The $308.6 billion CalSTRS has outperformed its custom benchmark in every asset class to deliver a historic fund performance of 27.2 per cent for the year against a return assumption of 7 per cent.

Global equities, which makes up the bulk of the asset allocation at nearly 50 per cent, returned 41.8 per cent for the year.

But the standout performers against their benchmarks were private equity, real estate and innovative strategies returning 51.9 per cent, 7.4 per cent and 11.7 per cent respectively. The outperformance over the benchmark for these asset classes ranged from 4.1 – 6.1 per cent for the year.

The fund’s chief investment officer, Chris Ailman, says the returns were outstanding but what is more pleasing is that every asset class outperformed.

“Our returns are astonishing and we knew that would be the case because of the government stimulus, and in the US fiscal and monetary stimulus has been off the charts,” he says. “I’m astonished at our results because every asset class outperformed. We haven’t had that happen for years, I’m sure it’s been decades.”

CalSTRS currently has a 12 per cent allocation to private equity, against a target of 10 per cent, and the asset class was a stellar performer with 51.9 per cent for the year.

The fund has hundreds of relationships in private equity with vintage years going back to 1999, but Ailman gives full credit to the team for this year’s performance.

“We had some really smart co-invesmtents that later on in the pandemic became unicorn investments,” he says.

CalSTRS has an investment bucket called “innovative strategies” that was created after 2008 to push for innovation and study new, interesting areas. It currently includes aircraft leasing, private credit and other kinds of debt. It makes up only a very small portion of the portfolio, currently 0.5 per cent.

“It is literally an asset class laboratory and we tried some things that did well. Some things that didn’t do well we got rid of,” he says. “It will always swing in performance because we are testing things.”

One of the success stories of the testing laboratory is the risk mitigating strategies portfolio which has grown to 10 per cent of the overall portfolio and $30 billion in assets.

“The goal for that team is to add value and diversify. And the question is not whether you can get a one-year return but can you scale it to our size and do it over multiple time periods?” he says. “We are always looking for something new and different, we studied tail hedges a lot but still not decided to use them.”

Ailman says the risk mitigating portfolio looks at how to hedge for differences in downturns. To deal with different phases of a downturn shock the portfolio includes 30-year US government bonds, global macro, CTAs, and momentum portfolios which are diversified between three-week momentum and three-month momentum strategies.

“Bear markets don’t come wrapped in the same package,” Ailman says. “From February 2020 to March 2020 we had a bear market lasting 20 days and was down 15 per cent so fast nothing could react. Our RMS portfolio did well. The question is what is the cost of the insurance? In our case RMS had a positive return so it justifies the cost of the portfolio.”

The fund’s giant equities allocation, half of which is managed inhouse using passive and enhanced indexed strategies, was a big contributor to the annual return.

“We captured everything global equities was giving,” Ailman says. “And with our internal team we are capturing the beta of the market at a very low cost.”

Ailman says he expects the returns of his global peers will vary widely due to asset allocation differences.

“We will see wide dispersions. Even within the US there is a full 10 per cent dispersion in returns because it comes back to the equities and fixed income weightings,” he says.

CalSTRS has been reducing its fixed income allocation for 30 years, and when Ailman arrived at the fund as CIO 20 years ago it had a 40 per cent allocation.

“When I got here we had $30 billion in fixed income now it’s still $30 billion but its 12 per cent of the fund not 40 per cent.”

Ailman says the fact all teams were working in isolation in remote environments in the past year is testament to the culture of the team.

“This is a year where culture and team helps separate people, if you’re working remotely and don’t have a team culture then it’s even worse,” he says.

Looking forward Ailman says he is more cautious than his team regarding the investment environment.

“I’m so worried the government’s put out so much stimulus, the US has built up such a debt load eventually we have to pay that back,” he says. “I’m looking at that deficit and the transition from remote back to the office and I don’t know what will happen. Personal income in the US will go down as people go back to work, it’s crazy.”

The official CalSTRS’ investment view is cautiously bullish and the fund is at market weight in equities.

“We’re all looking to the fall and trying to figure out what’s going on,” he says.

One thing Ailman can commit to is the fund’s positioning regarding climate change.

