The world’s emergence from the pandemic offers an opportunity for the investment industry to embark on transformational, rather than just incremental, change. In an impassioned call for a different type of investment, Carol Geremia, president, MFS Investment Management, urged FIS Maastricht delegates to help create a new investment model.

Today’s post pandemic world is a good junction for the investment industry to self-reflect. Investors are now taking five times more risk to get the same return as they were thirty years ago. It’s one of the reasons why the industry is now so vast – that increase in risk requires additional oversight and care allocating capital and ensuring diversification, she said. “No wonder money management has grown so much.”

The explosion in the number of asset allocators over the last 25 years creates an opportunity for asset managers to use their influence positively to create a new model. “The only way to generate returns going forward is to create a system that works,” said Geremia who joined  MFS in 1984, where she has spent her entire career to date.

Just moving capital around

Now is the time to examine the structural issues that come with taking risk; explore the limitations of passive capital and argue the case of ESG to be embedded in the investment process. “Do we just move capital around, or do we invest it,” she asked delegates.

The world has moved from shareholder primacy to stakeholder capitalism which requires a different way of operating. “We want companies to focus on stakeholder capital, but they won’t do that unless we operate differently. We are now able to ensure the companies we own take stakeholder capital seriously.” She urged investors to align their operations with purpose, embrace three dimensional investment that integrates risk, return and impact and allocate capital responsibly. “Trust matters; it’s what we sell,” she said.

Extended time horizon

A crucial component in building a better system involves extending investment time horizons. Many organizations have embedded short-term incentives within their organizations: although they espouse long-term horizons, in reality an overwhelming focus on three year performance records means they typically hold a single stock on average for just a few years. This means capital is not being committed for long enough to have any impact on the transition. “The only way to manage risk is to extend time horizons,” she said.

Investors need to re-think how they measure performance. If investors are going to engage with companies and try and influence the transition, it requires committing capital for longer, rethinking the ideal time to hold equity. If companies don’t change, active investors can withdraw capital. In this way, companies will have to compete for finance based on their sustainability credentials.

Extending investment time horizons requires difficult conversations and inclusive leadership. Leaders need to challenge incentives, get out of their comfort zones and build alliances with new stakeholders. This includes building new relationships with regulators. “I have never spoken to regulators as much as I do today,” she said.

Rather than argue hard with regulators to protect their own business, she urged delegates to explain to regulators how they planned to change their behaviour to better serve the people they represent. Regulators don’t want to hear that it is hard for investors; they want to hear new ideas and how to change the model, she said.  She urged investors to stop “whining” about regulation but welcome it. “The cost of inaction is catastrophic and a challenge to our survival.”

Limitations to passive capital

Geremia also noted the increasing limitation of passive capital to influence net zero targets and push sustainability. Increasingly, investors will need to know what they own and who they are lending to. “Bad” companies or companies that are not on a sustainable trajectory, should  struggle to access capital. “Sustainability applies to every company in the world. Should all companies get money all the time? I’d say ‘no’.”

Geremia concluded that this approach isn’t about putting companies out of business. However, investors should talk to companies about where, and how, they are making money and insist they are not short term when it comes to measuring results. Investors should demand honest conversations and data drawn from a full market cycle, she concluded.

 

 

It’s said that the roads leading to Maastricht’s city centre are curved to help prevent any attack on the beautiful city, famous for hosting the beginning of Europe’s economic and monetary union in 1992. In these uncertain times, beating a path back to Europe’s shared centre has never felt more challenging, said Karin van Baardwijk, chief executive, Robeco, speaking in the opening session of the Fiduciary Investors Symposium at Maastricht University.

That uncertainty is reflected in Robeco’s recently published five-year outlook which cites a reversal in monetary policy, inflation, climate change and volatility as key risks ahead. “It’s become very tough to forecast the future,” van Baardwijk told attendees going on to highlight the key areas where Robeco sees change and will focus in the year ahead.

