Disruption has become endemic. This was true before the pandemic. Of course, every generation has its sources of disruption (from the coming of the wheel, to steam, to the microchip) – and no doubt every generation feels like it is living through unprecedented disruption. The distinctive feature of our age of disruption might be that much of it relates to systemic stress.

Put another way, our collective activities have placed many of the core systems on which we rely under massive and unsustainable strain. Inequality stirs protectionist rage, upending democracies, and prompting trade wars. The productivity of arable land is sharply declining, accompanied by patterns of drought and water stress. Climate change is driving patterns of disruption that are comprehensive and existential in scope.

Facing this context, there are signs that corporations and institutional investors understand, to some degree, that these trends require a response. The rise of ESG suggests an acceptance that prior investment analysis provided an incomplete picture of the sources of value creation – and destruction. The discourse on corporate purpose suggests that corporate managers see value in charting a path toward approaches that balance outcomes across groups impacted by corporate practice.

Few of these efforts have been couched in terms of preserving systems – with a few notable exceptions. That should change and become a structured feature of corporate and investment practice. We point here to some recommendations and encouraging early signs.

Identifying and managing systemic risks

“Systemic risks” generally comprise events or trends that influence the interconnected aspects of our lives and can spike in intensity with surprising and often devastating consequences for our collective health and prosperity. They manifest in many forms. At the more obscure end, we see Lyme disease on the rise as warmer winters increase deer tick survival creating new populations with chronic health problems (just one chronic illness rising in intensity driven by climate change). At the all too well-known end, Covid-19 reminds us that urban sprawl and deforestation are among the factors behind the rise of zoonotic transmission.

Often these “systemic risks” are talked about as if they are uncontrollable acts of God; akin to bad luck, Murphy’s Law on a global scale, a bad roll of the cosmic dice. Yet research, including that conducted by The Investment Integration Project (TIIP), suggests that this framing is highly inaccurate and diminishes our ability to prepare for and cope with systemic risks. There are many ways, within reach of averagely sophisticated investors and corporate managers, to anticipate, mitigate, and even in some cases, control the existential threat of systemic risks in our lives. Fatalism leaves us unprepared and diminishes our capacity for foresight, planning and preparation.

Management of systemic risks through investments requires an evolution from a conventional approach to portfolio management. It also involves developing investment practice beyond the consideration of environmental and social factors or ESG integration. That next stage is system-level investing.

As covered in the soon to be released 21st Century Investing: Redirecting Financial Strategies to Drive Systems Change, system-level investors support and enhance the health and stability of the social, financial, and environmental systems on which they depend for long-term returns. They preserve and strengthen these fundamental systems while still generating competitive or otherwise acceptable performance.

Happily, a growing group of institutional investors are adapting to versions of system-level investing as part of portfolio management, capturing the broad implications of the systems approach in their investment policies and principles. The California State Teachers Retirement System (CalSTRS), for example, determined that climate change is a systemic threat to their members’ retirements, and developed a multi-year, multi-asset-class with an internally managed Low-Carbon Index (LCI) for passive equity management. Launched in 2017 with a $2.5 billion commitment, the LCI is made up of stocks in all industries in all markets (U.S., developed, and emerging) around the world. CalSTRS’ goal is for these holdings to have reduced carbon emissions and reserves in each market by between 61 per cent and 93 per cent in the coming years.

Consequences of narrowness and short-termism

A narrow and short-term view constrains our ability to think about systems. As a number of leading asset owners stated “if we were to focus purely on short-term returns, we would be ignoring potentially catastrophic systemic risks to our portfolios”. Systems command managers to not just think about what is “material” today but what may become material tomorrow.

There is some movement within the corporate community to focus on longer-term decision making to plan for a more sustainable future. Last year, the Business Roundtable released a statement from over 180 corporate CEOs to commit to leading businesses “for the benefits of all stakeholders–customers, employees, suppliers, communities and shareholders.” With such statements come questions about practical implications. It won’t be hard to find examples of corporations where real-world decisions appear at odds with the appealing stakeholder rhetoric. We do though see significant value in CEOs seeking to talk about a longer-term time horizon throughout their investor dialogue, including the earnings call.

In any event, corporations are key actors in the health of our systems (often by function of sheer scale of operations). We have seen countless negative outcomes of corporate practice on the systems on which we all rely. Consider: only 20 companies produce over one-third of all total greenhouse gas emissions. Partly this is enabled by the well-known structural feature of our economies that corporations externalize their negative social impacts – and have the financial heft to skew political decision-making and the marketplace for ideas in their favor.

It is worth noting that corporations are very capable of undermining the very systems that they themselves directly rely on. Stable accounting rules are a key feature of advanced market economies. Yet, corporations are often presented with opportunities that may cause them to undermine such systemically valuable features of an arm’s length financial system. As ever, there is some need to “constrain the merchant in the interests of capitalism” – better perhaps first to provide the merchant with the tools to see that they first need to save themselves.

