ESG-focussed investors are having a hard time justifying their China exposures to their boards, and will need to develop new narratives if they want to stay in the China game, argues historian Stephen Kotkin.

Two decades ago it was only perceived naysayers who were warning that China was unlikely to become the largest economy in the world or posed a threat to world order over its stance on Taiwan, says historian Stephen Kotkin, noting he himself was one of those naysayers.

Speaking at Conexus Financial’s Sustainability in Practice forum at Harvard University, Kotkin said that in the face of slowing economic growth making it harder to make money in China, and China’s rhetorical support of Russia’s invasion of Ukraine, ESG-focussed investors are having a tougher time justifying their China investments.

At the start of the millennium, in the face of China’s remarkable accomplishment in lifting hundreds of millions out of poverty, alongside the United States’ culpability in the Global Financial Crisis and the Iraq War, those talking about Western resilience and the problems inherent in the Chinese model were seen as being on the wrong side of history.

“Those of us talking about that had a difficult time connecting with the investment community because there was so much opportunity that seemed available and there was, as I said, a lot to answer for on the US side,” Kotkin said.

But it turns out this side may have been correct–at least on China’s long-term trajectory if not on the timing–argued Kotkin, senior fellow at the Hoover Institution and the Freeman Spogli Institute at Stanford University, and Birkelund Professor Emeritus at Princeton University.

Despite China’s stunning achievements, there are three fundamental problems in the Chinese development model “that have now come home to roost,” Kotkin said.

The first is the middle income trap, and the historical fact that it is much easier for a country to leap from low-income to middle-income than it is to go from middle-income to high-income. Looking at China’s education levels in particular, it would be “a miracle and against the run of history” if China were able to break through the middle-income trap.

Despite high absolute numbers of highly-educated people, China has 700 to 800 million people “who are outside the world economy,” with less than a high school education and almost no healthcare. China’s high-school-or-above graduation rates are the lowest for any middle-income country, he said.

“Many of them can’t even get prescription glasses,” Kotkin said. “There’s this giant population that the country didn’t invest in.”

The second problem is the demographic issue as China gets old before it gets rich. Lacking a social safety net for the vast majority of the population, getting old is a significant problem because there is no way to care for these people, he said.

“If you’re watching the pandemic and you’re puzzling over why the regime is locking everything down when they get one case, or three cases, or five cases, it looks ridiculous except if you know the size of the old age population; the lack of medical care, especially intensive care beds,” Kotkin said.

The third problem is investment-driven growth and the difficulties of transitioning to consumer-led growth. This has yet to happen despite officials talking about it for a long time, Kotkin said.

“No economy has ever had this much investment-driven growth this deep into its growth story,” Kotkin said. “It’s over 40 per cent and of course, a lot of that is waste; it’s misallocation of capital because they’re just pumping the GDP numbers and now we know that from the housing debacle.”

But the deepest problem is the Communist Party monopoly which “cannot reform itself successfully.” Liberalising the economy could only go so far before it threatened the party’s monopoly, leading to a crackdown on the private sector and increasing investment in state-owned enterprises, he said.

It is common knowledge inside Chinese government circles that the party cannot open up without committing suicide, Kotkin said.

Now with ESG high on the business agenda, Kotkin said he sometimes jokes that “the CIA invented ESG as a way, finally, to get the business community to stop being a cheerleader for China, because everything else the CIA tried failed.” When the Communist Party is put through ESG metrics, investing in China loses some appeal, he said.

China’s treatment of Tibet, Xinjiang and even Hong Kong share similarities with Russia’s treatment of Ukraine, he said, just as China’s rhetorical support for Russia’s invasion of Ukraine is also problematic.

With the above-mentioned structural problems reducing the ability of investors to make money in China, compounded with ESG concerns, there are a range of arguments investors will use to stay in the game, Kotkin said.

Engagement

Some investors may decide to engage with the hope of effecting change from the inside. China’s important role in the energy transition may also boost these views.

“It’s important because, as you know, China accounts for 50 per cent of global use of coal and that number is skyrocketing because China’s building 258 brand new coal-fired power plants as we sit here,” Kotkin said.

But the engagement argument is a difficult argument to make, because “the Chinese don’t care what you think,” Kotkin said.

However the Chinese government’s push for self-sufficiency may lead to greater use of renewables to reduce its reliance on oil and gas which are imported, he said.