Sustainable investment

Sustainable investment will be accelerated by a wave of new ESG policy interventions that will increasingly override the wrong incentives. Sustainable investment is mainstream, and current discussions now focus on how portfolios can have a positive impact on society. “There is still a long road to travel, but change is encouraging,” she said. “Legislation and changing consumer demand means every company is impacted by sustainability.” Moreover, ESG investments are increasingly comparable, preventing greenwashing.

Pioneering initiatives to progress the integration of sustainability at the asset manager include developing a biodiversity investment framework with the support of WWF, stakeholders and regulators. “We are raising the bar on integrating sustainability in all investment decisions,” said van Baardwijk. “Inaction is the biggest threat to all.”

So far, Robeco has decarbonised its portfolio by analysing and picking stocks; finding companies that contribute to the climate transition and generate healthy profits. In another endeavour, Robeco is giving clients and academics free access to some of its proprietary SDG data. In response to what van Baardwijk called a moral imperative, the company is sharing its SDG scores to help others learn from Robeco’s data and integrate it into their decision making. Opening the process also invites more expertise into Robeco’s own processes. “We want to get wisdom and feedback from the crowd,” she said.

Data

Data will become another key focus for investors in the coming years, providing a source from which they can derive alpha. The amount of data available to inform investment decisions is increasing at high speed, but investors are at risk of falling behind if they don’t secure the talent needed to interpret these new data sets.

Talent

The digital revolution leaves investors hunting new skills, particularly around data analysis. The battle for talent won’t decrease even as growth slows, she warned. Investors must remain flexible and innovative in their hunt for and retaining of talent. “To build a talented team, we need to maintain a culture of excellence and integrity,” she said. “We need to stay the course, and make sure responsible investment is at the heart of everything we do.”

Leadership

Leadership is an essential pillar in talent management. van Baardwijk stressed the importance of leadership instilling a message of hope and the need to prioritise technology.

Successful leadership also involves instilling key principles around long-term investment and corporate engagement. As stakeholders’ expectations grow, so investors need a clear vision. Investors should show flexibility and transparency around reporting and their investment outcomes. For Robeco, today’s challenging investment environment reinforces the need to remain true to the asset manager’s fundamental vision and commitment to promoting economic stability and ensuring returns flow back into society. It is also committed to a low carbon world and protecting biodiversity, allocating capital to companies that are leading the transition. Robeco recently set out interim carbon footprint targets for its investments and operations for 2025 and 2030, on its way to net zero by 2050.

Leaders also have a key role in building partnerships. She urged asset owners to lean into asset managers expertise and predicated asset owners will begin to have fewer, deeper relationships with their asset managers. “Asset owners will interact with fewer asset managers but in deeper relationships.” She predicted that pension funds will also become a leading voice around societal change, arguing that pension funds have a unique voice when it comes to influencing governments given their assets under management and a representation of society as a whole.

Active management

A final trend comprises a switch from passive to active investment. In today’s volatile environment, active investors are best positioned to deliver results. Moreover, an active approach is the most effective way to factor in sustainability needs and objectives. Opportunities exist amid the challenges too and active investment is a chance for skilled investors to tap alpha. She concluded that the combination of encouragement, active management and evolving regulation would make generating sustainable returns possible.

Markets are going to react to what’s not priced in – and analysis of what is currently priced in, doesn’t add up. So warned Bridgewater’s chief investment strategist Rebecca Patterson, speaking at FIS in Maastricht.

Markets are discounting that the Federal Reserve starts easing interest rates next year. But markets have not begun discounting that earnings, and earnings expectations, are expected to decline, and if Central Banks are serious about taming inflation, they will destroy demand which will feed into earning expectations. “In aggregate, and at a high level, equity markets would be up this year if we took out the impact of the discount rate,” she said.

