investors should also consider some of the potential risks of alternative investments:

Valuation risk. There is risk that the values used by alternative strategies to price investments may be different from those used by other investors to price the same investments.

Collateralized loan obligations (“CLOs”) involve many of the risks associated with debt securities, including interest rate risk, credit risk, default risk, and liquidity risk. The risks of an investment in a CLO also depend largely on the quality and type of the collateral and the class or “tranche” of the CLO. There is the possibility that the strategy may invest in CLOs that are subordinate to other classes. CLOs also can be difficult to value and may be highly leveraged (which could make them highly volatile). The use of CLOs may result in losses.

Environmental, Social and Governance (“ESG”) strategies may take risks or eliminate exposures found in other strategies or broad market benchmarks that may cause performance to diverge from the performance of these other strategies or market benchmarks. ESG strategies will be subject to the risks associated with their underlying investments’ asset classes. Further, the demand within certain markets or sectors that an ESG strategy targets may not develop as forecasted or may develop more slowly than anticipated.

The above are not an exhaustive list of potential risks. There may be additional risks that are not currently foreseen or considered.

Index Benchmarks

The indices referenced herein have been selected because they are well known, easily recognized by investors, and reflect those indices that the Investment Manager believes, in part based on industry practice, provide a suitable benchmark against which to evaluate the investment or broader market described herein. The exclusion of “failed” or closed hedge funds may mean that each index overstates the performance of hedge funds generally.

Conflicts of Interest

General Disclosures

Diversification does not protect an investor from market risk and does not ensure a profit.

THIS MATERIAL DOES NOT CONSTITUTE AN OFFER OR SOLICITATION IN ANY JURISDICTION WHERE OR TO ANY PERSON TO WHOM IT WOULD BE UNAUTHORIZED OR UNLAWFUL TO DO SO.

There is no guarantee that objectives will be met.

Any reference to a specific company or security does not constitute a recommendation to buy, sell, hold or directly invest in the company or its securities. Nothing in this document should be construed to constitute allocation advice or recommendations.

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Like many other US pension funds, West Virginia Investment Management Board’s (IMB) proxy vote has been a lightning rod for anti-ESG sentiment. The belief that IMB’s external managers, and the proxy advisory firms many of them use to guide them on board votes and shareholder resolutions, were using IMB’s vote to further climate and social goals that might be detrimental to the portfolio inflamed anti-ESG campaigners.

In a backlash to sustainable investment, visible in other Republican-led states across America, West Virginia has introduced legislation to prohibit its public pension fund from following shareholder advisers’ voting recommendations that consider ESG criteria.

But for all the talk that this will safeguard the $19 billion defined benefit public fund from a political ESG agenda that endangers the financial interest of beneficiaries, Craig Slaughter, CEO and CIO of West Virginia Investment Management Board, IMB, is worried.

He believes recent legislation introduced by West Virginia’s Republican administration to claw back direct control of IMB’s proxy vote marks the tip of an iceberg. Political interference in investment decision-making is back and threatens the fiduciary independence of the retirement plan.

Danger signs

Slaughter is better positioned than most to recognise the danger signs. He’s been at the helm of IMB for over three decades since he was recruited to right the ship after millions, including pension fund assets, went missing due to mismanagement in the Treasurer’s office in the late 1980s. He set about restoring IMB’s fiduciary independence, getting it out of the Treasurer’s office, and put in place structures to protect the pension fund from any perception that beneficiary savings were state money.

“Politics and investment don’t mix,” says Slaughter, speaking in an interview from IMB’s Charleston offices. “Our goal was to create a professional organization immune from changing political environments.”

“Politics and investment don’t mix,”

Under his watch IMB has occasionally faced pressure to invest in this, divest that, or use assets to achieve some policy or another. But conservative West Virginia always managed to shake off any influence from the left; politically influenced investment ideas never got much traction and a long spate of healthy returns (as of December 31, 2022, the 20-year return is 8.2 per cent) reflects the absence of political influence from the investment process. As Republican rhetoric grows more intrusive, Slaughter believes things are starting to change.

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 it, 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.

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

“The implication from discussions on the floor of both our legislative houses was that next year, this will be on the agenda,” he says. “We are a fossil fuel state and there have been bills in the past that have wanted us to overtly support fossil fuels. 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.”

