Power prices will not fall to zero in a world of renewables and renewable energy generation ebbs and flows require smoothing and investment in new technologies according to experts on renewable energy. Gas will be in the system longer as a bridge fuel, and investors should also explore opportunities in construction-ready or operational fixed-price renewable energy assets.

Power prices will not crash in a world of renewables, said Richard Howard, research director at Aurora Energy Research speaking at FIS Digital 2021, responding to one of the most frequently asked questions by investors and utility groups.

Renewables’ low marginal costs won’t gradually push the price of power to zero because renewables can’t offer a complete solution. Periods of no wind or sun will lead to renewable doldrums that require smoothing.

Looking ahead to 2050, Europe’s renewable power supply will be supplemented by nuclear (particularly in France and the UK) hydro (popular in the Nordics) or hydrogen generation and carbon capture and storage.

Investors should anticipate weeks or months where renewables can’t meet demand, requiring a flexibility in countries’ energy strategies. Power prices won’t collapse because countries will rely on expensive new technologies. It offers a huge investment opportunity, but involves understanding the risk of how flexible technologies will play their part in a new renewables world.

European countries began the transition to net zero 20 years ago and that early move is now starting to bear fruit with subsidised wind and solar driving down the cost of renewables that now compete with energy production from coal and gas.

“Wind and solar will form the backbone of global energy markets and solve the carbon challenge,” said fellow panellist Alex Brierley, co-head, Octopus Renewables. Renewables are also produced in country, solving the risk of dependency European energy consumers have on producers like Russia.

The transition to renewables will have a profound impact on legacy investments in coal, gas and oil. According to Aurora Energy Research, to keep warming within two degrees by 2050, coal emissions need to be reduced by 85 per cent; oil emissions by 60 per cent and gas emissions by 40 per cent.

“Gas will be in the system for longer as a bridge fuel; gas has a more favourable outlook over decades,” said Howard.

The cut in fossil fuel use will result in massive downward pressure on prices, and downside risk for investors. Moreover, much of the current oil, gas and coal discoveries will need to stay in the ground to limit warming, ending the need for more exploration. Panellists noted that China’s motivation to cut coal use is propelled by the need to cut air pollution.

The risks ahead are not fully priced into commodity markets where prices have recovered from their pandemic lows. “If you believe we are going to get to 2 degrees, you need to believe fossil fuel use will go down, and at some point, there will be a correction,” said Howard. Oil producers will likely pump harder when the reality hits that oil will be worth less in the future, causing prices to crash harder still. The pace of change will depend on how quickly reality builds behind a 2-degree target, and government action to rein in emissions.

As coal, oil and gas are phased down, renewables will form the backbone of the future energy system the panellists said. But investors need to understand the risks they are taking investing in renewables. It involves a grasp of the makeup of the power sector and how the future could evolve around price floors and negative prices particularly.

Harvard Management Company, which manages the university’s $53.2 billion endowment, is not making any new investments in the oil and gas industry, said Michael Cappucci, managing director, sustainable investing at Harvard Management Company.

The endowment is now looking for investments to replace this exposure but finding the opportunities that provide equity-like returns that will meet the fund’s long-term goals is challenging.

Biotech, green energy and climate solutions are now front of mind.

“We are seeing opportunities that weren’t around two to three years ago,” he said. Still, he noted these opportunities are in the millions rather than the billions.

Long-term, yield-seeking investors should hunt for construction ready or operational fixed price renewable energy assets. Higher returns come from assets going into development, in the land or planning stage in property-like investment. Other opportunities include network infrastructure, vehicle charging, and partnering with the hydrogen industry. Investors should think what they are trying to achieve and see the energy transition as a system change rather than discreet pockets, concluded panellists.

The Abu Dhabi Investment Authority, the state-owned investor with an estimated $700 billion assets under management, is introducing more technology in its own internal processes and determined to become a more active – and reactive – investor.

The fund’s decision to invest more in its own in-house technology came with the realisation that a slow down in its capacity to generate alpha was linked to a lack of investment in big data and AI. The fund’s early installation of new technology like Bloomberg terminals and other small data banks in its investment office 25 years back had bred a complacency that meant it was late to adopt and build a critical mass around new technology, said Jean-Paul Villain, ADIA’s director of the strategy and planning department, speaking at FIS Digital 2021.

