The increased adoption of RI principles was clearly visible in this second iteration of the Global Pension Transparency Benchmark. Scores within the RI factor saw the largest year-over-year increase with the average score across all funds increasing by 6.9, so where were these increased scores most evident?

Responsible investing (RI) is increasingly becoming a focus for many large funds across the world. Even funds that previous eschewed RI on the basis that their primary purpose was to deliver returns are coming round to the idea that RI is too important to their stakeholders to ignore.

For pension funds, concerned stakeholders are no longer limited to environmental activists and NGO’s , but also include regulators, plan members and their own employees. Results of early adopters of RI principles mean it is now becoming apparent that you can both focus on RI while still delivering value in the traditional sense – superior investment returns.

As more and more leading funds integrate ESG and RI principles and disclose such endeavors, stakeholders of other funds are asking why their funds don’t. This is forcing those lagging funds to catch-up. Evidence of the increased adoption of RI principles was clearly visible in this second iteration of the Global Pension Transparency Benchmark (GPTB).

Scores within the RI factor saw the largest year-over-year increase with the average score across all funds increasing by 6.9. Where were these increased scores most evident?
• Funds that scored below median in last year’s review saw slightly larger increases than funds in the upper half of last year’s rankings (an increase of 7.1 vs. 6.7).
• Within countries, the lowest scoring funds saw larger increases than average. Across all countries, the lowest scoring funds within countries improved their scores on average by 7.6 points.
• The increase in scores among the lowest scoring funds within countries was even more prevalent in countries that scored in the top half with an average increase of 9.1. Note that these funds didn’t all score poorly. Funds from top scoring countries (eg Denmark, Canada, the Netherlands) were often scored above average, even in last year’s review.

These results suggest that competition, peer pressure and comparisons between funds is driving change. Funds appear much more inclined to increase disclosures when they observe peer funds doing the same.

How are funds improving their disclosures?  Here are two examples that are informative and accessible to all levels of stakeholders.

Example 1: Impact investing case studies

One way funds can increase their transparency around RI, is by using case studies to demonstrate how their impact investing initiative. Eskom PPF from South Africa included a case study on its investment in sustainable housing in its annual report. This shows stakeholders clear examples of responsible investing in action and helps connect a fund’s words to their actions in a relatable manner.

There are similar impact investing disclosures at other funds as well. Many funds are already engaged in impact investing in similar ventures, so it is just one extra step to disclose and report on these sustainable investments.

Example 2: Corporate Stewardship Case Studies

Another way for funds to increase their transparency and reporting on RI is by reporting on their corporate stewardship activities.

For many funds, this involves disclosing an active ownership policy that describes how the fund should engage with portfolio companies. To increase transparency further, some funds also provide reporting on how they engaged with companies throughout the year, including their voting records. This is often done in a summary format, although some funds provide extensive details of their voting records.  These disclosures are useful, but often too technical to be accessible to all users.

Universities Superannuation Scheme (USS) from the UK published their UK voting policy in 2021, as well as a 2021 stewardship report. Its UK voting policy outlines how the fund should exercise its votes on various topics such as director elections, remuneration policies, and auditor elections. The USS stewardship report outlines its engagement activities throughout the year, including case studies on individual companies, as well as a section on significant votes. This allows stakeholders to understand the fund’s stewardship activities on a more tangible level. These two documents were the main factor in the increase in USS’s RI score this year.

The improvement in responsible investing reporting is encouraging to see and shows the need for leaders in this space. A pension fund that becomes a leader among its peers in the RI space is not only increasing long-term value for members, but is also driving positive change in the industry, and therefore increasing long-term value for members of pension funds everywhere.

Funds around the world do a good job of disclosing governance frameworks and policies related to financial and investment risks, as revealed in the Global Pension Transparency Benchmark. However, what is best practice for communicating governance around addressing large, one-off events such as the impact of COVID or war? Mike Reid says outlining governance approval frameworks and processes is a step in the right direction.

