The Future Fund, Australia’s A$226 billion sovereign wealth fund, has embarked on an ambitious project instigated during the COVID crisis which includes re-examining its investment assumptions, risk tolerance and the way it allocates capital. Amanda White talks to the fund’s new CIO, Sue Brake about where the fund will be allocating in the future including alternatives and active management.

The Future Fund, Australia’s A$226 billion sovereign wealth fund, has embarked on an ambitious project instigated during the crisis. The project involves a reconsideration of investment assumptions and a questioning of key themes as the investment team endeavours to navigate an environment that includes lower for longer, greater geopolitical risk, inflation risk and changing asset class correlations. As part of the project the investment team has been re-evaluating the board’s appetite for risk, reviewing its investment beliefs and questioning its comparative advantages. It’s an all-in review of all aspects of investment that will culminate with a plan to be presented to the board this month.

The past year has been frenetic for the Future Fund reflected in the doubling of its cash holding from 9 to 18 per cent and participating in 30 investment transactions in the past six months.

Chief investment officer of the Future Fund, Sue Brake says it has been a very deliberate strategy to increase cash over the past year, however she says the cash allocation can be misleading if it is viewed in isolation.

“We think about the market risk in the portfolio, the return-seeking risk, separately from the cash amount,” she says. “We only ever think about the total portfolio, it’s the aggregate risk we have.”

She says the cash allocation is not about risk aversion but about risk management – and the risk of not achieving the fund’s mandate is the primary risk it faces.

“There have been disruptions in the market and we thought there would be opportunities if we were quick,” she says. “We wanted cash to be able to move quickly and so we are not taking risk off but changing it.”

The team was having a daily investment committee meeting during the height of the crisis, and was able to make some very quick decisions and deploy capital to meet the market opportunities. Much of that took place in the alternatives portfolio which has always been a large exposure for the fund, currently around 14 per cent.

“There were disruption opportunities requiring us to deploy capital quickly to new funds being raised, like fixed income where there were arbitrage opportunities. So many things were happening at the same time,” she says.

This included a manager which had been closed to new capital for a long time coming to market and approaching the Future Fund, and changing the benchmarks of managers in accordance with the function they play in the total portfolio context.

When the dust settles: review everything

But once the frenzy of market volatility stabilised and the opportunities were not so obvious, the team at the Future Fund caught its breath. And when it did, Brake says, it was obvious there were some fundamental things that had changed.

The fund takes a scenario-based approach to investing and triggered by its signposts had been watching trends and arguing about probabilities: Would MMT eventuate? What’s the hangover to fiscal policy given monetary policy is exhausted? What about geopolitical tensions and the global economy? What would happen to interest rates?

“COVID moved us in a direction where a lot of those questions were answered. We have more certainty now in a way because we have certainty about where we are going. Some things are very clear now,” Brake says.

But together with Raphael Arndt, now chief executive whose shoes Brake stepped into as CIO, they mused that there had been some fundamental shifts. They started asking what assumptions had been made in the past that might belong to an old world? What was missing, what had they not questioned? And what investment assumptions were no longer true?

A project structure was developed around these questions – so the team didn’t get stuck in blue sky thinking – and that project is now coming to an end.

The first of five workstreams examined what might be already “known” and a number of points came out of that which have already been acted upon including: there is a higher chance of inflation on the horizon, geopolitical tension has increased, and markets are more fragile now which also has a currency impact.

These ideas fed some of the transactions the fund has made in the past year including taking advantage of some very cheap pricing in inflation. It has also diversified away from the US dollar, adding more currencies and it is now has much lower exposure to any one currency risk. And it made an allocation to commodities for the first time.

In addition, she says the listed tangible markets – in infrastructure and property – looked cheap compared to equities and the fund took a large position in those.

“Our managers are doing most of the hard work for us deploying capital into technology opportunities. It has been a very big transactional year across the board.”

But while the first of the five workstreams dealt with the more obvious themes in the market the rest of the project has perhaps been more challenging. Staff were engaged in a wiki survey – an evolving survey driven by contributions from respondents. It was ceded with five things that have changed because of COVID and as staff responded to the survey, and added and voted on peer contributions, that list grew to 40.

“My idea was to focus on 10 things but we got to 40 and they were all equally voted which was interesting but not helpful in prioritising,” Brake says. “We got it down to 10 and discussed those with the board. It was a deeper than usual review of the investment strategy and my first as CIO. It couldn’t have been a better topic to talk to the board about.”

The fund also then reviewed its investment beliefs, re-tested the risk tolerance of the board and refreshed its comparative advantages.

“We thought if we are going to be bold what should we bold with, what’s our edge?”

All of that thinking has been brought together with a new strategy that Brake and the team will present to the board this month on what it intends to do.


What is a defensive asset?

