In an unequivocal message to boards that climate inaction could cost them their positions, Exxon shareholders voted this week to replace atleast two of its directors with those that have experience in climate transition. It is a win for CalSTRS which has been vocal in its support of Engine No.1, the activist hedge fund that put forward the alternative directors. The proposal was also supported by CalPERS and New York State Common Retirement Fund.

Gregory Goff, former CEO of Andeavor oil refining company and Kaisa Hietala, former executive vice president of renewable products at Neste are two new directors.

Aeisha Mastagni, portfolio manager in CalSTRS sustainable investment and stewardship strategies unit who led the charge for the fund said it will not be the last time that energy transition will be on the agenda.

“While the ExxonMobil board election is the first of a large US.company to focus on the global energy transition, it will not be the last. We believe change is necessary for companies that do not have a long-term strategy for a responsible transition to a net-zero emissions  economy.”

“This is an unprecedented action by investors, putting all companies on notice that climate inaction can cost a board member their job,” says Andrew Logan, senior director, oil and gas at Ceres.
Climate Action 100+ the world’s largest investor engagement initiative, flagged the vote as worthy of shareholder consideration. Chair of Climate Action 100+ Anne Simpson, managing investment director, board governance and sustainability at CalPERS called it a day of reckoning.

“The votes for change by Climate Action 100+ signatories show the sense of urgency across the capital markets. Climate change is a financial risk and as fiduciaries, we need to ensure that boards are not just independent and diverse, but climate competent.”

Shareholders also voted to support other climate-related proposals at Exxon including a proposal asking the company to report how its climate lobbying aligns with the goals of the Paris Agreement and a proposal seeking disclosure of the climate change risks the fossil-fuel dependent company faces.CalSTRS and other investors want change to happen so that these companies succeed.

“This hits on all our stewardship priorities and how we make these companies more resilient,” Mastagni, who leads CalSTRS stewardship activities said. “We are not trying to argue with them about when this low carbon transition will happen, but it will happen. The biggest risk for Exxon is assuming the status quo – that is a very risky bet for us. Most companies should be preparing for multiple scenarios.”

Our February interview with Aeisha Mastagni outlines the background of the engagement with Exxon and  how CalSTRS plans to incorporate activist stewardship and take on large companies with the credibility of its argument for change.

Mastagni spoke at the Top1000funds.com Sustainability conference earlier this year and the session can be viewed here.

Liang Yin from the Thinking Ahead Institute examines omission bias as an explanation for vaccine resistance, and underweighting investments to China. He suggests a framework for overcoming this bias.

Recently, I had my first COVID-19 vaccine (Oxford / AstraZeneca) and excitement soon turned to concern as the media linked a small number of deaths to this vaccine and the EU’s medicines regulator announced that unusual blood clots should be listed as one of its side effects.

This focuses the mind on the importance of perspective and understanding biases. While this side effect is very rare (roughly one in every 100,000 people) and the risk of dying is even smaller (significantly lower than the risk of dying from COVID) knowing this doesn’t necessarily make my experience less unsettling. After all, I am only human and suffer from a cognitive bias that many people are prone to: omission bias.

Omission bias describes our tendency to focus more on risks related to our actions (me actively choosing to take a vaccine) while giving less attention to risks as a result of our inactions (me doing nothing to protect myself from a potentially deadly virus). Omission bias can cloud our judgement. It is often discussed as one of the plausible explanations for vaccine resistance while the science is very clear that the benefits of any approved vaccines far outweigh the risk, including the one produced by Oxford / AstraZeneca.

We researched this topic as part of the Institute’s work on asset classes of tomorrow which also revealed that most institutional investment portfolios are highly concentrated from a geographical standpoint. Indeed the MSCI ACWI index currently weights the US at around 58 per cent, while China – the world’s second largest economy – is weighted at less than 5 per cent.