Patterson told FIS delegates that Bridgewater’s views on inflation have evolved. Strategists at the world’s biggest hedge fund, which runs a celebrated pure alpha and all-weather strategy, now believe that although inflation will remain “sticky” and will be slow to fall, a more pressing challenge for investors looms in slow growth. Signposting a meaningful contraction ahead, she said slower growth than expected, combined with high inflation, raises the spectre of stagflation.

Almost every asset class will be impacted by central bank tightening in a process that is already starting to appear. The impact is becoming visible in the housing market, and it is increasingly apparent in consumer and business confidence. She said that data suggests the US will likely face a 2 per cent contraction next year, with Europe’s economy shrinking more. “We see a lot of downside risk on growth,” she reiterated.

Policy misstep

The difficult economic backdrop is leading to the appearance of economic stimulus in some jurisdictions like Germany and California. But the travails of the United Kingdom’s ex-Prime Minster Truss underscore the challenge of introducing fiscal stimulus in the current climate. “She thought the best way to help the UK was to cap energy and give subsidies to business,” said Patterson. “But she did it with high debt levels and while the BofE was trying to get inflation under control. With fiscal stimulus, monetary tightening, and high debt levels, it was no surprise that bond yields shot up.”

Europe faces slow growth and real incomes being hard hit; meanwhile companies are experiencing rising costs caused by high inflation and slower growth. A potential policy misstep could include the ECB using asset purchases to buy Italian bonds to stop spreads widening between Italy and other, stronger, European sovereigns, she warned. “What if some countries don’t want to use [asset purchases] to bail out Italy?” she asked. “The ECB’s job is challenging because the downside to growth is larger than what markets discounting.”

Strategies that worked in the past no longer work. For example, equities and bonds have both performed in a low inflationary world where growth has been mostly positive. Investors have moved into private investments and got paid to take overweight US positions. Moreover, in the past when equities have fallen, Central Banks have stepped in by lowering interest rates and adding stimulus. “Equities turned quickly, even with slowing growth,” she said. Now however, as Central Banks target getting inflation back to between three and two per cent by raising rates, this won’t be possible.

China

Patterson said Chinese growth is being hit on a couple of fronts. Consumer confidence has been hit by the property crisis while enduring lockdowns are crimping the economy. Exports have been hit by the slowdown in Europe. Positively, she said China doesn’t have policy constraints and can put in place fiscal and monetary stimulus. Still, China remains stymied by the absence of demand. “The problem is that even if you create the availability of credit, you still need demand.” China is also battling longer term challenges like its demographics; productivity will also be impacted by China struggling to access the technology it needs, she predicted.

Beta challenge

Investors will struggle to access beta in the current environment, meaning alpha becomes more important now than in years prior. This means country selection; manager selection and geographic diversification will become more important than before. Opportunity will come from looking below the hood, although she warned that Bridgewater remains cautious on European equities given the downside risk to growth is greater than what has been discounted. She said key factors to get capital flowing back into Europe depend on the war ending, and China reopening.

European equites may remain in the doldrums, but Bridgewater’s outlook for commodities is more positive. Many commodities have experienced under investment, particularly energy and metals. When demand picks up, supply may not be there, she warned. Moreover, the transition to a green economy will support commodity prices at the margins.

Patterson noted that inflation targeting by central banks has helped anchor expectations. Still, raising rates to tackle inflation will lead to people losing their jobs. “Raising rates isn’t easy,” she said. Moreover, when people start to lose jobs, Central Banks risk rate rises becoming politicised.

She noticed that foreign allocations to US assets are at the highest level since 1980s. Sure, investors may reduce their allocations to US assets when growth in other markets looks better, but she warned that just because another market looks cheap, it doesn’t make it attractive.

The funds management industry “does not look like the society we serve” despite being an industry concerned about talent, said Sarah Maynard, the global senior head of DEI at the CFA Institute, pointing to the importance of measuring and reporting progress on diversity and inclusion.

As with “green washing,” there is also a major issue with “diversity washing,” Maynard, pictured, said in a panel discussion chaired by Amanda White, director of institutional content at Conexus Financial, which is broadly “this sense of organisations making…a commitment that they’re not following through.”