Brake, who relocated to Melbourne for what might be classified as the top investment job in the country, came to Australia in 2016 with Willis Towers Watson and was hired by the Future Fund as its third deputy CIO for portfolio strategy in 2019. She had previously been at what many observers see as the Future Fund’s cousin, New Zealand Super, which also takes a total portfolio approach.

As she looks to the total portfolio she says she is very sceptical about bond and equity correlations going forward. The team has spent considerable time talking about bond yields and the potential for negative interest rates.

“The market is up 40 per cent for the year. The market is right it’s lower for longer and that could be extending out for quite a period because central banks are getting us out of this economic hole that COVID caused,” she says. “That is priced into markets and discount rates lowered so prices have jumped. But what that means is the sensitivity to those interest rates is higher. Bonds look very risky so the extent to which you have interest rate sensitivity in other assets they all look risky and are correlated. It may take a different environment and some time to go back to the world where the correlation is negative. A 60-40 is not such an intuitive portfolio anymore.”

To counter this, Brake says some investors are thinking about combining a risky asset with a short bond position and others are trying to find other defensive assets.

“Our conclusion is there is no defensive asset, so we have to think about how to risk manage our portfolio differently.”

She says because of that view the Future Fund has more interest in anything that is uncorrelated to equities, including the alternatives portfolio it is already active in.

The Future Fund returned 10.1 per cent in the year to March 31, 2021 with a 10-year return of 9.1 per cent per annum, versus a target of 6.1 per cent. But getting those results will not be as easy in the future, she says.

Brake is adamant there will be more focus on active management going forward. She says relying on basic betas, or passive exposures to anything, is much riskier than it used to be.

“We are using our comparative advantages and the excess return-seeking machine we have built and will work that hard and find non-beta return to have more confidence in this environment,” she says. “We have been on this ridiculous, longest-ever bull run in equity markets and we can’t project that forward and say it will keep happening.”

The fund is also looking more carefully at its regional exposures and will get more granular in its allocations.

“Because of increased geopolitical risk we have never been more conscious of where we are investing,” Brake says. “Asset specific geopolitical risk has gone up and that makes domestic investing more attractive because we understand the environment. We are exploring getting more granular in regional allocations, if we can eek out some extra returns or reduce risk by doing that we will.”

The task is large. Featuring in the top 10 issues being presented to the board include inflation, climate risk, the end of globalisation and what it means for cashflows, and the lower for longer environment.

“Because we have a scenario approach and we know risk is multi-faceted, it’s all encompassing. We’re looking at how we build scenarios and portfolios to give justice to it all.”

 

Future Fund asset allocation as at March 31, 2021

Future Fund asset allocation as at March 31, 2020

Key Points

    • The rebound from the Covid-19 crisis is set to be the most environmentally friendly economic recovery on record.
    • Fueled by abundant liquidity, investors are flocking to back projects in renewable energy, electric vehicles, plant-based food, social inclusion and the circular economy.
    • Liquidity can be a two-edged sword: money traditionally flows to the best ‘story’, rather than to the problems that are hardest to solve.
    • We see echoes of the dot.com boom and bust of the late 1990s and early 2000s – too much money potentially chasing too few profitable and enduring business models.

The thing about bubbles: they’re dazzling, they’re enticing … and, ultimately, they burst.

Anyone involved in the world of ESG for longer than the last few years will have mixed emotions over the recent surge in interest from investors. For much of the last decade, sustainable investing was a niche activity. Flows were meagre even though performance tended to be good, as recently demonstrated by a meta study on ESG by NYU Stern Center for Sustainable Business and Rockefeller Asset Management.[1]

The recent surge of flows into ESG investing is a vindication of the belief and tenacity of earlier pioneers, although it can be galling to see recent converts hoovering up much of the spoils. What is more gratifying, however, is that this burgeoning interest is reflective of wider shifts in society, including among politicians. Awareness of the importance of managing the environmental impact (for example, recent wintry conditions in an unprepared Texas) and social consequences (see last summer’s Black Lives Matter-led protests) of our economic lives is beginning to shift the focus from product labels to the fundamental reorientation of business models and the allocation of corporate capital.

‘Greenest’ Economic Recovery on Record?

Whether or not it is ‘growing green’, the rebound from the Covid-19 crisis is set to be the most environmentally friendly economic recovery on record. Fueled by abundant liquidity, investors are flocking to back myriad projects in renewable energy, electric vehicles, plant-based food, social inclusion and the circular economy. These flows are expected to bring enduring economic benefits: from the production of less waste, to cleaner and cheaper energy, to more resilient and climate-friendly agricultural practices. Achieving net-zero carbon status by 2050 has become a more realistic prospect too, beyond just ‘buying green’. While more recently we have seen a healthy correction in some of the pricing, it is no wonder that the companies providing innovative solutions and the support for transition across economies in these areas saw their stock prices soar earlier this year.

Innovation alone, however, is not going to solve the planet’s most pressing problems. Sustainable investing needs a pragmatic approach, and should not be limited to loftily valued solution providers. When profits cease to matter, you know problems are brewing. Investors need to embrace the successful implementers of sustainability solutions into business practices that drive efficiency, build brand value, and help companies remain relevant in a changing world.