ADIA only reports two performance numbers, for 20 years and 30 years annualized. As of December 31 2020, the figure was 6 per cent for 20 years and 7.2 per cent for 30 years.

Now ADIA is making up for lost ground investing in different kinds of quantitative approaches, collecting, cleaning and testing data to apply across the portfolio from long short equity allocations to tactical positions and facilitate access to the best managers – around 55 per cent of the portfolio is externally managed.

“We were seeing technology everywhere, but not very much in our own strategies,” said Villain. “We realised we had to start again.”

In another new seam, the fund is pushing more actively into private assets, especially private equity and infrastructure where it first invested in 1992 and 2005 respectively. The new focus is on building partnerships and targeting specific strategies; rather than invest much directly ADIA seeks co-investment opportunities in a new active and concentrated approach.

“We started years ago, so we have some experience,” he said.

The strategy was recently visible in ADIA joining a private equity led group that includes Canadian pension plan CPP Investment Board and Singapore sovereign wealth fund GIC behind the purchase of antivirus software company McAfee, in advanced talks to go private in a deal worth more than $14 billion.

More active means being more reactive. Like many institutional investors ADIA had fallen into the habit of waiting for change, said Villain. Now, the giant fund plans to be more granular in its approach, better able to react to increasingly apparent correlations between geographies and asset classes. “There is more correlation between buckets and countries than what we had twenty years ago.”

Fixed income

ADIA’s fixed income allocation (15-30 per cent) is a particular focus. Villain, who has been at the fund since 1982 bar a five-year absence well remembers years of stellar 7 per cent annual returns in liquid sovereign debt allocations in stark contrast to today.

ADIA invests in fixed income for returns but mostly to ensure liquidity on hand, needed to manage inflows and outflows in open ended activities, rebalance the portfolio following investment in opportunities and reduce volatility.

“Fixed income has different functions; we work out how much we need for each function and try to reduce it,” he says, describing fixed income’s role as bringing structure to the whole portfolio.

ADIA’s large asset allocation bands comprise equity (43-67 per cent) fixed income (15-30 per cent) alternatives and real assets (17-30 per cent) and cash (0-10 per cent cash)

Inflation’s impact on the fixed income allocation and valuations in real assets is another key focus. For sure, an inflation level of 3-4 per cent, especially as it is associated with higher economic growth, isn’t all bad. Moreover, its negative impact on fixed income is offset by its positive impact on other parts of the portfolio. The inflationary push pull on the portfolio plus questions around whether it is transitory or here-to-stay leave him reluctant to take a single view on its arrival on the economic landscape.

The economic bounce back in the wake of COVID accounts for one inflationary cause.

“We had a politically induced recession followed by politically induced recovery,” he says, adding that many companies have been shocked by the speed of the recovery and demand outstripping supply. “This maybe transitory.”

Another, longer-term, inflation cause is coming via societal shock and change particularly captured in the real estate market. People value a larger house, balcony or garden more than their short commute, he says.

The structure of the housing market can’t respond quickly and is taking much longer to adjust, he concluded.

At US pension fund CalPERS’ board meeting next week, the investment team hope to settle on a new discount rate and begin structuring a strategic asset allocation to support it. Interim chief investment officer Dan Bienvenue is due to explain the different risk implications for the giant portfolio, about to surpass $500 billion, if it targets a 6.5 per cent, 6.8 per cent (it’s current discount rate) or a mighty 7 per cent assumed rate of return year after year.

Leverage will be a key discussion topic as the investment staff press again for leverage in the strategic asset allocation to help reduce risk. It’s possible CalPERS could reach its return target via equity, but a leverage element will enable the fund to own more diversifying assets, said Bienvenue speaking at FIS Digital 2021 ahead of the November 15th meeting.

“We are recommending a total exposure of 105 per cent going into this ALM cycle – total assets at 100 per cent with that extra 5 per cent used to purchase diversifying assets. Through this lens, it’s a risk reducer.”

Mindful of board concerns that leverage adds operational risk and brings extra hazard in market environments where both equity and bonds sell off, the investment team have spent months exploring the fund’s ability to manage leverage – and liquidity. It has involved centralising the strategy at a total fund level rather than at an asset class level, running scenarios around what the portfolio would look like and modelling diversified pathways to liquidity during times of market stress when the pressure of leverage makes finding liquidity harder.

“Leverage and private assets make the premium on liquidity even greater,” said Bienvenue who joined CalPERS as a portfolio manager 17 years ago and replaced Ben Meng as interim CIO when Meng stepped down last year.