Speaking at Conexus Financial’s Sustainability in Practice forum held at Harvard University, Maynard said there is a marked under-representation of women when looking at labour participation rates by gender in investment teams. The view becomes more stark when adding in race and ethnicity, and other elements of diversity like gender fluidity, she said.

The CFA Institute has a history of producing codes and standards in response to issues, and so in response to this diversity problem in the industry, CFA worked on “developing a code to give the industry the structure to progress and also to lean on that infrastructure that we already have around codes and standards and indeed around aspects of professional conduct and enforcement,” Maynard said.

Released in February this year, and now with more than 50 signatories, CFA’s Diversity, Equity and Inclusion Code for investment professionals provides principles and implementation guidance on the “what and the how” of diversity and inclusion.

“We are collecting data from all of our signatories and essentially we will be reporting outwards on aggregated data, so that folks can actually see how their organisations look relative to their peer group and understand the need for accelerated change,” Maynard said.

While measurement and data collection is critical, there is also a need for a cultural shift that changes practices and people management to produce better outcomes, she said.

“Because one of the interesting things we’re increasingly seeing and hearing in the evidence from the allocators of capital is actually firms that can demonstrate greater diversity, equity, and inclusion are also producing better investment results,” Maynard said. “So I think that’s a point to really focus minds.”

Signatories welcome the fact that there are sanctions for non-performance, she said, and that they will be held to account on their progress.

Also speaking in the panel discussion was Juliette Menga, chair of ESG committee at Aetos Alternatives Management, who said investment professionals should look at the research of Harvard psychologist Dr Mahzarin Banaji, and her work looking at implicit bias around race, gender and sexual orientation.

DEI work needs to be “extremely intentional and actionable,” Menga said. “It’s not something that you can start with: ‘We are in a meritocratic world, let’s find the best people.’ There is a lot of unintentional biases that play out.”

Investors need to track progress, hire the right people and begin by looking at their own firms, she said.

“If you don’t have a diverse group of people doing that investment diligence work, you would likely not come up with a diverse group of managers.”

Aetos has a DEI committee spanning a wide group of people from senior leaders to junior professionals across different groups to think through issues such as hiring and promotion practices and partnering with different organisations on internships, she said.

Organisations need to question how widely they are opening their talent pipeline when they are filling vacancies, she said, noting Aetos has a system that tracks managers by gender and racial diversity, and allows the firm to “do a self audit to really explore some of the reasons why you passed on some of those managers, especially compared to some of the ones that you pick in their place.”

Kate Murtagh, managing director, sustainable investing and chief compliance officer at Harvard Management Company, said investment professionals sometimes “forget how closeted an industry it is.”

Aside from internship programs, outreach to community colleges and first-generation college students is something large and small investment firms can do, she said.

“Some of the big shops will tell me, ‘oh, well, people know how to get a job here.’ It’s like you go to this school and then you go to that business school and then you go to this investment bank. I grew up in Troy, New York. That was all news to me. I had no idea how this industry worked as a first-generation college student.”

Anne Westreich, managing director and senior consultant at Verus Investments, talked about teaming up with data firm eVestment for diversity disclosure. Verus helped create the Institutional Investing Diversity Cooperative or IIDC, which now has 26 investment consulting members advising on more than $43 trillion in assets.

“Everything in the light of day is much more clear,” Westreich said. “So we can then talk about progress and then we can see what the progress is with each of the managers and the industry as a whole.”

The Public Employees Retirement Association of New Mexico, PERA, is increasing its allocation to private markets to 40 per cent of its $16.6 billion portfolio in the hunt for illiquidity premiums, despite the spectre of markdowns ahead.

The proposal for a 7 per cent increase to private markets focused on private equity (where the allocation will grow from 12 to 17 per cent of AUM) and credit is about to go to PERA’s full board for approval, explains Michael Shackleford, the pension fund’s new CIO who took the helm in August. In the pipeline before he joined the fund, if approved, the boosted allocation sourced by reducing investments to emerging market debt and core bonds, will mark the first of several changes he plans for the portfolio.

