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, Nick Chamie who spoke to Amanda White in the Fiduciary Investors Series podcast.

 

 

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.

Brunel Pension Partnership is making cost savings of £34 million ($41 million) per year, two years ahead of its initial target of saving £27.8 million a year by 2025. The partnership’s latest annual report and financial statements reveals that Brunel is saving almost four times the costs it incurs thanks to the management fees it is able to negotiate because of its responsible investment expertise.

“Two years ahead of schedule, Brunel is saving around four times the costs we incur via the management fees we negotiate.,” writes Denise Le Gal, Chair, in her Forward to the report.

Brunel says its success reflects two defining characteristics. The professionalism and efficiency of its approach to pooling and the negotiating power it gains from leadership in sustainability. More than 80 per cent of client AUM has been transferred into the pool.

While the specific targets on cost savings were set by Brunel Pension Partnership, the broader ambitions of pooling were defined by the UK government when it launched the pooling process. The UK’s 100-odd small local authority pension schemes grouped into eight bigger pools six years ago, tasked with creating economies of scale, cutting costs and broadening access alternative investments.

Infrastructure investment

“Private markets have been an important part of the cost-saving jigsaw,” continues le Gal. At Brunel, infrastructure is a core focus, and the partnership is in its third cycle of allocating to private market portfolios. Through these portfolios, it has targeted a range of infrastructure projects and currently has around £819 million invested in the asset class which has delivered £6 million in cost savings.

“We launched Cycle 3 of our private markets portfolios in 2022. Private markets offer us a particular opportunity to construct and direct the new economy, one that delivers both the Net Zero transition, and the Just Transition needed to make it happen,” says chief executive Laura Chappell.

Other 2022 highlights include co-launching a new series of Paris-aligned benchmarks with FTSE Russell. Brunel also added two new mandates to its Sustainable Equities portfolio.

Small is beautiful

Brunel has also launched a bespoke local impact portfolio for client fund Cornwall Pension Fund. The £115 million Cornwall Local Impact Portfolio (its smallest ever portfolio) is the first LGPS multi-asset portfolio to target local impact.

Brunel was able to negotiate mandates with two leading global managers – one for affordable housing, the other for renewables – and to harness the portfolio to target those priorities in a county where both poverty and climate change are significant challenges.

Brunel recently launched a Climate Stocktake and published a new Climate Change Policy.

“The twin challenges of transition finance and accelerating global change are enormous. By delivering on the goals set by our partnership, we will not just benefit our clients and their members. In the long-term, we will demonstrate to the wider industry to our belief that RI is indispensable to achieving healthy long-term returns,” concludes Chappell.

High inflation and low risk premiums are making it difficult for asset owners to meet their return targets, according to the investment heads of several major global funds who participated in the 2023 CIO Sentiment Survey.

The return target expectations were particularly testing for those whose mandates limit large allocations to illiquid assets, but the CIOs said that improved fixed income returns will bring some relief.

Commenting on the findings of the 2023 CIO Sentiment Survey, a collaborative effort between Top1000funds.com and Deloitte Consulting business CaseyQuirk, heads of three major funds in the Netherlands, Australia and the United States explained why funds were taking a wait-and-see approach despite historic market shifts, and why the resource crunch inside funds has become so acute.

The survey found most asset owners were planning ‘no change’ in allocation shifts as they waited for clearer market signals, despite drastic market changes not seen in a generation. It also found resources and time were stretched, with CIOs saying their internal teams were under-resourced and they faced personal time constraints.

In the Netherlands, PGB Pensioendiensten, with around €35 billion in assets, has a minimum target to meet the nominal return of its liabilities, explained chief executive Harold Clijsen (pictured), and its “ambition is to meet inflation.”
But this has become a major challenge with 5 per cent inflation expected for 2023, Clijsen said, especially with risk premia in major equity markets currently around 2.5 per cent.

“So mathematically it is hardly possible to meet required returns,” Clijsen said, noting higher risk premia can be found in the market but typically in illiquid investments.

Having a “risk-off posture” at a time when markets have a relatively low risk premia would leave funds behind the industry benchmark, and therefore be a risky move in itself, he said, leading most investors to try to balance a relatively low risk premia with a dynamic approach to gain some extra return.

