Railpen, guardian and administrator of the United Kingdom’s £35 billion ($47 billion) Railways Pension Scheme is well known for its belief in the cost and control benefits of inhouse management visible in its large in-house fund management and fiduciary team. Rather than outsourcing stewardship, the investor has also built up an internal engagement team to better align stewardship with its ESG objectives, particularly its ambitious net zero targets.

“We don’t outsource our stewardship activities,” says Michael Marshall, head of sustainable ownership at Railpen. “We are rolling up our sleeves and doing this work ourselves.”

Railpen’s net zero strategy has targets along the way to 2050 set at 2025 (25-30 per cent fewer emissions in the portfolio) and 2030 (50 per cent fewer). With 47 companies making up around 70 per cent of financed emissions, the pressure is on to ensure these companies make most progress on limiting their emissions for Railpen to meet its targets.

“If we outsource engagement to a provider, there is no guarantee that they will target engagement on our largest and most long-term holdings, nor on the themes that we are prioritising,” explains Marshall. “By engaging ourselves we can be much more focused on what adds the most value to how we manage our clients’ money.”

It’s a level of control that is particularly important when it comes to timing engagement and knowing when to escalate it, he adds.

“If we externalised this aspect of strategy, we couldn’t be certain the services rendered would escalate company engagements on a time horizon that aligns with the milestones in our net zero plan.”

stewardship Strategy

Railpen structures engagement both from a bottom up and a top down perspective. In terms of bottom up, the investor seeks to engage all companies in its internal actively managed equity portfolios which is about 80 holdings across three portfolios. This runs alongside a top-down approach via a thematic overlay in recognition that even active investors with a strong record of stock picking are still exposed to systemic risk.

The four themes (the climate transition, the worth of the workforce; responsible technology and sustainable financial markets) captured in the overlay reveal another cohort of companies that can expect Marshall and his team of seven to knock on the door.

“On climate we engage with around 47 companies as part of our net zero plan. These companies contribute 70 per cent of our financed emissions. We also have an exclusions process structured around governance and corporate conduct that runs screens across the whole portfolio, shortlisting around 20 companies for focussed engagement and perhaps, ultimately, exclusion of those companies.”

limitations of Passive

Railpen holds very little passive equity exposure, however it does have some externally managed index allocations with LGIM which also manages stewardship and engagement on the investor’s behalf.

Moreover, Marshall notes that stock allocations in the actively managed portfolio are often repeated in the passive allocation, meaning that in some cases Railpen is already engaging with the company. Large passive houses like Vanguard, BlackRock and LGIM frequently pop up as significant shareholders for many companies and are increasingly influential.

“When it comes to winning votes, companies really want to keep them on side,” he says.

Still, he notes the inherent limitations of the ubiquitous ‘Dear CEO’ letter penned by stewardship teams to thousands of companies in a passive portfolio.

lEven the largest stewardship teams at index investors cannot meet every portfolio company, and the larger the stewardship team grows, the greater the risk of undermining the low-cost benefits of passive investment.

“Passive is a buy and hold strategy: companies know you are unlikely to divest in your mainstream index-tracking portfolios.”

the importance of Relationships

Marshall highlights the long-term nature of Railpen’s bottom-up engagement process. Many holdings in the fundamental allocation date from the beginning of the portfolio seven years ago, resulting in a longstanding stewardship conversations based on trust.

“If a concern surfaces, we would be unlikely to immediately write to the chair. Instead, we might raise our concern in our next company call and then escalate from there if the issue is not getting the attention required, but we are not starting an engagement process from scratch in terms of building the relationship.”

This contrasts with the higher turnover of the quantitatively managed equity strategies, run inhouse by Railpen, where allocations to value, momentum and quality stocks might not come with a long-term relationship.

“Establishing durable relationships of mutual trust with companies takes time if you’re going to do it well” says Marshall. “For our quantitatively run strategies we employ a thematic overlay, focussing on enduring themes rather than idiosyncratic issues at particular companies.”

Within themes companies are prioritised based on size, materiality, equity ownership, and likelihood of achieving change.