CalPERS’ board is as familiar with the investment team’s argument for a larger private equity allocation as they are its support of leverage. Building out the current 8 per cent allocation to around 13 per cent is a critical part of the return seeking allocation and central to the new strategic allocation.

“We get a higher return per unit of risk in private equity on a modelled and realised basis,” says Bienvenue.

Still, he told FIS delegates that deploying private equity at scale and gaining the cost advantage of co-investment all the while ensuring robust underwriting remains CalPERS’ enduring challenge.

“There is a tension between getting capital deployed and underwriting,” he said. “You can always get someone to take your assets; you just might not like what you get.”

He wants to make more of CalPERS co-investment strengths, shaping a decisive brand and acting quickly when the call to co-invest comes.

“It’s about knowing we don’t have a no risk or low risk option.”

He said CalPERS is a sought-after Limited Partner but needs to ensure it is also a consistent partner of choice; able to move quickly and leverage its strengths.

CalPERS’ bid to build out private equity sits within a wider push into private markets. In a new move it is seeking to add a 5 per cent strategic allocation to private debt – historically seen as an active risk.

“$25 billion is quite a lot of capital for that space,” reflected Bienvenue. Large funds like CalPERS raising their threshold to the asset class has begun to spark concerns amongst other investors with several FIS Digital chief investment officer’s voicing their concerns at the amount of money flowing into private credit.

 

Efficiencies in public equity

Other areas of recent change at fund include narrowing the equity benchmark which used to comprise some 11,000 securities. Many of the companies in the bottom half of the benchmark added complexity in trading and sub custody accounts, but little diversification benefits, said Bienvenue.

Narrowing the benchmark has involved finding a sweet spot between the additive value of additional securities and diminishing marginal returns. The change was part of CalPERS broader ambition to increase efficiencies in how it harvests public market risk premium, both operationally and by instilling cost and risk efficiencies to maximise the return per unit of risk. Elsewhere in public markets, the investment team is looking at adding exposure to emerging market sovereign debt.

“It adds risk but it also adds diversification in public markets.”

He concluded that CalPERS is also spending time integrating sustainability into decision making across public and private markets, aware that sustainability and regulation will affect assets differently.

Lastly, Bienvenue sounded a wary note on investment in China citing “stroke of the pen” unpredictability as a key risk. Despite Chinese economic growth and Chinese assets adding important diversification, he said the accuracy of data, shadow banking, real estate and challenges around finding the right partner make investment challenging. “There are lots of questions; the challenge is finding good answers.”

Investing in mega trends like technology, demographics and sustainability involves abandoning the benchmark in the ultimate active portfolio.

Trend investment offers asset owners exposure to key themes in the world today. Rather than ‘going with the flow,’ investing in trends means ‘anticipating the flow’ and is one of the purest forms of active investment, said Mark van der Kroft, chief investment officer fundamental and quant equity at Robeco speaking at FIS Digital 2021.

“It is the ultimate active portfolio,” he said. “We understand these trends and can see themes being played out.”

Investment in trends involves a long-term view and moving away from the benchmark to look at secular changes and different investment opportunities. It is important to leave the benchmark as this is a representation of the past. Trend investment involves trying to find winners and taking out stocks that won’t benefit from secular changes, he said.

Robeco isolates three main mega trends. Transforming technology and digitization; demographic changes and the emergence of new middle classes and what van der Kroft calls “preserving earth,” – picking winners in a deep and expansive sustainability trend.

Preserving earth does not just equate to finding opportunities in climate change; it includes investments that anticipate regulatory change and how the scarcity of resources will play out as well as changes in health. Mega trends are removing barriers to entry, disruptive, creating new products and changing our, and industry, behaviour.

Positive for equity

Trend investing is buoyed by Robeco’s positive outlook for equities in the coming five years. Investors will be rewarded for taking risk, although it will be less skewed to the upside, said van der Kroft. Despite a highly uncertain macro environment characterised by policy unknowns, and the challenge of governments maintaining economic growth whilst crimping personal freedoms to hold down the pandemic, the outlook is supported by technology boosting productivity.

“The environment for the economy is solid,” said van der Kroft, who added that tightening will arrive in response to inflation, but won’t derail the current liquidity in the market.

