The £74.8 billion University Superannuation Scheme (USS) has reported a funding surplus for the first time since 2008, with chief executive officer of USSIM, Simon Pilcher, saying one of the benefits of higher interest rates was it is cheaper to hedge the scheme’s liabilities.

“We took advantage of this opportunity, thus reducing our exposure to interest rates and inflation, which means the scheme is better protected should bond yields fall again,” he says in the USS annual report.

The investor’s 2023 actuarial valuation revealed a scheme surplus of £7.4 billion, allowing lower contributions and the restoration of benefits to pre-April 2022 levels in a turnaround marking the end of one of the toughest period on record for the DB pension scheme.

Less positively, the report also detailed how USS’s losses in troubled utility Thames Water has led to a “serious reflection” on investment in regulated assets in the future. This at a time the UK government is trying to persuade pension funds to invest more in local infrastructure.

“Economically regulated assets should be a good fit for long-term patient investors like USS, particularly where, as with infrastructure, they require long-term investment to address historical challenges,” said Simon Pilcher.

However, he noted that success is dependent on similarly long-term, consistent regulation that recognises the need for that investment and strikes a fair balance between risk and returns over the long term.

“While our overall experience of investing in private markets has been beneficial, we seek to learn the lessons of all our investments – whatever the outcome. Our experience with Thames Water will influence our future approach to investing both in economically regulated assets and more broadly.”

USS remains a shareholder in Thames Water but said that the value of the holding was now “minimal.” Two years ago its stake was valued at £956 million. Further revealing the scale of the losses, he said that since USS first invested in Thames Water in 2017, any profits that might otherwise have been used to pay shareholder dividends were reinvested into the business. “We have not received any dividends or payments of interest on any shareholder loans,” he said.

USS was not alone in this investment with fellow pension funds from around the world experiencing big losses including the Dutch PFZW and BCI and OMERS from Canada (OMERS wrote down its entire 31.7 per cent holding). See Thames Water losses hold lessons on the importance of a comparative view.

Despite losses in Thames Water, USS said private markets as a whole have delivered strong returns to the scheme over an extended period.  Over 10 years to the end of March 2024, infrastructure assets have delivered annual returns in excess of 11 per cent. During the past year the fund exited a number of private investments, generally at favourable prices to where they had previously been marked in its books. New acquisitions included growth-focused private equity, long duration income-generating property assets, and inflation-linked assets like renewables.

Pilcher said that returns across growth assets were generally positive particularly in the US driven by AI-fulled tech stocks. He said the outlook for equities was reasonable, and stated that bond markets are also likely to deliver solid returns now that yields have risen.

The pension fund flagged key risks from climate change and biodiversity loss, geopolitical tensions and the demographic time bomb where fewer people of working age must support rising numbers of retired people. USS employs tools like horizon scanning, scenario planning, diversification, and stress-testing as critical elements to help build a resilient portfolio and respond effectively to events as they unfold.

A developed markets equities team now manages a new £4 billion allocation to a long-term real return mandate designed to provide strong long-term returns at lower levels of risk than the wider equity market. Responsible investment has been built into every stage of the investment process for this mandate. Moreover the low-carbon emissions of the companies owned in the mandate supports the investor’s ambition for investments to be net zero by 2050 meanwhile the concentrated nature of the mandate allows it to hone in on stewardship activities.

Climate planning

USS  has developed four new scenarios in conjunction with Exeter University to better reflect the real-world risks and opportunities that frame climate investment and systemic risk decision making over the short and medium term. The analysis switches the focus away from climate pathways and allows USS to pay close attention to shorter-term changes to politics, markets and extreme weather events when assessing the long-term financial impacts of climate change.

“We took the decision to make this research publicly available for other investors because the real-world impact of climate change could be much greater than previous modelling has suggested. We hope this work will be of benefit to many others and help galvanise real-world action as people understand the costs of inaction associated with the current trajectory towards ever higher temperatures.”