Liquidity: A Two-Edged Sword?

There is another problem with maintaining a singular focus on solution providers: an estimated US$13 trillion of combined global monetary and fiscal stimulus (and with more likely to come) is providing ample firepower to fund many of our sustainability ambitions. Liquidity, however, can prove a two-edged sword. Money traditionally flows to the best ‘story’, rather than to the problems that are hardest to solve.

Earlier this year, the valuation of many of the ESG darlings reached eye-wateringly high levels that left any notion of intrinsic value far behind; a surplus of demand-over supply is never good for rational pricing of securities. High personal-saving rates and low interest rates have triggered a retail investor feeding frenzy that has driven some stocks to almost cult-like status.

Companies have become savvy to this trend and now label themselves on their websites as “solution providers” to optimize search engine optimization (SEO). Some even pay third-party consultants to optimize reporting to earn a coveted “high-sustainability” rating to boost the perception of their ESG credentials.

Dot.Com Bubble Echoes?

To us, all of this is redolent of other bubble eras, most notably the great late-1990s dot.com boom and bust. For a while, it was impossible to do any wrong if you were a technology investor: the environment was the investment equivalent of shooting fish in a barrel. In early 2000, the mood shifted as monetary conditions tightened. Initial public offerings (IPOs) started to fail, and the savvy, early investors quietly left the stage before the inevitable bust swept in.

It wasn’t that the long-term prognosis on how tech would change our lives was wrong; if anything, we were too modest about the shape of things to come. The problem was that too much money was chasing too few profitable and enduring business models. Even Amazon – one of the most successful business models to emerge from the carnage – took almost a decade to regain its 1999 market high, while many simply didn’t survive. We have watched with interest the recent rise to prominence of the special purpose acquisition company (SPAC), a shell corporation that is listed on a stock exchange with the purpose of acquiring a private company, thereby making that company public without having to go through the traditional IPO due-diligence process.

Harsh Reality of Market Forces

No matter how ardent one’s passion for sustainable investing, being ‘green’ is not a sufficient condition to being a successful company. Although too little regard is often paid to business models and valuation, reality has a nasty habit of intruding at some point. Similar to the 1990s dot.com boom and bust, and the ‘Nifty Fifty’ stocks of the 1970s and 80s before that, as money floods into sustainable investing, not all of the most exciting solution providers will survive the harsh reality of market forces, even though we can expect the innovations and benefits to endure.

Navigating the current febrile investment environment, pumped up on apparently never-ending supplies of liquidity, creates hazardous conditions for those looking for no more than shiny labels. The first rule of being a sustainable business is to survive. Business models and valuations matter, and sustainability matters. The trouble – for businesses, investors and Mother Earth – is that you won’t get the latter if you ignore the former.

Sources

[1] NYU Stern, Rockefeller Asset Management. ESG and Financial Performance: Uncovering the Relationship by Aggregating Evidence from 1,000 Plus Studies Published between 2015 – 2020, 2020.

Important information and disclosures

The securities shown are accurate as of March 31, 2021 and were selected based on being top-ten holdings in one or more of our investment strategies. The specific securities identified are not representative of all of the securities purchased, sold or recommended for advisory clients, and actual holdings may vary by client. It should not be assumed that an investment in the securities identified was or will be profitable. Any reference to a specific security, country or sector should not be construed as a recommendation to buy or sell this security, country or sector. Please note that strategy holdings and positioning are subject to change without notice. [General US and Canada disclosure] This is a financial promotion, which was originally published via www.WealthManagement.com. Issued by Newton Investment Management Limited, The Bank of New York Mellon Centre, 160 Queen Victoria Street, London, EC4V 4LA. Newton Investment Management Limited is authorized and regulated by the Financial Conduct Authority, 12 Endeavour Square, London, E20 1JN and is a subsidiary of The Bank of New York Mellon Corporation. ‘Newton’ and/or ‘Newton Investment Management’ brand refers to Newton Investment Management Limited. Newton is registered in England No. 01371973. VAT registration number GB: 577 7181 95. Newton is registered with the SEC as an investment adviser under the Investment Advisers Act of 1940. Newton’s investment business is described in Form ADV, Part 1 and 2, which can be obtained from the SEC.gov website or obtained upon request. Material in this publication is for general information only. The opinions expressed in this document are those of Newton and should not be construed as investment advice or recommendations for any purchase or sale of any specific security or commodity. Certain information contained herein is based on outside sources believed to be reliable, but its accuracy is not guaranteed. You should consult your advisor to determine whether any particular investment strategy is appropriate. This material is for institutional investors only. Personnel of certain of our BNY Mellon affiliates may act as: (i) registered representatives of BNY Mellon Securities Corporation (in its capacity as a registered broker-dealer) to offer securities, (ii) officers of the Bank of New York Mellon (a New York chartered bank) to offer bank-maintained collective investment funds, and (iii) Associated Persons of BNY Mellon Securities Corporation (in its capacity as a registered investment adviser) to offer separately managed accounts managed by BNY Mellon Investment Management firms, including Newton and (iv) representatives of Newton Americas, a Division of BNY Mellon Securities Corporation, U.S. Distributor of Newton Investment Management Limited. Unless you are notified to the contrary, the products and services mentioned are not insured by the FDIC (or by any governmental entity) and are not guaranteed by or obligations of The Bank of New York or any of its affiliates. The Bank of New York assumes no responsibility for the accuracy or completeness of the above data and disclaims all expressed or implied warranties in connection therewith. © 2006 The Bank of New York Company, Inc. All rights reserved. In Canada, Newton Investment Management Limited is availing itself of the International Adviser Exemption (IAE) in the following Provinces: Alberta, British Columbia, Ontario and Quebec and the foreign commodity trading advisor exemption in Ontario. The IAE is in compliance with National Instrument 31-103, Registration Requirements, Exemptions and Ongoing Registrant Obligations.