“Reports that say that something hasn’t happened are always interesting to me, because as we know, there are known knowns; there are things we know we know. We also know there are known unknowns; that is to say we know there are some things we do not know.” Donald Rumsfeld

As this article was being written in March 2022, it was more apparent than ever that successfully navigating risks is key to the success of investment management organisations both in the near and long term. For the second time in two years, funds across the globe are facing a major upheaval that has the potential to greatly impact financial markets. Stakeholders are right to be concerned and need to be informed about how funds are navigating through this tricky environment. Are global funds being transparent about how the view and manage risk?

Risk management frameworks need to adequately address both the more predictable risks that funds face continuously in their day-to-day as well as larger scale, less predicable “Black Swan” events. The exhibit below shows the standard deviation of net value added observed among CEM’s clients from 1992 through 2020. A higher standard deviation represents a higher level of idiosyncratic risk, which all else being equal is a drag on long-term returns.

This clearly illustrates that idiosyncratic risk is heightened during large, global events. Peaks are easily observed both for the dot-com bust and the global financial crisis. Idiosyncratic risk in 2020 was also elevated from the levels observed after the financial crisis. In fact, one can even observe an increase in 2013 due to the “taper tantrum”. This demonstrates the value of an effective risk management framework is heightened in times of extreme stress.

First the good news. The vast majority of funds do disclose their views on risk, both financial and other risk, and related risk policies and governance.

The Global Pension Transparency Benchmark, this year’s review of 75 of the world’s largest funds revealed that:
– 96 per cent of funds reviewed disclose their governance framework and policies related to financial and investment risks, and 81 per cent of funds provide at least some quantifiable measures around these risks.
– Although not as universal, disclosures of a fund’s governance framework and policies related to non-financial risks were observed at 81 per cent of the funds reviewed.

However two issues were identified:
– the quality of the disclosures varied considerably among funds; and
– risk disclosures invariably focus on common, easily definable risks of the sort that funds encounter continuously as part of the day-to-day management of the fund.

What is almost entirely lacking are defined plans or processes to deal with “Black Swan” events.

Before addressing the latter point, let’s first look at some of the better examples of risk disclosures that were observed.

South Africa’s Sentinel Retirement Fund provided very comprehensive risk disclosures. Not only was their list of risks exhaustive, including 21 risks, covering most elements of their business, they did so in tabular format with the relevant risk control framework expressed in plain language beside each risk.

Source: Sentinel Retirement Fund 2020 Annual Integrate Report pg. 73-77

In the United Kingdom, pension schemes are required to maintain a risk register. These risk registers are meant to document the full range of risks a pension scheme faces and include a judgement of the relative risk posed by each risk.

Universities Superannuation Scheme (USS) produces an annual Risk Management Supplement which summarises their views on risk. In this document:
– USS outlines its risk taxonomy and the risks it has  identified, by type, in an easy to understand exhibit.

-USS then explains that it translates these risks into 88 individual appetite statements where it outlines its views on the level of risk it is willing to assume for each risk statement using a five category scale which ranges from “averse” to “hungry” which are clearly described. These assessments are summarised graphically using the risk taxonomy.

The exhibits shown above are just two examples, the supplement as a whole provided a 360 degree view of their risk management program, presented in an easily accessible manner. While both examples given above provide valuable information to stakeholders, they focus almost entirely on risks that are encountered in the regular course of business. It is important however for stakeholders to know how a fund would react during a large-scale world or market event.

How can a fund best communicate to stakeholders on its governance for large one-off events when these events, by definition, are unpredictable? One way to address this issue is by clearly outlining governance approval frameworks and processes. How quickly can a fund respond to external events? Who has authority to make decisions, and what are the relevant thresholds? Is there an emergency framework in place?

If a fund must convene its investment committee for approval, approvals may come too late. Most funds will have some sort of operational business continuity plan, stakeholders would benefit from knowing how investment decision making will occur during emergency times.