The emissions intensity of the the scheme’s corporate investments is now 39 per cent lower than in 2019 and over half of the reduction seen in 2023 is a result of the  new LTRR equities mandate because the high-quality companies owned in this mandate typically have a very low emissions intensity.

Still the report does flag concerns raised following analysis of the scheme’s investment and advisory performance that covers factors from quantitative risk and return metrics, to qualitative inputs, flagging poorer performance in active management and private markets.

The £30 billion Greater Manchester Pension Fund (GMPF) the United Kingdom’s largest Local Government Pension Scheme is ploughing more money into affordable housing, targeting 30 per cent of its 10 per cent allocation to real estate to the residential sector.

The fund has just invested £120 million in a Legal and General fund that will invest in purpose-built social rent and shared ownership housing (where people buy a portion of a house and pay rent on the rest) that Paddy Dowdall, assistant director, GMPF, says has compelling low risk, inflation-linked income streams alongside measurable impact.

The allocation sits alongside previous investments in the “small” affordable rent sector, where rents are targeted at  30 per cent of tenant’s income and which has similar properties but is not part of the regulated sector.

GMPF has worked with L&G to design the allocation, composition of stock and pricing. “We wanted to make sure it was right for us,” says Dowdall.

A chronic shortage of housing in the UK has resulted in long waiting lists for social housing and young people left priced out of home ownership and Dowdall believes the sector is poised to attract much more institutional investment.

“In the US and Europe, the amount of investment by institutional investors in rented homes is far greater,” he says.

In recent months, Border to Coast, ACCESS and LGPS Central have all confirmed significant expansions of their real estate offering. Meanwhile, LPPI and London CIV have joined forces this year to launch the London Fund, which alongside infrastructure will also invest in affordable housing.

Investing in the social rental sector taps into large and growing tenant demand and constrained supply, he continues. For example, regarding build to rent where properties are built just for the rental market and don’t have targeted rents, he notes the UK’s private rental housing sector is valued at around £1.5 trillion but less than 2 per cent of that stock is build-to-rent compared to about 15 per cent in Germany and 40 per cent in the US.

Tennant demand is also boosted by more people stretching to afford a house and renting for longer. For example, today the average first time buyer age is 34 in the UK compared to 26 in 1997.

Meanwhile, individual private landlords continue to be squeezed out of the market, driven by tighter credit and government policy changes. Buy-to-let investor activity has slowed sharply due to adverse taxation changes including stamp duty and tighter credit, he explains.

“Tax, regulations, and access to leverage will make it much harder for small, private landlords to compete in the sector. There is a clear market opportunity for this provision to be replaced by financial institutions and social landlords.”

Historically, affordable housing in the UK has been financed via public sector housing providers called Housing Associations. Yet these organizations are also dealing with high costs to maintain large portfolios and facing rising construction costs to build new homes. Their affordability of capital is less, meaning social housing is increasingly funded by other forms of capital, says Dowdall.

“You now see a lot of annuity providers in the market.”

The sector offers long-term index linked cash flows. He calls the low net yield “fair” for the risk taken and says GMPF is happy to take liquidity risk given its long-term liabilities.

“Social housing is going to have low levels of voids and rent arears and a high correlation with inflation. The high inflation linkage makes it an attractive investment. It ends up a 6-8 per cent return on an IRR basis.”

GMPF’s seven-person real estate team invest in housing via two different portfolios: a well- established mainstream real estate allocation and a local impact portfolio that includes investments in SMEs and renewable infrastructure where this allocation will sit and where the fund is already financing close to 4,400 new homes which have either been completed, planned or are in development.

Certain real estate sectors may achieve higher yield than social housing, such as higher end residential or office. Yet these investments  carry higher risk because they are linked to the economy. “Occupancy and the level of rent for social housing is not linked to economy doing well in the same way as other real estate sectors giving it diversification qualities.”

GMPF has made a commitment to L&G’s national fund, but Dowdall says the fund would also like to invest to support the Manchester region.

Challenges include problems sourcing affordable homes. It is difficult to buy existing stock or buy new stock at rates that people can afford. The sudden collapse in rental incomes in London due to the Covid pandemic also highlighted another risk.