“So looking forward, probably the best is to navigate between the chances of lower inflation and maybe lower rates in the long run, and having still some risk budget available should markets come down due to further inflation and interest rate spikes in the near future,” Clijsen said.

The abundance of CPI+ targets among Australian funds explains why some Australian CIOs are not confident in meeting their targets, said Andrew Lill, chief investment officer of A$67 billion Australian superannuation fund Rest.

“When inflation is high but asset class returns moderate, it provides a challenge,” he said.

As a result of the market backdrop, many were planning ‘no change’ in their asset allocations “because it is not clear at this stage whether taking more risk, or de-risking, is the right course of action as markets are currently very data driven,” Lill said, noting funds were remaining broadly diversified and agile in the meantime.

“A wait-and-see approach to seeing what the data tells you is potentially the right approach in this market,” Lill said.

Increasing investment costs did not help with the pressure funds are facing. While the CIO Survey data had significant dispersion among respondents about the trajectory of investment costs, in comparison to previous years there were fewer respondents managing to get costs down, and greater numbers seeing costs increase.

This was likely due to the widespread shift into private assets, according to Chris Ailman, chief investment officer at $306 billion fund CalSTRS in the United States.

“I’m still very focused on lowering costs and doing so more efficiently,” Ailman said. “I can’t explain that trend on why we would be seeing costs rise, other than the shift from public market securities into private market securities which are inherently more expensive.”

Fortunately, improved fixed income and cash returns would bring some relief, said Ailman.

While he did not foresee a “massive asset allocation change,” he noted the 80/20 portfolio had been creeping away from fixed income towards an 85/15 allocation, but it was now returning to its prior 80/20 setting.
“Fixed income was becoming a smaller and smaller part of everyone’s portfolio, but now that it will have 4-6 per cent return, people will be putting in more money,” Ailman said.

Under-resourced, short of time

The survey also found fund CIOs were feeling resource-constrained, and were looking to hire more staff, gain assistance from investment consultants, and gain efficiencies.

Under-staffed internal teams and a shortage of talent were selected as top concerns by 58 per cent of respondents, and there was a large jump compared to previous years in respondents noting ‘personal time constraints.’

Clijsen said this resource crunch inside funds was most likely a combination of additional work resulting largely from ESG regulatory requirements and ESG data issues, and resourcing not being at full capacity following the pandemic, against a backdrop of general labour shortages.

“Also, work-private split may have changed following Covid, [with] people feeling the need for more private time,” Clijsen said.

In Australia, asset owners have been tackling market uncertainty, greater internalisation and greater regulatory oversight while looking to build improved technology into their investment process, Lill said.

“The above has been happening during the pandemic, which in Australia has meant zero immigration of core skills, so the pressure on finding new skilled workforce has been acute,” Lill said. “Given the above, a lot of the pressure to change has been placed on leaders to deliver, and therein lies the time constraints challenge.”
Ailman noted a similar situation in the United States, noting “the pandemic experience made younger generations in particular think more about their career and lifestyles, and turnover has increased across the industry.”

But he also pointed to drastic changes to work habits driven by technology, notably how cell phones had “broken through the work/life boundary.”

“I have a pretty disciplined 8.00am to 5.00pm lifestyle but see staff doing work late at night, on weekends, I’m not asking them to do that but now that they’re at home, suddenly the…natural boundaries we used to have to help with work/life balance have disappeared,” Ailman said.

With the home now the office for many people, it will take “self-discipline and technology” to recognise the problems and return balance to peoples’ lives, he said.

With regards to flexible work arrangements, not a single respondent of the survey is running a fully remote operation anymore, with 40 per cent requiring their employees to be in the office 3-4 days a week and 35 per cent requiring 1-2 days. Most of the remainder have relatively flexible policies, with only 6 per cent requiring employees to be in the office 5 days a week.

 

As Silicon Valley Bank has just discovered – and UK pension funds were sharply reminded last year – every financial crisis is essentially a liquidity crisis. It’s why Peter Lindley, president and chief executive of $25 billion OPTrust, one of Canada’s largest defined benefit pension plans, puts liquidity management front and centre.

“Liquidity is everything and we are very liquidity aware and build it into our investment planning,” he says, speaking on the eve of OPTrust reporting a small net investment loss of -2.2 per cent in 2022 alongside being fully funded for the 14th consecutive year.

Moreover, liquidity is fundamental to resilience which, when assets suddenly correlate like in 2022, can be even more important than diversification.