The long-term nature of trend investment does not make portfolios static. Instead, portfolios are dynamically tilted to benefit as trends evolve and change. For example, smart phones, invented 15 years ago, went on to change the world of advertising, gaming and banking to name a few.

“It is about staying on top of trends and understanding how mega trends can split into sub trends,” he said. Importantly, investors shouldn’t bet on small, thematic risks.

Avoiding losers is a critical element of the jigsaw. Investing in a benchmark already has losers, but by choosing a trend, investors exclude corporates outside trends and narrow their universe. It requires deep research and an analytical edge, alongside outspoken positions, he said. Many investors underestimate long term trends and under-utilise long-term information, not extrapolating its true significance for businesses. It requires the right tools in the box, of which one is sustainability analysis.

“We try to have a very independent analysis from a sustainability perspective,” he says.

Investing in sustainability mega trends requires looking through the noise of the current ESG landscape. It also involves avoiding short term quarterly reports which blur trend investors’ view.

“Stick to your guns and believe in what you do,” he said.

Trend investment is different to factor investment. In response to a question from Fred Nieuwland, chief investment officer, Mars Incorporated, van der Kroft explained that factor investing is tied to looking backwards to see how value, momentum or size trends determine premia that lead to out- performance. Most factor investment is based on past results, but trend investment doesn’t take the benchmark as the starting point and is more focused on quality and growth.

Nieuwland said trend investment can be somtimes difficult because mega trends conflict with each other. For example, demographic trends titled towards consumption by emerging middle classes in developing economies conflicts with sustainable world trends.

As the demise of the office component in real estate allocations continues investors are favouring data centres, warehousing and low cost accommodation.

Office and bricks and mortar retail have suffered most at the hands of the pandemic. However, the pandemic-triggered impact on real estate from working from home and buying online varies across regions. For example, UK department stores and malls have been hit harder than their German counterpart, typically characterised by a grocery anchor.

Offices able to offer sought-after locations which help companies showcase their brand will thrive most. Moreover, offices in cities like Tokyo, where many employees’ preference is to come into work rather than work from home, will also thrive. In contrast, demand from office space in city’s like San Francisco, where most workers are now fully remote will stay weak. London offers opportunities for office investors. The pricing is much softer on a Brexit discount compared to other European capitals.

“The GFC offered an opportunity to get into London, now we are seeing the same thing,” said Tony Brown, global head of real estate at M&G Real Estate. Speaking at FIS Digital, he argued that investors should distinguish between offices that are magnetic and able to draw employees back with a better offering, from those that are mandatory.

It is important to view the current challenges in real estate in the context of the asset class’s evolution. For example, data centres and logistics overtook bricks and mortar retail a while back just as the listed equity giants of old like oil groups and big banks have also lost their crown.

“We haven’t been that positive on office for a while,” said Jon Cheigh, chief investment officer and head of real estate at Cohen & Steers, who estimates a fall in demand for office space of between -2 per cent to -10-15 per cent.

This was a sentiment echoed by fellow panellist Andrew Palmer, chief investment officer at Maryland State Retirement and Pension System. Overseeing a $7 billion allocation to real estate – $1 billion of which has been committed to managers over the last 12 months – he told delegates that the pension fund has been underweight office for while.

“It’s a difficult asset to release; it’s very expensive to make changes.”

Retail opportunities will shift to residential areas. Similarly, people are moving further away from their places of work, triggering a decentralisation in GDP and creating opportunities around major cities.

Maryland has structured a concentrated portfolio to core managers with allocations including storage and properties with lower price points like multi-family and workforce housing. Single family rentals and senior housing are also in the portfolio, and the allocation to industrials was recently ramped up.

However, investing in real estate alternatives like student accommodation or multi-family units requires investor patience and local knowledge.

“It’s difficult to invest in markets where you don’t have local experience,” said Palmer. “There are sectors we want to emphasise in the portfolio but we are not taking advantage of distressed assets; we are not sure they will return to peaks.”

Investors have flocked to warehousing and cloud computing facilities – both sectors that were initially found in the listed market. It’s behind the current trend of big money investors pivoting their sector composition and using the listed market to access real estate segments like large data centres and healthcare companies, said Cheigh.

“We are seeing investors selling billion dollar office buildings and shopping malls and deploying into self-storage facilities They are going from big assets to aggregate in a bunch of small assets.”

Logistics low yield

Money has poured into logistics and yields are now notably lower. Although panellists noted some opportunities exist globally in logistics, appetite for logistics has waned.