One example of how this could be addressed was observed in the disclosures of Swiss fund BVK, the manager of funds underlying pension for employees in the canton of Zurich. This exhibit, from BVK’s investment policy presents the approval processes for many major investment functions. Additionally, it shows how these processes vary based on certain investment limits when applicable. This information can allow stakeholders to assess how the fund’s governance structure would allow the fund to respond in times of market stress.

Source: BVK Zurich Investment Policy pg. 21-22

Unfortunately disclosures such as this were extremely rare.

We would like to see more funds disclose this information. An added bonus would be if they discussed how the process may change in times of stress, perhaps building on real world experiences from both the global financial crisis and the market crash at the beginning of the pandemic.

The transparency of pension fund disclosures has improved in the past year across the 15 countries and 75 pension funds measured in the Global Pension Transparency Benchmark, a collaboration between Top1000funds.com and CEM Benchmarking.

The GPTB, now in its second year, examines the transparency of disclosures across four drivers of value, namely cost, governance, performance and responsible investing.

In this second year, governance disclosures showed the biggest improvement with the average score of 65 out of 100 marking an improvement of seven from last year’s average score of 58. Governance was the best overall average score of the four factors.

The Canadian funds continue to excel in this category which CEM Benchmarking’s Michael Reid says is consistent with their reputation for excellent governance.
In last year’s review CEM noted that governance scores were most closely correlated with the overall score: good governance produces positive results and creates greater incentive (or perhaps less disincentive) to be transparent with stakeholders.

This year responsible investing disclosures showed an equal correlation with governance. Good governance allows funds to move beyond simply managing assets and towards addressing wider environmental and social issues.

The overall average performance score was 62, a slight decline from 64 last year and the second highest scoring factor after governance. The performance factor was the only factor to have a decline in the score this year. Average country scores ranged from 43 to 84.

The average country cost factor score was 48, unchanged from last year’s review, with individual scores ranging from 10 to 77.

The average country score for responsible investing was 49 out of 100 up from 42 in last year’s review, marking the biggest relative improvement among any of the four factors. These improvements mean that responsible investing is no longer the lowest scoring factor overall, having surpassed the average score for the cost factor. Improvements to disclosures were evident across all components and most countries. RI did continue to have the greatest dispersion of scores reflecting that countries are at different stages of implementing responsible investing within their investing framework. Average country scores ranged from 11 to 77, a slightly smaller range than last year.

“It was apparent from the reviews that many funds are actively taking steps to improve communications on responsible investing to stakeholders. In particular, many funds are expanding their disclosures to include quantifiable measures and progress towards climate related targets,” Reid says.

The GPTB ranks countries on their disclosures and found the following countries to be the outstanding performers in each category:
• Canada for governance
• The Netherlands for cost
• The Netherlands for responsible investing
• The United States for performance.

The Netherlands continued to lead the way in cost disclosure with the highest country score of 77. Scores were tightly banded from 71 to 89 and the top four cost factor scores were held by Dutch funds.

The Netherlands also ranked number one in the responsible investing factor, usurping last year’s winner of Sweden, with a score of 77. Both countries had improved disclosures over the past year. The Nordic countries – Sweden, Denmark, Finland, and Norway – continued to do very well on RI as a region, with all countries receiving scores well in excess of the overall average.

In the performance factor, the components with the highest scores continued to include asset mix and portfolio composition and risk policy and measures. Similarly the lowest scores were seen for asset class returns and value added and benchmark disclosures.

The US funds continued to lead the way, with an average country score of 84 for the performance factor. The US funds typically had extensive and good quality reporting across all performance components.

To examine the results for 2022 across factors, countries and the underlying funds click here.

Climate Action 100+, the $68 trillion investor-engagement initiative on climate change, is advising its 700 signatories to step up engagement with companies ahead of the US and European proxy season to pressure top emitters to do more to cut their carbon emissions.

Following on from a record number of majority votes on climate proposals last year that included a dramatic board shake up at ExxonMobil, the coming months will be a critical time for investors to support key climate shareholder resolutions at companies including Berkshire Hathaway and energy groups Phillips 66 and Valero Energy.