“I’m really committed to turning our portfolio around in terms of climate change and this is not a one-year thing. At COP26 we need to see something happen and commitments to come out. It is such a profound change, it won’t be smooth on the economy and it is also a very long-term impact.

“We want to concentrate on actually doing stuff. We’re going to do some investments, change the portfolio and do things to be an example for others, to get the portfolio set up to be prepared for 2030 and beyond.”

 

Asset owners that are PRI signatories had higher returns and lower costs than non-PRI signatories over a five-year period according to analysis by CEM Benchmarking.

Analysis of the PRI signatories in the CEM database in the five-years leading up to 2018 showed that not only did being a PRI signatory not hurt performance, but those funds performed better than their non-signatory peers with a 52 basis points difference net of fees.

CEM has 340 funds in its database, 68 of which are PRI signatories. The research compared the performance and costs between the PRI and non-PRI signatories, with being a PRI signatory a proxy for funds that implement responsible investment.

The analysis found that PRI signatories had higher average total fund net value added than non-signatories: 0.53 per cent for PRI signatories versus 0.01 per cent for non-signatories over the period. 2018 was chosen for the completeness of the data set.

Kam Mangat, vice president at CEM and one of the co-authors of the research, said that on average the funds that were PRI signatories were larger in size and had more internally managed assets than non-PRI signatories.

PRI signatories in the database on average manage 35 per cent of their assets internally, compared to 11 per cent for non-PRI signatories. Previous CEM research has shown that funds with internally managed investments have lower costs.

Value added by large institutional investors the research which examined this attributed 12 basis points of return to the “characteristics of large and internal”.

Mangat said when an adjustment was made for this it leaves a 40 basis points outperformance by PRI signatories versus their non-signatory peers.

“There has been a lot of talk about whether ESG really impacts performance, and the initial indication is that it doesn’t negatively impact performance,” Mangat said. “It doesn’t hurt performance, but we want to be cautious in making that statement because we only looked at a five-year period and ESG is long term in nature and so we need a longer time frame to be definitive on ESG investing.”

Lower costs

Further, being a PRI signatory did not increase total fund cost. In fact, on average, PRI signatories were lower cost than non-signatories on both an absolute basis, and relative to a benchmark that adjusts for each fund’s size and asset mix differences.

The average total investment cost for PRI signatories in 2018 was 44.8 basis points compared to 52.1 basis points for non-PRI signatories.

Again, Mangat said that implementation style was a reason for the reduced cost, because the PRI signatories had a larger share of internal investments.

“There is also a governance angle to it,” she said. “The PRI signatories were larger asset owners and had more internal investing and they also probably have the capabilities and capacity to build out ESG investing and have a better governance discipline.”

 

Regional differences

PRI signatories had a higher five-year average net return in USA, Canada, and the UK. In the Netherlands, PRI signatories had lower returns, but this is due to larger fixed income allocations and investments focused on their liabilities.

Mangat said there was further research to be done.

“When we take a step back and look at what we have done we are only using being a PRI signatory as a proxy. How those funds are implementing ESG could be very different across the board, we don’t know how they are implementing it beneath that headline of being a signatory.”

PRI signatories made up 20 per cent of the 2018 CEM database and accounted for 60 per cent of total AUM in the 2018 CEM database.

Broken down regionally, the US was an outlier. Only 18 per cent of the PRI signatories were from the US. But US funds made up 58 per cent of the non-signatory funds.

The $160 billion Teacher Retirement System of Texas (TRS) has a long and celebrated prowess when it comes to investing in energy yet enduring underperformance in the asset class was a key focus during a recent board meeting.

TRS, whose beneficiaries live in the state responsible for around 40 per cent of US oil production, increasingly sets itself apart from other public pension funds grown wary of investing in fossil fuels as the world begins to tackle climate change.

A 10-strong internal team of GP, engineering and industry expertise runs a 6 per cent target allocation (currently 4.9 per cent) to private energy, natural resources and infrastructure assets in the ENRI portfolio, set up in 2013 with fossil fuel investment at its core in the hunt for inflation protection and uncorrelated returns.

Despite infrastructure (only added to the allocation in 2017) now accounting for more than energy (43.4 per cent vs 50 per cent with a 40 per cent weighting to energy in the benchmark) the poorly performing energy allocation continues to drag returns.

