Chris Hulatt, founder, Octopus Group, and Olivier Rousseau, executive director of France’s FRR, reflect on the European energy crisis. Speaking at FIS Chicago, they warn of consumer pain ahead, urging governments to do more to build renewable energy infrastructure.

Cripplingly high energy costs in the UK where the average annual household bill is forecast to near £2000 is already compressing discretionary income and leaving one in five UK households in fuel poverty. “The sheer brutality of the rise in bills is different to anything in the past,” said Hulatt. He noted how the rising cost of energy will also impact businesses like supermarkets with high energy usage, low profit margins and little pricing power. “Profits will be under pressure at businesses like this,” he predicted.

Building renewables is the solution, but it comes with complexities, particularly bureaucracy. Red tape stalls quick construction around solar farms and onshore wind, the lowest cost renewable energy that can be built quickly once grid connection and planning are in place. “Governments should shorten this process to build new assets,” he said.

Leadership

Hulatt outlined the role of western nations in helping developing nations move away from coal and said that political leadership plays a crucial role in delivering the transition. In South Africa, the move away from coal is essential; power stations are old and South Africa can’t grow its economy if it doesn’t have access to electricity.

Most governments now recognise the need for change. When the United Kingdom’s former Prime Minister Theresa May put in place a net zero commitment it was deemed radical in a way that it wouldn’t be today. Reflecting on the importance of the “tone from the top,” Hulatt noted how Australia’s new prime minister Anthony Albanese is already signalling a change in Australia’s approach to renewable energy.

Still, he noticed how war in Ukraine and the ensuing spike in energy costs has paused talk on the transition and net zero. “It feels like the topic is on hold,” he said. He noted that bigger European economies failed to diversify from Russian energy but shifting to other energy suppliers is difficult. For example, Germany’s ports are not equipped to import LNG, posing a logistical challenge with no easy solutions.

Nuclear option

European countries are going in different directions around nuclear energy. France has an established nuclear industry; Germany is closing its nuclear plants, but the UK is building more. Panellists heard how nuclear is costly and takes years to build – future nuclear supply will do nothing to reduce bills or wean the UK off Russian energy today.

Olivier Rousseau, executive director, FRR, counselled on the correct policy response to the spiralling cost of living. The wrong policy response in France provoked social unrest. France’s Gilets jaunes (yellow vest) protesters took to the streets following a hike in diesel fuel and petrol taken by a political elite that effected poor people the most. Policy makers have learnt from the protests and are now targeting relief from energy prices to the neediest, he said. “This was a good response after a misunderstanding,” he said.

France developed its nuclear energy industry in response to the oil shock in a rare example of long- term decision making. The massive programme was completed in the 90s and today France derives 85 per cent of its power generation from nuclear and 10 per cent from hydro.

However, Rousseau observed how some sectors of French society have grown sceptical of the nuclear industry. The Fukushima disaster and Germany deciding to shut down its nuclear power have increased resistance to the industry. He said that countries investing in nuclear need to be mindful of the risk posed by huge power plants and associated grids.

Panellists heard how many pension funds are reluctant to invest in nuclear power. Although nuclear has been included in the EU’s new taxonomy of sustainable investment, many pension funds have restrictions on their ability to invest. It means the British government has been unable to tap long term pension fund investment to build Hinkley power station in Somerset. “Traditional providers of long-term capital are unlikely to be big contributors; the government needs to find different types of funding mechanisms,” said Halett.

Rousseau countered that nuclear is a sovereign risk and should be financed by governments. It is too risky for the private sector to finance, and investors would demand too high a premium, he said. In an example of the risk of outside investment,  panellists reflected on how the UK is now trying to roll back on China’s 20 per cent stake in Hinkley.

Rousseau said that FRR’s pioneering decarbonisation strategy involved convincing conservative colleagues but drew impetus from Paris hosting COP 2015. The fund has created indices to support the reduction of its carbon footprint and is also decarbonising its smart beta and factor investing allocations.

Real assets

Hulatt noted how real assets have become an increasingly compelling investments for pension funds. Real assets also have an inflation linkage and wind energy offers stable long-term growth that is compelling against the backdrop of falls in equity. Investment is also being driven by pension funds own net zero targets.

