This was the first COP meeting that I have missed in a very long time. As I watched from afar, I was at first disappointed not to be there in person but as I read much of the commentary about the lack of progress along with ‘the first world problems’ of long queues and bad food, I was at the same time glad to be home watching from the sidelines.

Despite much of the disappointment around the lack of 1.5C commitments and clear language on fossil fuel phase outs along with the slow pace of change, COP still remains the critical multilateral climate convening of nations, and is now attracting an increasing host of finance, corporate and civil society representation which provides a separate stream of momentum alongside the official negotiations.

I have witnessed firsthand many investors rally around COP to make major climate announcements, to update on progress on past commitments and the same on the business side, so we shouldn’t underestimate how important COP meetings are to both governments and the private sector. Without them momentum would be completely lost.

In the post-COP twilight with the initial assessment of pass or fail all written, institutional investors are rightly asking where we are up to at the end of 2023. What has changed and what remains the same?

The divide between aspiration and reality on 1.5C as an achievable outcome has already been noted in many quarters. After last year’s COP, we talked about 1.5 being still alive but on life support, this year many have pointed to the fact that as it currently stands, there is no credible pathway to limit warming to 1.5 degrees with the latest data showing that the world is on track for a temperature rise of between 2.4 and 2.6 degrees by the end of the century. The Inevitable Policy Response (IPR) analysis released during the conference helpfully revealed the policy gap between commitments and action, against both 1.8C and 1.5C outcomes for both developed and developing countries

Another disappointment which was yet again on display at this COP was the delaying hand of the carbon lobby seeking to water down commitments and many would argue that sadly they were successful.

Yet the COP process is still important and it may yet overcome both political and private sector inertia.

Investors looking ahead are aware that next year’s conference in the UAE will see the global stocktake take place, where nations will have to table their climate homework and their progress against their NDCs. I don’t think it takes a great leap of faith to know that many countries will receive a “can do better” on their report cards.

In 2025 COP will see the global ratchet embedded in the Paris Agreement, where the pivotal fight will be about what new national targets should be.

If Australia and the Pacific Islands are successful in their bid to host the 2026 event, additional attention will be on north/south finance and large-scale investment in low-carbon development paths, along with the reality of climate change for many low-lying Pacific nations.

For policymakers the next three to four years will bring relentless pressure to act. Clause IX of the Implementation Plan highlights that $4 trillion annually needs to be spent on renewable energy until 2030, to reach net zero by 2050 and an additional $4-6 trillion a year to achieve a low-carbon global economy.

For investors, the longer-term energy security impetus unleashed by the Ukraine War and the combined impact of US legislative developments are increasingly evident. The Inflation Reduction Act is providing new impetus and will give some confidence that at least part of investor net zero portfolio commitments can be met with increased investor support.

Where we have progress on one side though, unfortunately, much has also been made of the negative effect of anti-climate lobbying at a national level and at Sharm el-Sheikh. Influence Map has been unfailing in its efforts to expose the contradictions between corporate image setting and climate action sabotage. Let’s call it for what it is.

The fossil fuel lobbyists will again be out in force again in the at COP28 in the UAE. But a reckoning will have to come. Investors must redouble their efforts to end the funding of membership and the power of trade associations, think tanks and other third-party organisations that slow policy shifts and investment flows.

COP organisers cannot continue to give free reign to climate deniers and wreckers indefinitely either.

Limiting tobacco advertising was once seen as being an almost impossible task and an untenable restriction on business. Policymakers seeking elbow room need to find the courage to begin restricting and regulating anti climate lobby efforts.

A social license will no longer be a nice to have post 2025.

Silencing the carbon lobbyists will free up space to deal with the fundamental questions of north/south finance, just transition and accelerating investment.

All reasons why COP must step up so it can continue to occupy the climate centre stage.

John Pearce, chief investment officer of the A$115 billion UniSuper discusses his long-term view on China, inflation and the impact on the fund’s portfolio.

China’s ability to escape a “middle-income trap” where population decline has pushed up labour costs making exports less competitive is dimming according to UniSuper’s chief investment officer John Pearce.

“In the long term, I’m a bit pessimistic about China. If you look through history, at countries that have managed to escape the middle-income trap that China is in, it’s got nothing to do with geography or resources. it’s got everything to do with the institutional frameworks of those countries,” he said at the Investment Magazine Fiduciary Investors Symposium in Healesville.

“It seems to me that China’s going in the opposite direction and so we’ve got Xi Jinping, looking much more inward than his predecessors.”

But he recognised there may be “some fantastic cyclical opportunities in the short term… but you’re just going to have to accept that you’re probably going to miss it”.

Rising rates

Rising inflation around the globe has been driven by massive government spending to support their citizens as economies were shut down and travel restricted to limit the spread of the Covid-19 virus before effective vaccines were rolled out.

“We are paying the price for the Covid policies, we’ve been getting the bill and the bill is called inflation,” Pearce said.

The solution is not hiking interest rates aggressively like the US Federal Reserve but to increase the supply side of the equation like opening borders, he said. “We know that governments have to spend but you can’t spend everywhere. You’ve got to ease back on some stuff because there’s just not enough supply.”

“Governments should just look at the supply side of things, cut spending and get out of the way… let nature take its course.”

He also challenged the orthodoxy of central banks maintaining a two per cent inflation target. “Is the world going to be a terrible place if we actually settle at three and a half percent with bond yields at four or four and a half [per cent] and real rates around 50 to 100 basis points? What’s the drama, we’re going to have a decent cost of capital curve, we can get back to sensible pricing of risk,” he said.

One of the most significant impacts of rising interest rates is on balanced options for members. “There’s going to be a much larger role for credit and fixed interest in typical balanced options,” he said.

“The end of financial repression will have a profound impact on portfolio construction. The bottom line is that investors can hit target returns while taking less risk.  To hit a target return of seven per cent in 2000, an investor could hold 80 per cent cash.  In the middle of Covid, you basically had to hold 100 per cent in risk assets to achieve that target. These days you could hold up to 40 per cent corporate bonds, 60 per cent growth assets and get to an expected seven per cent return,” said Pearce.

Internalisation model

UniSuper manages over 70 per cent of its assets internally with a team of less than 60. The main driver was the need to tailor portfolios to accommodate a significant $30 billion defined benefit scheme, though the massive cost savings was another boon for members.

“We always felt that developing an in-house capability to manage a liability driven investment portfolio was much better than just farming out the money,” Pearce said.

“It was always a case of logical incrementalism, this was working well for the defined benefit and we just started applying it across all the other options. A very positive benefit is a massive reduction in costs.”

Pearce said the operational leverage from having an inhouse management capability has meant there was no need to add any new staff to deal with the enlarged asset base after the merger with the $12 billion Australian Catholic Super.

The asset classes that UniSuper outsources to external managers require specialised skills and labour-intensive due diligence processes such as infrastructure, private equity, US high-yield and Asia small cap.

“The governing principle is that you stick to pretty sensible, generic types of assets that don’t require large teams. That’s the model that I’m comfortable with,” Pearce said.

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

A refresh

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

Potential scenarios

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

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

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

Case study

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

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

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

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

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

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

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

Good beta bad beta

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

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

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

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

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

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

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

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

Knowing what you own

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

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

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

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

Cultural change

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

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

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

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