The $298 billion California State Teachers’ Retirement System (CalSTRS) has struggled to find meaningful investment opportunities to protect its portfolio against inflation, highlighting one of the key challenges funds potentially face as they grow, according to the fund’s chief investment officer Chris Ailman.

Speaking via video link at the Investment Magazine Fiduciary Investors Symposium in Melbourne, Australia, earlier this month, Ailman said funds can reach a point where it becomes increasingly difficult, if not impossible, to make significant portfolio allocations to some asset classes.

“Scale and size helps in some cases; in other cases, it’s a deterrent,” Ailman said.

“And I think, like CalPERS figured out, you’ve really got to pick your battles and figure out where it is a meaningful place to invest, that’s going to do something for your portfolio,” he says of his Californian peer across the river in Sacramento.

“We’ve all realised you can’t just throw money at an idea and invest in, you know, a giant portfolio where you end up with an index return; you’ve got to be very strategic and intentional about what you’re doing in your portfolio.”

Ailman said CalSTRS has about 6 per cent of its assets invested in inflation-sensitive investments – mostly in infrastructure, but also including timber and agriculture – which was not enough to protect its total portfolio against rising inflation.

“For these unique periods, where inflation suddenly rises rapidly, at least it buffers part of the portfolio,” he said.

“But, you know, the benchmark for it is inflation. And that’s very difficult to beat in this environment.”

Ailman said the adage of “go big or go home, I think honestly you have to look at that”.

He told the forum that on the flipside, scale gives CalSTRS the luxury of being able to innovate and test new investment ideas. While they do not always uncover investable opportunities, again because of the fund’s scale, at other times they help the fund pinpoint areas to avoid.

“I realised many years ago, prior to ’08, actually, that innovation was part of my duty statement,” Ailman said.

“But we just didn’t have the time. Everybody was so busy managing the portfolio and doing what we’re doing. We’d studied some of the new ideas that Wall Street would be sending our way, but we really didn’t have a research team who could just spend time test driving ideas, because at our size, ideas had to be able to be scaled.”

Ailman said that as a government entity CalSTRS is required to have struct rules around on contracts and structures.

“And so I, I literally joke with the board, I need a team who can test ‘as-shown-on-TV’ [ideas] – does it really work in our life, in our structure, at our size, and does it live up to its claim?” he said.

“They actually presented to the board wearing lab coats and safety goggles. But the point was, they’ve tested everything from global macro to microfinance, and literally everything in between. I think some of their best work has actually been in areas we chose not to invest in and avoided some pitfalls.”

“That’s given us a chance to test drive a number of things, a good example would be risk parity. We test drove that for, goodness, almost six years, longer than we wanted to, thinking it would work but thankfully – knock on wood – just a year ago, in the summer here in the US, we got rid of it, because that’s just done horribly, unfortunately, here as interest rates went up and bonds and stocks both went down.”

Ailman said the benefit of scale is that it allows a fund to develop some capabilities that smaller funds can’t.

“There are some pluses and some minuses of being big,” he said.

“So, certainly take advantage of economies of scale, you can by passive beta, or run it yourself, for next to nothing. You can achieve economies of scale when it comes to the size of accounts and pressure on fees. But then on some other areas, when you’re as big as we are, there are areas where you simply can’t invest, you can’t be nimble. You can invest in areas where they won’t move the needle, and it drives the cost up. And I think diversification, we know it’s the number one benefit to spread risk, but there’s a point of diversification that I really began to wonder if we’ve all gone too far, and just simply owning you know, too many securities.

“When you when you step back, and you look at your US equity portfolio, and you realize you own all 3000 traded stocks, or you look at your non US portfolio and are in 44 countries, very small exposure in some of those when I scratch my head and wonder, is that really worth it, because it brings on ESG risk and all kinds of challenges and costs.”

The Principles for Responsible Investment (PRI) is reviewing its strategy, program of work and operating model to better serve its more than 5,000 signatories.

“There’s a lot of risks in the world, signatories are under a lot of pressure and how do we support signatories become better at what they do now,” chief executive David Atkin said in an interview.