Japan’s 245.98 trillion yen ($1.5 trillion) Government Pension Investment Fund’s (GPIF) annual survey of listed companies designed to ascertain the stewardship activities of its external asset managers, reveals engagement in Japan remains an uphill struggle.

The survey seeks to gauge the degree of “purposeful and constructive dialogue” between listed companies on the Tokyo Stock Exchange and asset managers, offering a window into the ability of institutional investors to effect change in corporate Japan.

Only 717 firms (33 per cent) of the 2,154 listed companies on the Tokyo Stock Exchange responded to GPIF’s survey request.

Engaging on governance

Since the introduction of Japan’s Corporate Governance Code in 2015 the country has been trying to modernize corporate boards, long dominated by in-house executives. Outside directors currently occupy 44 per cent of the board seats of companies listed on the Tokyo Stock Exchange’s Prime section, up from 28 per cent in 2017, according to a data compiled by the Japan Association of Corporate Directors.

Still, 70 per cent of respondents said they did not receive a request from asset managers to conduct dialogue with outside directors and outside statutory auditors.

The Tokyo Stock Exchange, leading calls for stronger governance, is also demanding listed companies take “Action to Implement Management that is Conscious of Cost of Capital and Stock Price.” This new regulatory pressure is designed to improve underperforming companies, lift valuations and improve capital efficiency.

Although regulatory pressure was cited amongst corporate respondents as a focus of engagement activity alongside climate – only 10 per cent of companies said that they had received a request from their asset managers in the past year to conduct collaborative engagement.

Lacklustre asset manager engagement with investee companies comes as GPIF seeks to widen its manager pool.

The process will see the fund open up to new managers by reviewing criteria that have long-governed selection. Like its stipulation that its managers must have at least 100 billion yen assets under management and a fixed number of years of experience servicing financial products. The fund now says it will accept applications from investment management institutions with “a sufficient track record.”

Disclosure impRoves

Encouragingly, asset manager pressure on companies to disclose in line with Task Force on Climate-related Financial Disclosures (TCFD) recommendation is reaping change. Approximately 90 per cent of respondents voluntarily disclose non-financial information in line TCFD recommendation.

Still, asset manager engagement regarding Task Force on Nature-related Financial Disclosures (TNFD) is much less with only 35 companies responding that they have disclosed information in line with the TNFD – 79 per cent of respondents said they had no engagement from asset managers on TNFD.

Despite challenges around engagement, corporate responses highlight the effectiveness of engagement.

“They [asset managers] understand our company deeply and their advice through engagement is helpful. Many investors tend to hesitate in expressing their opinions to management, but asset managers give harsh opinions directly to the President and CFO. Therefore, the meeting is very beneficial in the sense that management can hear the voices of investors directly. For this reason, they have won deep trust from our CFO,” wrote one survey respondent.

“In particular, they explained frankly their way of thinking behind their ESG analysis and evaluation of our company, which helped us understand the “investor perspective.” We had a frank exchange of views on sustainability. Especially on materiality, we were able to obtain opinions on what institutional investors want,” said another.

Other corporate responses flagged continued short-termism among asset managers.

GPIF runs a policy asset mix of 25 per cent each in domestic and foreign equities, and domestic and foreign fixed income and targets a real investment return  of 1.7 per cent with minimal risks. Investment in alternatives, began 10 years ago, remains under a 5 per cent target at just 1.4 per cent of total AUM. The GPIF has been discussing changes to investment strategy, including its asset mix and will announce a new investment policy at the end of this year to enact through 2025.

The rally in global markets powered record returns at the investor, according to its annual results. Domestic equities are the fund’s best performing investment although the weakening yen lowered GPIF’s asset size in dollar terms to $1.53 trillion compared to Norway’s $1.6 trillion fund. The fund posted a 22.7 per cent annual return for the financial year ending March 31st.

