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

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

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

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

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

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

Mark to market

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

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

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

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

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

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

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

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

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

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

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

Climate change resilience

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

In the last few years, Ivanhoé Cambridge, the $70 billion real estate subsidiary of $283 billion Caisse de Depot et Placement du Quebec (CDPQ) has turned its portfolio on its head. Five years ago, two thirds of the allocation was invested in return-dragging office and retail assets. Now, in a complete reversal, two thirds is invested in logistics and residential real estate alongside a growing allocation to alternative life sciences facilities and office and retail assets are in the minority.

“Over the last few years, we have pivoted the portfolio to make sure we are aligned with longer term trends,” says Michèle Hubert, chief operating officer at Ivanhoé Cambridge in an interview with Top1000funds.com.

The intensive churn of transactions as assets with less potential or that had reached maturity were sold and money redeployed to growth areas required a keen investment focus and adrenaline-fuelled, long hours to get the volume of deals over the finish line.

In 2022, the team executed more than 70 transactions totalling over $15 billion investing either directly, with strategic partners or via real estate funds.

New priorities

The process highlighted new investment priorities that are now central to strategy.

For example, Ivanhoé Cambridge increasingly seeks property assets that can adapt and evolve, able to change in use alongside changing demand and changes in society. Like the potential conversion of office assets into residential – or malls (which have a 11 per cent weight in the portfolio today compared to 22 per cent in January 2020) doubling up as logistic centres or places to work as well as shop. Similarly, assets should be able to adapt to incorporate new social impacts like the rehabilitation or public spaces, she says.

“Many assets are not designed to allow this conversion, but I’d like to see a new way in how we plan developments to incorporate a mix of uses that could evolve, opening the door to flexibility,” she says.

“The way we use real estate in a post pandemic world is changing. We must make sure we position the portfolio to not just play on current trends but align with future needs of people and communities.”

Risk spotlight

Alongside the physical churn in the portfolio, Hubert highlights another profound change now always influencing decision making.

“Geopolitical and ESG risk have come to the fore, shining the spotlight on the risk team,” she says.

From the fallout of Russia cutting off gas to Europe to de-globalization trends or an asset’s physical vulnerability to climate change and climate regulation, geopolitical and climate risk are now integral to how the investor assesses opportunities.

She says her approach to risk has become increasingly prescriptive, evolving in a forward-looking approach. New tools include Ivanhoé Cambridge’s bespoke risk premium model, that has sharpened how the team rate risk and opportunity, judging and challenging the expected return against external risk models and assumptions.

Rather than have a centralised risk team sitting in the Montreal headquarters, risk teams are present in all key markets, working alongside local investment teams. The risk function is also connected to other teams in the organization – notably the sustainable investment team.

“They have become an integral part of how we manage risk,” she says.

Climate risk

Integrating climate risk (Ivanhoé Cambridge targets a carbon neutral portfolio by 2040) is well underway.

As of December 2021, low carbon buildings account for around $17 billion of the portfolio and 56 per cent of the portfolio has green building certification.

New initiatives to cut carbon emissions are regularly rolled out. A current pilot involves trialling energy efficiency technology in the electric motors that drive water pumps, air conditioning and heating in buildings that uses algorithms and intelligent control systems to reduce utility bills.

Still, measuring carbon remains a key challenge, and is difficult to integrate into the valuation process.

“We are convinced integrating ESG in this way will increase the resilience of the portfolio,” she says. “But the industry is still using traditional measures to assess risk and return and doesn’t integrate carbon.”

granualrity of Data is essential

Data is an increasingly crucial component in risk analysis, offering insights on the market and Ivanhoé Cambridge’s own portfolio.

From a property’s energy and water use to occupancy rates and tenant habits, the construction of smart buildings and the rollout of apps to improve life for tenants is giving a new granularity to the information feeding up to the investment team. Occupants can stay connected to their building via exclusive concierge services allowing them to reserve parking spaces remotely, order a meal or enrol in a group class. It amounts to a vast store of strategic information that will go on to shape the spaces of tomorrow.