In our above-linked paper on Chinese capital markets, we show that over the 31 years since two major stock exchanges were established in 1990, China’s capital markets have grown at a rapid rate, underpinned by fast economic expansion. Today, China is home to the world’s second largest stock market and also the second largest bond market. Since the beginning of the 21st century, barriers to foreign ownership have been gradually reduced. Recent programmes such as Stock Connect in 2014 and Bond Connect in 2017 are viewed by some investors to have revolutionised accessibility to this enormous market. Trillions of dollars’ worth of Chinese onshore assets are now within reach for foreign investors.

As such, there is a strong case for global investors to add or increase exposure to Chinese assets in their portfolios, based on:

  1. Its role as a diversifier and return enhancer in a global portfolio
  2. Opportunities for active managers to add value, and
  3. Improving portfolio resilience with respect to an evolving, albeit uncertain, world order.

With respect to the last point, over recent years, there have been increasing concerns about setbacks in globalisation and rising trade / geopolitical tensions between the US and China. These events were often perceived to be negative for China’s economic prospects and led to elevated market volatility.  Some investors view them as reasons not to invest in China. This could be omission bias at play.

While the future is impossible to predict, indications are that we are moving into a new world order and, as we do so, using scenarios can be helpful in dispassionate decision making and overcoming omission bias. Here is a simple thought experiment where the world is shaped only by two key dimensions: global economic integration and global geopolitical order, and from which we can build five future (2030) scenarios.

We can then assign an estimated likelihood to each scenario, and also a portfolio weight to Chinese assets that would make sense in that scenario (see our paper for our probabilities and weights). Only in scenario five would it make sense to have a 0 per cent weight to Chinese assets. And in all other scenarios we think a significantly higher weight than the 5 per cent implied by the MSCI index, or current average exposures, would be appropriate. Combining across the likelihood of all five scenarios and we end up with an allocation to Chinese assets that is a multiple of current levels.

The usefulness of this simple construct is that it is flexible and helps investors with their omission biases.

A useful historical perspective is that US economic output overtook that of the entire British empire for the first time in 1916 and, if investors hadn’t seen that coming and diversified accordingly the United Kingdom’s underperforming capital market should have been an enduringly strong clue.

 

More than 100 years later, the world could be at another point of similar flux and yet many investors today hold highly concentrated portfolios built for the past, rather than thinking about incorporating asset classes of the future.

Liang Yin, CFA, PhD  is a senior investment consultant in the Thinking Ahead Group, an independent research team at Willis Towers Watson and executive to the Thinking Ahead Institute.

The definition of what it means to invest is changing, according to Jon Lukomnik and James P. Hawley, which means examining the limitations of the 75-year old legacy of modern portfolio theory.

It’s difficult to spot a paradigm shift while it happens, but we believe the definition of what it means to invest is changing.  Increasingly, investors are acting to affect the feedback loops between the real society and economy where value is created, and the capital markets, where it is priced.

Evidence is everywhere.

Environmental and social proxy resolutions in the United States are racking up numbers never seen before.  The PRI has pushed its members to look at stewardship in terms of systemic risks. Money is flowing into ESG- and sustainability-themed products. We read of investor-led efforts to mitigate real world risks to the environmental, social, and financial systems virtually daily. Investors are tackling issues as disparate as climate change, fair taxation policies, income inequality, gender and racial discrimination, anti-microbial resistance, deforestation, biodiversity, and the governance of technology as well as traditional governance concerns like executive compensation.

Even regulators around the world are contributing: The chair of the Securities and Exchange Commission in the US has said he anticipates rule-making on climate and human capital management  issues; the European Union has published its disclosure regulations on “green” funds and is working on its dual materiality framework; and the UK stewardship code asks asset managers about systemic risk.    Even the nature of who is a regulator is changing: In the UK the chief markets regulator just hired the most high-profile head of stewardship in the country, Sacha Sadan, to helm its ESG efforts.

All this is a welcome refutation and reversal of the 75-year old legacy of modern portfolio theory (MPT) that suggests investors focus only on trading and portfolio construction.

MPT is brilliant in providing the maths to diversify and therefore extract the most efficient risk/return portfolio from the extant market but provides no tool or theory to improve the market’s return.