Proxy process, external managers

IMB outsources all asset management to external managers, mostly trusted to use the pension fund’s proxy vote at shareholder meetings in a way that safeguards its fiduciary interests just as they are on every other investment decision.

“We may not have agreed with every single vote they cast, but we don’t believe they were being crazy with it,” says Slaughter who believes (with the benefit of hindsight) if he’d paid closer attention to this tiny corner of the portfolio he might have been able to pre-empt the crisis. “The idea is that the left, pro-ESG forces, have infiltrated the proxy voting process and are using it to further their vision of the world. To the extent they have, I have some sympathy for the anti-ESG crowd.”

From now until the legislation comes into force, Slaughter plans to dig into every proxy vote cast in West Virginia’s name, analysing the process and educating IMB’s trustees to make sure they understand the issues at stake in a burdensome process. On one hand, it may result in West Virginia continuing to use the bespoke proxy services of some of its external managers.

On the other, where IMB invests via a commingled pool structure, the pension fund may be required to use an alternative solution. This would include BlackRock, mandated by IMB to run its index fund and under particular scrutiny for promoting sustainable investment. It would be a change that may not be in the best interests of the fund.

“Although we may have to use an alternative platform for voting in BlackRock’s case, it may not be the best solution. I’m convinced BlackRock takes its proxy vote very seriously. They just may have the most robust proxy voting platform out there,” he reflects.

In another scenario, if the analysis reveals managers are not voting in West Virginia’s best fiduciary interest IMB may have to vote the proxies itself, developing its own policy in a new approach that will require a boosted internal team. This would most likely happen, he predicts, because these managers rely completely on the services of proxy advisors.

“These are the ones, I’m guessing, we’ll have most of the problem with.”

Trusting the trustees

One of the trustees’ key tasks will be developing an ability to analyse issues that appear to be pro-ESG for no good reason, but on digging a little deeper, reveal financial utility in the best interests of the pension fund.

One of the best examples of which, says Slaughter, appears to be activist investors forcing oil giant Exxon to take on three board members to bolster its alternative energy expertise. (See How CalSTRS took on Exxon.)

“Ever since that happened, Exxon has outperformed its peers. The logic behind the vote seems legitimate under any fiduciary standard. To say that this was not a responsible vote from a fiduciary standpoint doesn’t seem to hold water.”

But his confidence in IMB’s trustees’ to only look at the voting process through a fiduciary lens is clouded by political influence on the board that encapsulates the wider challenge ahead. Of IMB’s 13 trustees, Slaughter describes 10 as experienced businesspeople from the private sector, whose allegiance to the fund is enshrined in their own personal liability for any breach of fiduciary duty.

Three remaining trustees (the Treasurer, Auditor and Governor) serve by virtue of their office. Their primary allegiance, he says, is to the state and West Virginia’s taxpayers.

“Our beneficiaries are a different group of people from taxpayers. As a trustee of a pension plan your obligation is solely to your beneficiaries. These people are trying to wear two hats, and it’s difficult to do that successfully. Amazingly, it has not been an issue until this last legislative session when the Treasurer appeared to choose taxpayers over beneficiaries.”

managers cultivating greenwashing

Slaughter also believes some of IMB’s asset managers have also gotten out of their lane. He is just as critical of those in the asset management community that have rushed to sell products as sensitive to ESG, but which have led to greenwashing and inaccurate rhetoric.

“It’s absolutely true that some money managers talk a big game about ESG to cater to pro-ESG investors when in fact these managers aren’t really doing anything any different than what they ever did,” he says.

“Of course, we don’t want our asset managers to change what they are doing if they are genuinely good at it. But we don’t want them to imply that they are doing something they are not. Some factors that fall under ESG are relevant to successful investing, but most of them are not.”

In fact, he believes that ESG has incited such a political and cultural battle in some US states it would be better if the term was ditched altogether.

“I say to money managers, quit talking about ESG and just talk about the things that matter to your process. Don’t get over your skis, don’t try and be more than you are.”

It’s part of a growing call to tone down ESG language that he believes is starting to be heard. Asset managers are tweaking proxy voting policies, and he has noticed that at least one bank has modified its marketing material depending on the state they are working in.