Thailand’s $34 billion Government Pension Fund leads the region’s asset owners when it comes to integrating ESG, focusing on an optimal return for members and a social return for other stakeholders. Top1000funds.com talks to Man Juttijudata, responsible for GPF’s active investment strategy, outsourced funds management and RI strategy about the key challenges – like how to treat EV companies – and how he relies on fund managers for nuanced assessment.

Thailand’s $34 billion Government Pension Fund has developed a leading ESG strategy among institutional investors in the region that integrates sustainability into two thirds of its holdings spanning all asset classes, with the exception of government bonds and hedge funds.

“Our objective is not to just maximize returns,” explains Man Juttijudata, senior director, strategic and tactical asset allocation who is responsible for GPF’s active investment strategy, outsourced funds management and responsible investment strategy, and has been at the fund since 2006.

“We prefer to achieve an optimal return for our members and a social return for all our other stakeholders. We are not investing just for this generation but for future generations too and sustainability is the most important return.”

Sixty per cent of the portfolio is in fixed income comprising Thai government and corporate bonds, global sovereign and corporate bonds, and a smaller allocation to short term bonds and emerging market fixed income.

Risk assets claim the remaining 40 per cent, divided equally between equity (domestic, global and emerging market) and alternative assets where allocations include global real estate, infrastructure, private equity, commodities and two mandates with absolute return managers to support tactical allocation and with a low correlation to other assets.

“The economic cycle between the global and domestic allocation is different and by investing globally we can tap a wider and deeper market that gives us more opportunity to bring back returns for our members,” says Juttijudata.

Weights and scoring

The fund integrates ESG in its actively managed equities by applying negative screens and using an ESG weight and score asset valuation methodology that adjusts the weighted average cost of capital and stocks in the portfolio.

In place since 2018, the methodology scores companies using MSCI ESG data but also draws on additional, local analysis of Thai companies that includes governance data, a particular concern at the fund.

“We seek to assign a greater weight to governance in our investment process. We modify MSCI’s ESG data and scoring processes to integrate Thai-specific data sources to reflect our concerns,” says Juttijudata.

In fixed income, the fund draws on credit research that includes ESG performance, and also applies a negative screening process. It does not currently analyse ESG issues for its sovereign bond holdings, but does invest in sovereign Green, Social, and Sustainability (GSS) bonds which contribute to ESG outcomes.

Juttijudata won’t add any more fossil fuel holdings to the portfolio, but says the fund won’t divest on climate or emissions grounds either – although it does on governance concerns. He argues that divestment only leads to less scrupulous investors buying dirty assets and also worries that the data is too sketchy to inform accurate divestment decisions.

“We are trying to introduce more emissions data and quantitative analysis into our reporting. But right now, we are not confident that the data is accurate enough to make a decision on divestment so we concentrate on engagement.”

Recent engagement wins include persuading companies in Thailand’s power sector to increase efficiency.

“We engage with small cap stocks as well,” he says.

He observes that Thai companies are increasingly open to engagement. Last year the investor engaged with Thailand’s top 10 companies, most of which have a net zero target and have set caps on emissions.

“Companies that export to Europe know that if they don’t do this they may face a tax on their exports.”

Key challenges to the ESG strategy include the oftentimes absence of coherent beliefs around investing in sin stocks like alcohol. He is also struggling to develop the right nuance around stocks like EVs.

“EVs are good companies but lithium mining is ESG negative and you are always going to have this dispute with electric cars.” For now he relies on managers to conduct a trade off in the scoring process.

Looking to the future his focus is on improved reporting on GPF’s climate exposures; extending ESG to all assets in the portfolio and driving higher standards of responsible investment in Thailand, and across the Asian markets.

He says he has no plans to move into impact investment, primarily because he’s worried about the impact on returns.

“We do try to have a positive impact, but if we trade too much of our return we will lose the consensus from members,” he says.

The internal team manages the domestic allocations to Thai equity and bonds. In global investments where the team don’t have the expertise, he outsources and incorporates ESG into external manager selection, appointment, and monitoring processes.

He likes the competitive tension between the internal and external team and despite outsourcing, the internal team is still able to add top down tilts when they see an opportunity between sectors or regions that complements bottom up active management.