Recent analysis of climate progress at 166 companies revealed in the investor pressure group’s  Net Zero Company Benchmark gave the lowest scores to eight companies including China’s largest vehicle maker SAIC Motor and Berkshire Hathaway, which owns companies in sectors heavily exposed to climate change risk such as insurance and rail groups.

“We will continue to use the power of collaborative engagements and proxy voting to drive action at our portfolio companies to align their climate ambitions with their long-term strategies and capital allocation decisions,” says Simiso Nzima, a member of the Climate Action 100+ global steering committee and managing investment director of CalPERS global equity allocation – around 49.3 per cent of the giant $478.1 billion portfolio.

“As a long-term investor, we want our portfolio companies to execute sustainable business models and thrive in a low carbon economy.”

CalPERS is a long-term owner of Berkshire Hathaway shares and together with a group of other investors including Brunel Pension Partnership, Caisse de Dépôt et Placement du Québec and State of New Jersey Common Pension Fund is behind shareholder proposals for change at the conglomerate flagged for this proxy season.

“We know that the current climate trajectory presents a systemic risk to investment portfolios and long-term returns to funds’ beneficiaries,” adds Andrew Gray, director, ESG and stewardship at AustralianSuper, also a member of the Climate Action 100+ the global steering committee. “This demands intensified engagement from investors, calling for near-term action from the companies they are invested in. Long-term engagement works, and accountability is key.”

High level progress

Positively, the Net Zero Company Benchmark found some corporate climate progress against key climate indicators and year-on-year improvements on cutting greenhouse gas emissions, improving climate governance, and strengthening climate-related financial disclosures. For example, 69 per cent of focus companies (the world’s largest corporate greenhouse gas emitters) have now committed to achieve net zero emissions by 2050 or sooner across all or some of their emissions footprint, a 17 per cent year-on-year increase.

Elsewhere, encouraging signs of change include 90 per cent of focus companies having some level of board oversight of climate change and 89 per cent of focus companies having aligned with TCFD recommendations either by supporting the TCFD principles or by employing climate-scenario planning.

Challenges

However, the research also reveals more action is urgently needed from companies to support global efforts to limit temperature rise to 1.5°C. One of the most alarming findings reveals the vast majority of companies have not set medium-term emissions reduction targets aligned with 1.5°C or fully aligned their future capital expenditures and the future investment meeting the goals of the Paris Agreement requires, despite the increase in net zero commitments.

According to the assessments only 17 per cent of focus companies have set medium term targets that are aligned with the IEA’s 1.5°C scenario and only 5 per cent of focus companies explicitly align their capital expenditure plans with their long-term greenhouse gas reduction targets.

Elsewhere the survey found a continued failure to integrate climate risk into accounting and audit practices. “Climate accounting and audit appears to be a topic that many companies and their auditors have yet to fully consider when preparing their reports,” state the Benchmark findings. “Climate Action 100+ investor signatories should therefore engage focus companies on this topic to better understand the financial impact that climate-related matters can have on company financial statements and audit work, and the financial implications of company climate targets and decarbonisation strategies.”

Launched in 2017, Climate Action 100+ is now in its fifth and final year of its first phase. The pressure group will move onto a second phase in 2023 set to bring more ambition, urgency and accountability for both companies and signatories.

 

 

 

Risk parity, the investment strategy designed to function well in almost any market environment due to its perfect balance between different asset classes, has had a hard time in recent years. So much so even long-time enthusiasts for the rules-based approach pioneered by hedge fund manager Ray Dalio have lost faith.

Credit risk has crept into fixed income, ending any notion that government bonds are risk free cash flows. Bonds and equities increasingly correlate and risk parity flounders when liquidity is being drawn out of the market and stagflation is creeping in. Elsewhere changes to the macro environment also mean the constituent assets in a risk parity portfolio often throw off the same cashflows and stack up the same exposures, lists Kasper Lorenzen, group CIO at Denmark’s $94 billion pension provider PFA who had used risk parity to simultaneously tap returns in PFA’s fixed income and equity exposures since he joined from ATP, Denmark’s statutory pension fund, where he also oversaw a successful risk parity strategy.