Railpen is a member of multiple collaborative initiatives designed to increase investor pressure like the United Kingdom’s Investor Forum. Railpen also uses third party suppliers to advise on proxy voting which talk to companies through the course of the year, advising them how the investor might vote.

“Our success often depends where companies are based. We have good purchase in Europe and UK, but it’s more difficult in emerging markets,” he says.

Alongside climate, Marshall’s team also engage on One Share One Vote. He argues that dual class share structures, which give company founders or the family more votes per share, may suit young, entrepreneurial companies that have just listed. But as a company matures and broadens its shareholder base, it is important investors can hold it to account.

“When investors only have one tenth of the voting power compared to the founder, it’s more challenging for investors to exercise stewardship obligations in the way policy makers want. This isn’t a niche issue as huge companies including Meta and Alphabet have a dual class share structures so many investors will have exposure to this issue.”

 

 

 

 

It is not war between Russia and Ukraine that investors should be concerned about, according to Professor Stephen Kotkin, but the destabilising effects of Russia’s actions that could impact globalisation and harm the west.

“The big geopolitical risk is not the war but that Ukraine gets broken up,” Kotkin, the John P Birkelund Professor in History and International Affairs at Princeton University, told Top1000funds.com in an interview. “A lot of what Russia could do could be very destabilising for investors. Investors should be in favour of cutting a deal.”

Kotkin who is a Russia expert and was shortlisted for the Pulitzer Prize for his book Stalin: Paradoxes of Power, said investors should not looking at the tension itself but what could be done by either side, in particular Russia breaking up Ukraine.

“Things like making their cities unliveable and poisoning the air and rivers, using cyber war to shut down the utilities and repercussions beyond Ukraine because everything is interconnected,” he said. “99% of the world’s communication goes through under sea cables. They are mapped and Russia knows where they are, they could cut them. Globalisation is worth a lot more to the west than it is to the Russians.”

Kotkin said this tension will not stop and Russia can come back again and again.

“I’ve been on record for seven years saying we should cut a deal with Russia over Crimea. It’s the big bargaining chip the western side has for a larger settlement to protect Ukraine but give Russia a stake in the deal.”

Kotkin, who among other things is the co-director of the program in history and the practice of diplomacy at Princeton and a senior fellow at the Hoover Institution at Stanford University, believes it is not in Putin’s interest to go to war.

“There is no support in Russia for a prolonged military war in Ukraine,” he said. “There are all sorts of reasons why Putin is in a bit of a bind here. He could undermine himself by going to war. This is a situation where we need to find a way out, not just for the west and Ukraine but for Russia as well.”

He also believes that President Biden also in a bit of a bind because many of the measures the US is threatening, like economic sanctions, against Russia could boomerang against the west.

“The pressure can be as long as Putin wants it to be. And if he withdraws temporarily he can ramp up again. On the sanctions being threated I don’t think it makes sense for Europeans to go without heat and shut their industry down by cutting off gas. It doesn’t make sense for Russia to be excluded from the SWIFT banking system. The international financial system is worth a lot more to the west than it is to Russia.”

He said one option with regards to the economic sanctions, which was effective during the cold war, could be technology transfer limits.

Generally he believes the west is in a better position now.

“Investors can only hope the Biden administration does up its game, that NATO and the EU stay united, that there is an off ramp and more importantly there is pathway to negotiation for a better settlement where Russia has a stake and Ukraine is protected at the same time.”

In the interview Kotkin also discusses the tension between Taiwan and China and reminded investors that the big problems are always perverse and unintended consequences.

In presenting to the board for the first time this year CalSTRS’ long-time chief investment officer Chris Ailman borrowed an image used by Goldman Sachs in its economic outlook for 2022 of an icebreaker smashing through icebergs.

“Images of icebergs are just the best example of the forecast and the outlook for the year. It’s pretty frightening, there are submerged problems everywhere,” Ailman said in an interview with Top1000funds.com citing the Ukraine and Russia, climate change, supply chain shocks and the ongoing uncertainty of the virus as issues causing concern.