The challenge, she says, is making sure data is used correctly and linked to decision-making.

“There is a value lying there that we have to harness,” she says. “It involves taking data from external sources and layering it with data from our own portfolio.”

risk drives Governance evolution

Integrating geopolitical and ESG risk into investment decision making has required an evolution in Ivanhoé Cambridge’s governance.

She is responsible for an investment process whereby investment leaders and the risk and sustainability teams present all material issues to committees overseeing strategy and investment decision making. Governance, she says, must be robust and solid, but also able to evolve to align with changing priorities. Governance and investment decision making is always viewed through a ‘one portfolio’ lens rather than regional portfolios and pipelines to better optimize risk-return, she says.

“A one portfolio view is critical to us taking better decisions,” she says.

She is also responsible for ensuring staff spend time on asset management and extract the maximum return from existing assets in the portfolio – particularly in the wake of a pivot that demanded such an intense investment focus

“When you keep an asset, you make a decision not to sell,” she says. “It should be seen as a decision to constantly re-buy and we are trying to make sure our committees and governance also looks at assets we own, dedicating time and space to go through important decisions.”

There are many elements to being a successful real estate investor, she concludes. It involves selecting the right opportunities and being intentional. It requires playing to different horizons and adjusting the execution and tilting strategies to play on different time frames. It also requires a global view, identifying areas that can perform better in particular regions and sourcing investments aligned to cyclical (the inflation proof revenue growth in the logistics portfolio, for example) and structural trends that could play out over the next decade. In short it requires building a portfolio that comes together to generate a superior performance.

“We  strive to have a selection of good deals that together lead to something even more,” she says.

Australia’s second-largest superannuation fund, the A$240 billion Australian Retirement Trust, will likely “do more, not less” investing in China, said the fund’s head of strategy, following significant internal debate over geopolitical developments and how they will impact the portfolio.

Speaking at Conexus Financial’s Fiduciary Investors Symposium held in Singapore, Andrew Fisher, head of portfolio strategy at ART – formed last year after the merger of Sunsuper and QSuper – said debate is ongoing about whether and how to invest in China and “the narrative and the position has moved so rapidly” over the past 12 months.

“We will keep investing in China, is my thorough belief, and I think we’re going to do more, not less, because China is going to be bigger as a part of the global economy,” Fisher said, in a panel discussion with heads of funds from Canada and Malaysia. 

When Russia invaded Ukraine, the newly merged ART decided immediately to sell all of its investments in Russia, figuring “why are you investing in a country that’s sanctioned and invading other countries?” Fisher said.

He asked hypothetically if it would it be the same playbook if China invades Taiwan, and even whether the fund should “be out of China already” so it doesn’t get “caught out in a similar fashion.”

But the conversation around China is different, he said, as there are no sanctions on China, there is a lot of posturing, rhetoric and propaganda on both sides, and while it is “romantic and compelling to get caught up in all of that…the reality is as Australia, we are right in the middle of this, and…it’s very hard to take sides.”

The fund’s exposure to China is relatively small, making it easy to say the fund will increase its exposure, he noted.

With a lot of uncertainty about the future direction of markets, the fund is focussed on diversification to build resilience, he said. ART was “a little concentrated in terms of the defensiveness  in our portfolios…fixed incomes have been quite short duration for a few years now and quite long foreign currencies, underweight Australian dollar.”

The fund is now moving towards a “more balanced position”, and looking more favourably on bonds than previously, he said.

Marlene Puffer, chief investment officer at AIMCo from Alberta, Canada, said AIMCo is working through plans to set up a Singapore office to “have boots on the ground to have a more direct, clear understanding of the complicated region that is Asia and South-East Asia.”