Pension funds have grown much more comfortable investing in the construction phase of renewables; they understand the risks and fierce competition for operational assets has pushed them into new sectors. Investors could buy operational assets that are bond like and offer 4-5% returns, but more are choosing to build assets from scratch for a bigger return.

Hulatt concluded that building renewable energy infrastructure incurs a high carbon footprint. Investors are mindful of the concrete and supply chain issues in solar products sourced from China. But analysis supports the lifetime benefits of building renewable infrastructure. “A solar farm earns its keep,” said Hulatt, noting the importance of looking after local communities and counting decommissioning costs.

 

 

 

 

 

Globalisation, the cross border flows of trade, capital, people, and information, has had a profound impact on efficiency, competition, growth and inflation, all factors keenly watched by investors and influencing asset allocations. It is no surprise the appearance of de-globalisation trends has investors worried, but speaking at the Fiduciary Investors Symposium at Chicago Booth School of Business, Patrick Zweifel, chief economist, Pictet Asset Management, said although trends in globalisation are changing it is not about to disappear.

History

The origins of globalisation date from steam power. More recently it has grown with the globalisation of information dating from the mid-90s. Against a backdrop of growth, globalisation has also gone through phases of decline however. The most recent decline began in 2008, visible in protectionist measures like the US-China trade war while the pandemic slowed trade and the movement of people, reducing tourism and business travel. “The question is whether the pandemic and war [in Ukraine] will exaggerate the trend over time,” asked Zweifel.

Other factors are also feeding into the de-globalisation narrative. Emerging economies are producing more goods of their own than they used to; consumers in emerging markets are wealthier and consume more domestic production. US foreign direct investment has declined since 2008, and he noted a decline in companies investing abroad or outsourcing production.

Elsewhere, weak institutions are exacerbating the trend like the WTO, struggling to influence decision making. However, Zweifel noted that this hasn’t stopped regions in the world making their own free trade agreements like the Regional Comprehensive Economic Partnership (RCEP) made up of 10 Southeast Asian countries, as well as South Korea, China, Japan, Australia, and New Zealand.

Climate change has also changed consumer behaviour, leading people to buy more locally and travel less. However, Zweifel noted that the energy transition is creating new trade flows. For example, new trade corridors will open up as flows from oil exporting regions in the Middle East give way to flows from metals exporters in countries like Chile, the DRC and Australia. Moreover, although protectionism is rising, he said it may be confined to certain protected areas like technology and medical supplies where he says re-shoring is most likely.

Reshoring vs friend shoring

Re-shoring will bring challenges for many companies. Often touted as the best response to reducing supply chain vulnerability, companies that re-shore will lose their comparative advantage and see their labour costs rise. Moreover, reshoring is happening when labour markets are already tight. The only way to counter higher wages will be for countries to open their borders to immigration creating a paradox. “Countries could be forced to import a labour force into their own country,” he said. Countries with better demographics are best positioned to reshore, he said. “Demographics will make a difference.”

Near shoring, or friend-shoring, provides an alternative that successfully reduces or shortens the supply chain but does not rely on domestic production. Zweifel also counselled on the importance of companies diversifying their supplier base.

Drawing on several, diversified, suppliers ensures companies are better positioned to always be able to produce their goods. He suggested companies see this strategy as a kind of insurance premium. Although it will cost more, it means they won’t have to halt production or see their margin impacted by reshoring. He noted how European economies have woken up to the risk of not having a diversified energy source away from Russia. Only now are countries making deals with other producers like Algeria.

New trends

He noted how internet access is fuelling growth in emerging markets – however internet access is still low across Asia, creating room for these economies to catch up. This will allow societies to have more access to the services like banking and finance on their phones that are essential for economic growth.

Elsewhere, Zweifel noted how the pandemic has fuelled tech innovation and reduced the cost of face-to-face contact, leading to new telemigrants (people sitting in one nation and working in offices in another) allowing companies to reduce the cost of labour by employing talent overseas and holding benefits for emerging markets. Elsewhere the cost of production of goods is falling because of technology and AI.

All these changes will feed into the inflation narrative. The price of goods might rise with reshoring, hitting companies cost of production and profit margin, however technology will also drive down production costs. Zweifel concluded that  investors should gain exposure to new themes like digitisation, robotics, and clean energy.