Other investors may stay exposed to China arguing that Chinese society is extremely dynamic, and that they are betting on China’s “people and its human capital, in its talent, in its future, and its dynamism,” which unfortunately means being “in bed with the regime to a certain extent.”

Other investors may seek to capture some of the growth in China without being China-centric, seeking plays on the growth and dynamism of developing societies around the world that will leave them less dependent solely on the China story, he concluded.

There is a glaring gap between the lofty words of corporations on the topic of racial equity, and the resulting actions and outcomes, experts say, demonstrating time and again that organisations do not actually value the pronouncements they make.

In a panel discussion dedicated to the social impact revolution, and in particular racial equity, James Andrus, interim managing investment director, board governance and sustainability, at CalPERS, said lofty public statements can actually harm the process when they mask a lack of real action.

Speaking at Conexus Financial’s Sustainability in Practice forum held at Harvard University, Andrus said major funds including CalSTRS and CalPERS had long participated in numerous initiatives–dating back more than 20 years–to give more money to diverse fund managers, but they were forgotten in the chaos following the dot-com bubble and the GFC.

“Still nothing has happened,” Andrus said. “I mean the amount of money given by people in this room to diverse managers is roughly one per cent. The problem with that is that it does not align with the policies and what people say.”

When the Institutional Limited Partners Association’s DEI committee established the Diversity in Action initiative, general partners rushed to join but only 5 per cent of the ILPA’s limited partner members joined, he said.

“Diversity is not embraced throughout entire organisations,” Andrus said. “When it’s raised, there are people within the organisation who have the coattails of the leaders, who pull the coattails and say they don’t like it, it’s wrong, it doesn’t earn money, it doesn’t provide returns. We shouldn’t do it.”

Panel chair David Wood, director of the Initiative for Responsible Investment at Harvard Kennedy School, asked what actions asset owners can take to confront the divergence between claims and outcomes.

Andrus said in addition to operating “in line with what you say you are,” asset owners need to overcome resistance. “Whenever you talk, especially about race, there’s going to be resistance,” Andrus said. “If you’re actually in favour of racial equity, you have to overcome that resistance.”

Also on the panel was Renaye Manley, deputy director, strategic initiatives department, at Service Employees International Union which about 2 million members in the United States and Canada, primarily in the public service, healthcare and property services.

With SEIU members’ collective retirement savings estimated to add up to over a trillion dollars, Manley’s work with the strategic initiatives department involves leading a team who work with trustees and pension plans to think about best practices, and how they can be more effective advocates and fiduciaries over the funds that they’re responsible for.

Manley has been involved with highly successful shareholder activism requesting racial equity audits at publicly held corporations. She said the civil unrest following the murder of George Floyd by Minneapolis police officers led to an outpouring of corporate commitments to racial equity and inclusion.

“Hundreds of millions of dollars, from the same corporations who could not find a black person or a woman on their board for the last three years,” Manley said. “There was some clear misalignment here.”

These companies were either lying or highly misinformed, she said, so she began tracking the commitments these companies were making. Other organisations like Color of Change had engaged companies like Facebook, Starbucks and Airbnb in doing racial equity audits, and SEIU took up this concept and brought it into shareholder resolutions.

Investors such as CalSTRS and CalPERS did extensive work in supporting shareholder resolutions calling for board diversity, and previous work on gender diversity had helped set the stage, she said.

Racial equity audit proposals ask companies to conduct an independent third-party review of policies and practices and the impact on stakeholders, including interviews or participation by third-party stakeholders.

“So, folks outside of the company have to be engaged as well,” Manley said. “That means either community groups, civil rights groups, those types of groups have to be engaged. Having civil rights groups and activists groups, community groups as a part of the dialogue with the company creates a different level of accountability.”

Manley admitted she doesn’t have all the answers to questions organisations ask, such as what parts of the company are going to be examined as part of the audit, or about the standardisation of the audit.

“I say: ‘Have you looked at any of these audits that have been done? The Facebook audit does not look like a Starbucks audit. Why? Because they are individualised to the company and their operations. No two companies are going to be the same.’”

The SEIU does have a document listing some best practices and standardisation around what the elements of the audit should be, but “you can not dictate that the audits are going to look the same,” Manley said. “This is not a financial audit, this is an audit around policies and process.”

With 48 per cent of Gen Z identifying as BIPOC, public sector pension plans need to represent the communities they are hiring from and serving, she said.