“I’ve lost my faith in risk parity,” he says. “We stopped using it as a strategic lever in 2021.”

Risk parity investors typically use leverage to increase their exposure to safer fixed income. This acts as a counterweight to volatile equities and ensures the different assets in the portfolio contribute an equal amount of risk. However it also means the allocation to fixed income is much higher than in most other balanced funds. During 2020, and the early part of 2021, PFA used to increase, or balance, equity risk by buying equity and bond futures. But the approach grew increasingly challenging through 2021 as interest rates remained low and inflationary pressure built. “Initially, interest rate risk diversified equity risk and worked well, but this started to change through 2021,” explains Lorenzen.

Today the backdrop has become even more challenging. The cashflows thrown off by the different assets have become similar so that the same exposures are stacking up in different asset classes. It’s leaving risk parity investors struggling to reduce risk – and running more risk than they thought they had. “Diversification had meant that if one element doesn’t perform, another does. Now the cashflows are more similar than what they used to be five years ago, and investors are just stacking up their exposures,” he says.

Looking out on the macro landscape and central bank endeavour to reverse their big money experiment without undermining economies, he doubts risk parity will come back into favour anytime soon. “Don’t fight the Fed,” he warns. “You had to be bullish interest rates in order to be a risk parity investor,” he says.

Moreover, he believes stagflation is in danger of setting in for the long-term as globalisation retreats.  “We are living with higher costs, and more resilient and robust global value chains. All this is going to drag productivity and give inflation support – these ingredients are stagflationary in nature which is not good for asset markets.”

Despite his loss of faith, Lorenzen hasn’t totally abandoned the approach. PFA still runs a systematic overlay introduced in January 2020 to increase and balance out risk depending on market developments that holds many elements of a risk parity approach. “In 2020 and 2021 we used this tool to increase our allocations to shares and for certain periods to reduce our exposure to government bonds,” he says. “Back in 2021 we were always long or neutral – never short. Today’s uncertain market conditions require a more balanced risk-on, risk-off approach. The easy part is increasing risk, but you only want to do this if you are compensated.”

He is also still a strong proponent of the idea that the most compelling single assets have multiple components. For example, real estate comes with a combination of corporate exposure, fixed income characteristics and inflation protection. “We still believe stable, illiquid investments with a bit of everything are a good investment.”

Indeed, real assets (particularly those shielded from business cycle risk) including core real estate and infrastructure supporting the green economy will play a key role in the portfolio going forward and offer some of the most exciting opportunities, especially as the transition gathers pace. Rather than a comeback in fossil fuels driven by European economies scramble to avoid Russian energy exports, he believes the evidence suggests the transition is about to speed up.

Before conflict in eastern Europe broke out, he had already noted much more enthusiasm for large offshore North Sea wind investment than a year ago. Now Russia’s invasion of Ukraine has accelerated European economies move away from Russian fossil fuels at the same time as many governments have a new preparedness to spend, evident during COVID and now war in Ukraine that he believes could signal more finance flowing into the transition. “It’s no longer just about climate and climate polity; it’s about geopolitical policy and independence,” he says.

PFA sold its listed Russian equity allocation in 2018 after ESG analysis raised governance red flags. A shake up of portfolio construction led the fund to also sell its allocation to Russian government bonds last year. “We decided a diversified global emerging market portfolio doesn’t need government bonds in all parts of the world. A combination of corporate credit exposure and FX takes you a good part of the way,” he concludes.

 

 

The traditional 60/40 portfolio allocation is no longer enough. The opportunity for alpha is not gone, but the low-hanging fruit has long been harvested, and the path toward higher absolute returns has gotten far more nuanced. Today, five distinct marks define the ‘Portfolio of the Future,’ according to a new report from the Chartered Alternative Investment Analyst (CAIA) Association, the professional body for the global alternative investment industry.