 

 

“We’ve had significant success hiring people who care about the mission and have bought into who and what we are,” says Richard Tomlinson, CIO of Local Pensions Partnership Investments, the £22 billion asset manager for three Local Government Pension Scheme funds in the United Kingdom. Public sector pension funds might not be able to pay investment teams as much as the private sector, but as fierce competition for talent rages, particularly in sustainability, asset owners have key ways to attract talent. “It can take quite a while to hire, but you can find good people,” he says.

Success comes down to culture, clarity on goals, appreciation and offering an environment where people can grow and feel valued. “Many people want a job with purpose; they want to be empowered,” says Tomlinson who’s studying of leadership and team building techniques practised by the likes of New Zealand’s All Blacks and the Navy Seals has instilled his own belief that these factors are just as important as pay in recruiting and retaining talent in LPPI’s 57-strong investment team.

It’s a particularly important message to get across in the hunt for mid-career investment expertise where the competition of talent is most intense. Mid-level candidates, often at the most expensive time in their life, will still opt for purpose, culture, and people over salary, he insists. “Money matters much more for the middle bracket but purpose, culture and people really do matter too.” In contrast, the hunt for talent isn’t as fierce at junior or senior levels: junior hires without huge experience can’t command top whack, while senior roles are often filled by candidates who are less motivated by money.

Costs

The rising cost of talent and salary inflation could play into LPPI’s ability to continue to cut costs. LPPI’s total investment management fee savings was £164.13m at the end of March 2021 thanks, in the main, to bringing investments in-house with a third of the portfolio now managed internally.  However, not only are internal salaries going up, Tomlinson explains that sustainability and data systems to support net zero commitments are pushing costs up even more. “When I started, we had one person in the responsible investment team but now it’s five.”

Nor does he see much room to cut costs further via changing the asset allocation or bringing more assets in house. “We can probably do a bit more internally, but we have a healthy spread now between what we are paying externally and internal efficiencies: we have a good frame around our fees, costs and performance.”

He also argues that driving costs down should always been seen in the context of risk and performance – increasing costs can often drive better outcomes. “If you wanted to save on costs, you could buy some ETFs or take out the private equity allocation – it just might not meet your needs. Alternatively, you don’t just want to naively lock money into private markets in search of an illiquidity premium that is not always positive and where fees can be painfully high.”

Looking ahead

LPPI’s long-term, growth-orientated portfolio is already skewed to lower risk with sizeable investments in defensive equities and real assets. It means the portfolio is well positioned for today’s investment climate where Tomlinson is concerned about Central Bank’s clear and hard pivot to get inflation under control and the growing likelihood of a hard economic landing. Any adjustments to the portfolio will only be on the margins, like, for example, selectively buying the hardest hit equity names.

Although he’s not casting around for opportunities, he has liquidity on hand should they arise. LPPI re-forecasts its 12-month cash flow expectations monthly, stress testing cash flows on contingent liability and he can draw on liquid allocations to cash and fixed income if needed. Moreover, because a large part of LPPI’s real asset allocation is internally managed, the fund is protected against untimely capital calls – something he describes as every CIO’s nightmare if liquidity is scarce and pensions need paying. “The need for liquidity doesn’t keep me awake at night,” he says.

Dollars in a downturn

The large allocation to dollar investments will also act as ballast. In a downturn, it is common to see capital getting pulled back to the US causing the dollar to strengthen while any tighter funding lines also see a rush for dollars. “The dollar is a nice place to hide at times of market stress,” he says.

Around 30-40 per cent of LPPI assets under management are in dollars and Tomlinson doesn’t hedge the allocation to US stocks – although he does manage the FX impact at a total aggregate level via an overlay for some clients.  Elsewhere, he notes how the portfolio also gains exposure to dollar earnings via many FTSE listed companies. So much so some UK pension funds hedge the FX exposure – although it’s not a strategy he advises. “The realised volatility of an unhedged UK equity allocation is lower than a hedged allocation.” Away from equities, LPPI does hedge all its dollar-denominated credit and fixed income allocation.