As HOOPP chief investment officer Michael Wissell celebrates one year in the job Amanda White spoke to him about the sources of return for the fund’s excellent performance, it’s world-leading funded status, the evolution of the investment allocations and the fund’s biggest sources of risk.

The headline facts about HOOPP’s performance since Michael Wissell became CIO include a return of 11.28 per cent for the year to March and a 120 per cent funded status.

Behind the headlines Wissell and the team have been hard at work building the risk function and rolling out Aladdin, dynamically adjusting the portfolio to market conditions which included a doubling of the real estate commitments on the previous year, furiously building out the infrastructure team and making a commitment to be net zero.

The C$114.4 billion plan for Ontario’s healthcare workers keeps a keen eye on its liabilities managing its investment in two distinct portfolios: a liability-hedging portfolio and a return-seeking portfolio. It’s this liability-driven approach which means the funded status is roaring and the returns are good despite the volatile environment.

“This is the nuance,” Wissell told Top1000funds.com in an in-person interview in the fund’s Toronto office. “We are in the pension delivery business not in the money management business. We live and breathe that here and it’s been that way for 10-15 years, that is our focus. Our liabilities are our biggest risk and protecting ourselves against those growing is our biggest priority.”

Real estate and fixed income make up the liability hedging portfolio while the return seeking portfolio is made up of equities, private equity, corporate credit, short term money market and foreign exchange, infrastructure and other return seeking strategies. The fund also uses derivatives to manage risk.

Traditionally a liability-driven approach means a high allocation to bonds, but HOOPP sold off a lot of bonds in the past couple of years and is slowing building back.

“We focus on the risks, by doing that you end up having good market calls. We are not sitting here saying we think stocks will go up by x per cent. It’s the risks we focus on: are they riskier than they were before?”

Wissell says during the period of extraordinary low rates the fund reduced bond holdings but he now thinks the efficacy of bonds is coming back.

“We want to get paid for the risks we are taking and when something is unduly expensive or risky we will do less of it, you have to be able to adjust to the forward risk profile you are facing,” he says. “As rates came up in the second half of 2022 we have been buying some of our bonds back. We are not forecasting bonds but we think the value as a liability hedge has returned. We look at market prices for indicators, on the inflation front we have some reasons to be more optimistic than what we have been.”

Wissell says it is important to be able to adjust allocations to the changing environment.

“Ideally our allocations wouldn’t be so dynamic but it’s just that the environment has changed so much. The portfolio I have today feels like the right one. But if there is an exogeneous shock or if something really happens then we can take advantage of that or we might want to protect against it. I don’t consider our approach dynamic I consider the world we live in dynamic.”

Asset classes under focus

In the past year the fund has made a net zero commitment and carved out 1 per cent of its equities portfolio to be dedicated to climate-sensitive equities.

The fund has allocated 50 basis points into two different strategies labelled enabling and optimising.

The enabling portfolio invests in technologies that help with the decarbonisation of the system or companies that are using those technologies; and the optimising portfolio invests in existing companies doing a good job in transitioning.

“They are outperforming the broader equities portfolio and we are really pleased with how things are going so far,” Wissell says. “We made a net zero commitment this year which I am very happy about and we are literally in real time engaging internally and thinking about our near-term targets and how to align against those.”

For a large Canadian fund, HOOPP was relatively late to infrastructure, first investing in 2019.

It has now deployed more than $4 billion in the asset class – with a focus on digital and communications infrastructure, transportation and utilities – and Wissell says the allocation is well ahead of its 2 per cent policy portfolio allocation.

“Even though we have 425,000 members our plan is younger than many and we only got the AUM to broad thresholds recently. As the AUM grew we felt we could get the infrastructure program under way, that has worked well and we are head of our plan.”

The focus is on being a good partner, and with a “considerable amount of dry powder” Wissell believes HOOPP to be a partner of choice in infrastructure.

“We are an extraordinarily strong partner. Our approach is not to lead a globally large transaction. We want to partner and be quick to a no or yes and come in alongside the bigger plans and GPs, and that’s working well.”

Infrastructure delivered very strong performance in 2021, generating a return of 14.2 per cent for the year, compared to 7.3 per cent in 2020.

HOOP’s hefty allocation to real estate, 20 per cent of the total portfolio, has also been a great contributor for the fund with a return of 12.5 per cent on a currency hedged basis and a well-diversified portfolio.