Important Information

This is a financial promotion. Issued by Newton Investment Management Limited, The Bank of New York Mellon Centre, 160 Queen Victoria Street, London, EC4V 4LA. Newton Investment Management Limited is authorized and regulated by the Financial Conduct Authority, 12 Endeavour Square, London, E20 1JN and is a subsidiary of The Bank of New York Mellon Corporation. ‘Newton’ and/or ‘Newton Investment Management’ brand refers to Newton Investment Management Limited. Newton is registered in England No. 01371973. VAT registration number GB: 577 7181 95. Newton is registered with the SEC as an investment adviser under the Investment Advisers Act of 1940. Newton’s investment business is described in Form ADV, Part 1 and 2, which can be obtained from the SEC.gov website or obtained upon request. Material in this publication is for general information only. The opinions expressed in this document are those of Newton and should not be construed as investment advice or recommendations for any purchase or sale of any specific security or commodity. Certain information contained herein is based on outside sources believed to be reliable, but its accuracy is not guaranteed. You should consult your advisor to determine whether any particular investment strategy is appropriate. This material is for institutional investors only.

Personnel of certain of our BNY Mellon affiliates may act as: (i) registered representatives of BNY Mellon Securities Corporation (in its capacity as a registered broker-dealer) to offer securities, (ii) officers of the Bank of New York Mellon (a New York chartered bank) to offer bank-maintained collective investment funds, and (iii) Associated Persons of BNY Mellon Securities Corporation (in its capacity as a registered investment adviser) to offer separately managed accounts managed by BNY Mellon Investment Management firms, including Newton and (iv) representatives of Newton Americas, a Division of BNY Mellon Securities Corporation, U.S. Distributor of Newton Investment Management Limited.

Unless you are notified to the contrary, the products and services mentioned are not insured by the FDIC (or by any governmental entity) and are not guaranteed by or obligations of The Bank of New York or any of its affiliates. The Bank of New York assumes no responsibility for the accuracy or completeness of the above data and disclaims all expressed or implied warranties in connection therewith. © 2020 The Bank of New York Company, Inc. All rights reserved.

Global Real Estate Outlook: Navigating the road to recovery

The unparalleled economic disruption and acceleration of structural trends caused by the pandemic has focused investors on positioning for the long term. But what is the final destination? And with the journey unlikely to be smooth, could cyclical opportunities get lost? In our latest outlook, we map the potential road to recovery, from today’s starting point, to signposts to look out for, to the direction of travel for real estate portfolios.

