In the latest development of its private market portfolio, Swiss pension fund PUBLICA is investing in infrastructure equity in a partnership with three other Swiss pension funds and Dutch pension investor APG.

Private markets now account for 30 per cent of PUBLICA’s CHF40.5 billion ($46.6 billion) portfolio in an allocation that has been steadily built out since 2015 when the pension fund’s only real asset was an allocation to Swiss real estate.

Since then, risk has been added incrementally via an allocation to investment grade long-term private debt and foreign real estate. A 3 per cent allocation to infrastructure equity was added in 2022 to boost returns and add diversification divided equally between three open ended funds – and the latest allocation via partnerships.

“As we progressed through private asset classes we have added risk,” explains Dominique Gilgen, who joined the pension fund in 2015 to help build up private markets and now oversees a team of three in line with the portfolio’s growth. “At the same time, we have developed our experience, competence and confidence with these asset classes and vehicles.”

Although infrastructure equity brings higher risk, Gilgen believes in volatile markets it will be relatively stable given its long-term cash flows and the fact it sits in a more conservative space than equity. He also likes the inflation protection and ability to integrate ESG.

“Infrastructure equity has attractive characteristics from a sustainability point of view. It fits well with PUBLICA’s responsible investment approach and positive selection criteria are easier to integrate.”

Private equity remains notably absent from the real asset allocation. Equity risk, explains Gilgen, has always been the biggest risk in the portfolio (the listed equity allocation is 32 per cent of AUM) and the fund has been reluctant to go into an illiquid asset class with a risk factor that will build on existing risk.

Other concerns include how to efficiency implement private equity and high fees. He lists transparency, investor influence and the possible misalignment of interests as other issues.

“It is more difficult to access private equity and get compensated for the additional risk. For us, whether or not private equity can deliver risk premia after fees remains a question.” In 2023 PUBLICA’s total asset management expenses were 0.22 per cent.

Partnership in action

PUBLICA’s partnership with Swiss funds City of Zurich, Kanton Aargau, and Credit Suisse together with Dutch pension investor APG targets an initial commitment of €1 billion to jointly gain access to global infrastructure in the private market space. The quintet, hailing the collaboration as a benchmark for cross-border pension fund partnerships emphasize stability, transparency, and a long-term vision and hope to make the first investment “in the coming months”.

PUBLICA’s previous experience of partnerships includes collaborating with US insurance companies in private debt where stakes include real estate debt, infrastructure debt and corporate private placements. US insurance companies act as both asset manager and co-investor, typically contributing over 50 per cent of the investment, he explains. Gilgen particularly likes the alignment of interest in the active allocation that such a partnership brings.

He hopes the partnership with APG, which has a long track record of investing in private infrastructure and an experienced, large team, will bring another opportunity to learn. “We are partnering with someone who has vast experience in this area and capability to do this investment,” he says.

The partnership has been structured to incorporate differences between Swiss and Dutch legal and tax frameworks. He says the investors share many similarities including values and philosophies.

“The relationship was strong before we started. Although we are five distinct pension funds we have a common understanding that has helped bring such a project to a successful start.”

It’s often said that one cause of anti-ESG sentiment at some US public pension funds can be traced to external managers and proxy advisory firms pushing climate and social goals in the investment strategy without buy-in from beneficiaries.

In contrast on the other side of the pond, both literally and metaphorically, a unique endeavour to ensure participant buy-in and trust at Dutch pension fund Detailhandel is under way. The results from three beneficiary forums conducted earlier in the year to seek out participants’ ESG opinions and values are now being woven into investment strategy. [See also Dutch fund commits to member preferences.]

Critics of such an approach argue that boards abdicates their responsibility by asking members what they want. But Louise Kranenburg, Detailhandel’s responsible investment manager, is adamant the process has rooted the next leg of the pension fund’s bold responsible investment strategy in trust and credibility to support long term performance.

“ESG also involves values and we need to know what participants’ preferences are and what topics are important,” she says

Detailhandel has already written the importance of beneficiary preferences into its investment beliefs and regularly surveys its membership: in 2019 it used beneficiary preferences to shape a new equity index, for example.

But now a new qualitative process has embellished the binary yes/no questions of a survey to garner context and unearth beneficiaries own preferences. In February and March Detailhandel brought a representative group of 50 of its 1.2 million beneficiaries together in person to deliberate on complex questions, learn from each other and come together as a collective to present recommendations to the board.