“The PRI is now at a point where it needs to go to its next level of maturity, we’ve got to be able to industrialise the way we set the place up.”

A refresh

The agency has embarked on a consultation to refresh its mission statement, program of work and operating mode. “We have a mission statement that the board was worried wasn’t fit for purpose of the next phase of the PRI’s work,” he says.

Atkin and his team have been travelling around the world to conduct workshops with signatories to explore ideas around different pathways and seeking views around six themes around accountability, the PRI’s policy work and the diversity of signatories and their different needs. A report will be tabled to board of directors in February with recommendations.

“What we’re learning is that context matters. That the environment that you’re operating in, the geography, the regulatory environment, your customer base or your beneficiaries you’re serving, all will shape the way you approach ESG and so to believe that there’s one way is flawed.”

One of the ideas being considered is adopting a menu of pathways around net zero, sustainability, stewardship or asset class.

“You choose the pathway and then we would provide you with the tools, the networks, the convening groups, where you would share your experience, and then we would use the reporting and assessment to report back to you on your progression of the pathway you select,” he says.

“We will have all this rich data to work out what is the right strategy, program of work and the right target operating model to support the strategy.”

Established in 2006, the PRI has now grown to over 5,000 signatories, representing more than $120 trillion of the world’s assets under management.

“Part of being a member of the PRI is joining the mission to improve your own practices, but also to work collaboratively to create enough momentum influence to change the settings so that it’s rewarding,” says Atkin who has been in the CEO role for almost a year.

“My role as the CEO of the PRI is to ensure that we plot out a strategy that makes sense to signatories for the next phase of responsible investment,” he says.

One of the agency’s key roles is to help signatories manage the growing burden of regulation on the sustainability reporting. “We’re seeing this regulation just accelerate. There is a very important role to play for the PRI to try and harmonise that regulation to bring a practitioners’ view,” he says.

The steady increase in investors allocating more to private assets comes at the same time as a new period of heightened macro uncertainty including supply-driven inflation, less-credible central bank policy, rising real rates and slowing productivity growth.

Navigating these two challenges could require a fundamental evolution of the asset-allocation process, argue Grace Qiu Tiantian and Ding Li from Singapore’s GIC in a paper written with MSCI’s Peter Shepard entitled Building Balanced Portfolios for the Long Run.

Long term investors seeking to construct portfolios resilient to macro uncertainties should focus less on backward-looking, short-term risks, argue the authors in their latest paper, building on previous research into portfolio construction.

Instead, they should focus on understanding the long-horizon investment landscape, including the benevolent effects of mean reversion, a broader opportunity set of private assets, and the risks posed by potential regime shifts in the macro environment.

“This framework could provide long-term investors such as GIC with a consistent and long-horizon view spanning all asset classes, support with strategic portfolio positioning, and offer a practical tool to build greater macro resilience into portfolios,” say Qiu and Li, both senior vice presidents, total portfolio policy and allocation, economics and investment strategy at GIC, Singapore’s sovereign wealth fund with an estimated $799 billion assets under management. GIC doesn’t disclose its AUM.

Potential scenarios

Qiu, Li, and Shepard map five potential macro scenarios for the decades ahead focused on shocks impacting demand, supply, trend growth, central-bank policy, and long-term real rates. Their research then applies asset cash flows and discount rates to these underlying macroeconomic drivers. Next, they integrate macro risk into an allocation framework spanning public and private assets.

By putting public and private assets on the same footing, long-term risk and return may be systematically managed across the total portfolio. The underlying macroeconomic drivers provide a common lens to view all assets consistently and intuitively, allowing comparisons and trade-offs across public and private markets.

The multi-horizon nature of the framework also enables decision-making over different time horizons, potentially facilitating strategic and tactical positioning. The long-horizon view also allows asset-allocation decisions to more closely align with investors’ mandates to meet liabilities and preserve wealth over the long run.

Case study

Qiu, Li, (pictured) and Shepard construct a hypothetical macro-resilient portfolio, able to withstand long-term macro risks while maintaining the same level of expected returns as a portfolio optimised to a shorter horizon. The macro-resilient portfolio has less exposure to nominal bonds and more to real assets and the equity risk premium.