“For at least the last two years we have had central banks pushing us but now we don’t. When we look back at the history of US markets usually after two years of double-digit returns the third year is up but in single digits. But none of that research reflects living through a pandemic. I don’t know we can use the past as a guide given the strange uncertainties of the future.”

With this cautious outlook Ailman is expecting lower returns than the fund has experienced recently. Mind you, it’s 2021 return was a record where it outperformed its benchmark in every asset class to deliver 27.2 per cent for the year against a return assumption of 7 per cent. Standout performers were the large allocation to global equities and the outperformance of the private equity portfolio which returned 51.9 per cent.

“The last two years have shown us the unknowns: two years sitting in our own rooms working in isolation,” he says. “And now with interest rates where they are we expect it to be a tough return year.”

In response CalSTRS is adding to the defensive allocations in its portfolio and concentrating on diversification.

“With rates so low but likely to go higher fixed income may have a negative return for the year. It’s going to be tough to make returns,” he says. “We are finally at the market weight in private equity and had a great return last financial year. But I doubt that can keep up. We are adding to the diversifying and defensive areas, not a tonne to fixed income but other things we think will diversify.”

But when probed about where he is looking to allocate his cautious perspective prevails again.

Ailman thinks the fund is at the limit of what it can do with commodities and is looking at different inflation-hedging investments; he thinks real estate is priced to perfection and the fund is underweight because of a lack of things to buy; he is concerned about private debt because of the flow of money; and while he is watching agriculture and timber he won’t buy “at these prices”.

Emerging markets, he says, have been cheap for two and a half years and are still cheap, but investors are now afraid to allocate.

Overall from a historical price perspective he says most asset classes look like they are priced near perfection, supporting the strategy to focus on diversification.

“We have been a little bullish due to the Fed and that worked well in the past two years. But right now it is hard to have conviction,” he says. “I’m always worried in my spider senses and now I’m super worried about all the things that could happen.”

2022: A focus on net zero

After many years leading the ESG charge in the US among large asset owners, last year the CalSTRS’ board finally made a formal commitment to net zero by 2050 with the caveat it would take a year to figure out the plan to get there.

“If you use Google maps you can pipe in a destination but it has to know the starting point for their to be a path,” Ailman says.

The fund is due to come out with a measurement report in May this year which will map public markets. Ailman says the fund is also working with the real estate and private equity industry on how to measure carbon intensity, noting that many in private markets use estimates.

The fund will also invest in opportunities and look at the portfolio from a risk standpoint with regards to net zero, Ailman says.

“We will make strides this year. We are starting to talk to the board about the path to take, there are multiple routes,” he says.

But Ailman takes a slightly different approach to his view of net zero looking to a closer alignment of Wall Street and the High Street as an indicator.

“I could make my portfolio net zero but if we are not living our lives closer to net zero – like driving electric cars – then as investors we are making a big bet on the future. The world should get there, but the pace of governments is so slow. A good chunk has to come from the companies changing their behaviour,” he says, citing the need for companies like GM to stick to their carbon neutral plan.

His prediction is that from the year 2025 there will be a huge corporate governance push on companies especially if global governments haven’t put demands on consumers.

As part of this focus on net zero a special team within investmenst has been set up to do research – Ailman himself is tasked with doing research on hydrogen.

He says the team will focus on two main areas: climate solutions and net zero and engagement with dirty industry.

Size matters in institutional investing, but how exactly does it result in better returns? Research by CEM Benchmarking shows large, internalised, active investors produce more net value added than small, externalised, passive investors. When private equity and unlisted real estate are included into the analysis, internalisation of asset management becomes a significant predictor of value add.

Analysis of Toronto-based data insights group CEM Benchmarking’s database of large asset owner costs and performance data, shows that the largest institutional investors do add incremental value over and above smaller funds. Net of costs, funds with more than $10 billion in assets under management have consistently delivered excess returns that are significantly higher than smaller funds with under $1 billion in assets under management.