Simple steps – to reframe behavior 

How can corporations and investors better manage systemic risks and strengthen our institutions? The how-to of system-level investing is laid out in 21st Century Investing. They can invest in solutions to systemic problems, like green energy or workforce development. The Dutch pension fund manager PGGM, for example, has allocated $17 billion to what it describes as a solutions or impact portfolio that focuses on four issues: climate change, food security, health care, and water. Of this $17 billion, $1.53 billion was invested in climate change, pollution, and emissions solutions—producing over 11.6 megawatt hours of renewable energy, or enough to power around 3.5 million homes for a year. Another $477 million was invested in water-scarcity solutions in 2018 alone—saving enough water to cover the average water consumption of 1.6 million residents in the Netherlands for a year.

They can also collaborate with each other, rather than compete, to strengthen the systems they operate in. For example, the California Public Employees Retirement System (CalPERS) has compiled academic research in a database called the Sustainable Investment Research Initiative (SIRI). SIRI facilitates scholarly reviews of system-related research, convenes researchers to discuss environmental, social, and governance (ESG) factors and related issues, and manages a public online database of 1,900 studies on sustainable investing.

Finally, instead of working around the government, they can pay their share of taxes and work with governments to try and create more resilient systems. For example, in 2017, Norges Bank Investment Management (NBIM), a unit of the Norwegian central bank, issued a position paper on taxes because of their concern that excessive short-term emphasis on allocating profits to shareholders may not be in companies’ or investors’ best interests, NBIM clarified its belief that “Managing long-term value does not require aggressive tax behavior.” NBIM also solidified that it expects corporate boards of directors will “discourage the pursuit of aggressive tax avoidance not in shareholders’ long-term interest.”

These examples can and should be a model to us all. We are not recommending corporations and investors do this out of the goodness of their hearts. Companies benefit when systems run well. As climate change worsens, income disparities grow, and we remain polarized, we expect to see more disruption in our lives – and the potential for huge and unmanaged value destruction. Focusing more on preventing these disruptions rather than reacting to them can benefit everyone – corporations, investors, governments, and workers.

 

William Burckart is president of the The Investment Integration Project and Brian Tomlinson is director of research at the CEO Investor Forum.

The CalPERS board will make a decision next week on whether to include a long-term incentive compensation element as part of an incoming CIO’s remuneration package, something that the fund’s chief executive, Marcie Frost, said is a contributing factor to the fund putting its search for a new investment head on hold.

The fund has been without a CIO since Ben Meng’s resignation last year, and put its search for a new CIO on hold last week citing a number of factors including the need for greater clarity regarding the positions’s compensation and incentive structure.

In an interview with Top1000funds.com, Frost said the board would decide next week whether to include a long-term incentive structure as part of the remuneration for the role. It currently does include a long-term incentive despite other roles at the fund having this as part of their structure.

“One of the problems we have is the retention of that position. The long term incentive is intended to get people to think five years out. The board will make a decision on that next week on whether to include the long term incentive for the CIO position and will be taking guidance from our compensation consultant,” she said.

Frost said an additional contributing factor was the competitive environment in recruiting for this level position, citing many funds currently recruiting for chief investment and chief strategy officers.

“When we compare to say the top Canadian funds our compensation is not that competitive,” she said. “We do think the long term incentive plan will help, but in talking to candidates there is some caution, and a lot of questions about working in a very public, often characterised as a political, environment. Is the CIO able to focus on the portfolio and the people in the investment office or is the CIO more externally focused?

“Most of the candidates we were talking to are in the former. They are talented investors they want to work with a talented team and really want to have structure to keep the CIO focused there and not so much externally around stakeholders. They want to execute on the strategy.”

Frost said that potential candidates also expressed reluctance to move their families during the pandemic.

“It’s not a good time to ask people to relocate,” she said.

The CalPERS board is also considering whether to require a new CIO to transfer all of their personal stock holdings into a blind trust while they are a CalPERS’ employee. The move follows Meng’s resignation and an ethics investigation related to some of his personal investments.

CalPERS will begin a new search for a CIO in early summer.

 

 

 

 

Should we be thinking about investment differently in 2021? Certainly, there appears to be cause for challenge of current thinking on inflation rates and the rise of China in the new world order. There is also room in our view for more capital-efficient liability-driven investment and greater diversity of investments with more downside protection.
But the opportunities also extend to the nature of investing and different ways to approach it that may support better outcomes.

Click here to read the full article 

2020 was by just about any measure, unprecedented. Market volatility, regulatory change and the need to make decisions quickly – but largely remotely – put more emphasis than ever on dynamic and effective decision-making in pension investment committees. It was a true test of robust governance.