Explore the outlook here
Disclosures and important information

For Investment Professionals only. Not for onward distribution. No other persons should rely on any information contained within. This guide reflects M&G’s present opinions reflecting current market conditions. They are subject to change without notice and involve a number of assumptions which may not prove valid. The distribution of this guide does not constitute an offer of, or solicitation for, a purchase or sale of any investment product or class of investment products, or to provide discretionary investment management services. These materials are not, and under no circumstances are to be construed as, an advertisement or a public offering of any securities or a solicitation of any offer to buy securities. It has been written for informational and educational purposes only and should not be considered as investment advice, a forecast or guarantee of future results, or as a recommendation of any security, strategy or investment product. Reference in this document to individual companies is included solely for the purpose of illustration and should not be construed as a recommendation to buy or sell the same. Information is derived from proprietary and non-proprietary sources which have not been independently verified for accuracy or completeness. While M&G Investments believes the information to be accurate and reliable, we do not claim or have responsibility for its completeness, accuracy, or reliability. Statements of future expectations, estimates, projections, and other forward-looking statements are based on available information and management’s view as of the time of these statements. Accordingly, such statements are inherently speculative as they are based on assumptions which may involve known and unknown risks and uncertainties. Actual results, performance or events may differ materially from those expressed or implied in such statements. All forms of investments carry risks. Such investments may not be suitable for everyone. United States: M&G Investment Management Limited is registered as an investment adviser with the Securities and Exchange Commission of the United States of America under US laws, which differ from UK and FCA laws. Canada: upon receipt of these materials, each Canadian recipient will be deemed to have represented to M&G Investment Management Limited, that the investor is a ‘permitted client’ as such term is defined in National Instrument 31-103 Registration Requirements, Exemptions and Ongoing Registrant Obligations. Australia: M&G Investment Management Limited (MAGIM) and M&G Alternatives Investment Management Limited (MAGAIM) have received notification from the Australian Securities & Investments Commission that they can rely on the ASIC Class Order [CO 03/1099] exemption and are therefore permitted to market their investment strategies (including the offering and provision of discretionary investment management services) to wholesale clients in Australia without the requirement to hold an Australian financial services licence under the Corporations Act 2001 (Cth). MAGIM and MAGAIM are authorised and regulated by the Financial Conduct Authority under laws of the United Kingdom, which differ from Australian laws. Singapore: For Institutional Investors and Accredited Investors only. In Singapore, this financial promotion is issued by M&G Real Estate Asia Pte. Ltd. (Co. Reg. No. 200610218G) and/or M&G Investments (Singapore) Pte. Ltd. (Co. Reg. No. 201131425R), both regulated by the Monetary Authority of Singapore. Hong Kong: For Professional Investors only. In Hong Kong, this financial promotion is issued by M&G Investments (Hong Kong) Limited. Office: Unit 1002, LHT Tower, 31 Queen’s Road Central, Hong Kong. South Korea: For Qualified Professional Investors. China: on a cross-border basis only. Japan: M&G Investments Japan Co., Ltd., Investment Management Business Operator, Investment Advisory and Agency Business Operator, Type II Financial Instruments Business Operator, Director-General of the Kanto Local Finance Bureau (Kinsho) No. 2942, Membership to Associations: Japan Investment Advisers Association, Type II Financial Instruments Firms Association. This document is provided to you for the purpose of providing information with respect to investment management by Company’s offshore group affiliates and neither provided for the purpose of solicitation of any securities nor intended for such solicitation of any securities. Pursuant to such the registrations above, the Company may: (1) provide agency and intermediary services for clients to enter into a discretionary investment management agreement or investment advisory agreement with any of the Offshore Group Affiliates; (2) directly enter into a discretionary investment management agreement with clients; or (3) solicit clients for investment into offshore collective investment scheme(s) managed by the Offshore Group Affiliate. Please refer to materials separately provided to you for specific risks and any fees relating to the discretionary investment management agreement and the investment into the offshore collective investment scheme(s). The Company will not charge any fees to clients with respect to ‘(1) and ‘(3) above. M&G Investments is a direct subsidiary of M&G plc, a company incorporated in the United Kingdom. M&G plc and its affiliated companies are not affiliated in any manner with Prudential Financial, Inc, a company whose principal place of business is in the United States of America or Prudential Plc, an international group incorporated in the United Kingdom. This financial promotion is issued by M&G International Investments S.A. in the EU and M&G Investment Management Limited elsewhere (unless otherwise stated). The registered office of M&G International Investments S.A. is 16, boulevard Royal, L-2449, Luxembourg. M&G Investment Management Limited is registered in England and Wales under number 936683, registered office 10 Fenchurch Avenue, London EC3M 5AG. M&G Investment Management Limited is authorised and regulated by the Financial Conduct Authority. M&G Real Estate Limited is registered in England and Wales under number 3852763 and is not authorised or regulated by the Financial Conduct Authority. M&G Real Estate Limited forms part of the M&G Group of companies.

The appointment of Karen Karniol-Tambour and Carsten Stendevad as co-CIOs of Bridgewater’s new sustainability business marks a major milestone in the hedge fund’s business, applying its deep research-driven systematic approach to a new set of problems. Amanda White speaks exclusively to the two CIOs.

The co-CIOs of Bridgewater’s sustainability business, Karen Karniol-Tambour and Carsten Stendevad, call for investors to be as explicit and upfront as possible with their investment goals – whether they are financial or non-financial. They say the clarity of purpose allows portfolio construction engineers, such as Bridgewater, a greater chance of achieving those goals.

As a portfolio construction challenge Stendevad says that being explicit about financial and non-financial objectives is an important step in meeting sustainability goals.

“If you look at the entire ESG industry of the past 10 years and the number of challenges, investors had non-financial objectives but they didn’t say it. The truth is if you look more and more at climate or modern slavery in reality investors actually have non-financial goals. If you don’t say you have them and make the case for non-financial goals in a financial way then people make all kinds of academic exercises.”

He says it is important that investors have clarity around how they express their goals, as without clear logic the portfolio construction approach could become circular.

“For example diversity on boards, you can make the case in a risk and return way or you can say it’s just an objective,” he says. “If you make the intellectual leap then it becomes easier, you can approach it as engineers and in a portfolio construction way. Being intellectually clear on why you do certain things makes it easier to build portfolios.”

