Following the launch of its groundbreaking paper: Net Zero in the Balance: A Guide to Transformative Industry Thinking, the global association of investment professionals continues to highlight the financial risks of climate change and the potential returns to investors in addressing this challenge.
CPP Investments, the C$675.1 billion asset manager for the Canada Pension Plan, has already hit its reduced long-term strategic exposure to emerging markets of 16 per cent in a quick paring back of the allocation from 2023 levels when emerging markets accounted for 22 per cent of assets under management.
Edwin Cass, chief investment officer at CPP Investments tells Top1000funds.com that although the investor still believes there is both an opportunity to diversify and generate alpha in emerging markets because of inefficiencies, that window of opportunity is narrowing.
“This is changing over time due to a number of factors, including geo-political risk and improving market efficiency,” he says.
On one hand, deglobalisation can be positive for emerging market investors because it adds to diversification by decoupling relationships between various trading blocs, he explains. However, geopolitical risk is the “flip side” to deglobalisation and brings real complexity.
“We need to understand the impact that deglobalisation and regional trading blocs will have on sectors and specific assets within the countries we invest in. Due diligence and appropriate investor protections become even more important.”
Successful emerging market securities selection during the past several years has been a source of alpha, and he says CPP Investments has found the strongest returns in emerging market infrastructure, notably through investments in toll roads. For example, the asset manager owns toll roads in Mexico, Chile, Indonesia and India that Cass says “are performing well.”
The energy transition also continues to present opportunities. Investments include renewable energy providers, such as Renew Power in India, and Auren Energia, one of Brazil’s largest platforms for renewable energy and energy trading.
However, more expensive active management in emerging markets is important because these markets are less efficient. And successfully navigating the risks is an intense process that relies on an in-country presence resting heavily on “boots on the ground” to stay close to political and regulatory developments and monitor any impact to existing assets.
CPP Investments has opened emerging market offices in Mumbai and São Paulo to allow it to “do its homework,” better understand the businesses it invests in; the environment in which they operate and sensitivity to local risks. Cass explains that offices in emerging markets also allows CPP Investments which manages assets both internally and with external partners to position itself to partner with the best regional and national firms.
“We also spend time building relationships with governments to understand the regulatory environment in the countries where we invest. These local and regional factors are incorporated into our organisation-wide integrated risk framework, which covers a wider variety of investment risks and includes various types of stress tests on our portfolios.”
“Our presence in the regions where we invest combined with our company-wide focus on building relationships with governments and monitoring regulatory changes also enables us to mitigate issues as they arise.”
CPP invests across 56 countries with more than 320 investment partners. Just over 50 per cent of investments are in North America.
CalPERS, America’s largest public pension fund, is more than halfway towards its goal of investing more than $100 billion in climate solutions by 2030. The investor, which manages $502.9 billion in assets, recently announced it has committed more than $53 billion to climate adaptation, transition, and mitigation efforts.
The investment goal is enshrined in CalPERS Sustainable Investments 2030 strategy where the pension fund pledges to cut portfolio emissions in half by 2030 – on route to net zero 2050 – in spite of the political pushback against ESG investment in the US.
CalPERS’ push into green assets also comes when many governments are trying to drive pension fund investment into green solutions.
“The energy transition underway represents one of the biggest investment opportunities in history,” said CalPERS chief executive officer Marcie Frost. “We are providing the capital necessary to plant the seed for the low-carbon economy of the future.”
In a reflection of the growing allocation, CalPERS is in the process of building out its sustainable investment team to 20, hiring eight more staff members in this area in the next few months.
CalPERS’ latest commitments comprise $3.6 billion in climate solution investments made over 2024 focused on private equity and infrastructure. The pension fund has partnered with asset manager Brookfield and where investments will focus on the clean energy transition, including investments to enhance power grid reliability across multiple Midwest and Mid-Atlantic states.
Last year, Mark Carney, vice chair of Brookfield Asset Management and head of transition investing at the manager, was a guest speaker at the CalPERS investment committee meeting. He said that asset emissions will be inextricably tied to financial performance in the years ahead and argued this is already visible in how low-emitting companies within a sector currently trade at a premium.
CalPERS’ climate investments also include a private equity investment partnership with TPG Rise Climate. The fund focuses on scaling climate solutions globally and the partnership seeks to invest and collaborate in opportunities across the fund’s core themes including energy transition, green mobility, sustainable fuels and molecules, and carbon solutions.
Other climate solutions funded by CalPERS over the past year include an investment in Octopus Energy, a fast-growing renewable energy company based in the United Kingdom. The company uses an advanced operating system to power six million homes in the UK and 60 million homes globally, and is expanding operations into the US.
CalPERS made this investment alongside Australian pension fund Aware Super, both partnering with Generation Investment Management, Al Gore’s investment fund. The Canada Pension Plan Investment Board also increased its stake in Octopus at the time
“We believe that making sound, long-term investments in climate solutions will generate outperformance while also providing the clean energy needed to meet the increased demands that people have for their homes, cars and technology,” said CalPERS CIO Stephen Gilmore.