He would also like to build out the allocation to risk assets, namely public equity and a new allocation to private debt.

Governments and the private sector are supporting climate technology. Learn why net zero is the future.

(more…)

The $202 billion Texas Teachers is pioneering efforts to change the fee structure in hedge funds. Two thirds of its allocation is managed on a 1-or-30 structure and it is leading an industry-wide initiative, with more than 60 other asset owners, calling for cash hurdles in incentive fees. CIO Jase Auby says earning cash returns is not the reason institutional LPs invest in hedge funds.

The $202 billion Teacher Retirement System of Texas (TRS) pioneering effort to transform hedge fund fees is gathering momentum, according to chief investment officer Jase Auby, speaking during the investor’s July board meeting.

He said that around two thirds of TRS’ hedge fund allocation is now managed on a new 1-or-30 model counting for around two thirds of the number of managers in the portfolio. TRS has been investing in hedge funds since 2001 and has around $20 billion in the allocation.

Earlier this year, the pension fund launched an industry wide initiative to advocate for cash hurdles in the calculation of hedge fund returns that included an open letter to the industry signed by 29 Limited Partners. This year’s push builds on an initiative dating from 2016 when former CIO Britt Harris first began advocating to move from a 2:20 structure to a new 1 or 30 model. [See a podcast conversation with Albourne CEO, John Claisse, on the innovative fee structure Are managers rewarded for fee alignment?).

Under a 2:20 structure hedge funds are paid a 2 per cent base fee and 20 per cent of the profit. TRS is advocating to lower the base fee to 1 per cent and “make it an or, rather than an and” 30 per cent of the profit. Under the model, TRS pays hedge fund performance fees only after managers meet an agreed upon hurdle rate. Managers can then earn whichever is greater – either a 1 per cent management fee or a 30 per cent cut of the alpha or performance after benchmark.

Auby said that over the years the initiative has been well received, but that was when cash was at zero per cent and so the concept of a cash hurdle was not as necessary as today.  With cash currently up at 5.25 per cent approaching the industry again to put meaningful hurdles in place to better calculate hedge fund returns has been even more welcomed.

“We had 29 total signatories to our letter in May, now this is up to 60 and we’ve also received numerous calls (double than that amount) from others that are similarly inclined rooting us on anonymously,” he said.

The TRS portfolio is divided between (54 per cent) global equity (22.3 per cent) stable value including government bonds, absolute return and stable value hedge funds ( 21.6 per cent) real return and (7.3 per cent) risk parity with remainder in cash.

Introducing new fee structures takes time

However, Auby cautioned that introducing new fee structures takes time.

“We approach the ones that have had the worst performance recently first because they are the most amenable. As we go through the cycle we will approach others.”

Auby explained how the cash component is the preferred return. For a long only large cap manager the SP&P500 is the risk appropriate benchmark. For hedge funds which are not supposed to have any residual market risk, he said the risk adjusted return should therefore be cash.

“We are approaching the industry and advocating for a cash hurdle and the risk appropriate hurdle,” he said.

His comments are echoed in the industry letter, published in May, which stated how hedge funds may collect significant incentive fees based solely on skill-less returns generated from short rebate, securities lending, or unencumbered cash.

“These returns are easily obtainable by LPs outside of a hedge fund structure for free. Earning cash returns is not the reason institutional LPs invest in hedge funds,” it stated.

“In 2023, a $1 billion market neutral hedge fund could have earned ~$52 million (5.25 per cent) returns just by holding cash, and if that fund charged a 20 per cent incentive fee on absolute returns, would have taken home $10.5 million in compensation for taking zero risk. This is not sustainable, especially as it seems the risk-free rate may remain elevated for the foreseeable future; and it is not what LPs are asking GPs to do.”

Signatories to the letter include Canadian pension fund CDPQ, Singapore’s GIC, Korea Investment Management, UTIMCO, Healthcare of Ontario Pension Plan  Brightwell Pensions and Trans-Canada Capital.