“It really is a tale of two cities,” explained Carolyn Hansard, senior investment manager, ENRI. “Energy has consistently underperformed since the portfolio was started. We had 14.5 per cent negative returns last year, we have seen negative returns of 7.1 per cent over three years and a negative return of 3.4 per cent since we started the portfolio.”

In contrast, infrastructure, which includes energy infrastructure assets in the midstream sector alongside other infrastructure assets, has delivered “pretty consistent” returns of close to 10 per cent on average over the same time periods. Returns from energy have been even tougher for public market investors, noted Hansard.

“If we had invested our portfolio in the public markets, the S&P1500 in energy over a one-year time period would have been a -35 per cent return versus our -14.5 per cent, over three years it would have been -19.6 per cent versus our -7.1 per cent.”

ENRI investments are split between funds and principal investments, which include direct and co-investments and are a key focus in the fund’s drive to cut fees. However, poor performing energy investments have also knocked the shine here. Principal investments have underperformed relative to funds because most of them have been in energy in line with TRS’s historical energy focus, said Hansard. Today 39 per cent of the ENRI portfolio is currently invested in principal investments, with a target of 40 per cent versus funds.

Opportunities

Yet while more investors flee fossil fuels, TRS sees opportunities and is ploughing on. Despite the underperformance of the allocation, Hansard believes unique opportunities still lie ahead for skilled investors because of the lack of capital now flowing into the sector.

“As one of few public investors with an energy focus, we think this is an opportunity as a sophisticated energy investor to provide capital,” she said.

The shortage of capital – exacerbated by the exodus of public investors in the sector too – is forcing energy companies to boost efficiencies, cut costs and only produce the best assets. It is also spurring an endless trail of M&A transactions in the space.

“It seems like one is announced every other day,” she told the board, describing the corporate scramble to combine and cut out excess cost in the US.

Elsewhere, the traditional cash infusion via the IPO route is increasingly blocked.

“There are very few new IPOs into the market,” she said. “Investors are leaving this space in the public markets. When we started this portfolio, energy accounted for over 10 per cent of the S&P500, now it’s less than 3 per cent.”

Difficult IPOs is one reason for the sharp fall in private equity investment in the sector. Private equity managers have failed to return any significant capital to investors in a sharp drop off most noticeable from 2017.

“Over a 10-year period private equity (in broad energy) has seen no appreciation of capital,” she said.

Meanwhile, managers trying to raise private equity energy focused capital are facing a difficult time – TRS only considered one fund last year.

“Our portfolio currently has $4 billion invested in the energy markets and we put in $2 billion of new capital every year. This far exceeds the last two year of private equity capital that was raised and was on par with 2018.”

It is not only efficient, cash-short producers with the best assets she sees as an opportunity. There is also a need for capital in rig financing where private equity investment now accounts for 50 per cent of total rig financing in the US. That said, the rig count in the US is down by half compared to several years ago as producers grow increasingly more disciplined about bringing oil out of the ground.

“With less supply there is a better price,” she countered.

Hansard concluded that the only sector of the energy industry not starving of capital is high yield where more risky producers can still access capital.

“There is still capital here, but only for the best producers with free cash flow,” she said. “Most of the capital is being used to shore up balance sheets.”

Hands on investment experience overseeing a large, a mostly internally run investment program, AUM with layers of complexity that targets a 7 per cent rate of return; leadership skills and ease under the media spotlight and monthly board scrutiny plus the ability to commit for at least five years. The role of CalPERS next CIO isn’t for the faint-hearted.

The $469.8 billion pension fund has been without a permanent CIO for a year following the resignation of Ben Meng in the wake of regulatory filings disclosing he had invested in shares of private equity managers with which the pension fund had invested in the past. A search last year was abandoned because of challenges inherent in recruiting during the pandemic and issues with the compensation package – since resolved to now include a long-term incentive approved by the board. Still, discussions at the July board meeting on the key characteristics the board seeks in its new CIO offer a revealing window into the task and trade-offs that lie ahead.

Drawing on CIO data from 100 global asset owners in CalPERS’ peer group, Charles Dore, chief executive and founder of executive search agency Dore Partnership tasked with filling CalPERS empty CIO seat, highlighted the challenge afoot.