Yet diversification only works on idiosyncratic risks, whereas overall market movements – non-diversifiable systematic risk – determines 75 – 94 per cent of return, depending on which academic study you want to cite.  This is the MPT paradox: MPT provides a powerful tool to affect that which matters least.

The result has been the development of a self-referential school of investing.  Returns are relative, benchmarked against market indices divorced from real world needs of investors.

If the market is down 10 per cent, and your account is only down 8 per cent, your portfolio manager is a star, despite the fact that you have less money to fund retirement, buy a home, or whatever.

Risk is similarly siloed. To MPT, risk is volatility, and the cause of the volatility (often systemic risk in the real world that becomes non-diversifiable systematic risk in the capital markets) is irrelevant.

Academic theories have facilitated this imaginary, self-contained world: By assuming 1) rational investors, 2) efficient markets, and 3) random walk theory, MPT does away any need to deal with the messy feedback loops to the real world.  Together, they create the perfect myth. They enable the math. They are easy to understand. They are explanatory. They are wrong.

Fortunately, practitioners increasingly reject the paradox.

Think of it this way: If the market itself were a portfolio, investors are trying to improve its Sharpe ratio by mitigating risks to the real world’s financial, social and environmental systems before those risks enter the capital markets.  And, at last, theory is finally catching up to practice.

Three years ago, we wrote a paper that foreshadowed these arguments. It was controversial, to say the least.  But in just the month of April, three important publications have examined various aspects of these issues and progressed the arguments for investors seeking to mitigate real-world risks, rather than just moving electronic dots on a trading terminal.

Bill Burkart and Steve Lydenberg’s 21stCentury Investing shows investors how to think about systems, the Predistribution Inititative’s “ESG 2.0” paper looks at the impact of institutional investors and investment structures on various ESG issues, and our book, “Moving Beyond Modern Portfolio Theory” provides the first coherent finance theory of why investors confront the MPT paradox.

When paradigms shift, they can shift quickly.

Jon Lukomnik and James P. Hawley are co-authors of Moving Beyond Modern Portfolio Theory: Investing That Matters” (Routledge, 2021)

The latest annual CIO Sentiment Survey, a collaboration between Top1000funds.com and Casey Quirk, part of Deloitte Consulting, finds asset owners on track to hit return targets as risk on and active strategies reap rewards. Elsewhere, after consecutive years of cutting back on manager and consultant relationships, investors want more partners in 2021.

Click here to explore the findings

Keith Ambachtsheer responds to an article on the negotiations by CalSTRS’ outgoing chief executive, Jack Ehnes, to achieve fully funded status by 2046.

Dear Amanda,

I was surprised to see the recent article titled “CalSTRS’ CEO achieved fully-funded status”.

In fact, CalSTRS’ own 2020 funding report states that its DB plan is only 70 per cent funded using an aggressive 7 per cent liability discount rate. The funded ratio would drop to 55 per cent if a more realistic 5 per cent discount rate were used. In comparison, Ontario Teachers’ Pension Plan reported an almost double 103 per cent funded ratio with a 5 per cent liability discount rate at the end of 2020.

It is true that CalSTRS reached agreement in 2014 with California employers and the State to target 100 per cent funded status for the DB plan by 2046 by making additional contributions.

While this agreement clearly represents progress, its importance is easily overstated for two reasons.

The first is the assumption that fund assets (including the additional contributions) will earn an aggressive net investment return of 7 per cent per year over the next 25 years.

The second is that the agreement will actually stay in place that long. While this is not impossible, many things can happen over a 25 year period, including in the State of California. For example, a recent CalSTRS review document noted that California employers and the State are looking for COVID-related relief from making additional CalSTRS contributions.

Despite this problem and possible future ones, the CalSTRS report noted somewhat hopefully “we still expect to make progress towards full funding”. However, its authors clearly recognise there can be material gaps between hope and subsequent reality.

I thought your readers might appreciate this additional information on CalSTRS’ funded status.