“Resilience involves understanding all the risks in the portfolio, including liquidity. You can’t be resilient if you don’t have liquidity. Diversification is important, but even the most diversified portfolio can find unexpected correlations,” he says.

Pension funds need liquidity to pay benefits, invest in opportunities during market disruptions and on hand to meet capital calls. For pension funds that use leverage (borrowing to invest more using bonds as collateral) like OPTrust, liquidity is also needed to cover interest rate payments on borrowing as rates have cranked higher.

OPTrust’s so-called member-driven investment strategy (similar to LDI) incorporates liability hedging aswell as strategies using derivatives to mitigate downside risk in the return allocation and boost liquidity by making more underlying cash available.

Mark to market

Rising interest rates are not entirely a bad thing for a pension plan because they allow investors to re-price their risk-free rate to a higher level, notes Lindley. However, he explains, the challenge from rising rates comes from the fact hedging liabilities in a bond portfolio involves having a mark to market on assets – but not a mark to market offsetting that from a liquidity perspective on the liability side.

“We are very aware of this risk and make sure we have a high degree of liquidity, especially when central banks are raising interest rates. Risk management doesn’t just involve managing investment risk. The funded status of the plan is the most important consideration, and this involves looking at the assets and liabilities together.”

OPTrust typically hedges between 30-40 per cent of its liabilities. This was reduced by around half at the end of 2020 when the pension fund cut back its liability hedging portfolio with long-term Canadian federal and provincial government bonds because of historically low interest rates reducing the efficacy of the hedge.

“We found that with very low interest rates, the hedging benefits of holding bonds was reduced.”

As interest rates started to increase through 2022, OPTrust has began to increase the liability hedging portfolio once again.

It leads him to reflect that one reason for the crisis in the UK LDI market last autumn was the high hedge levels of many UK pension funds, some of which hedge 100 per cent of their liabilities. “My suspicion is that UK funds had grown over reliant on falling interest rates and low volatility in the bond market, and no one was expecting a spike in either.”

Liquidity is all the more important given so much of the portfolio (50 per cent) is tied up in illiquid markets. An essential source of the returns that helped keep the plan fully funded in a difficult year.

Returns from infrastructure (21.1 per cent) and real estate (15 per cent) did better than private equity (4.8 per cent) where the lower return reflected the challenges in public equity and the fact private equity doesn’t have much protection from the impact of inflation as other private markets.

“That said,” he qualifies, “in many cases we target companies for our portfolio that are able to implement pricing strategies which allow them to pass along some or all of the increased costs of doing business in an inflationary environment. Private equity has provided excellent long-term returns for our portfolio, which we expect to continue in the future, and we expect infrastructure and real estate to provide additional diversification benefits, along with attractive risk-adjusted returns, in an inflationary environment.”

Nor does he expect private assets to be overly impacted by higher borrowing costs and the ability to tap low cost funding.

“There is a higher bar to access funding from various sources including banks, and that changes the economics. It will impact illiquid asset classes to an extent, but it will also result in higher returns.”

Climate change resilience

Resilience is also central to Lindley’s approach to climate change and once again trumps diversification which he says “can’t help”  navigate the combination of short-term challenges and long term opportunities encapsulated in climate change that are coming down the track.

One way the pension plan is building resilience is via a novel in-house team structure whereby the sustainability team are also able to invest, either directly or via third party managers.

Their dual mandate comprises assisting and providing insight to the investment teams by providing systemic analysis and expertise on an assets physical and transition risk, for example. On top of this they are also mandated to invest themselves which brings them much closer to the challenges on the ground.

“It gives them more credibility with colleagues because they are an investor, not just an advisor, and it is more engaging for them,” he says.

Other corners of OPTrust’s portfolio are also eye catching. Like a small allocation to digital assets with third party managers in an approach that aims to align interests and double due diligence in the unregulated, risky market.

The allocation particularly seeks opportunities adjacent to the digital world like custody and underlying technology and is tasked primarily with informing and educating the team as they begin to invest in another transition.

Making a portfolio more resilient to climate change, and playing a role in decarbonising the real economy, requires a range of creative solutions to complex problems, along with a good measure of determination, said a panel of leaders driving ESG efforts at GIC, New Zealand Super and APG.