“The larger the funds are the more consistent outperformance on a both a gross and net basis you will find,” said Rashay Jethalal, chief executive of CEM Benchmarking speaking in a presentation hosted by Canadian Club Toronto accompanying publication of the report. “Scale really matters.”

The research found that large funds have been able to achieve these positive results while taking on less active risk than smaller funds. The advantages of scale most prominently manifest in these investors’ ability to implement private assets internally, resulting in much lower overall private asset management costs.

Net of costs, the largest institutional investors deliver more value added than smaller funds in both public and private markets, an advantage driven almost entirely by lower staffing per dollar invested and lower fees paid to external managers. On average, smaller funds delivered 47 basis points of outperformance before costs, 36 basis points lower than the 83 basis points of outperformance delivered by funds with more than $10 billion assets under management.

Scale trends

Typified by the successes of the large Canadian funds, there is an increasing belief within the investment community on the benefits of scale in asset management.

In the Netherlands, the pursuit of economies of scale by defined benefit pension funds has been underway for more than 20 years. In 1997 in that country there were 1,060 defined benefit pension funds. By 2015, consolidation had reduced the number of Dutch pension funds to 290.

In the UK, over 90 previously stand-alone local government pension schemes are merging into eight larger asset pools.

Nor is the trend unique to defined benefit as evidenced by the rampant merger activity with the Australian superannuation funds.

Value added

The CEM research focuses on value added, the difference between a fund’s policy benchmark and the actual return realised by the fund.

Value added is the sum of both manager value added within asset classes and tactical portfolio decisions between asset classes. Value added has the advantage of being relatively agnostic to asset mix, enabling comparisons across funds.

One possible explanation for larger funds’ outperformance is that the largest funds are taking on more active risk than smaller funds. However, the research shows this not the case – not only are larger funds generating higher value add, but they appear to be doing so while taking a lower level of active risk – or as likely, diversifying away more of their active risk.

This observation is especially important considering the almost complete lack of persistence observed in value add. Put another way, much of the variability in value added can be attributed to randomness rather than skill.

Prior research conducted by CEM Benchmarking has shown that the most important quantitative features of funds for determining value added are active management, internalisation and economies of scale. Private equity and unlisted real estate are large contributors to gross value added at the fund level and reflecting their higher allocations to private equity and unlisted real estate, more of the gross value added realised from these asset classes accrue to large investors. While it would be easy to suggest that smaller funds should simply invest a higher proportion of their fund in private assets, one cannot ignore the impact of costs.

“There is a small list of things that improve returns but don’t involve taking more risk,” Bert Clark, president and chief executive officer of IMCO says.  “There is a free lunch of diversification and building a better portfolio; costs are also a free lunch – get your costs down you will have better returns. Sadly a lot of risk-free, return-enhancing strategies are only open to bigger investors.”

Public markets

Moreover, the economies of scale advantage of large investors in public markets is also driven by cost advantages and not skill differences. The research found that as assets under management increases efficiencies in public markets are found which improve the bottom line by approximately half, if not more. Economies of scale are found in investment costs for external managers as well.

For example, total investment costs for externally managed active US small cap equity portfolios increases slower than assets under management. Where an external $200 million portfolio of active small cap. US stock is expected to cost 55 basis points, a $2 billion portfolio is expected to cost only 40 basis points.

For public market assets the data is clear; as you get bigger, costs increase slower than AUM which translates directly into improved net value added, even excluding the impact of private market assets.

Large, internalised, active investors produce more net value added than small, externalised, passive investors. When private equity and unlisted real estate are included into the analysis, internalisation of asset management becomes a significant predictor of value add; internalising private equity and unlisted real estate improves net performance.

While internally managed portfolios of private equity and unlisted real estate perform marginally worse than external investments gross of costs, the cost savings, measuring in the 100s of basis points, far outweighs any difference in top line return. Investment costs alone may not be the only cost benefit of internalising private equity and real estate. A second advantage that can be gained by internalising private equity and real estate is the ability to exert control over the use of leverage.