Five investment experts including Commonfund’s Mark Anson, Thinking Ahead Institute’s Roger Urwin and Franklin Templeton’s Anne Simpson explain more.

Broadly Diversified

Mark Anson, CEO and CIO of Commonfund, the pioneer of outsourced CIO services for non-profits, argues that responsible portfolio management consists of collating a series of uncorrelated beta and risk premia that offers a combination of income, inflation protection, capital preservation, and principal growth to meet a required return.

During recent years the unlikely narrative has been heralded that financial assets, particularly public equities, eternally march upward. The proliferation of new, low-cost products has created complacency and “beta creep.” As such, fiduciaries must be more creative in expanding their investment opportunity set. That begins with a return of the foundational principle of diversification across asset classes, geography, sector, and purpose.

Less Liquid

The traditional 60/40 public equities and fixed income allocation has provided extraordinarily well in the last decade. But Andrea Auerbach, Cambridge Associates global head of private investments, counsels not to take solace in the recent past. Investment professionals will have to look to differentiated sources of return, notably private capital, to increase the potential of being able to fully meet their obligations with responsible control of risk.

Private capital has become increasingly attractive for earlier stage, new economy, and growth companies. And, because private capital is detached from the short-term machinations of public markets, it liberates investors to take advantage of market dislocations, information asymmetry, and out-of-favour or countercyclical opportunities. Avoiding private capital in a portfolio denies access for clients to an increasingly large portion of the global economy. Still, private markets are not a silver bullet given their opacity, high fees, need for patience, and wide risk-return dispersion. They must be carefully considered in light of client liquidity, income needs, and risk tolerance. Extensive due diligence and thoughtful, deliberate manager selection is imperative.

Fiduciary Mindset

Investment management is an agency business. Asset managers exist to deliver trust, care, and expertise to clients. Roger Urwin, global head of content at the Thinking Ahead Institute, explains how a fiduciary mindset begins with an existential understanding of purpose, alignment, and service to the client. “Systems leaders” are responsible for translating these values into behavioural norms that influence ownership structure, client communication, compensation, fees, talent recruiting, culture, and definition of success (benchmarks). The investment profession—and each client’s Portfolio for the Future —still has work to do on this journey through mitigating conflicts of interest, asymmetric payoffs, incentive dislocations between limited partners (LP) and general partners (GP), and unnecessary financial engineering

Actively Engaged

The age of the universal owner has arrived. Clients are demanding both positive financial and social outcomes from their capital allocation and underlying holdings. No one knows this better than Anne Simpson, global head of sustainability, Franklin Templeton and former managing investment director of board governance & sustainability, CalPERS. With a devastating global pandemic, climate consciousness, and the pursuit of clean energy alternatives at a fever pitch, investment professionals are integrating sustainability elements such as carbon footprint, progress on diversity, equity and inclusion (DEI), human-rights records, and labour practices into their security evaluation, risk management, and return expectations. Further, non-financial disclosures, as well as ESG ratings, are becoming more accepted as a regular, integrated part of security analysis. The Portfolio for the Future will be much more insistent and proactive in ensuring that it contributes to a more inclusive and sustainable tomorrow.

Operational Alpha

The modern investment profession is highly competitive. New sources of comparative advantage are being cultivated among enterprising professionals, argues Ashby Monk, PhD, executive director, Stanford Research Initiative on Long Term Investing. Firm culture, governance, and technology are much more predictive of sustained performance than previously thought and should be emerging priorities for any leader. The Portfolio for the Future will be driven by firms that innovate and exploit new organizational and operational models to save cost, reduce risk, and pioneer new investment ideas.

The industry needs to be reoriented back toward a north star of sophisticated portfolio construction, one that prioritizes client and beneficiary outcomes and works tirelessly to achieve those outcomes in a long-term, sustainable way. This essential definition of professionalism will usher in a new identity of enlightened self-interest that culminates in a much-improved public warranty. The Portfolio for the Future is CAIA Association’s contribution and call to action for that transformation.