 

 

 

Theresa Whitmarsh, former executive director of the Washington State Investment Board and Hiro Mizuno, former CIO of the Japan Government Pension Investment Fund, the world’s largest pension fund, are behind the latest investor tool to support ESG integration and prevent greenwashing.

The Pension Fund Coalition for Inclusive Capitalism, part of the Coalition for Inclusive Capitalism and co-chaired by Theresa Whitmarsh and Hiro Mizuno, has released an open resource template to help pension funds’ structure contract language in their investment agreements with asset managers around ESG integration in public and private equity. The resource is intended to protect against superficial implementation of ESG and enable asset owners to better direct their asset managers to invest in line with their priorities.

The model contract language establishes minimum ESG guidelines for use in investment agreements with asset managers as well as private equity side letters and LP agreements. Whitmarsh and Mizuno collaborated with pension fund managers and legal advisors to draw up the template which includes a prototype for integrating asset owner reporting requirements and voting rights and is another building block in the crucial market infrastructure supporting sustainability and impact investment.

The templates can also be tailored to asset owners’ ESG and long-term investment priorities. “Our aim is to give asset owners better tools to evaluate asset managers in terms of their alignment of beliefs and how they get expressed,” says Whitmarsh.

She adds that the initiative has its roots in an initial asset owner survey exploring how investors expressed their views on ESG in their contracts with asset managers. “We found nothing,” she recalls. “Although asset owners had discussions with their managers and expressed views via proxy voting and exclusion criteria for example, no single asset owner had contract language: although the whole ESG approach has evolved, contracts haven’t.”

Whitmarsh adds that Mizuno also led on the initiative when he was at the GPIF, working with Japan’s asset management community to try and get contract language into GPIF’s mandates to enable the pension fund to better control how its assets were invested in line with its ESG wishes. “GPIF is such a large asset owner and his requests were responded to but still, even with his clout, he struggled to get language into contracts.”

It led them to talk to the legal profession to draw up a playbook to support asset owners. She notes how the template avoids being too prescriptive given ESG is still an expression of judgements and viewpoints. “We recognised there are a wide range of approaches to ESG. There is no one way to express ESG beliefs so we have created a workbook and template approach with many options.”

Asset owners have been quick to welcome the initiative. “It’s important that large asset owners, including pension funds, treasurers, and endowments, know how to structure an optimal relationship with their investment managers,” says Illinois State Treasurer Michael Frerichs. “Asset owners have a vested interest ensuring that their managers are using best-in-class practices that add value and serve their needs. This includes the integration of ESG factors into investment decisions, the adoption of strong proxy voting practices, and the provision of robust reporting on investment management and stewardship activities. The model language will help investors structure strong relationships with their managers and it will help create uniform standards across the market.”

“Pension investors and asset managers must create long-term value for clients and beneficiaries by considering social and environmental outcomes,” said Gordon J. Fyfe, Chief Executive Officer  and CIO at British Columbia Investment Management Corporation (BCI). “Standard tools like model mandates can support the approach portfolio managers take to consistently apply ESG principles.”

Whitmarsh also believes asset managers will welcome the template, particularly given the legal language in the contracts has been heavily vetted. She notes how managers are reluctant to enshrine strategies around for example proxy voting into contract language despite clear guidelines from asset owners lest it trigger compliance issues.

“This language has gone through a lot of legal review,” she concludes.

 

 

 

“A forecast is a prediction; we’re saying what we think will happen. A scenario is different . . . it generally looks much further out and is trying to build a picture of the future in extreme uncertainty.” — Seb Henbest

(more…)

British Columbia Investment Management Corporation, BCI, the $200 billion asset manager for around 30 Canadian pension funds and insurers, is planning to double its private debt allocation. Sarah Rundell spoke to Daniel Garant about the shifts in the portfolio and the focus on active management.

BCI began building the allocation to private credit after the GFC when new regulatory burdens on banks requiring they hold more capital opened a gap for investors to lend more to private companies. Today, one reason opportunities in the asset class have spiked is because of its competitive advantage over the syndicated loan market, explains Daniel Garant, executive vice president and global head of public markets at BCI where he oversees a $137.8 billion allocation to fixed income and public equity, the bulk of which (79.5 per cent) is managed internally.