“I believe we have the most diversified real estate portfolio that I am aware of, across multiple sectors,” Wissell says. “We don’t have a real estate platform company likes some of our peer plans do, but the upside of that is it gives us incredible flexibility with portfolio construction so we can alter the portfolio or can move into niche areas more nimbly. That diversification has really continued to pay dividends.”

The increase in private assets has also been a key contributor to the investment team growing by 100 per cent in the past four years.

“As we have grown those allocations have had to grow the teams, to make sure it’s done in a proper and robust way. It takes more humans to run a large allocation to private assets.”

Wissell says the fund continues to look at expanding its investments including to private credit and an ongoing investigation into inflation-sensitive assets.

HOOPP doesn’t have a formal allocation to private credit but does invest through private equity and public credit allocations.

“Private credit has been an incredibly successful asset class and we will bring those investments together in a more formalised way going forward.”

The fund has weathered the recent inflationary period very well but inflation-sensitive assets is something it continues to investigate.

“There are pros and cons to all of these choices, we’ve come through it alright so should we have more inflationary sensitive assets? This is something worthy of ongoing consideration.”

Focus on risk management

Wissell who joined HOOPP in 2018 and was previously senior vice president, capital markets and total portfolio, says organisations that have a strong risk culture are better able to manage their way through this extraordinary environments.

Four years ago HOOPP didn’t have a risk team the same way some of the other Canadian funds had. Before HOOPP Wissell spent nearly 17 years at Ontario Teachers.

HOOPP started implementing Aladdin a couple of years ago and that came online in the past year.

“This gives us a whole broad suite of risk analytics across all of our assets which is compelling. That is new for HOOPP,” he says.

The fund had historically relied on just doing asset shocks and draw down risk analytics and now that has been augmented with a full suite of analytic capabilities from Aladdin that sit on the investment team’s desktops.

“You can measure the success of that by the quality of the conversations you have when discussing the individual portfolios. A risk system doesn’t solve the problem of making good investments, that is still the driver where we get paid for the risks. But when you want to consider the aggregation of those investments that is where it becomes a useful tool. People are having portfolio construction conversations in different ways than they did before because they have more insight, these analytics are really powerful.”

The system gives the team a view of aggregated risks which is useful for the current environment where it is important to have line of sight across risks that might impact the whole portfolio.

“This is where this system is a really powerful, every asset at the fund is inside the tool. This is a big thing in terms of managing the portfolio you don’t want to get blindsided in aggregate,” he says.

A prolonged recession is Wissell’s “greatest fear”.

“That’s not our forecast or what we think will happen right now we are little more optimistic than we were a year ago, but deep prolonged recessions are the thing I worry about the most.”

He says the pension industry generally is long growth and risk assets which means it is most exposed to deep long recessions.

“We all have a lot of growth assets. That’s why we are adding back some of those bonds we sold to protect us against that. We are not forecasting a deep recession but you should protect yourself against the things you are most worried about. We still have a long way to go before we are back to the pre COVID days on bond allocation but no one is sending me an email saying ‘this is the high’. This is what I really love about the Canadian pension industry it is rooted in humility among the people that run the plans. We are humble in our ability to forecast the future.”

Africa’s largest pension fund, South Africa’s Government Employees Pension Fund, GEPF, is scrambling to protect its R2.1 trillion portfolio against the impact of inflation. GEPF invests around 90 per cent of its assets in South Africa in a strategy designed to match its assets with liabilities. Of the many issues buffeting the portfolio, safeguarding it from South Africa’s 7 per cent inflation is top of the list. “The impact of high inflation and how to protect the portfolio is really key at the moment,” says Sifiso Sibiya, head of investments at GEPF in an interview with Top1000Funds.com.

Strategies include building exposure to assets linked to goods and services that benefit from inflation and buying inflation-linked government bonds. “Government-issued linkers carry a sovereign guarantee and are tied to inflation, the thing we are trying to fight,” he says. That said, he notes government issuance of long-duration linkers that best match GEPF’s long-term liabilities has been slow. “Long dated linkers are in short supply.”

Alongside these explicit hedges to inflation, implicit strategies include exposure to equities particularly South African commodity producers or industrials which over the long-term typically outperform inflation. GEPF has a 50 per cent allocation to local equity, 80 per cent of which is passive. All stock selection is outsourced to GEPF’s state-owned asset manager the Public Investment Corporation, PIC, guardian of over 80 per cent of the portfolio.