Returns in private equity or unlisted real estate are usually amplified with leverage, either through subscription lines of credit or portfolio company bond issuance in the case of private equity, or through mortgages or capital structures financed with debt in the case of real estate.

Large Canadian funds such as CDPQ, CPPIB, HOOPP, OMERS and OTPP all issue debt and participate in repo markets at significantly lower rates than are available to real estate funds or private companies. Doing so however requires scale.

Successfully internalising private equity and/or unlisted real estate demands scale. While smaller investors have some internally managed real estate, the asset base is usually low, and the performance tends to trail those of larger funds.

“It’s not easy to access private investments, typically people invest through funds – certainly smaller investors. The fees you pay to invest in a fund may well eat up all the benefits of being in that asset class. Scale typically allows you to get the fees down, and co-invest alongside in select transactions,” IMCO’s Clark says.

Bringing private equity assets inhouse is an activity limited to the largest funds – the smallest investor in the CEM database that reported having substantial internal private equity investments in 2020 had $18 billion in total assets, while the average investor with internal private equity investments in 2020 has total fund AUM of $152 billion.

This is the real win for scale, the ability to deliver cost-effective and diversified private asset management by leveraging scale to implement these assets internally.

When PensionDanmark’s chief executive Torben Möger Pedersen meets members of the $49 billion labour market pension fund, the conversation doesn’t just focus on the fund’s healthy spate of returns. Lately, his regular tete-a-tete with stakeholders has focused on PensionDanmark’s growing renewable energy investment in assets that churn out the equivalent to the fund’s 800,000 members yearly energy consumption.

“It’s a compelling story,” says Pedersen. “We are not only a pension fund for our members, we also provide them with green energy.”

Denmark: A new Norway

The narrative is about to become even more compelling. PensionDanmark is investing in Denmark’s first energy island, a North Sea hub the size of 18 football pitches that will serve 200 wind turbines, linking production to the shore by a single cable. PensionDanmark’s investment, part of a consortium of other long-term investors, is small at around DKK 2.5 billion and from a construction perspective, the energy island is not a particularly complex, or risky investment.

Its allure lies in its scalability. The investment will be a stepping-stone to the pension fund financing bigger projects in the North Sea needed to fulfil Europe’s green power targets as well as further afield in South-East Asia.

“This is the investment case for us,” he enthuses. “It is a chance for Denmark to become a new Norway not in oil and gas, but in green power.”

The energy island still has hurdles to overcome. New wind farms around the hub need to get up and running.

“It is important for us that the construction of the island is in sync with the construction of the windfarms. We don’t want to build the island and ask ‘where are the wind farms?’” he says. Other steps include reaching an agreement with the Danish government on a payments structure that will determine returns, he says.

Skills

PensionDanmark’s ability to conceive, construct and operate ambitious energy infrastructure is rooted in a pivotal decision taken 10 years ago to become a developer of infrastructure and real estate assets. Back in 2012, led by Pedersen who has been CEO since the fund was established in 1992, PensionDanmark decided that investing in brownfield sites wouldn’t bring the same return as development, construction, and management of an asset.

“The only way to get access to attractive returns is to accept the risk of being a developer,” he says.

In PensionDanmark’s real estate allocation, he estimates that around 50 per cent of the returns are associated with development.

“If you are not able to be involved with this stage of the project, you have to accept half of the returns and that the other half will go to someone else,” he says. “If you are buying an office building, the return is 3 per cent but if you are involved in the whole value chain it is 5-6 per cent. That difference is attractive.”

It has required building an alternatives team that includes architects and engineers with boots-on-the-ground expertise across the whole value chain in contrast to desk-bound, listed market investment expertise.

PensionDanmark’s skills and expertise in green infrastructure are housed in fund management company Copenhagen Investment Partners (CIP) founded in 2012 by the pension fund with senior executives from the Danish energy industry. Today it invests on behalf of some 140 other investors too, and has a reputation as one of the largest investors in renewable energy globally.

“In the beginning, CIP was active in the UK and Europe. Now we are in the US, South East Asia and established in emerging markets like India and Brazil an Vietnam.  It’s become a global business.”