The authors also generate a macro-resilient efficient frontier, demonstrating how asset allocations may vary according to the level of tolerance for long-term macro risks. The new frontier lies above the expanded mean-variance frontier, suggesting that by accepting more short-term volatility, long term investors can align with their long-term objectives.

The expanded mean-variance portfolio substitutes public equity for equity-like private assets (private equity and equity-like infrastructure). Government bonds continue to play the role of portfolio diversifier, even though a portion of bonds are replaced by real estate.

For the same level of volatility as in a 60-40 portfolio, the expanded mean-variance portfolio has a much higher expected return (4.8 per cent annual real return versus 3.1 per cent for the 60-40), predominantly driven by the assumed private-asset returns. But it is still largely a barbell portfolio, loading up high-risk, high return asset classes and using bond-like assets to balance the risk profile.

The macro resilient allocation is constructed to have the same expected return as the expanded mean-variance portfolio while minimising long-term macro risk rather than volatility. In this example, the authors measure long-term macro risk as the real-return impact at the 10-year horizon, averaged over the five key macro scenarios.

Investors can choose a different time horizon to align with their mandate or assign different weightings among the macro scenarios to reflect a view of their likelihood and importance.

Private assets are not uncorrelated over a long horizon, but their spectrum of exposures to macro risks may enable them to be used to help manage long-term risks across the total portfolio. In addition, while equity is highly volatile over a short horizon, the authors find that volatility driven by fluctuating equity risk premia may be much milder for the long-term investor.

Good beta bad beta

Long-term investors stand to benefit by allocating more to the return opportunities that are typically riskier for short-horizon investors. For example, market dynamics like discount-rate shocks and mean reversion tend to benefit long-term investors.

Higher discount rates typically lead to lower asset prices in the near term – but also lead to higher expected returns. A long-term investor benefits by harvesting the higher returns and can eventually come out better off in the long run, they explain. Discount-rate risk therefore tends to be much more benign to a long-horizon investor and is an example of the concept of “good beta/bad beta.”

However, long-term investors are more exposed to other types of risk. They are vulnerable to the risk of a persistent economic slowdown or a trend growth shock. This may have only small, short-horizon effects but can build up gradually to significantly impact the long-horizon investor.

Secular change and regime shifts are also risks for long-term investors. Today, potential regime shifts include the effects of deglobalisation and the decarbonisation of the economy which require a fundamentally forward-looking asset-allocation process. Elsewhere, many investors are considering the possibility that new levels of high inflation could persist and worsen into stagflation, they conclude.

The world is changing so rapidly, traditional five-year investment plans are increasingly difficult to implement. Asset owners, head-down and concentrating on just the next five-years, risk “opening the curtains” to find the world around them has moved on much faster than they realised, said Geraldine Leegwater, CIO, PGGM speaking at FIS in Maastricht.

Leegwater, who took the helm in 2020, cited new European ESG legislation as an example of the fast-changing investment landscape. Elsewhere, NGOs are putting more pressure on investors and pension fund participants are demanding action. “You cannot work with a five-year plan because the world is changing. There needs to be a better solution,” she said.

Leegwater urged delegates to come up with a vision that extends into the future. “Let’s go to 2030 and look at what the world will be like and what this means for pension funds and goals in the investment portfolio,” she said, adding that five-year plans accentuate the gap between the financial world and the real world.

PGGM’s current five-year plan dates from 2019. It is focused on sustainability and ESG integration, including an allocation to SDG compliant investments. Strategy at PPGM, founded in 2007 as the asset manager for the healthcare scheme PFZW, is shaped around a large allocation to long dated fixed income. Risk assets comprise real estate and listed and non-listed equities in a long-term strategy that avoids tactical allocations and is increasingly focused on providing inflation protection, she said.

Knowing what you own

Sustainable investment involves many active decisions – even if investors are tracking a benchmark ESG integration involves taking out pieces of that investment universe.  Given the scale of the transition ahead and the implications for risk premiums, investors will increasingly move from traditional benchmarks to “knowing what they own.” This more active approach around portfolio construction will also be driven by the need to invest for impact, she said.