SAA

GEPF’s long-term, strategic asset allocation aligns with the pension fund’s long-term liabilities. “Investment theory says 90 per cent of investment performance is driven by asset allocation. Our asset allocation is constant and not triggered by short-term market moves like we see today,” says Sibiya.

That SAA decrees the overwhelming home bias, imposing strict limits on the ability of the fund to diversify. “We are obviously highly exposed to the South African economy, but we consider this with our eyes open,” says Sibiya. “Our liabilities are rand based so it makes sense that most of our assets also rand based.”

Unlisted push

Still, two seams of strategy are evolving to allow more diversification. GEPF has re-started its allocation to unlisted African investments with the PIC after last year’s pause in the mandate. That followed a Judicial Commission of Inquiry into allegations of impropriety and political interference at the PIC during Jacob Zuma’s presidency, focused particularly on the PIC’s management of the unlisted allocation and oversight of a clutch of external asset managers. “Our relationship with the PIC has improved,” reflects Sibiya. “The mandate is more targeted and more deliberate in terms of meeting the GEPF’s investments.”

Although the unlisted allocation is currently capped at 10 per cent of AUM, it gives the GEPF exposure to important new sources of investment. Strategy follows key developmental themes including water, sanitation, digitization, technology and financial inclusion. Although investments will likely be diversified across Africa, all allocations will begin with the transaction first – rather than be made on a country-specific basis.

Targeted investment sizes will fall between R200 million to R500 million ($11 million to $28 million) with any larger allocations reviewed on a case-by-case basis. All investments will be made either via the PIC or via PIC-mandated third-party managers. “The allocation is given to the PIC which then decides how to split it,” explains Sibiya. “The allocation itself is dependent on factors like market capacity to absorb a certain amount of capital over a time period; our SAA, the deal flow and the pipeline on the ground.”

Sibiya adds that unlisted investments will also offer the opportunity for higher impact from a developmental point of view in keeping with GEPF’s ESG strategy where engagement and reporting are key tenets.

Other sources of diversification also come from GEPF’s overseas investment. The GEPF could, in theory, invest up to 15 per cent of its assets overseas. The current allocation is much less at around 9 per cent to foreign equities and bonds mandated to JP Morgan, Robeco and BlackRock. “We are still far from this target. We must apply this transition very gradually given our market impact in South Africa,” he concludes.

 

 

The only way to make the earth cooler over a relevant timeline for humanity is by changing the climate through technological interventions such as carbon removal or solar geo-engineering, according to physicist, climate policy expert and author, David Keith.

Emissions cuts, while hugely important, “stop the problem getting worse” but “don’t make it better,” said Keith, author of the influential book ‘A case for climate engineering’, the Gordon McKay Professor of Applied Physics at the Paulson School of Engineering and Applied Sciences, and Professor of Public Policy at Harvard Kennedy School.

In a discussion about technologies and public policy for decarbonisation at Conexus Financial’s Sustainability in Practice forum held at Harvard University, Keith asserted that decarbonising the industrial economy is something “that we must do.” Ultimately, “you need a regulation that puts some price or penalty on using the atmosphere as a free waste dump for carbon dioxide,” Keith said.

However if we want to cool the planet back down after the cumulative effect of emissions over history, technological interventions like carbon removal and solar geo-engineering will be necessary, he said. There is “some level of substitutability between carbon removal and solar geo-engineering, because they both could be used as a supplement to emissions cuts to reduce climate risk later this century,” Keith said.

In a discussion with Stephen Kotkin, Senior Fellow at the Hoover Institution and the Freeman Spogli Institute, Stanford University, and Birkelund Professor Emeritus, Princeton University, Keith explained that carbon removal involves taking carbon out of the atmosphere, and is sometimes referred to as “carbon geo-engineering.”

Keith drew a distinction between carbon removal and carbon dioxide capture and storage (CCS), which is the idea of capturing carbon dioxide from fixed emitting sources and injecting it deep underground.

CCS 1.0, which was widely discussed around 20 years ago, failed but may not have been a waste of money, Keith said.

“I think a fair summary is that the reason CCS 1.0 didn’t go anywhere was because renewables got a lot cheaper than people thought, and (at least for the first half of emissions cuts in power systems) building wind and solar is just clearly the best thing to do.”

CCS 2.0 may turn out to be effective in reducing industrial emissions from cement plants, steel and chemicals “which are hard, or in some cases arguably impossible, to mitigate by any other means,” Keith said.