It takes participant engagement to a new level – even by standards in the Netherlands where mandatory membership of a sectoral or company pension fund means engagement with participants is already pervasive.

“We didn’t want a group that was all sustainability-minded, and we didn’t want to just attract people who are vocal and have the time,” says Kranenburg. “We don’t know what our beneficiaries all feel and this model has allowed us to bring all their opinions together and make sure they come to a common ground.”

Ring in the changes

A suite of new initiative has emerged from the process.

The pension fund already under and over-weights companies in the index according to human rights but will now toughen its stance and remove companies that violate human rights and labour rights, tightening its divestment policy in line with participants’ wishes.

“Participants feel very strongly about these topics, which made the board decide to also formulate minimum thresholds for companies and introduce more strict norms than we currently have.”

She says the process will take time because the team will have to see how it impacts the risk profile.

In another indication of the 10-person board’s commitment to the issue, they have all agreed to undergo human rights training to better understand investors’ responsibilities and international frameworks

Participant engagement has also resulted in the pension fund seeking to invest more in affordable housing.  Currently, 41 per cent of the allocation to housing within the real estate portfolio is invested in affordable housing. “We will have to investigate what is feasible,” she says.

The pension fund is also exploring whether to increase the allocation to impact, currently at 1 per cent. The next step in the process will involve drilling down into the extent to which participants are prepared to trade impact for returns and in what topics and themes they want to focus.

Detailhandel is a mostly passive investor (around 90 per cent of assets are in listed strategies) but uses custom indexes to shape what the market gives to its own preferences. The only exception is the allocation to long duration sovereign debt which doesn’t have an ESG custom index, but does have a sustainable bond objective.

“A custom SDG-index did not make sense because we invest in only a few European countries that score pretty similar on ESG-considerations. So under-/overweighting based on these countries’ ESG-characteristics did not achieve its goal.”

Another project in the pipeline includes integrating forward looking climate data in the custom-built equity index for developed markets.

“We have just started doing the first simulations.”

Private market strategies include allocations to real estate, mortgages, private debt and impact.

Understanding the trade off

Kranenburg explains that during the forums the investment team articulated the trade off and dilemmas around risk and return that come with investment, particularly responsible investment.

“We know from practice that things aren’t black and white; if you are positive on one thing it will affect something else.”

Moreover, she says Detailhandel’s board don’t agreed to all participant demands. In some cases, the board unanimously agrees to the idea, in others they have said it is something they are already doing, and may increase their ambition. Often they say this is not something the pension fund is in a position to solve.

The process has also given the investment team more confidence to divest. Beneficiaries said they prefer engagement but they are prepared to divest if companies don’t respond. Detailhandel is already well versed at engagement, escalation and collaboration. But she says divestment is always a more difficult decision.

“The last step of divestment is a struggle for the board, and this gives us as a pension fund more confidence that we can step up and beneficiaries will support it.”

A model for others

Kranenburg says no other Dutch funds have offered their beneficiaries a similar forum experience, but she reports lots of interest and growing efforts at inclusion.

In many ways it is now just a question of whether the board can keep up. Participants have requested a similar forum experience in two years time.

“This is ambitious because it will take us two years to complete all these actions,” she says.

University of Texas Investment Management Co (UTIMCO) the $75.5 billion asset manager and one of the largest public endowments in the US, believes a rise in small cap valuations could be on the horizon.

History tells us that equity markets always do well after a rate cut, said Richard Hall, UTIMCO’s president, chief executive and chief investment officer speaking to the investment committee in the September board meeting at the fund’s Austin headquarters.

But he flagged a noticeable lag in small caps relative to the rise in the S&P500, up roughly 50 per cent of the main index.

“We are starting to see some research that small caps have lagged,” said Hall. He suggested this could be an area of opportunity for investors going forward, particularly because small caps might rally off the back of positive earnings expectations.

“S&P500 earnings are expected to grow by about 11 per cent in 2025 over 2024, but small caps in the S&P500 are expected to grow at double that rate.”

He linked this to the fact small caps are heavily impacted by moves in interest rates – for example, when rates fell in 2022, small caps noticeably underperformed compared to large caps.

He said that rate cuts flow through to small cap profits to drive investor returns because small caps have a much higher portion of floating rate debt. It means when rates climb, it is punishing but when they fall it provides welcome relief.

“As rates go down small caps rally, we saw this in early 2020 and the flow through to free cash flow is extensive. It’s why the market is talking about small caps.”