Insight and knowledge of the assets held in a portfolio requires data, also key to measuring impact. It is challenging building portfolios with return targets and impact targets, demanding correlation analysis, a strategic asset allocation and a robust framework amongst other things, she said.

Mapping and measuring a portfolio for impact is also easier in some asset classes. For example, investment in infrastructure is easier to measure. While in real estate, it’s possible to measure net zero improvements in properties but these are often only a small part of the portfolio. Measuring impact in listed, passively managed mandates is more challenging. “We have thousands of holdings and measuring what you have in there and all the types of SDG indicators is very difficult.”

She said investing for impact still comes with more questions than answers – and not everything can be measured. Digging into SDG themes is complicated: a euro invested in emerging markets has more of an impact that the equivalent investment in developed markets. Yet governance unknows complicate emerging market investment. It involves investors questioning themselves when they can’t realise impact goals – and realising “you can’t do everything.” Affordable housing for healthcare workers is a good place to start, she said.

Cultural change

PGGM is characterised by a long stakeholder chain comprising participants, advisors, board members and executive officers amongst others, complicating the ability of the asset manager to integrate real world issues and change allocations. However, shortening the chain is also difficult, especially given PGGM’s responsibilities to its beneficiaries and the importance of beneficiary participation. For example, PGGM’s  seven SDG goals are based on the issues its participants care most about.

PGGM’s strong culture has been shaped by these multiple layers, ensuring issues are thoroughly debated and analysed. Now Leegwater’s priority is to try and foster a culture that also contributes to a bigger goal and avoids silos. She espoused the importance of looking at people’s potential rather than at what they have done in the past, and said PPGM, with one main client, was able to do something different to a typical commercial asset manager.

One way to achieve this kind of change is via incentives aligned to team goals. “It is about finding people around you with the same language and drive,” she said.

Leegwater concluded that it will be difficult to fulfil PGGM’s impact goals and the Netherland’s new pension contract if the asset manager continues to stick to the way it has worked in the past. “Sometimes you need to change the tools to achieve your goals,” she said.

 

 

 

At the height of the GFC, CalPERS was forced to sell assets it didn’t want to sell at the worst possible time. “What was actually liquid, was the high-quality stuff,” recalled Dan Bienvenue, deputy CIO at CalPERS who joined the fund back in 2004, speaking in a recent board meeting.

The Californian pension fund found itself overweight assets it no longer wanted to hold but finding a bidder was like staring into an abyss. In short, the GFC exposed a profound liquidity crisis, revealing that the giant fund had lost control of its own funding levels with a large securities lending book lent out for cash, liquidity spread throughout asset classes, and poor visibility on what capital calls lay around the corner.

Lessons learnt during those traumatic months rewrote CalPERS approach to liquidity, fed into the decision to add a 5 per cent strategic allocation to leverage and instilled a determination to be able to lean into opportunities in a down market.

Years in the making, these changes are now crystallised in the fund’s latest strategic asset allocation, in execution since July this year. “I can think of few things that are more important than we are prepared to be a buyer as opposed to having to be a seller when the market turns,” said board member Lisa Middleton.

Strategy in Action

Today, the $429 billion pension fund has dry powder on hand to invest, recently witnessed in an ability to buy into opportunities during the pandemic-induced sell off. Unfunded commitments sit ready in dry powder for partners. Dry powder also sits in separately managed accounts, at the ready to deploy alongside handpicked strategic partners in co-investment vehicles. Unlike in the past, all capital calls are in line with assumptions and models, and come at the right pace.

CalPERS sources of liquidity are deliberately diverse. Alongside dry powder stores or the ability to tap pension contributions as a source of liquidity, the fund can seize the opportunity to invest in distressed assets by selling equities, using that cash to purchase the asset while using an equity future to maintain the equity exposure. It amounts to liquidity on demand from the fund’s huge pool of liquid public market assets that are both saleable and desirable. A centralised approach also allows the fund to choose which funding sources best optimises the cost and composition for the portfolio at the time.

Today CalPERS has shrunk its securities lending book, and collateral calls are based on equity for equity the means collateral levels don’t change but move at the same pace as the market, Bienvenue said.