Yours truly,

Keith Ambachtsheer

Director Emeritus, International Centre for Pension Management, Rotman School of Management, University of Toronto and President, KPA Advisory Services Ltd.

 

Investment risk is often viewed as the possibility of incurring a negative return over the short-medium term, as reflected in measures like volatility or drawdown. Such measures are useful for investors with shorter horizons. But they become increasingly less effective as the horizon lengthens, especially when investing over multiple periods where cash comes into or out of the portfolio.

The classic example is investing for retirement: return volatility says little about the risks of failing to generate an adequate income stream over future decades. This article draws out the main themes from a recent paper (found at this link) where I discuss risk from the perspective of long-term investors – those investing for a decade or more.

Long-term objectives

Risk may be defined as the failure to attain an objective. The objectives of long-term investors fall into three groups: building wealth (real return targets, bequests, some sovereign wealth funds and family offices); generating an income stream (retirement income; endowments and foundations); and funding long-term liabilities (defined benefit pensions; life insurance). Two questions arise. First, what could lead to failure to achieve the objective? Second, how might the risk of falling short of objectives be measured?

Issues with volatility-based measures 

Measures based around return volatility describe the possibility of suffering shorter-term loss. What matters to long-term investors is incurring a loss that is sustained over their investment horizon. Volatility-based measures do not distinguish between losses arising from forces that can result in sustained loss, from transient effects with no consequence for ultimately achieving objectives. Further, volatility can be as much a source of opportunity as a risk for long-term investors, as market fluctuations can provide opportunities to buy assets at attractive prices for the long run (or exit, and redeploy the capital). An alternative framework is needed.

Nature of risk for long-term investors

Viewing wealth accumulation as associated with four drivers – initial expected return, cash flow risk, discount rate risk and reinvestment risk – can help identify the factors that long-term investors should worry about. This decomposition derives from asset prices as the present value of future cash flows. Initial expected return equates to the discount rates on which assets are priced. Deviations from the initial expected return stem from subsequent changes in the cash flows being discounted, and the discount rate applied. Wealth accumulation also depends on the rate at which cash flows released by assets are reinvested.

  1. Initial expected return – For assets that offer relatively high expected returns in excess of that required, the probability of achieving an objective will not only be higher but also increases with investment horizon. The reverse holds for assets offering sub-par expected returns. The rub is that higher-returning assets tend to be more variable, raising the possibility of even worse outcomes in the ‘lower tail’ of the distribution of outcomes. The upshot is that equities may appear more attractive (in terms of shortfall risk) to a long-term investor on the balance of probabilities, but they need to be willing to bear some chance that things might turn out even worse than investing in (say) fixed income. Meanwhile, fixed income may offer more reliable outcomes, but could be almost certain to fall short of a long-term objective.
  2. Cash flow risk – Sustained losses occur when the cash flows generated decline versus what was originally reflected in the price. For example, equities will suffer a permanent downward adjustment upon a sustained reduction in the future cash flow stream due to an earnings revision. For bonds, rising inflation can generate sustained losses by eroding the real value of their promised cash flows. Investing in assets that do not deliver on their promise for (real) cash flows is a key risk faced by long-term investors.
  3. Discount rate risk – Asset prices also fall when discount rates rise. However, the fall leaves the asset priced to deliver higher returns thereafter, meaning that the wealth losses are gradually clawed back. Consider how bonds respond to rising yields: there is an immediate capital loss, but the bond resets to a higher yield. If the bond is held to maturity, the investor gets the return they expected initially. The relation between asset duration (i.e. term of the cash flows) and investment horizon establishes a pivot point. An investor faces discount rate risk when duration is longer than the investment horizon; but no discount rate risk when the two equate. If duration is shorter than horizon, then reinvestment risk comes into play.
  4. Reinvestment risk – Most assets release cash flows to be reinvested, creating exposure to uncertainty over reinvestment rates. For equities, this uncertainty relates to reinvestment of dividends and retained earnings (assuming they equate to cash flows). For bonds, both coupons and principal at maturity need to be reinvested. Reinvestment risk increases as asset duration shortens relative to investment horizon, and as horizon lengthens given that most assets continue releasing cash over time. The concern when exposed to reinvestment risk is that rates will fall; while the concern with discount rate exposure is that rates rise.