Instead, investors should focus on healthcare, self-storage, data centres and towers and selective office and retail opportunities.

Real estate and infrastructure investors are often competing for the same assets with assets like data centres and cell towers crossing between the two buckets. It is a symptom of more money chasing fewer opportunities and investors becoming more active and flexible. It’s also a symptom or real estate’s evolution from just being viewed as “shiny” buildings, concluded Cheigh.

“Ultimately, investors want a physical asset with positive supply and demand trends. It doesn’t have to be shiny and beautiful.”

More investors are moving into private credit. Opportunities from the pandemic are far from over and the asset class is proving an important allocation in a wider, simplified fixed income portfolio. Investors at FIS Digital discuss their allocations and approaches.

Prevailing wisdom has it that the opportunities that characterised private credit in 2020 are fading with the recovery. Not so says credit solutions investment manager SVP Global with deep roots in distressed investing.

“We have never seen more opportunities. We are extraordinarily busy,” says Ranji Nagaswami who is chief strategy and chief commercial officer and co-head of the ESG committee at the firm.

SVP Global has made $9 billion of new investment in the last two years, $5 billion of which has been made in 2021 in an evolving opportunity that began with rescue financing and corporate restructuring and is now focused on private debt. Investments include restructuring a mall business and investing in aviation debt where the sources of recovery are linked to the underlying aircraft and a claim against the airline, Nagaswami told delegates at FIS 2021.

“We’ve got two to three years of this opportunity still to run,” she said.

Opportunities in the US outpace those in Europe, but investors should expect more opportunities in Europe through 2022. For example, the ECB estimates bad debt on European banks’ balance sheets could grow to trillions in 2022.

Correlation with equity and widespread leverage bring risk to private credit allocations.

“In a crisis, high yield and equity are correlated,” she warned. She also noted investors should understand the dangers of leverage both in the underlying investment, and another layer in the underlying fund. Although this “bumps up the yield,” she said the additional layer is worrying for investors particularly in a protracted crisis.

Leverage and correlations makes manager selection – and only working with managers who have experience through credit cyles – crucial, said fellow panellist Michael Hitchcock, executive director of South Carolina Retirement System.

“We look for mature programs to see how the manager has performed through different scenarios,” he said, warning investors that once they are in funds, they can’t get out since the premium comes from the illiquidity.

At peer fund Ohio School Employees Retirement System private credit accounts for a 5 per cent target allocation and generates a 7 per cent cash yield. The portfolio has generated nearly 9 per cent total return in the history of the private credit portfolio, set up seven years ago in an original opportunistic portfolio. Today strategy is focused on providing better terms to borrowing firms and using less leverage, said Farouki Majeed, chief investment officer at the fund.

In dislocation-orientated direct lending strategies, the pandemic provided opportunities to provide liquidity to cash-strapped companies in the small to mid market, he said. Ohio’s allocation is divided between structured credit, distressed and dislocation opportunities and the fund also co-invests in private credit with long standing partners.

Today Majeed is particularly concerned at the amount of money flowing into private credit as large funds like CalPERS seek to allocate more, raising their thresholds to the asset class.

Investors are increasingly allocating to private credit as the role of fixed income changes within portfolios. South Carolina used to have an overly complex portfolio with 18 different asset classes, explained Hitchcock.

Now the portfolio has been remodelled to five asset classes based on a philosophy of simplicity rather than an “always on complexity” so that any complexity must prove it offers risk reduction or additional returns. Private credit is focused (75 per cent) on direct lending and (25 per cent) on opportunistic allocations and tasked with providing a persistent source of income with downside protection. The wider fixed income allocation is tasked with providing diversification and liquidity.

Simplicity is also a watchword at Ohio where the portfolio is structured to have the minimum possible number of asset classes.

“What you can do with less there is no point trying to do with more,” said Majeed.

In one recent evolution, hedge funds have been dropped from the strategic asset allocation. The fund has migrated from hedge funds into real assets and private credit after the realisation that hedge fund returns had not been as strong in recent years. The allocation to real assets has risen to 17 per cent from 10 per cent.

Elsewhere, Ohio has worked with one of its tech-focused private equity managers to tap private credit. The asking price for a few companies was “too high” and not a viable equity investment, recalled Majeed. But by providing a structured capital solution, the asset owner and manager were able to create a new avenue for the firm.