CalPERS regularly reports on its liquidity and leverage position – liquidity levels have been lower in recent months and could fall further on another leg down in markets. But a central pillar to the strategy and mark of its success lies in the fact the investment team doesn’t need to continually focus on liquidity because the pacing and framework is set in place. “We can focus on investment,” CalPERS’ investment director Michael Krimm, told the board.

Today, liquidity provisioning takes into account capital calls and margin for derivatives all with an eye on market movements and volatility based on internal forecasting models. Managing liquidity involves participation from across the fund, forecasting rebalancing needs, planning for capital calls and identifying market trends in a robust process.

The board heard how deep dive analysis over the years involved an exploration of the liquidity inherent in CalPERS assets, exploring the ease with which an asset can be traded and the income it generates. Findings revealed cash, government bonds and equities have the highest level of liquidity and are easily sold to meet funding needs. In contrast private equity and private debt have higher returns, but less opportunity to generate cash on demand.

Private markets

Alongside a new strategic allocation to leverage, CalPERS latest asset allocation promises a boosted allocation to private markets spanning private equity, real assets and private debt. November’s board meeting saw the investment team petition again for fresh tools and flexibility in managing the allocation – namely an increase to staff delegation limits.

“We need more tools and a refresh of policies put in place when the fund had a lower allocation to private assets,” urged CIO Nicole Musicco,  determined to build an agile investment philosophy that goes beyond simply setting a SAA and pressing the button. Set every four years using capital market assumptions stretching 20 years into the future, assumptions must also be reviewed along the way, working with partners and checking the governance, she said.

Although hard to accurately account the opportunity cost for not allocating more to private assets because of staff delegation limits (knowing CalPERS would be unlikely to invest, GPs don’t tend to come forward with opportunities) the investment team warned the cost had been high. For example, every $1 billion invested in co-investment earns around $335 million more over ten years than the same $1 billion invested in fund investments.

Higher delegation limits mean the team can accept the larger deal sizes needed to ramp up private equity exposure as CalPERS targest an annual commitment pacing of over $15 billion to achieve a target allocation of 13 per cent. The private equity team will have to look at as many as 50 deals per year to get close to annual coinvest commitment targets, making the ability to accept larger co-investment deals critical while reducing the monitoring burden of smaller deals.

As for private equity fund investment, CalPERS expects that 70 per cent of commitments will exceed the investment team’s current delegated authority limits. The team expects to commit to around 20 funds this year leading to over 70 core managers over time.

The team made 116 fund commitments in the last 5 years about half of which have exceeded the delegated authority. Two recent investments exceeded the CIOs authority and were scaled down. “It’s difficult to achieve scale with lower delegated authority limits and detracts from our ability to reach our SAA,” said Musicco.

It’s the same problem in infrastructure where investment needs to more than double in size over the next three years to meet SAA targets.  The team needs to commit $5 billion per year to infrastructure with an average commitment size of $1.25 billion per deal. The infrastructure team have made around 19 commitments in the last five years and 32 per cent were above the delegated authority and were approved by the CIO. Two deals exceeded the CIOs authority, and were scaled down to meet the CIO’s delegation limit.

Decision making culture

In the last investment committee meeting of 2022, Musicco explained that a crucial element to building CalPERS private market expertise includes revamping the Investment Underwriting Committee. The committee, one of three CIO-chaired committees and tasked with reviewing all private market allocations above a certain size, is now structured to draw on expertise from all corners of the investment team in a collaborative process.

“I chair it, but the real secret sauce is the asset class heads and other experts providing a diverse lens,” said Musicco. “You have better decisions when you have the right eyeballs round the table,” she said, concluding that a collaborative approach allows the team to  “learn a ton from each other.”