This decomposition changes how a long-term investor might perceive the risks associated with various assets. Equities emerge as less likely to fall short of long-term objectives by virtue of their higher expected return. But they carry exposure to cash flow (i.e. earnings) risk, and reinvestment risk related to companies reinvesting at value-destroying rates. Equities may also bring exposure to discount rate risk, unless the investor has a very long horizon of beyond 20-25 years (see chart).

A key concern with fixed income is the likelihood of falling short of objectives due to insufficient expected returns; although mismatches between duration and horizon and whether inflation might erode the real value of cash flows should also be considered. The quantum of these exposures will vary with duration, and between fixed income assets with fixed nominal versus inflation-linked cash flows. For instance, cash may offer the lowest return, but otherwise is essentially an exposure to reinvestment risk. Indeed, cash might provide a hedge against across-the-board rises in discount rates if the overall market return structure adjusts back upwards. Long duration treasuries may offer higher returns; but can be very exposed to both discount rate risk, and cash flow risk related to inflation. Inflation-protected bonds may carry virtually no real cash flow risk; but could actually exacerbate the risk of shortfall versus some long-term objectives after taking into account their zero-negative real yields and heightened exposure to discount rate risk due to longer duration.

Path Dependence

Path dependence emerges where the sequence of returns may result in shorter-term losses being crystalized, thus generating sustained losses. Two situations are notable. First is where poor initial returns disrupt the ability to follow-through on well-founded long-term investment plans. For instance, a fund might be forced to sell assets cheaply after a bout of poor performance if their investors withdraw, or support is lost from within the organization. Second is sequencing effects arising from the interaction between returns and cash flows. For instance, a retirement account will be exhausted more quickly if a fixed amount is drawn and poor returns are incurred early in retirement.

Measuring long-term investment risk     

I will briefly overview the key elements involved in measuring long-term risk, and leave it to interested readers to access my paper for guidance and examples. Long-term risk analysis involves scoping out potential future ‘paths’ (or states of the world), and then identifying the paths where objectives are not attained. This requires conducting stochastic modelling that allows for variability in investment outcomes. It will likely entail some form of simulation or scenario analysis.

As real spending power is typically the concern over the long run, it will usually be appropriate to model in real terms. Although analyzing real long-term returns may sometimes suffice, in many situations real wealth accumulation should be modelled to account for cash inflows and outflows and reinvestment at rates other than available in the market, e.g. company reinvestment. Risk metrics should convey the likelihood and magnitude of shortfall versus objectives. This involves estimating both the probability of failing to meet the objective, and measures to capture the size of the shortfall that might occur.

Finally, it is important to allow for initial market conditions, especially with regard to baseline expected returns. Currently, returns on offer appear well below what has occurred historically. Fixed income is largely priced for low-to-negative real yields. The high pricing of risk assets like equities can be interpreted as a signal that they too are priced to deliver low expected returns. The risk of falling short of long-term objectives would be misrepresented significantly if the analysis drew on historical data, rather than calibrating to the current market return structure. Further, acknowledging that market discount rates have more upside than downside from current low levels will have implications for discount rate versus reinvestment risk, and hence the relative attractiveness of assets with differing exposure to these two drivers.

Takeaways

Evaluating long-term investment risk requires shifting the mindset away from a focus on shorter-term losses towards failure to achieve a long-term objective. A key question to ask is: what developments might result in losses that are sustained over the investment horizon? Answering this question will help distinguish exposures that need to be managed from those of little consequence. When it comes to measuring risk, analysis should be directed towards generating the range of potential future paths, and estimating both the likelihood and magnitude of any shortfall versus objectives.

Dr Geoff Warren is an Associate Professor at the Australian National University.