While it is not resolved one way or the other if ESG considerations affect return objectives Karniol-Tambour says there may be times when there is friction between impact and return.

“There could be a time when those are in tension and investors will have to make that choice. Investors have had to justify it, which is really just saying you care about other things,” she says. “But we think with clever engineering you can do both.”

Being intellectually clear on why you do certain things makes it easier to build portfolios.

Both CIOs say there is increasing comfort with investors to express other goals outside of simple return objectives. For example pensioners want a world they leave behind to be aligned with goals such as addressing climate change.

“That is as important to them as returns,” Karniol-Tambour says. “Then you look at those dual goals as cleverly as you can, and that’s where our expertise lies.”

Bridgewater approaches sustainability the same as it approaches all investment conundrums; building a rigorous research-oriented process based on the best data and systems it can build.

“We are trying to do it in a research-oriented manner. Before we answer the questions we build out a rigorous investment process, build out our understanding of what it means to be sustainable and tackle the challenges including tradeoffs. We don’t stop at the conceptual argument, we are trying as engineers to build the car to these specifications and see how well it drives,” Stendevad says.

Systematic processes to overcome murky data

Bridgewater’s sustainability efforts are twofold with ESG considerations integrated into the overall investment research process, and available as standalone offerings.

“We look at how you think about ESG or sustainability in terms of reaching risk and return objectives. Are there environmental or social issues pertinent for return-seeking portfolios? We will look at that in all of our portfolios and do that in pursuit of risk and return,” Stendevad explains. One example is examining all aspects of inequality as an increasing driver of fiscal policy.

“That work is done as part of our overall macro research, to advance our understanding of markets and economies and improve the risk-adjusted return of our existing portfolios. This is very important and we’ve done it for a long time. Then we have this additional, different thing. In addition to thinking about how these things effect risk and return, clients are saying we want to consider it irrespective of risk and return.”

An example of how the sustainability research is contributing to the broader research efforts and tools used in portfolio construction, Karniol-Tambour points to climate.

“Not many investors at Bridgewater had thought about climate,” he says.

As climate was examined a number of things emerged, for example in the pure alpha fund there is a climate specific risk control.

“We need that,” she says. “Issues like the long-term supply and demand for commodities was not weighing properly with climate change and what might happen. We now have a better understanding of what that means in climate transition across all portfolios.”

Karniol-Tambour says there are a lot of possibilities of where the manager’s offerings might go.

“For example yesterday I had a conversation with a client that has committed to net zero but is not sure what it means or how to do it,” she says. “Some things we are not sure about but will keep exploring. This is an area that will keep growing and expanding and we have made a commitment to that.”

Karniol-Tambour believes one edge that Bridgewater has is the 40 years of tools and research knowledge and that plays out when it comes to data.

“People talk about the mess of ESG data all the time. There is also a lot of mess in other data we deal with. The China data for example is chaos and we have built processes to deal with that data and triangulate it. Now our outlook is as reliable as it can be. A background in doing that in a systematic way is very helpful.”

For more than a decade data has been touted as a key problem of integrating ESG considerations into the investment process, Karniol-Tambour says part of the problem is that what is actually opinion is called data in ESG. Having the background to look at the process and data in a more systematic way is hugely helpful, she says.

Stendevad describes the aspiration as deploying the Bridgewater tool kit to a new problem.

“Especially in sustainability but investment in general, the only thing you can control is the depth of thinking, processes and how systematic you are. The inputs into logic can be clear or murky, the more systematic you are the more you can get through the grey zones. That is particularly relevant in sustainability.”

Sustainability in the broader business

At Bridgewater an investment committee has been set up specifically for the sustainability business which is made up of Karniol-Tambour, Carsten Stendevad and Daniel Hochman and could potentially expand to include further internal or external members in the future.

In addition to the structure of the new sustainability offering there is also a more conventional investment committee structure for the business at large, with Karniol-Tambour’s previous position of head of investment research across the business becoming obsolete.

“In the past I was on every project from creation to completion and bringing that all together from the research side. Now we have the better structure of an investment committee which is made up of six of us as permanent members,” she says.

As co-CIO of the sustainability business Karniol-Tambour also has oversight in integrating the sustainability considerations across the business, as well as the separate function and offering.

Stendevad, who was previously chief executive of ATP, the largest pension fund in Denmark, has been thinking about sustainability issues for a decade or more across an entire portfolio of assets. He says when investors are actively allocating capital over a long time horizon then the natural space to invest is sustainability.

Now he is co-leading Bridgewater’s sustainability efforts which includes a broad approach to thinking about sustainability solutions including private assets.

“We are thinking about everything, we are nowhere near doing anything [in private assets], but want to be open and think about how we make impact,” Karniol Tambour says.

Stendevad was hired by Bridgewater in 2017 as a kind-of executive intern and has been working on the sustainability solution for the past three years, alongside other big thematics like China.