“In red states, they don’t mention ESG,” he says.

It may be a sign of the ESG debate starting to cool, but after decades of experience, Slaughter is battening down for one of the most important battles in his career.

“Until now, I’ve always felt like I had it easy on the political front,” he concludes.

Investors are currently facing the end of uncertainty around assumptions they have made for decades, and need to shore up their portfolios with greater inflation protection, more active management, and by fostering innovation, according to chief strategist at the Investment Management Corporation of Ontario.

Investable themes that have pushed down inflation for decades are reversing, forcing investors to build more resilient portfolios that hitch a ride on new, emerging global trends, according Nick Chamie, senior managing director at the Investment Management Corporation of Ontario which manages $79 billion of assets.

Speaking with Top1000funds.com editor Amanda White on the Fiduciary Investors Series podcast, Chamie said long-term investment trends and themes began changing dramatically in 2020 and 2021, with a move away from the “Reagan Thatcher policy view where governments were engineering a move towards more competition, towards smaller governments, towards lower barriers to international trade, and an overall penchant for lower taxes.”

This has been in train since the early 1980s, coinciding with a long-term decline in inflation and interest rates, Chamie said. As IMCO’s senior managing director of total portfolio and capital markets and chief strategist, Chamie leads several top-of-the-house functions including investment research and economics, portfolio construction and strategic asset allocation, total portfolio management, fixed income and currency portfolio management and centralized trading. He was speaking about some of the trend’s driving the fund’s view and recorded in the recent document, IMCO’s World View.

“What we saw beginning in the late 2010s, and then deepening and accelerating as we came through Covid in 2020, was a true reversal in many of those trends.”

This has major implications for inflation, he said, with companies and governments replacing a focus on the lowest cost producers with a prioritisation of closer and more secure supply chains, strategic goods and critical resources, due to geopolitical and strategic objectives.

“This reprioritisation, we believe, is going to ensure that inflation doesn’t return durably back to the kinds of lows that we experienced in the last decade, where inflation was stubbornly stuck around 1 per cent,” Chamie said. “Instead, we see inflation being meaningfully elevated compared to that.”

In response, IMCO began to focus on income inequality as a driver for changes in policy and the focus of governments. Deglobalisation was also becoming more entrenched, ESG and climate change became more important, as was the trend of disruptive technologies, Chamie said.

IMCO has been looking for opportunities to build inflation protection, including increasing exposure to inflation-linked bonds, prioritising infrastructure assets which have some natural inflation linkage, and looking at equity sectors that correlate with inflation.

Cash, as an allocation, is also more important, Chamie said, having been “a four-letter word for decades [and] shunned as an asset class.”

“I think investors, and long term investors in particular, understand that one of the main implications of the new world is that liquidity has become a much more important element of portfolio management,” Chamie said.

Greater dispersion accompanying higher market volatility has improved the odds for active investment approaches, Chamie said.

“There really is a much broader universe of assets and markets within asset classes than there has been at any time in the past,” Chamie said. “Ensuring that you have the flexibility to be able to pivot and seek out the best opportunities with the best reward to risk trade-off is one of the important ways in which we’re implementing for this new regime.”

Having a “nimble and empowered culture” has been critical to enabling the team to respond efficiently to investment opportunities, he said.

In the midst of the great power rivalry between the US and China, “we need all the help we can get to carve out a future that works well for all of us” says Danny Quah, Dean and Li Ka Shing Professor in Economics at Lee Kuan Yew School of Public Policy at the National University of Singapore, in a talk examining the future of the global economy and the role of Asia. Listen here.

What is the Fiduciary Investors series?

Through conversations with academics and asset owners, the Fiduciary Investors Podcast Series is a forward looking examination of the changing dynamics in the global economy, how decision making should adjust for different market pressures and how investors are positioning their portfolios for resilience.

The much-loved events, the Fiduciary Investors Symposiums, act as an advocate for fiduciary capitalism and the power of asset owners to change the nature of the investment industry, including addressing principal/agent and fee problems, stabilising financial markets, and directing capital for the betterment of society and the environment.

Like the event series, the podcast series, tackles the challenges long-term investors face in an environment of disruption, and asks investors to think differently about how they make decisions and allocate capital.