Beyond the fully executed deals, CalPERS is reviewing an additional $3.2 billion in climate-related investments. The investor said some of these investments could be finalized in the coming weeks and months.
Earlier this year Peter Cashion, managing investment director for sustainable investments told Top1000Funds.com that CalPERS doesn’t target a a fixed number of climate investments for each asset class but focuses instead on a range. He said the aim is to both generate alpha and reduce the carbon intensity of the portfolio. CalPERS approved plans to increase its overall allocation to private markets from 33 per cent of plan assets to 40 per cent.
“We see investment opportunities across the spectrum with the most tangible in infrastructure, private and public equities,” he said.
If successful investment in venture capital relies on accessing top-tier managers, Prabhu Palani, CIO of the $9 billion City of San Jose Retirement System, has got an advantage over others. The pension fund sits in the heart of Silicon Valley’s venture ecosystem, uniquely placed to meet companies, entrepreneurs and fund managers, attend AGMs and glean the latest developments in AI. Not surprisingly, the pension fund also boasts tech and venture expertise on its board.
In another advantage, many VC funds actively want the pension fund in their investor cohort in a rationale that Palani also pushes hard. San Jose’s firefighters and policeman have helped contribute to the community that has allowed Silicon Valley’s technology sector to flourish and become home to some of the biggest companies in the world, and they deserve a slice of the profit too.
“Our beneficiaries have helped create the infrastructure that supports this ecosystem, so they should also benefit from the tremendous wealth in the area. Who better to invest in venture than San Jose Retirement System in the capital of Silicon Valley. We are ground zero when it comes to venture,” says Palani.
For all that, San Jose’s venture portfolio is relatively new. When Palani joined in 2018, the portfolio included buyouts and private debt but there was no exposure to venture. The fund now targets a 4 per cent allocation with long-term partners (rather than GPs “chasing flavour of the month” opportunities) diversified across vintage, stage, and industry, with a tilt toward early-stage investments where valuations have not increased exponentially.
San Jose hasn’t seen any distributions so it’s too early to see how much proximity pays. Moreover, because Palani believes venture valuations are still high, less than half the target allocation has been put to work. He is also wary of the growing trend in multi-billion dollar fund sizes because it is easier for smaller funds to produce the outsized returns of 10-15 per cent. “You are in venture because you are shooting for the stars,” he says.
But because many funds are now coming back into the market to raise more money for the first time since 2021, he believes investors are poised to see true valuations for the first time, increasing opportunities. “This needs to happen in venture,” he says.
It’s an approach that speaks to the wider interaction between the pension fund’s growth and low beta buckets that define strategy. When assets are expensive, Palani drains the growth bucket and switches more into low beta strategies, and when assets are cheap, the team takes from low beta.
Given the growth bucket has done well and US assets, where San Jose is overweight, are at an all-time high, he is eyeing low beta options. For example, ten-year bond yields have picked up, representing an opportunity to increase the allocation to fixed income. The team are currently exploring manager offerings including looking at where to position and if the fund will be paid for longer duration investments, ahead of a new asset allocation study next year.
Elsewhere, he says the gap between developed market international and emerging market equities compared to US equities offers a potential hedge. San Jose invests in US equities passively on a low-cost basis but takes active risk in US small cap, international developed markets and emerging markets where he argues it’s possible to add value over the benchmark and inefficiencies mean high conviction managers can outperform.
Still, the portfolio remains risk-on, partly because Palani believes another wave of growth could lie around the corner. In a recent post on deregulation (written before Trump’s electoral victory) he argued that the conservative majority in the Supreme Court promises to fan deregulation that will boost stocks like airlines, banking and financial services, energy, transportation, and telecommunications. Businesses that support environmental protections such as alternative sources of energy and climate change may suffer.
“As the pendulum of regulation swings to the side of absence, we can expect a gradual unfolding of the gilded era of The Great Gatsby. Ceteris paribus, pools of capital that remain long equity beta and have the luxury of a very long horizon can ride this wave of economic prosperity.”
He acknowledges that the large exposure to growth factors means if growth does poorly, it will impact the portfolio: in standard deviation terms, the fund targets between 12-13 per cent volatility. But he is also confident that San Jose has the right risk levels and is in a better position than at any other time in the past.
“Whatever happens we have a playbook; we have the governance and confidence of the board and the ability to move quickly with our stella team. Other than that, we don’t have any control.”
Roots of a turnaround
Much of his confidence in that playbook is rooted in the fund’s dramatic turnaround. In 2020, around 35 per cent of the portfolio was in low beta because growth assets were expensive. The outsized allocation comprising short-term fixed income and market-neutral hedged strategies left San Jose falling further behind peers, languishing in the bottom 1 per cent of peer public pension plans based on 1-3-5 and 10-year numbers.
Meanwhile, 15-20 per cent of the general plan budget was being ploughed into funding the pension system every year.
The team had been looking for opportunities to increase risk ever since 2018 when Palani put new risk parameters in place to allow more investment in growth assets. Yet as assets grew steadily pricier, they did the reverse and put more capital in the low beta bucket.