“We are not getting started on the work now, we have been working for three years on the question of how to deeply embed sustainability into the existing research process and how to think about building portfolios with financial and non-financial dimensions. This marks the formalisation externally of that effort,” he says. “When it comes to building portfolios that deliver strongly on both financial and non-financial aspects that is a great challenge, it is not trivial. To do it well you have to invest in talent and analytical resources. This is an expression of how important it is for Bridgewater and what it takes as well.”

Stendevad says it is the first time that Bridgewater has taken an investment effort and turbo charged it, taking one of the firm’s most senior investors in Karniol-Tambour and building a whole capability around it, demonstrating the firm’s commitment in an ongoing major way.

“We ask what are all the ways to think about sustainability and we consider impact to be a third dimension as important as risk and return, if clients want to use it that’s great, but if they don’t that’s fine. Our main priority is this is a difficult problem and we want to be world class about it.”

See Karen Karniol-Tambour discuss the impact, risk and return framework in a video interview here.

 

 

Investors all over the world are pondering the inflationary environment: is inflation coming; will it stick; what does it mean for investments; is stagflation possible; how should portfolios be hedged?

The Fiduciary Investors Symposium to be held online on May 25 and 26 will take a deep dive into the inflationary expectations of investors and look to history as a guide on asset class performances during different inflationary regimes. It will hear from investors who argue both sides of the coin with regard to inflation and the outlook for investors, providing indicators to look for to know whether a particular scenario will play out.

Chief economist of Pictet Asset Management, Patrick Zweifel, argues that the growth environment is as important as inflationary regime and shows that in periods of low and high inflation, so long as there is growth, risky assets will perform well. He says it’s also a good environment for emerging markets.

The event will look in detail at emerging markets including how a lack of transparency and sound data remain huge challenges in many emerging markets. A dedicated session will look at how investors assess the risk of investing in emerging markets given the inefficient access to information and the role that ‘economic transparency’ has in affecting asset prices. Another session will look at the need for investors to back companies with strong secular growth to find alpha in emerging markets.

Professor Stephen Kotkin, Professor of History and International Affairs at Princeton University and long-time collaborator of Top1000funds.com will look at the rising simultaneous threat and an opportunity for investors in China. Kotkin will guide investors on how to navigate a worsening geopolitical situation and what it means for economic growth. He will examine whether the current course is a steady state, or whether big shocks, for the better or for the worse, are possible and even likely.

The other key theme for investors, and policymakers, is the extreme debt levels in the global economy. In 2020 governments, companies and households around the world raised $24 trillion to offset the pandemic’s economic toll. This has brought the global debt total to an all-time high of $281 trillion or 355 per cent of global GDP, according to the Institute of International Finance. The event will examine what this level of debt means for investors and how they allocate capital including a deep dive into infrastructure – including the expanded definition of infrastructure to include things like data centres – and private debt markets

Farouki Majeed, chief investment officer of Ohio School Employees Retirement System and one of the investors speaking at the event, says his concerns in the medium to long term are centred around the growing debt burden and the implications of that on returns.

“There is huge stimulus in the US and it is all being borrowed from the future. The latest round of stimulus probably went a little too far. The new administration is trying to incorporate some of their other agendas into the COVID relief which is fine in the short term, but it’s a lot of money.”

Majeed points out the $27 trillion debt bill in the US has pushed the debt to GDP ratio to 130 per cent, up from 91 per cent a decade ago and 55 per cent 20 years ago. In 1929 at the time of the market crash the debt to GDP ratio was 16 per cent.

“We have that federal debt to GDP and have never seen such erratic prices at that level. That will be a drag on future economic growth,” he says.

As an investor, Majeed’s job is to figure out how these concerns and opportunities can be reflected in the asset allocation, and this event will examine the various responses by investors around the world.

The COVID crisis has been an accelerator for certain key themes driving markets, and has highlighted that some long-held assumptions in investments should not be made anymore. Bob Prince, co-CIO of Bridgewater will look at the assumptions in an MP3 world, where monetary and fiscal policy are coordinated, and what portfolio construction looks like in this environment.

He says in an MP3 world, direct government spending rather than mostly efficient markets will be a much larger influence on the investment assumptions we take for granted, the drivers of growth and inflation, the flow of liquidity and how it impacts the cash flows of each asset, the pricing of the assets, their discount rate and the currency they’re denominated in.

Another session will look at the financial system as an amplifier of regime probability and examine the structural trends in the financial sector post-COVID and whether the crisis has reinforced a paradigm of lower for longer, or poses a threat to it. It will showcase the signposts for investors that we are heading in one direction or another and what that means for capital allocation. The discussion will look at the resilience of the sector including how effectively the debt overhang caused by policy responses will be dealt with, and the physical and transition risks posed by climate that have been accelerated by the crisis. The session will debate whether there is a possibility of financial repression and what that would mean for investors.