Despite his positive telegraphing of a spike in returns for smaller companies, Hall cautioned that small cap valuations have not spiked following September’s rate cut.

Hall also flagged risks in the wider equity landscape despite the prospect of more rate cuts. On average, the year coming up to rate cuts shows equity markets typically climb 9 per cent. Last year the S&P500 was up 21 per cent, raising the prospect that markets and investors have pulled returns forward, and offset returns over the next couple of years.

Returns look bright in public equity, but he warned that private equity remains challenged.

Capital calls from private equity managers have dropped off, and the lower quality companies in UTIMCO’s buyout allocation are struggling, resulting in longer hold periods. Although this degrades the IRR, he said it probably wouldn’t degrade the multiple of return over time.

On the venture side the landscape is even more challenging.

“Things have slowed down a lot,” he said.

However, he forecast that strong venture businesses will increasingly emerge, promising the “next crop” of winners. For investors, this involves staying the course and continuing to plant new seeds in venture today to harvest tomorrow.

He said the big risk in private equity remains ensuring enough liquidity on hand to meet distributions. UTIMCO revisits its commitment models and proactively looks at how any extension on the average hold period of a company from three-to-four years to five-to-six years flows back through the system. This ensures the investor doesn’t get out of its bounds on unfunded commitments relative to the total endowment value.

Asset allocation at the endowment is neutral relative to targets, apart from a 1 per cent overweight to equities. The fund has 29.1 per cent in public equity, 6.1 per cent in directional hedge funds and 26.2 per cent in private equity. Cash, long treasurers and stable value hedge funds account for around 17 per cent. Inflation linked bonds (0.2 per cent) natural resources (3.3. per cent) infrastructure (4.5 per cent) and real estate (8.4 per cent) make up the rest.

Hall said returns have been driven by public markets with public equity providing the standout performance by returning 21 per cent with a 2.2 per cent outperformance. The hedge fund allocation has been a “consistent performer,” but private equity has been challenged by venture and real estate has also struggled.

He said UTIMCO is the “envy of peers” because it is supported by oil and gas royalties. The fund received $1.9 billion from oil and gas royalties last year.

Benchmarks are highlighted in the CFA Institute paper, Net Zero in the Balance: A guide to transformational thinking as among the historical norms in finance practice that make investing in climate challenging. MSCI Institute’s Linda-Eling Lee talks to Top1000funds.com about the complexities and evolution of climate benchmarks including the use of balanced scorecard-toolkits that are improving the technology.

Benchmarks, incentives and time frames are highlighted in the CFA Institute paper, Net Zero in the Balance: A guide to transformational thinking as among the historical norms in finance practice that make investing in climate challenging.

The paper stresses the importance of mindset shifts and transformative thinking, highlighting some strategies for success, such as balanced scorecards, total portfolio thinking, universal ownership and stewardship.

In the five years to April 2023, investment in net-zero benchmarks increased from $10 billion to $100 billion, reflecting the growing alignment of investor portfolios to climate goals. This was driven in large part by the European Commission, which had set out the criteria for an official EU Paris-aligned benchmark focusing on emissions reductions. But one unintended consequence of that structure for investors was the potential for portfolios to reduce emissions on paper, while having no impact in the real world.

Linda-Eling Lee, founding director and head of the MSCI Sustainability Institute, says this remains a concern for investors, and the challenges of benchmarks and portfolio construction related to climate goals is not about performance or risk, but an ongoing determination to align portfolios to real-world outcomes.

“It’s not that hard to decarbonise your portfolio but it is difficult to see how that reflects the real economy around that,” Lee says.

“This has been a preoccupation and challenge everyone is trying to work through.”

To this end, last year MSCI developed an attribution tool and a framework to allow investors to better understand the changes in a portfolio’s carbon footprint and what was due to a company’s real world decarbonisation efforts, a portfolio manager’s investment decisions, or changes in the company’s financing.

Challenges of benchmarks

To comply with the EU focus on emissions reduction, benchmarks tend to overweight sectors such as communications, technology and healthcare, which are less material in the real world to reducing climate change. The simplicity of this approach overlooks the potential for high-emitting companies to deploy capital to low-carbon solutions, and the potential for investors to influence that transition through stewardship.

But Lee says benchmarks should be considered a tool, not a constraint.

There has already been “quite a lot of progress” in incorporating toolkits and balanced scorecard-type measures in benchmarks, she says, shifting the focus away from backward-looking data. One example is MSCI’s Climate Action Index series, which uses a balanced-scorecard approach.