We observed that those with the most effective governance structures and processes were able to do three things. They were able to protect the investment portfolio against the severe market downturn. Then, they were able to re-risk when equity markets recovered from the short, sharp shock. And finally, they were able to take advantage of other opportunities brought about by market dislocation, such as those in illiquid credit. Together, they demonstrated how the quality of decision making is actually financially material.

That’s not a new concept. It’s been true for decades, but it perhaps merits rethinking what excellent looks like in this environment. We have set out ten key attributes of high performing investment committees supported by an effectiveness tool, to help investors measure and manage their governance quality.

Click here to read the full article

The big macro changes that have taken place over the last year require a rethink and action from investment professionals.

If we think about how investment risk changed in 2020, we can’t of course ignore the impact of COVID-19, but another risk has simultaneously been brought more into the spotlight – climate risk. That is, the physical, transition, legal and reputation risks associated with climate change and the growing recognition of the need to move to a lower carbon economy.

Climate risk is increasingly material to pension funds, both through asset holdings and liabilities, but also in relation to a sponsor’s covenant and the attitudes of members who may have to live with the physical impacts of climate change. Disclosure requirements are also multiplying.

Click here to read the full article

The COVID crisis and the volatility of 2020 has revealed some lessons for the investment team at Coal Pension Trustees (CPT). It has taken a more top down view of managing its portfolio looking at economic themes, risk exposures, cashflows and its manager roster holistically. Amanda White talks to CIO Mark Walker about where it sees return opportunities, the prospect of manager consolidation and how it has embraced technology for better investment practices.

The two pension funds of the legacy coal industry in the UK are unique in many ways. Where most defined benefit funds in the UK are looking to match liabilities in their allocations, Coal is focussed on return-generating returns. They are probably the most mature defined benefit funds in the country – having not received any new money in 26 years since privatisation of the industry – but they take the most amount of risk, all in order to meet their obligations (and with a Government guarantee sat behind the liabilities).

The volatility of 2020, combined with the fund’s approach to risky assets meant there were cashflow challenges last year. But this is not all bad news, the experience prompted the fund to leverage a new relationship with a technology company in Silicon Valley to aggregate data for an improved top-down view for management of cashflows and allocations.

The main test in 2020 was on cashflow says the fund’s chief investment officer, Mark Walker. The 30 per cent drawdown in markets came at the same time as a 10 per cent depreciation in the pound sterling, which meant the funds were “looking for £1 billion pounds in cash quite quickly to fund obligations”.

“We didn’t want to sell equities and lock in losses,” Walker says. “We had some low risk assets to use to meet cashflows – TIPS, investment grade credit, government bonds – and were already focused on cashflows as an key part of our strategy.”

The funds were facing £600+ million of currency hedge payments and all the contingent capital managers were drawing down (albeit for good reasons – there were new opportunities to make outsized returns!). And the government announced rent holidays for real estate tenants who couldn’t pay, which came into effect just before the funds’ quarterly rents were due. This meant it faced an immediate 40-50 per cent reduction in income from its UK real estate holdings.

“For two to three months it was all about finding cash, and making sure we could meet commitments, manage currency hedge payments, and make sure we had cash to pay benefits – that was our starting point,” he says. “By June everything had started to turn positive: the Sterling was appreciating again, we had positive cashflows in July from private market assets, and in September we completed on a few property sales.”

One of the funds also had some equity hedges on which it monetised at the bottom of the market, delivering much needed cash.

“It was all about cash management, and making sure we were funding commitments and planning for a more conservative situation with less income.”

The new technology  has meant CPT now has its own system to aggregate and manage data to see where it is at a point in time (and reduce the number of spreadsheets used to aid decision-making).

“We have a projection tool on cashflows and can look at a granular level on individual funds in private equity etc. if we need to” Walker says. “Not only that but we’ve had access to datasets to look at what we might expect in different circumstances from drawdowns and distributions from different types of private markets managers, and how that might vary if they are median or top quartile, that has been fascinating.”

By the end of the year Walker says the volatility looked like a blip. Overall the fund received distributions of £500 million from private equity managers and sold a few properties.

“Last year was a very unusual year. It was very testing from February to April, then markets recovered really quickly. Contingent capital managers that drew down in March were already giving back money a few months later so it didn’t last very long,” Walker says.

“We finished the year well, we paid £1.4 billion out of the schemes through the year, and still ended up with more money at the end.”

But in the middle of the year, when things had settled down a bit, Walker and the team started to look at how they were going to make money in future.

 

Finding returns

Another top down consideration has been a change in the way the funds describe their asset allocation which is now in “purpose” categories.

“This works well from a governance perspective, the Trustees understand why they have the allocations, and can align the capital allocation more directly with their objectives and risk tolerances.”