The conference ends with a keynote address by one of the most famed economists, Nobel Prize winner, Professor Joseph Stiglitz. He says the big differences between the vaccine rollouts and the scale of the stimulus measures across the world could result in a K-shaped global economic recovery, with much of the developed world booming but poorer countries continuing to struggle. However the west, with its growing debt, is not out of the woods either, he argues.

The event program has more than 20 investors from all over the world responding to speakers, provoking questions and giving insight into their thinking on these important issues.

 

If you are an asset owner and would like to register to attend visit www.fiduciaryinvestors.com

 

Popular papers document positive alpha for equity strategies that favour ESG leaders, and asset managers readily adopt the idea of positive ESG alpha, viewing “ESG as a source of alpha that could lead to positive portfolio performance over time. […].”

In recent research conducted by Scientific Beta, we construct ESG strategies that have been shown to outperform in popular papers. We construct six different strategies in US equity markets and in developed markets outside the US. Each strategy goes long ESG leaders and short ESG laggards, using a different type of ESG score. The scores we use are the aggregate ESG rating, each of the three component ratings, the rating trend, and finally, a combination of ESG rating level and trend.

Our contribution is that we conduct a thorough risk adjustment when analysing the performance of these strategies. We assess performance benefits for investors when accounting for sector and factor exposures, downside risk, and attention shifts. These adjustments to performance are necessary to obtain a fair view of potential performance benefits for investors.

We first confirm that simple returns of ESG strategies may indeed look attractive, with annualised returns of up to 3 per cent per year. But even if ESG strategies have high returns, investors do not gain if these returns are due to sector biases or exposure to standard factors. The relevant question for investors is whether non-financial information in ESG scores offers additional performance benefits.

When accounting for sector biases and exposure to standard factors (size, value, momentum, low risk, and quality), none of the strategies we construct to tilt to ESG leaders adds significant outperformance, whether in the US or in developed markets outside the US. We find that 75 per cent of outperformance of ESG strategies is due to quality factors that are mechanically constructed from balance sheet information. ESG strategies in the US equity market also have a heavy tilt to the technology sector. After adjusting for such exposures, none of the strategies shows significant alpha. This implies that ESG ratings do not add value over information contained in sector classifications and factor attributes. Despite relying on analysis of non-financial information by hundreds of ESG analysts, ESG strategies perform like simple quality strategies constructed from accounting ratios.

We also extended the analysis in our paper to account for possible benefits in terms of downside risk reduction. The results show that ESG strategies do not offer significant downside risk protection. Accounting for exposure of the strategies to a downside risk factor does not alter the conclusion that there is no value-added beyond implicit exposure to standard factors such as quality.

Even if ESG strategies do not provide outperformance over an extended period, they may outperform in the short term. In particular, if attention to ESG shifts upwards, ESG strategies have positive short-term performance, but their long-term expected returns decline.

For investors, it is crucial to disentangle long-term returns from the effects of attention shifts. If upward attention shifts drive ESG returns over the recent period, returns of ESG strategies are inflated. Increasing attention raises demand for a firm’s shares, leading to higher prices. Investors need to deflate returns by subtracting the tailwind from rising attention to come up with realistic return expectations.

We assess the impact of attention shifts on ESG performance by distinguishing between time periods with high and low flows into sustainable funds. Outperformance during high attention periods is spectacular. Strategies based on overall ESG ratings show substantial outperformance of 4 per cent per year, relative to the market. However, outperformance shrinks to 1% when considering the low attention states, and disappears completely when adjusting for additional factors.

Investors need to be aware that alpha estimated during low attention periods is four times lower than alpha during high attention periods. While returns during high attention states may be relevant for investors who want to bet on rising future attention, returns during low attention periods provide a conservative estimate of long-term returns. Our analysis also reveals that attention shifts occurred over the later part of the sample period with a strong rise in attention since 2013 onwards. For this reason, studies that focus on the recent period tend to overestimate ESG returns. Investors need to be wary of analysis of ESG alpha that is limited to short periods which coincide with rising attention to ESG.

Overall, the effect of risk adjusting the performance of ESG strategies is clear-cut: the apparent alpha of ESG strategies shrinks to a level where none of the strategies delivers positive alpha.

Our study delivers important insights for investors. As a general matter, our analysis provides an example of how one can document outperformance where there is none: it is sufficient to omit necessary risk adjustments. Concerning ESG strategies, our findings question a widespread practice of using ESG as an alpha signal. They do not question the value-added of such strategies on other dimensions. Investors should ask how ESG strategies can help them to achieve objectives other than alpha, such as aligning investments with their values and norms, making a positive social impact, and reducing climate or litigation risk.

Investors would benefit from further research on these important questions. A full copy of our paper can be found here: “Honey, I Shrunk the ESG Alpha”: Risk-Adjusting ESG Portfolio Returns, Scientific Beta Publication, April 2021.

Felix Goltz, PhD, Research Director, Scientific Beta