Carbon removal, distinct from carbon capture, involves two broad categories. One is manipulating ecosystems to increase the amount of carbon they hold, such as planting large numbers of trees or adjusting farming methods to put more carbon in soils.

The second is a range of measures to permanently remove carbon from the system. This could involve using biomass energy to burn biofuels, capture the released CO2 and inject it deep underground, known as Biomass Energy with Carbon Capture and Storage or BECCS.

“That does represent a removal because in the end, you’d be taking CO2 back from the atmosphere and putting it into the same kind of formations we got oil and gas…a kilometre or two underground where it would be securely stored.”

It could also involve direct capture, using a machine for capturing carbon dioxide out of the atmosphere and injecting it deep underground, known as Direct Air Capture with Carbon Storage or DACCS.

These measures might also include adding alkalinity directly to the ocean to reduce rising ocean acidity due to higher levels of mildly acidic carbon dioxide. “My view is that this is actually potentially more important than people think, it gets very little attention because it doesn’t fit in the investment climate,” Keith said.

A second direct intervention is solar geo-engineering, otherwise known as solar climate intervention or sunlight reflection methods. This refers to altering the radiative balance of the earth–how much heat gets in from the sun or is released back into space–by putting small aerosols, which are tiny particles, into the stratosphere.

“At best, it can partially and imperfectly offset the risks of CO2 in the atmosphere,” Keith said.

This could involve spraying sea salt into some kinds of low-level clouds to make them whiter. But most of the research has looked at adding aerosols to the stratosphere. This would aim to scatter “about half a per cent of sunlight” back into space, “in order to lower temperatures something in the order of half a degree…in the second half of the century.”

“That could be done–I think it’s pretty undisputed–relatively cheaply and easily with pre-existing technologies,” Keith said. Using off-the-shelf commercial aircraft technology, the amortised cost of this would be around $5 billion, “which, on the scale of a global climate problem…is really zero.”

It could involve putting a million tons of sulphuric acid into the air per year, which may sound frightening, but “humans already put roughly 50 million tons of sulphur in the lower atmosphere, which kills several million people a year from air pollution,” Keith said.

“So one extra million tons empirically is not very much, and it means we have an enormous hundred years or more of science and epidemiology telling us something about the risks of these things. So it’s not like we’re doing something we’ve never done before.”

Admitting humans have never directly injected sulphur into the stratosphere before, he said volcanoes do this and the impacts have been studied.

These substances would gradually leave the stratosphere over several years, meaning the programme could be ceased if problems emerge, and not leave behind long term consequences.

The results of these technologies in climate models “look surprisingly good” on a purely technical basis, he said. “I think we’re beginning to see that, quantitatively, the risks of these technologies look pretty small compared to the benefits.”

Cooling the earth by one degree Celsius would save millions of lives, and increase the GDP of hot countries like India, reducing income disparity, according to studies, he said.

But there are other potential risks, Keith said.

“I’ve got, pages and pages of technical risks,” Keith said. “Some of which we don’t know very much about; some which we know more about; and then there’s a set of political risks to do with the fact that we really don’t have any system for governing these technologies for making the decision about how they would be implemented and to resolve disputes between nations about that.”

The main reason there has been an unwillingness to research these topics is “because of concerns that if we even talked about solar geo-engineering, it would take away the incentive to cut emissions,” Keith said. “And I think that’s a legitimate fear.”

However the willingness of the policy elite to talk about this topic is changing, he said.

A consistently low allocation to private markets, too little exposure to growth and a damaging decision to jettison a home bias in favour of poorly performing international equity have been some of the key contributors to CalPERS weak historical performance relative to peers. Speaking during the latest board meeting in an especially carved-out agenda item, new CIO Nicole Musicco put her stamp on the giant pension fund, laying out errors of the past and her plan for the future.

A hypothetical benchmark composed from peer funds’ performance over the last ten years sheds light on where CalPERS has persistently underperformed. Between July 2014 and July 2018, America’s biggest pension fund lagged peer funds in the index by 2 per cent with most achieving hypothetical annualised returns of 7.6 per cent compared to CalPERS 5.6 per cent.

The reason, she said, was the fund’s over-prioritisation of downside risk. “We constructed a portfolio to limit the downside and with that missed out on a big chunk of growth,” she said. “This is a hypothetical portfolio of peer funds, but the messaging is consistent.” With assets of $439.6 billion, down $30 billion compared to June 2021 and having just posted the lowest fiscal return since 2009 at -6.1 per cent, Musicco stressed it was time to act.