Dore’s analysis of the world’s top 100 institutional investors finds 82 have incumbent CIOs – out of those that don’t five have an open vacancy while 13 (mostly SWFs in the Middle East and Asia) don’t follow a traditional CIO structure.

Of the incumbent 82, around 54 per cent were appointed in the last three years; 63 per cent were appointed internally and the overwhelming majority are men. Over two thirds of incumbent CIOs hail from the asset owner community with the rest split between asset management and other backgrounds like banking or government.

Delving further into the data, Dore’s analysis found only 31 per cent of the sample 100 asset owners have, like CalPERS, a 7 per cent rate of return – and two of these funds (Yale and Washington State Investment Board) are without CIOs.

Of this ever-smaller cohort, the average AUM is just $158 billion, and the typical CIO tenure is just over five years. Again, CIOs in this handful of highly performing asset owners are also, overwhelmingly, white and male. Of the top performing CIOs in CalPERS’ immediate peer group, 50 per cent managed less than $25 billion and one third managed less than $10 billion in their prior role, indicating that scale is not a factor in predicting long-term investment success.

Still, the CalPERS board will have to reconcile that with some members’ priority that the new CIO has experience managing a large AUM.

Cue Dore’s counsel on the importance that the board keep an open mind, considering candidates with experience of managing small AUMs and mindful of the benefits of hunting for talent among current deputy, or rising CIOs, rather than only fish from a pool of proven CIOs.

“Around 48 per cent of performing CIOs were recruited internally – they were not CIOs before their current role,” he said, adding that assets under management is too rudimentary a proxy and that many of this group have also come from overseeing a single asset class. That said, all agreed that direct investment experience was vital.

“We are looking for a big I in CIO,” said CalPERS CEO Marcie Frost.

Diversity

Any trade off regarding diversity will be just as difficult for CalPERS board. Board member Margaret Brown flagged that the data points to this being one obvious casualty of the process.

“It’s very clear this is going to be challenging,” she said, arguing that pushing for female candidates or historically underrepresented groups will make the candidate pool even smaller.

“While we are all big on DEI, the most important thing we are looking for is qualified candidates.” This might mean not hitting on the diversity piece, she said.

“If that’s what we are searching for, no wonder that’s why we came up empty first time around.”

Against Dore’s insistence that the search company would “lead a systematic A-Z search” and “if the market has diversity to offer” the firm would capture it, other board members pleaded for diversity to be a centre piece in the search.

“It is incumbent on us to ensure we have diversity at the highest level of investments,” said Stacie Olivares. “We have seen time and again when there is diversity there is outperformance.”

Dore will conduct a data and reference-led process that will include people on career breaks targeting end of September for the first round, and an early March 2022 joining date. Dore added that the search process will also seek candidates with a succession plan, able to build continuity and with a track record of elevating others.

“It is very important we find someone aligned to the mission of the organisation.”

Once the latest criteria are approved, board president Henry Jones will select a committee to conduct the first round of interviews along with Frost. Final interviews will be conducted by Frost and the full board. The board and the CEO share the hiring of the CIO who will report to Frost.

CalPERS’ next CIO must be just right – but it remains to be seen whether the fund will get its fairytale ending.

A review of the legal barriers to investing for sustainability impact in 11 jurisdictions gives confidence to investors wanting to re-think old investment paradigms and include impact alongside risk and return.

The report commissioned by PRI, UNEPFI and The Generation Foundation was conducted by global law firm Freshfields Bruckhaus Deringer provides the first ever comprehensive analysis of how far the law requires or permits investors to take deliberate steps to tackle sustainability challenges in discharging their duties, described as investing for sustainability impact

It brings much needed clarity on the legal framework for sustainability impact investing, and also looks at the opportunities for policy reform that would better enable investors to have coherence on the legal frameworks to invest sustainably.

Some of the suggested policy reforms include changing investors’ legal duties and discretions, such as allowing the pursuit of sustainability goals as long as financial return goals are prioritised, and a presumption in favour of investor collaboration in tackling sustainability challenges.

“This report is the first of its kind. This detailed legal analysis shows investors they should feel empowered to rethink old investment paradigms by considering risk, return and impact as the pillars of successful investment practice,” said David Blood, senior partner, Generation Investment Management.