The journey to date has involved laborious translation of scientific analysis into investable insights, cross-checking climate and market models to gain more confidence in imperfect data, investing in solutions-providers at an earlier stage than a large fund would otherwise invest in a new company, and proverbially wringing a few necks, they said, in a panel discussion at Conexus Financial’s Fiduciary Investors Symposium held in Singapore.

Speaking with Amanda White, director of international at Conexus Financial, the panel members were Rachel Teo, head of total portfolio sustainable investing in the economics and investment strategy department and head of sustainability at Singaporean sovereign wealth fund GIC; Yoo-Kyung Park, head of responsible investment & governance Asia Pacific at Dutch pension giant APG, and Anne-Maree O’Connor, head of sustainable investments at pension fund New Zealand Super.

Measuring exposures using available data has been an ongoing challenge, said Teo, but the data has been improving.

Scenario analysis before the arrival of the NGFS Climate Scenarios framework involved going through materials provided by the Intergovernmental Panel on Climate Change and translating scientific analysis into investor insights such as the impact on the macro economy and asset returns, with the help of consultants.

Around 2018, models were new in their development and the team did not know which model to use, so they picked several and triangulated their information. “We had to cross check the work we did with one model with other models to give us some confidence that the impact is either material or in a certain direction,” Teo said.

Looking at how asset class returns were affected in different climate scenarios, “the ranking of broad asset classes didn’t change in the scenarios,” Teo said, “so it suggests for strategic asset allocation, if you’re allocating across broad asset classes, climate change drivers shouldn’t affect that strategic asset allocation.”

But when allocating at a more granular level such as to industries and countries, “there are big winners and big losers within asset classes, and that could affect how you might want to allocate,” Teo said.

For example in the Divergent Net Zero scenario by NGFS, 12% of the equities listed by MSCI will experience an earnings impairment of more than 50% due to extreme carbon pricing, Teo said. Findings like this were what the fund then brought to its investing teams, establishing sustainability and climate chance as material, with an impact on earnings.

Climate change impacts GIC’s portfolio in various ways that are relatively easy to articulate, Teo said. There is a transition risk from related policies, technological progress in clean tech, physical risks from both chronic global warming and also acute risks from extreme weather events.

“Those affect cash flows, affect our investments, disrupt businesses,” Teo said.

A third insight through the fund’s research was market risk related to climate change, based on the belief markets were not adequately pricing in the risks.

“So we have to consider and know when will markets price in climate change related risks, and will it be done smoothly or disruptively,” Teo said. “It will be smooth if you know policymakers are telecasting their intentions ahead of time. But if there are sudden changes…the potential for disruptive pricing could be pretty high, and will there be an over-reaction in markets?”

Large investors like GIC typically invest in the growth stage where companies need large amounts of capital to scale, but when it comes to investments in solutions that decarbonise the real economy, GIC is “willing to now maybe invest a bit earlier in the life cycle of the company,” Teo said, owing to the urgency of decarbonisation.

“We’re really going out looking for companies that have promising technologies with viable business models, and they are small but we’re willing to go in and support them,” Teo said.
“But this means that in GIC we need to have the deep technology core capabilities to assess the technology and the commercialisation rates, and we need also to be able to cover broad sectors and markets.”

Park said there are three components to APG’s efforts to decarbonise its entire portfolio, each with their own set of challenges that often involve tactfully applying pressure to related stakeholders. The fund needs to measure its carbon footprint, which is easier said than done when it involves companies or managers reporting to the fund, sometimes you have to apply pressure and even then it sometimes takes them years.

The next step is to set targets and steer the whole portfolio towards net zero by 2050. “By 2030 we have to already be halfway,” Park said. Attending and influencing shareholder meetings can be challenging, because “In Asia, most of the CEOs, they do not know the carbon [emission] number. If they don’t know the carbon number, how do they cut?” These are the people who “sign the cheques,” she said.

“We try to steer our portfolio, but at the same time, the companies that we invest in, they need to steer themselves and we need to help them by squeezing their neck a little,” she said.

The third part of the strategy is investing in solutions, and helping companies reach their potential in this area, Park said.

New Zealand Super made its first big move in managing climate risk in 2016. The fund set “quite a small carbon intensity target [and was] quite comfortable with making that move because we saw climate risk as unrewarded,” O’Connor said. “So part of our mandate is to maximise returns without undue risk.”