There is a small proportion of assets in lower risk assets such as government bonds and everything else is in growth assets aimed at delivering returns. The growth assets are split in three ways: core public markets predominately equities; real and income assets such as property, infrastructure, ships and private credit; and “high octane” which is targeting 10 per cent per annum and includes private equity and special situations debt. Across the two funds this category has an allocation of over £4 billion, which is a pretty significant allocation.

“When we are investigating new high octane investments we might also look at a property we already own and say if we invest some money in a re-development opportunity that could make it a high octane asset. Any kind of capital allocation that gives us a big potential return fits but we still have to plan how much future exposures will be and what distributions will be and then that comes back to cashflows again.”

The funds are trying to evolve the connection between top-down strategy and the bottom-up implementation.

“Our overall view is it should be done differently than in the past,” he says.

“One of my bug bears is sometimes we’re too within asset class, trying to fit the allocations to a target and not very top down. That’s not the right starting point. Our starting point also has to integrate key themes that we believe will present return opportunities like climate, technology and Asia. More connection between the top-down strategy and bottom-up implementation is what we are trying to do. This includes being more directive and selective in where we want to take risk exposures, and then maybe more flexibility in adapting to the opportunities that come along.”

This also requires a mindset shift and an eye on the team culture in order to resist working in silos.

“We look at how we work together and understand the importance of the different inputs and how we share information and communicate, we have to be able to do that to get this working,” Walker says. “Technology is an enabler especially for us where we have such high return targets, cashflows and private asset allocations. Understanding the variables, the cashflows at a granular level and expected return scenarios has been invaluable.

“We still have a long time horizon but assets will gradually decline and being able to plan illiquid assets, which you can’t change quickly, over a long time horizon is becoming even more important to us. Technology gives us the starting point: if want to achieve x in 10 years then how much do we need to commit now, model strategy first then we can look at the granularity like individual fund selection.”

The use of technology has been a great enabler for the fund, but it hasn’t been easy to set up.

“The big thing it that it is about data to begin with, knowing where you are but you have to have the systems to manage and data organised in the right way. When we started working with the technology company we spent a lot of time organising our data. One of the pieces of cashflow data for example is the “known unknowns”, for example if a property manager says we might get some sale proceeds in a month, it’s a might, that’s not a fixed cashflow, but a known unknown, there is still some uncertainty. We have lot of those, and we need to make sure we incorporate them, so we don’t sell £50 million in equities to pay pensions when 5 days later you have proceeds from other asset sales.”

 

Cost and complexity

Another consideration for the funds is to examine costs and complexity.

“If you have a look at most people’s forward looking return estimates then not much looks like good value right now. One way to lose money is costs, if you pay less costs then net returns should go up, all else being equal.”

Walker and the team are examining areas where they can “think and work more smartly”.

One of those is in the manager roster where he concedes there are too many external managers.

“We need to consolidate that list and are in the process of thinking about how to do that,” Walker says. This includes asking existing managers questions about relationships and how they would manage being on a shorter list of core or strategic relationships.

“There is a lot of commonality between the two individual pension schemes but we have 225 individual accounts or direct investment positions in each, that’s far too many.”

In addition, there are 33 managers across the two funds which manage over £100 million in assets but then a whole tail of managers with less than that including another 35, typically private market managers that have mandates of £25-100 million.

There are around 170 funds and co-investments in private equity and special situations and it can be difficult to get on the roster because there is such a legacy.

“What we look for is something differentiated – if something is new that we don’t have access to it but it fits our strategies or is a niche part of the market. We are a risk taking organisation, we need to take risk to generate returns. We can’t look at everything because we are a small organisation, but if we see something that looks interesting and we haven’t already seen it there’s more chance of us taking a look.

“Hopefully with some external managers we will have a more strategic relationship in future, not just about assets under management but sharing ideas, training and a connection between the organisations to work on new things. And hopefully being able to see things in development. We also want to work with people who give us access to investments that fit our themes such as climate, Asia and technology.”

Coal has been investing in onshore China A shares since 2019 and its public equities allocation is already quite balanced between Asia and the US.

“It’s quite different to the market cap, its already more aligned towards Asia and that will stay. We also need to think more broadly around other assets beyond equities and Asia.”

The use of technology has highlighted the importance of data management and being able to coordinate it and everyone being aligned.

“We have had teething problems, but we are doing pretty well and are now thinking more about risk and position sizing at the fund level rather than mandate or asset class level. Add to that less managers and lower costs and we are moving to have more conviction and sizable positions,” he says. “It’s exciting – what a time to be an investor. I’m thinking how do we make money to meet future cashflows, that’s an exciting place, a little bit scary because the world is changing rapidly, but there will be a lot of opportunity. We have to get more right than wrong and ensure we have some good winners. The investment industry makes the job more complex than perhaps it needs to be, our job is simply to create wealth and not lose it again!”