The research will provide insights on how far investing for sustainability impact is legally required or permitted across 11 jurisdictions: the EU, Australia, Brazil, Canada, China, France, Japan, South Africa, the Netherlands, United Kingdom and the United States. The project reference group of experts will also support and test the legal analysis.

The PRI’s chief executive, Fiona Reynolds, said that Freshfields has identified a diverse spectrum of actions that investors and policymakers could take to better facilitate investing for sustainable impact.

“These are based on an extensive analysis of the unique legal and regulatory conditions they face in their respective jurisdictions,” she said.

 

To access the report click here.

 

In June, G7 nations endorsed mandatory climate-related financial disclosures based on the Taskforce for Climate Related Financial Disclosures (TCFD) framework recommendations. A recent report identified that only 23 per cent of Canadian listed companies are reporting in alignment with those recommendations, exposing its public entities to the risk of diminishing their access to capital while limiting investors’ access to their returns.

Although late in 2020 Canada’s largest pension funds made news by publicly declaring that they wish to see issuers disclose to both the SASB and TCFD frameworks, of the 228 companies listed on Canada’s S&P/TSX Composite Index only 23 per cent provided a clear statement indicating that their climate reporting align with the TCFD recommendations, with an additional 14 per cent expressing a desire to align with those recommendations and 54 per cent with no mention at all.  Although, the extractives and minerals processing and the financials sectors led the way in terms of TCFD-aligned reporting, the study discovered that there were no TCFD-aligned reports found in the healthcare, renewable energy resources & alternative energy, and services sectors.

And how are investors responding to this lack of climate reporting?

To get a pulse, Canadian ESG Advisory firm Millani Inc. focused its recent Semi-Annual Institutional Investor ESG Sentiment Study on climate reporting, and more specifically, on investors’ expectations for issuers disclosures to the TCFD framework*.

The study concluded that the Canadian investment community is mindful of the challenges of reporting in line with the TCFD, with most respondents suggesting that issuers start their reporting now but to consider that ­reporting will need to be iterative and progressive going forward.  However, regulators and investors are expected to become less forgiving with time.

Regarding emissions disclosures, 100 per cent of investors surveyed said they are assessing scope 1 & 2 and 75 per cent are looking to assess scope 3. Meanwhile, 90 per cent of those issuers who have TCFD-aligned reports, provide scope 1 and 2 emissions, and 50 per cent report scope 3 emissions.  Much of this sentiment aligns with the proxy voting trends that the market witnessed in 2021, with multiple shareholder resolutions asking for climate strategies or disclosures to scope 3, surprisingly getting mainstream investor support.

But the study also highlighted those investors find that TCFD disclosures are less insightful than most had anticipated. Given that issuers can choose which climate scenarios they can use, investors expressed that companies are putting forth scenarios that provide positive results, and not providing a thorough disclosure of potential risks and opportunities to their business strategies.

Early in 2021, there were many organizations that made net-zero commitments.  While these announcements were initially well-received, the investor community quickly realized that for some, there was little substance behind the targets.  The report collected investor’s sentiments to issuer target-setting and noted that they are most interested in seeing interim targets and an articulation of how the organization plans to get there.

The study outlines those investors themselves were surprised by the accelerating pace of change in ESG regulations and at the rate at which investors and corporates are progressing on this topic.   A well-articulated climate strategy is becoming a necessity for any issuer, and investors alike.

While having been driven by Europe until recently, North America is about to undergo seismic shifts as the new US administration begins to focus its regulatory and legislative agenda towards climate change. As much as the markets are already feeling pressures, several new regulatory initiatives are expected to be announced to drive the markets forward.

As the world, and its regulatory and its financial systems prepare for COP26, one thing is certain. Further changes are expected, and the stakes are increasing with each passing day for issuers, and investors alike.

*Millani’s Semi-Annual Study was published in two distinctive reports which can be read in conjunction with one another and can be found on our website

  • TCFD Disclosure Study: A Canadian Perspective
  • Semi-Annual Sentiment Study of Canadian Institutional Investors: Climate Change & TCFD-Aligned Reporting

Milla Craig is the founder and president of Millani.