With that, CIP’s reach has extended beyond on and offshore wind to green energy storage and transmission and green hydrogen. As the transition gathers pace, investments will include using renewable energy to generate ammonia at scale used to produce carbon-free fertilizer and as a fuel for shipping and the logistics industry, he says.

“The clock is ticking if Denmark is to fulfil its promise to have reduced CO2 emissions by 70 per cent by 2030 compared to 1999,” he says.

Economic outlook

The investment case for alternatives,  an allocation PensionDanmark plans to increase from 30 per cent to 35 per cent of total AUM, has become more compelling given Pedersen’s belief that the long period of low interest rates and buoyant equities is drawing in.

“Looking forward, we are comfortable with a large allocation to real estate and infrastructure, the type of assets with a low correlation to macro-economics and listed equity markets.”

Even small increases in interest rates will diminish the benefits of holding bonds, he says.

“We have had 8-10 per cent in annual returns for the last decade and we are now looking to having to be satisfied with something between 2-5 per cent that is only attractive if inflation is kept to 2 per cent. An allocation to alternatives although difficult and resource demanding will be necessary to deal with the challenges in the listed market,” he concludes.

 

It is fundamental that asset owners contribute feedback to the exposure drafts on climate and general sustainability disclosures issued by the International Sustainability Standards Board (ISSB) according to Janine Guillot, special adviser to the ISSB chair.

In March, the ISSB-issued prototypes will become exposure drafts and after the consultation process and will ultimately be the first two standards issued by ISSB.

“We expect some time in the first quarter for those exposure drafts to be issued. It is very important for asset owners to be part of the consultation process,” Guillot says.

The climate prototype has largely been based on TCFD and SASB and many asset owners had significant input into those, but it will also have a cross-metric industry component which is new. There is also a prototype on general requirements for sustainability disclosures.

Guillot says the ISSB will finalise a climate standard and general requirements standard by the end of the year partly because there are many regulators keen to mandate climate disclosures and the ISSB standard will be a helpful tool for those regulators.

Asset owners are increasingly challenged by the disclosure requirements of climate risks in their portfolios. Guillot says the most efficient way to implement those is to have globally accepted sustainability disclosure standards which are used by companies around the world. “If that happens asset owners can source the data they need for their own disclosure requirements sand integrate climate risks into their assessments,” she says. “It is vitally important they give feedback to what those disclosures might look like.”

The formation of the ISSB has been described as a historic opportunity to establish a global sustainability disclosure standard-setter for the financial markets. The ISSB is the second standard setting board, alongside the International Accounting Standards Board, under the umbrella of the IFRS Foundation.

Guillot suggested that as well as issuing two standards in the next year, there will be other significant priorities for the ISSB. While these have not been endorsed by the board, her opinion was there were three big research themes for the ISSB to focus on.

These include the next generation of climate risk metrics, human capital and biodiversity.

With regard to human capital, the SASB standards team had a two-year research project underway on human capital to get feedback on the issues most relevant to value, and where disclosure could improve. The main theme to come out of that is DEI and Guillot said a standards-setting project has begun on that.

“There is high demand for quality metrics but it is hard to do globally,” she says, encouraging asset owners to give feedback on priorities for the board’s agenda.

At COP26 the IFRS Foundation consolidated the Climate Disclosure Standards Board and the Value Reporting Foundation, itself a merger of the Sustainability Accounting Standards Board Foundation and International Integrated Reporting Council.

Guillot, who was a founding executive of SASB and before that chief operating investment officer at CalPERS, says while she feels a sense of collective accomplishment with the establishment of ISSB there is still a lot of work to do.

“When I did that first interview with you back in 2016, did we ever envisage these years later we would be talking about ISSB with support of the regulators and SASB would be rolling into that? It is important to acknowledge what a monumental and historical moment this is and the important role investors have played in driving the understanding of how important standardised sustainability reporting is. It is a tremendous collective accomplishment and a huge shout out to asset owners and managers,” she says. “Having said that, this is like another beginning. It’s not like the mission is truly accomplished yet.”