“Private debt competes with syndicated loans in the upper-mid market, but syndicated loans are more subject to market volatility. For instance, private debt transactions saw a higher certainty of execution than syndicated loans when Russia invaded Ukraine – private debt brings certainty of execution.”

According to BCI’s 2021 annual report, private debt accounted for 9.1 per cent of the $71.2 billion fixed income portfolio.

Another reason he favours the asset class is because private debt is tied to a floating rate, meaning returns will adjust to inflation.

“There will be a lag, but a floating rate will adjust with rising rates and this is a good protection against inflation.”

In a third seam, the allocation also supports BCI’s clients’ liability profiles. “In this sense, private debt fits with assets like infrastructure and real estate,” he says.

BCI invests in private debt via partnership with external managers either in separately managed accounts or co-investments. In a hybrid approach, the internal team carry out the screening and research on each individual credit.

“It is not a passive model where we allocate to external managers; we get to select the credits we like and the pricing we are comfortable with,” says Garant.

Bias for Active

It’s an active approach that is reflected across the portfolio. In another strategy born from today’s investment landscape (where Garant says volatility will bring plenty of opportunities despite the challenges) he is increasingly prioritising active equity over owning the entire market to strike when opportunities are mispriced, add value, and better manage risk as lockdowns in China and war in Ukraine cause a prolonged supply chain crisis for many corporations.

Active allocations in the public equities program include two active funds with a strong ESG focus (global thematic and global quant ESG where ESG scores drive the stock selection). The global thematic fund’s investment process focuses on long term trends based on internal research.

“Allocations are really based on our expectations of where trends are going in the next three to five years,” he says.

The Global Quantitative ESG Equity Fund has outperformed its benchmark since its inception in 2019.

“In addition to risk management, our ESG screens are a source of value creation.”

Emerging markets

BCI’s belief in active management over indexing is also apparent in emerging market equities. BCI has started to integrate ESG analysis into emerging market equities (23.1 per cent of the $66.6 billion public equity allocation) for some client funds.

“The effort on the ESG side in emerging markets is significant,” he says, describing how emerging market assets have a wide dispersion that requires a bottom-up and top-down analysis. “We can’t just do stock selection; country selection also matters,” he says.

BCI decided to shift more from indexing to active in emerging markets over a year ago, a prescient decision given today’s darkening economic picture of rising rates and slower economic growth in emerging economies.

“We are now seeing clear signs that geopolitical developments in emerging economies are going to be a factor in the future in a way we haven’t seen for the last 15 years,” he says.

Leverage

He is also mindful of the impact of rising rates on other investment seams in the portfolio. Like leverage, where ensuring financing costs are adequately compensated with expected returns is a growing theme for investors.

For example, he believes private equity will increasingly feel the pinch given its dependency on the availability of cheap leverage, particularly if the selloff in public equity proves a warning shot of tougher times in private equity too.

“Things are getting pricey,” he says.

BCI increasingly filters opportunities in the portfolio, steering clear of investments where bidders are getting on top of each other; happy to be outbid and only allocating to the best transactions.

In an approach that differs from Canadian peers, BCI’s member funds decide their own level of leverage in line with their own liabilities and funding ratios. They make the decision when they select their asset allocation in an approach that Garant argues offers more transparency than other approaches where investors struggle to gauge how much leverage they have because it is already embedded in products.

“Instead of embedding leverage in asset classes at the corporate level, we have structured an application of leverage at a client level. Some clients will want to increase leverage because of where they are in their asset mix, others won’t, and we don’t make a decision on their behalf – it is client specific.”

Economic landscape

Looking out on the macro landscape, Garant is most concerned about wage increases, already starting to come through, fuelling inflation further. “Wage inflation worries us most because it is more persistent,” he says.

Moreover, investors are in the hands of central bank policymakers who have been slow off the mark in anticipating and taming inflation: rates will continue to rise more than what is already priced in, he predicts.

Although he is confident central bankers have the tools they need to fight inflation, he is worried about whether they will chart a soft or hard landing for the global economy.

“The Fed will be able to tame inflation, this is not the issue. The question is whether they do it in a way that will cause a short-term recession. There is a risk of an economic slowdown.”

He concludes, however: “Nothing lasts forever; I don’t believe in strong inflation for the next 10 years. Central banks have the tools to bring it under control.”