“It was a tough decision. Low beta strategies in an environment that favours high beta are not going to do well but we weren’t ready to pull the trigger; it was the wrong time to increase risk,” he says.
As it was, Covid hit and the market dropped 35 per cent from peak to trough in one of the sharpest bear markets in history. San Jose leapt at the once-in-a-generation opportunity to start buying and snapped up growth assets at rock-bottom prices. “You buy things when they are cheap, but you don’t know the catalyst that will bring assets to their full valuation. Healthcare solutions and monetary behaviour are out of our control, and we didn’t expect the turnaround to happen that quickly.”
A key part of the decision-making process included a belief that challenges in the market were not structural like they were in 2008. The downturn had been driven by a healthcare event that would be solved by a vaccine; the world had come to a screeching halt, but it would restart with a solution. When the government threw trillions at the problem and the market took off, San Jose was the second-best performing public pension fund in the US.
Once again, the team had to resist the urge to do the obvious thing and pull back.
“We knew we’d had a good run but we felt that we had come to the right level of risk. So give or take a few tweaks the decision was made to keep the growth allocation high,” he concludes.
At just 15 per cent of the total CHF39 billion ($43 billion) assets under management, Switzerland’s Compenswiss doesn’t have a large allocation to private markets and no allocation to private equity at all.
It’s a source of relief for Frank Juliano, chief investment strategist and member of the executive committee, reflecting on the phrase du jour: the fact that the DPI ratio has become more important than IRR for investors navigating the lack of distributions from private assets.
“We don’t have many private assets and no private equity which is the most impacted asset class by the lack of distributions. But we see that DPI ratios are forcing investors to sell liquid assets to fulfil new commitments. They are ending up with an imbalance in their allocations and becoming overweight private assets,” he says.
Still, liquidity and flexibility are key priorities in the portfolio’s growing allocation to private credit. Initially set at 2 per cent, in 2025 Compenswiss targets 3 per cent in an allocation that includes nine funds across Europe and the US with another RFP in the market that should bring a few additional managers to the portfolio.
Compenswiss will invest in evergreen vehicles and senior corporate private credit funds (avoiding mezzanine structures) and is active in all segments from the lower-middle market to the upper-middle market. The preference for evergreen structures instead of closed end funds has become a central tenet to strategy, explains Juliano, who likes the flexibility they offer by allowing investors to increase their allocations over time or reduce if they need to, without having to select new funds or deal with capital calls or subscriptions.
“We like evergreen structures because it means we have to manage fewer capital calls and our money is faster at work unlike in closed end funds where investors have periods of underinvestment.”
In most evergreen structures, capital is locked up for two-to-three years after which withdrawal requests kick in periodically. In contrast, in drawdown vehicles, it can take three years for a fund to be fully invested, by which time investors will have to go back out and find another fund.
Juliano is not alone. Other investors say they also favour evergreen structures because they allow more detailed due diligence on the covenants and corporate loan documents in the portfolio. Enabling the process of checking that a new cohort of external mangers will deliver all they promise, and the bona fide credentials of the team behind the strategy.
Rich equity valuations
Looking out on the investment landscape he notes that rich equity valuations will most likely see the fund sell some equity towards the end of the year to rebalance the portfolio to the 2025 target (29 per cent).
Elsewhere, Compenswiss’s allocation to gold has grown from 3 per cent to 3.5 per cent this year and he believes the value will continue to climb off the back of geopolitical uncertainty and the scale of sovereign debt in developed markets. He also singles out the strong performance of the real estate allocation in Asia which is subject to different growth and interest rate cycles than western markets.
“Central business districts in Asian cities continue to attract lots of people so office hasn’t suffered like it has in the US.” In contrast, the allocation in the US and Europe is focused instead on industrials, family and data centres.
The passive allocation to large-cap emerging market equities is struggling because of China’s poor performance dragging returns, exacerbated by the growing allocation to China in the index because of the introduction of A Shares. “We plan to decrease our allocation to emerging market equities as we do not expect China to outperform in spite of the recent stimulative measures.”
In recent years, Compenswiss has also scaled back derivatives exposure apart from an FX hedging programme.
“We really only use derivatives when strictly necessary,” he says.
A debt risk hedging programme sheltered the fund from spiralling liabilities around 2017/18 and the portfolio was also hedged on the eve of the pandemic – a programme that was monetised just at the right time when the market started to go up. “It got too expensive,” he recalls. “It was like when the cost of car insurance gets more expensive than the car itself.”
Compenswiss is also overseeing the integration of AI throughout the organisation via a sweeping education programme. Everyone, at every level and in every department from investment to back office and legal, is being trained on how to use the technology to add value.
“The way you integrate AI within your firm has become very important,” he concludes.
“Over the course of four months, a member of the team coded a wonderful state-of-the-art tool to manage how we measure ESG. Nowadays, using Gen AI it would have taken maybe a couple of weeks. That’s a huge productivity gain.”