The fund gradually became more aggressive with its carbon targets including significant reduction to fossil fuel reserves, and found it was able to achieve market-tracking and diversification with its passive equities, while reducing its carbon footprint and carbon exposure.

The fund also launched a project called RI Compass where “the board said, imagine it’s 2030, what does our social license to operate look like there? And then look back to now and think about what should you be doing now, what should we be looking at now?”

This project was a more broadly-focussed work on improving the ESG profile of the portfolio, with the fund ultimately choosing an off-the-shelf MSCI Paris-aligned index with around 3500 stocks in the portfolio.

“So that was one big leap forward In terms of improving the ESG profile of our portfolio, retaining that lower risk through having a lower carbon footprint,” O’Connor said. “It doesn’t mean that we don’t still engage on climate change, because there’s still plenty of companies in the portfolio and our next focus, our current focus, is on whether our multi-factor portfolio managers can improve their ESG profile as well.”

Investment returns have long been somewhat disconnected with the social returns of ESG-related and impact investments, leading to confusion around different targets and how to integrate them into an investment framework, according to a leading expert in sustainable and green finance.

Speaking at Conexus Financial’s Fiduciary Investors Symposium, Associate Professor of Finance Weina Zhang, Academic Director of MSc in Sustainable and Green Finance Programme and the Deputy Director of Sustainable and Green Finance Institute (SGFIN) at the National University of Singapore, ran through a case study demonstrating how investors can better allocate their capital by explicitly incorporating impact preference and returns into portfolio theory.

Zhang chose the WaterCredit Investment Fund 3 (WCIF3) as a “testing ground” for her team’s theories, after a high-net-worth colleague received an invitation to invest in the fund launched by WaterEquity whose founders are Gary White and Matt Damon. WCIF3 aims to provide clean water solutions to four developing countries including India, Indonesia, Cambodia and the Philippines.

The blended finance initiative involves equity sourcing and debt sourcing. Investors give money to WaterEquity as a fund manager, and then the manager disperses this to micro-finance institutions and water credit enterprises, who will lend to provide clean water solutions. The initiative has also received loans from entities including the Bank of America and the IKEA Foundation, she said.

Her team looked at three types of investors interested in putting money into these kinds of funds: foundations, financial institutions and high-net-worth individuals. The team assigned financial institutions as having the lowest risk aversion, and high net worth individuals having the highest, with foundations in the middle. 

The team also used a parameter called “impact preference,” which looks at how much the investor cares about the social and environmental returns of the investment. The team assumed foundations are the most interested in the impact, caring 70% about the impact and 30% about the traditional financial returns. Financial institutions would be in the middle, and high net worth individuals would care the least about impact. 

“Don’t blame us for the exact numbers, and if you disagree it’s okay, because the numbers are basically for us to understand how the math works out,” Zhang said.

In assessing the expected outcomes of the investment, there were some challenges because WCIF 3 fund only described what it was going to do with the money–distribute it to 25 MFIs–without providing the names. Investors would need to know about the expected social or environmental outcomes of the project and the associated risk before they make the decision to invest, such as how many people it aims to be given access to clean water, Zhang said.

The team resolved this problem by accessing a microfinance institution database to calculate social outcomes and the associated social risk based on how much money was lent to the poorest among the population, and how many were female borrowers.

“Because in the microfinance literature, reaching to the poor and woman empowerment are two important social outcome indicators,” Zhang said.

A few months later, WCIF3 did in fact publicly report these two numbers together with other social and environmental outcome, but this was “realized outcome,” Zhang said, “because investors actually need these numbers ex-ante when they are making the rational investment decision.”

Incorporating social risk into the parameters involves more sophisticated mathematics, she said, but is crucial as risk aversion applies both to the financial returns and the expected social returns of the project, Zhang said.

This would lead ultimately to the highest allocation coming from financial institutions because they are more comfortable with risk, “and there’s a lot of social risk with this kind of micro-finance institutions investments where many difficult things can happen on the ground during the actual implementation,” Zhang said.

The team then calculated the utility, or level of satisfaction, from the different types of investors, finding financial institutions had a level of satisfaction 57% higher than if the capital was allocated to comparable financial investments alone. 

“So this is how you can convince your traditional investors to move into a new paradigm because you can show them that they actually would be happier about this type of investment and you have a very quantitative model to parameterise all these things,” Zhang said.