“Relative to peer funds, we are near the bottom in terms of the amount of risk we take. Increasing our investment in private markets will allow us to take incrementally more risk to generate incrementally more return,” he says.

Although darkening economic clouds put the risk of investing in private markets increasingly front of mind, Shackelford says it remains outweighed by the potential returns compared to public markets. “It’s true that investors are driving down the illiquidity premium in private markets – the more you pay, the less the return. At some point that premium will be driven down so much it may not be worth it and we might as well all be in public markets, but this is still a few years down the road.”

Those risks are most prevalent in private credit where Shackleford notes that the illiquidity premium has reduced on the back of higher interest rates. “High yield bonds and leveraged loans are closer to where private loans are at the moment.”

Still, long-term he expects private credit to outperform public credit once interest rates come down again. “Over the long term, we will be paid to own private credit over public debt. We still have a meaningful allocation to core bonds, high yield and leveraged loans but private credit is a good way to add returns.”

New managers

PERA will most likely re-up with existing managers in private equity but in credit the hunt for new managers is underway. A key element of the bigger allocation involves moving away from credit hedge funds and investing instead with direct lending managers focused on middle market companies with a good track record in terms of yield. Strategies could include making loans to solid companies with a private equity sponsor able to step in and provide the capital, he says. “If the business gets into trouble, you can take possession of the assets and pay off the loan.”

The hope is this approach will do better than PERA’s allocations to credit hedge funds where he says success has depended on managers performing in volatile public markets and successfully picking winners and losers, rather than a simplified approach making loans based on the fundamentals of a company. “Credit hedge funds have had a hard time – it’s much harder for a manager to get it right.”

Private credit managers in contention include relationship formed at North Dakota Board of University and School Lands where as director of investments he was involved in seeding funds with a raft of managers. “I am already talking to them,” he says. Elsewhere, Shackelford plans to draw on PERA’s own bench which he has spent his first months vetting and getting to know.

Open ended

Shackleford is a keen proponent of open-end fund structures which, rather than a one-off commitment, allow investors to add money over time. “I want to give money as we have it. This way we also will get distributions back in terms of interest payments, but no principle back until we want it.”

He is also interested in credit managers offering opportunities to seed funds in an approach that allows PERA to influence the structure and model of the investment alongside lower fees. “Say we go into an existing fund paying 75 basis points in a management fee,” he says. “Compare that to seeding a fund and paying 30 basis points in a manager fee – that equates to an increased alpha of 45 basis points. Almost half a percentage point is meaningful over a long period of time.”

There are a few caveats, however. Seed funding requires chunkier sized investments and inhouse skills to evaluate direct investments. It also involves investing in a smaller number of companies with more concentration risk than a pool. “If you have a good staff of people who can review investments and you have faith in the manager, you can make those types of investments.” PERA, which outsources all asset management excluding a cash management piece, has an internal staff of about 13.

In private equity he increasingly favours co-investment but via open-end fund-of-one vehicles rather than bespoke co-investment transactions. Once again, this structure allows him to add capital as he goes, and seed funds without a management fee. “Funds-of-one are open ended so you can add more capital as the manager does more deals,” he explains. “All we do is add capital to the fund of one and then we can co-invest alongside the manager’s second fund. If the manager does a third fund, we add more capital to the fund of one and co-invest in the third fund.”

Risk parity

In another shakeup, Shackelford is cutting back on PERA’s risk parity allocation setup by his predecessor Dominic Garcia in 2018. He plans to pare back the allocation from 10 per cent to 8 per cent of assets under management in the first step of a reduction that is likely to go further still. “It could get cut back more in the future, but 8 per cent is a good start. We will continue to monitor it.”

The decision isn’t just based on the fact risk parity has had a difficult year. He is also questioning the role of risk parity in a multi-asset portfolio – namely the rationale for a meaningful allocation to a substitute multi asset portfolio that mirrors the large portfolio.