Eliminating home bias is a clear focus at the moment to build resilience through geographic diversification, as the fund has “more Canadian equities than we should,” Puffer said.

Innovation is driving growth across the region in areas like food and agriculture, she said. “We think of Singapore as a hub of investment activity where many managers who are permeating the rest of the region have been settling here.”

The office, which the fund expects to have between 15 and 20 people over the next couple of years, will focus primarily on infrastructure and renewables, public equities and private equity, and further diversification within some of the fund’s private asset strategies.

The fund previously had a Hong Kong office but “it’s much easier to make a choice for Singapore rather than Hong Kong at this moment,” Puffer said. “China’s growth is a complicated story at this time, and we’re definitely underweight China.”

Also on the panel was Abbas Ramlee, chief strategy officer at Permodalan Nasional BHD, one of Malaysia’s largest fund management companies. With a focus on the retail market, the fund has around a third of Malaysia’s population as contributors, Ramlee said.

Close to 95 per cent of the bank’s assets are located in Malaysia, and the bank is “close to business owners ourselves,” which helps drive value creation activities. However in the past five-or-so years, PNB has started gradually diversifying outside of Malaysia, and increased exposure to other asset classes, “trying to give better optimised risks to our unit holders.”

Investors in South-East Asia need to develop an understanding of each country, he said, as there is enormous variation between countries in the region, and in the investments that are favourable in each country. 

Ramlee said employing dynamic asset allocation helped the bank take advantage of macro trends. “So, for instance, going a bit more aggressive in inflation protection assets, real estate, infrastructure, things like that to really try to provide resiliency in our portfolio.”

There is a plunge in confidence among CIOs that they will meet their return targets, with only 36 per cent of participants in the 2023 CIO Sentiment Survey expecting they will.

This is almost half the response from the previous year where 63 per cent of CIOs were confident in meeting their return targets.

The 2023 CIO Sentiment Survey, a global collaboration between Top1000funds.com and CaseyQuirk, part of Deloitte Consulting, finds asset owners keeping their allocations static but focusing on agility as they observe dramatic market changes not seen in a generation. And only 11 per cent are taking on additional risk to achieve return targets due to the uncertainty of markets.

With a majority lacking confidence that they will meet their return targets, respondents are re-evaluating their equity exposures, re-structuring their fixed income allocations and de-emphasising private markets.

While most investors were in a wait and see holding pattern regarding allocations The data found liquid equity exposures in a holding pattern, but 31 per cent said they are considering shifting their equities to more inflation-proof sectors.

They are also de-emphasising private markets and expecting write-downs to continue until at least the end of 2023.

Fixed-income allocations are also being re-structured due to fundamental changes in the rate environment, leading to a resurgence of high-quality active fixed income, and tactical increases in active emerging market debt to take advantage of high yields.

Chris Ailman, chief investment officer of CalSTRS, which is the second largest public pension fund in the United States, said fixed income allocations had shrunk in recent years but higher returns are now reversing that trend.

“Now that [fixed income] will have 4-6 per cent return, people will be putting in more money,” Ailman said. “It’s not a massive asset allocation change, the 80/20 portfolio was creeping to 85/15, and it will go back to 80/20. That return on cash and fixed income will help with overall returns.”

Internal management and external relationships

The ongoing shift towards internal investment continues, with 75 per cent of respondents saying they plan to decrease or retain the number of managers on their roster – a figure that is 8 per cent higher than in 2022.

Understaffed internal teams and a talent shortage are the top challenges impacting investment teams, cited by 58 per cent of respondents.

While asset owners have been working hard to build improved technology into their investment process, 57 per cent feel digital advancements have not significantly enhanced their manager due diligence process.

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

Only 20 per cent of respondents feel it is “important” or “very important” for asset management partners to require their investment teams to be in the office.

The survey asked CIOs extensive questions across their asset allocation, costs, ESG, manager relationships, operations and risk.

The full results can be found here.