Private markets PAIN

CalPERS consistent failure to allocate more to private markets is the biggest single cause of the poor performance relative to peers. “The private markets programme is the problem,” she said. CalPERS failure to consistently pace capital deployment in private equity – and private markets more broadly – between 2009 and 2018 resulted in the portfolio missing out on between $11-$18 billion in a lost decade.

Still, Musicco insisted the future is bright and that CalPERS can make up for lost time. Many asset owners are currently overallocated to illiquids, but CalPERS, late to the game, has room to invest more. “It’s an excellent time to go into private markets,” she told board members.

This could manifest in an opportunity to backfill and pick up secondary buys. The current environment will also play to CalPERS strength in value investments given today’s focus on traditional corporate metrics like cashflows and margin. CalPERS in-house private equity team is thoughtful, agile, well governed and increasingly sought-after for its ESG expertise. She pointed to a list of excellent partners and CalPERS own, growing reputation as a decisive partner, quick to “give a yes or a no” that will help build out the co-investment programme. “We are in a position to become the first call and invest in needle-moving opportunities from a scale perspective.”

International mistake

Musicco’s historical analysis highlighted another painful mistake: abandoning the home bias. Some years ago, in a bid for diversification, CalPERS ploughed into international public equity. Relative to peers who maintained a home bias, that decision backfired. A source of consternation for board member Theresa Taylor who recalled questioning the decision at the time. “I asked, ‘how come we are overweight international’ and I was brushed off,” she said. “We stayed that way, even though we returned poorly.”

Elsewhere, CalPERS’ factor-weighted segment, added to the strategic asset allocation in 2018, has proved problematic. Designed to reduce the beta exposure in public equities and avoid excess volatility, it has come at the expense of important upside growth. “For an extended period of time, the active strategies have not been working,” she said.

CalPERS historical over-emphasis on downside risk has coupled with the fund not getting paid enough for the risk it did take. Turning the conversation to risk return, Musicco said CalPERS’ frustrating sharp ratio proves the fund has not got the return on risk it should have.

For example, CalPERS wasn’t sufficiently rewarded for its riskier real estate investments. The portfolio is portioned between core, opportunistic and value add, but the latter, riskiest allocation, didn’t always result in expected higher compensation. In recent years CalPERS has transitioned the portfolio back to core whereby the opportunistic and value add allocation (a combined 10 per cent of the portfolio) is dominated by legacy investments.

She said it was still too early in her analysis to clarify for sure if CalPERS had taken on more or less (unrewarded) risk than peers since this would depend on asset class analysis. Still, she said “in general” the fund had taken less risk overall and been paid less for the risk it had taken.

Cultural change

Going forward, Mussico will devote much of her attention to ensuring CalPERS gets sufficiently rewarded for the risk it does take and leans into active risk to fully grasp the value creation inherent in an active programme.

Rebooting active management will involve reviewing the risk budget, deciding what the pension fund needs most from its active programmes. At its heart it requires a cultural shift whereby the investment team are held accountable, but also empowered to take risk, backstopped by innovation and resilience.

“My hope is that we are going to get more focused and accountable regarding active risk,” she explained. “The next chapter of my first year will go on developing the right tools and culture for risk taking. I don’t want us to fear risk taking; if you’re punished every time you won’t be motivated or incentivised, but we also need to get the appropriate level of return.”

She is not just rebooting CalPERS approach to alpha in the equity book. Active risk budgeting will span the whole portfolio, targeting every opportunity to generate value-add dollars. “When we transition to the next phase I want to look at how we apply our entire risk budget across different strategies; how we set metrics, if we are being paid and held accountable. Our behaviour and culture are not focused in this way. Rather than beating the benchmark I want to look at where we are adding dollars to pay benefits.”

Consistent governance

Musicco also stressed the importance of consistency in the investment process. Pulling out of the private markets programme hurt CalPERS dearly, she said. “It doesn’t serve us to come in and out of programmes.” It’s why she will particularly focus on governance and decision making, avoiding stop-start decision making and ensuring the board thoroughly vet the consequences of both investing but also frequent changes in strategy.

This, combined with a philosophy that goes beyond just setting a SAA and pressing the button. She also espoused the importance of a sufficiently robust governance to allow agile decision making that is visible to all investment partners “We need the tools in place to act, rather than just wait it out,” she concluded.