“Using futures and derivatives to get exposure to stocks and bonds and commodities and trying to balance those risks is fine, but in this market where all stocks and bonds are down because of high inflation this strategy doesn’t do very well. My view is that we can cut this back and do other things with our risk dollars.”

ESG

Shackleford is steering clear of the ESG debate raging amongst fellow US public pension funds. New Mexico currently views ESG integration by its managers as a nice-to-have, add-on that is not essential. “It’s not required by law and the board haven’t spoken on the issue,” he says. ESG integration only manifests in a tie break between two managers offering the same returns, style and strategy. “There are arguments on either side of the debate. It’s not something we ask our managers to have. It’s a contentious issue; the best thing to do is for the legislature to speak otherwise you are dammed if you do and dammed if you don’t.”

 

Sustainable investing needs to be defended from external attack as questions are raised about how much change it is actually achieving within portfolios and out in the world, argued David Wood, director of the Initiative for Responsible Investment at the Harvard Kennedy School.

Simple stories of “politicised versus non-politicised investment” do not make sense in light of the history of ESG, he said. Rather, ESG has come out of attempts to make sense of the relationship between finance and society, he said.

“I think the point of history we are in right now [shows] a growing consensus that ESG can’t be an end in and of itself,” Wood said.

Speaking with former PRI CEO Fiona Reynolds, now the chief executive of Conexus Financial, at the Sustainability in Practice forum held at Harvard University, Wood said sustainable investing has always been a way for investors to navigate the world and steward their assets according the belief that there is more to risk than simply volatility.

Against a backdrop of anti-ESG discussions in the media and a backlash by politicians, particularly in the United States, Wood said criticisms of “woke capitalism” are “mostly bad faith” and “there’s nothing necessarily politicised about investors addressing the climate crisis or economic equality or racial injustice.”

“These may not fit neatly into the relative valuation of enterprises or deals, but that doesn’t mean they’re not investment issues. I think that’s the whole point of the growth of this field.”

Wood pointed to a tension within the field that had existed from the beginning. A focus on values, not value, led to the social and environmental analysis that is at the heart of what ESG investors do today, he said. This meant sustainable investment has always been both a critique of, and an embrace of finance.

“You’ve got to believe that finance can fix things, and that we need to fix finance,” Wood said. “Everybody in the field of responsible investment believes those two things at the same time,” although the proportion or weighting of these clashing ideals varies from person to person, he said.

The years following the GFC saw an explosion of developments in the field, with asset owners embedding ESG into investment beliefs and strategies, collective action on topics like sustainable palm oil, and the take-up of these ideas in public policy. But this came with a cost.

“The essential tension–at least the critique of finance part–got buried in the public story and the growth of the field. You hear instead that sustainable investment is just investment…it’s not something different. But if it’s not different, what are we doing?”

History has now reached a point where people are asking how much we are getting out of these efforts, how much is changing within portfolios, and how much is changing out in the world, Wood said.

In his summary of the history of ESG, Wood also took aim at other misleading arguments such as the “simple division between divestment and engagement.” The two have always been inherently interlinked, he said.

The anti-apartheid movement drove divestment discussion into the institutional world by linking retail and institutional investors in the United States, and catalysing the development of engagement networks starting with the Interfaith Center on Corporate Responsibility, and feeding into later developments like the PRI Collaboration Platform and Climate Action 100+.

“There’s no simple division between divestment and engagement,” Wood said. “The divestment movement built the infrastructure for engagement.”

He also praised the UN’s PRI as offering “a master class in institution building and organising,” as it got the world’s biggest asset owners to sign first, who then leaned on asset managers to sign on.

“The principles were aspirational so they were non-threatening,” Wood said. “And you know, lo and behold the Great Financial Crisis comes along and responsible investment was seen as a response from investors: how to think maybe more broadly about the role of finance in the world.”