The German economy will feel the impact of the energy crisis more than other European countries, and energy dependent industries will increasingly explore moving production to the US and Canada where energy is cheaper, said Jeroen van der Veer, Chair, Phillips and former chief executive, Royal Dutch Shell speaking at FIS Maastricht.

van der Veer, who warned that stalemate between Russia and Ukraine means Europe’s energy crisis will endure for some time yet, said Germany’s particular crisis lies in previous Chancellor Merkel allowing the economy to develop a 40 per cent dependency on Russian gas. A trajectory mirrored to a lesser extent in countries including Italy, Belgium, and the Netherlands. Europe is now sourcing from Norway and Algeria, and extra LNG from the US. However, suppliers in the Middle East are unable to divert much production to Europe because they have long-term contracts with China and South Korea, he said.

High gas prices in Europe are linked to the unique characteristics of the industry, explained van der Veer. Oil is globally available, but gas is semi-regional evident in European gas prices trading much higher than in the US. It is possible to export LNG, but this is costly and requires infrastructure. “It is not a market with the same flexibility as oil,” he said.

Europe’s energy market is also distinct from the US and Asia, he continued. US energy demand is in synch with supply while Asia, a huge net importer, taps diverse supply from Australia, Indonesia and Russia, amongst others. “Asia has many alternatives if one source falls away,” said van der Veer. Europe is not only a significant importer of energy – the region has also carved ambitious net zero 2050 climate targets. “Europe is in a different situation to the rest of the world,” he said.

Refill storage

Come 2023, Europe’s key focus will be on refilling storage capacity, but this will be difficult without using Russian gas. “Europe has enough gas this winter, but next year could be more challenging,” he said.

Governments will face difficult decisions around slowing their economies, or switching to diesel or coal, he said. Strategies for Europe’s large energy users include raising prices while industries like fertilizer and steel are exploring mothballing European production and increasing production in other areas of the world. However, not all industries – for example cement producers – can do this.

Germany will struggle to drive economic growth in Europe. German companies pondering relocating production to countries like Canada and the US, risks the de-industrialisation of Europe and the loss of manufacturing jobs. This will accelerate Germany’s transition, but is challenging for social solidarity and job creation, things that have built German economic success.

But moving production may not pay off for Europe’s energy intensive industries, he warned. Building new plants involves huge investment, paid back over the long-term, but high energy prices might not last that long. “I think I would wait a bit,” he cautioned. And he argued that although moving heavy industrial production elsewhere will reduce Europe’s carbon footprint, CO2 is harmful to the planet wherever it is produced. “Short term, there are big problems for the chemical industry,” he surmised.

Nuclear

Europe’s ability to come out of the crisis depends on how quickly governments can create other forms of energy at scale of which nuclear is a key component. As Europe explores alternative energy sources key factors come into play. Renewables are capital intensive, and as such require incentives for companies. Nuclear requires building plants in a steep learning curve – and France’s experience shows it takes years to finally garner cheap electricity. He urged investors to explore opportunities in nuclear power, and said that Germany’s decision to close its nuclear power stations now looks naive.

Carbon capture and storage

One of the biggest challenges with carbon capture and storage is the energy intensity of the technology required to capture and pump carbon  into the ground. “It equates to running up a down escalator,” he said. He suggested countries build carbon capture and storage facilities close to industry away from populated areas. “I see it coming, but it will not make much of a dent in the problem,” he said.

van der Veer said transitioning to a green economy will be impossible without partnering with oil majors with the skills and expertise. “I don’t believe the energy transition will be done by a bunch of start-ups,” he said. It is only the oil majors who know how to develop offshore wind and nuclear power stations. He also urged delegates to never underestimate US companies, slow to transition. “They can accelerate too,” he said.

He counselled against shale gas (where much depends on the type of shale gas) as an alternative. “Without capturing the carbon, shale is not viable.” Moreover, new coal fired power stations take too long to build. “One day there will be peace and part of that peace will mean the west has to buy gas from Russia, although it will be nothing like the levels is was” he said.

The energy transition also requires industry working with governments and consumers. Putting all the pressure on companies to solve it, and punishing them, doesn’t work if consumers are still demanding fossil fuels. Moreover, the energy transition will take years to achieve.

He also counselled on the importance of the world working together. Europe’s transition won’t stop the climate crisis if the rest of the world doesn’t also transition. van der Veer concluded that the energy industry will become more capital intensive per unit of energy; it will attract huge amounts of capital but he said investors will only finance the transition if they can make a decent return.