“Climate benchmarks do prioritise forward-looking measures…and are about balancing the different objectives,” Lee says in an interview with Top1000funds.com.

“A lot of asset owners are moving towards variations of benchmarks and reflect quite different priorities.”

Some of this progress is related to the evolution of climate investing, from being focused on reduced emissions to a focus on transition finance.

“If you look at the newer transition-related benchmarks they use a balanced scorecard-toolkit way of looking at constructing the benchmark,” Lee says.

“In the conversations we are having, asset owners have been quite open to changes in benchmarks that incorporate these aspects. Like any technology, it will continue to get better.”

In addition, some level of standardised best practice, and groups like IIGC working with the industry on the principles of a climate or net zero aligned benchmarks, act as building blocks for index providers who can then customise to reflect different objectives and preferences of investors.

Beyond Europe

Europe’s leadership on climate investing is evidenced by the level of engagement from investors and the fact European companies are decarbonising quicker than those in other jurisdictions. MSCI data shows that 14 per cent of EU-domiciled companies are aligned to a net-zero pathway, compared with just 3 per cent outside the EU.

But Lee points out that Europe is only a small sub-set of the global conversation and, if alignment between the portfolio and the real world is the aspiration, investors also need to focus on where the decarbonisation needs to happen.

More than three quarters of the global coal-power generation capacity is in Asia Pacific, a region that also has less disclosure of transition plans by listed companies.

More than 90 per cent of large, listed companies in developed markets have disclosed their Scope 1 and 2 emissions, compared with 65 per cent in emerging markets. And about half of smaller listed companies have done the same. Transition capital flows to companies with better plans – typically, large companies in developed markets.

Lee says that both policy and capital needs to be focused on decarbonising the most impactful assets, and this will require an open mind and thinking beyond the norm – something that systems thinking can also provide, according to Roger Urwin, author of the CFA Institute report. Urwin says the features of climate risk present challenges to investors that their imaginations and toolkits have not previously tackled.

In part the problem lies in climate-focused capital chasing a dwindling number of fast-decarbonising companies, but these companies represent a smaller fraction of global greenhouse gas emissions. For example, an investment strategy designed to track a Paris-aligned benchmark must, by EU regulation, reduce average emissions by at least 7 per cent annually. This means only about one-third of the original investment universe of global companies are eligible to be included in such a strategy. And split by region, only 28 per cent of emerging markets companies are eligible compared to 62 per cent of companies in Europe.

“I worry about the movement towards more disclosure and more resourcing for disclosure,” Lee says.

“You will always have larger companies in developed markets benefit from that, and that gap is growing.”

The data challenge

The quality and volume of data has always been a concern for investors when it comes to climate. But investors need to understand that the data challenge is perennial, according to MSCI’s Lee.

“There has to be a recognition, and an embrace, of the fact that you will never get all the data you want. There is no data nirvana,” she says.

And while the amount and quality of information has improved, it is not keeping up with the demand for even more forward-looking data. The answer to that, Lee says, is for investors to look beyond company disclosures.

“I feel like in the beginning investors were asking companies for disclosure because it was a sign of transparency, but that assumes companies had the information and didn’t want to disclosure it,” she says.

“I feel like we have reached the limit of that.”

The second wave has been investors asking companies for information and data as a means, rather than the end of disclosure. This is a way of getting companies to think about their transition plans and how they can actually implement them.

“This works because it gets companies to do things that they would not normally do,” she says.

“But the disclosure itself is not that useful because it is not comparable.

“There is so much more technology and data about companies now, we can get things like asset locations and map them to different hazards or biodiversity risks. And we have the ability to model companies on emissions or water and project that forward, and this is what investors really need.

“There is a noise aspect to this data, but investors need to embrace that.”

The MSCI Sustainability Institute, which Lee founded about a year ago is driving better connections between capital market providers, academics, companies, and policy makers to help solve investors’ problems, including the need for more dynamic and more forward-looking data.

One clear initiative by the institute is bringing academics closer to the concerns of investors and focusing on the future, not on the past.

“We are trying to help them understand the real questions investors have today so academics can work on those that are relevant,” Lee says.

“Pricing and mispricing will evolve over time, and we have little information on that today.”

In helping academics solve these problems MSCI has given 300 academics licences to use all of its climate data. And just last month it launched the world’s first climate finance e-journal on SSRN, to be co-edited by Peter Tufano, Baker Foundation Professor at Harvard Business School, senior advisor to the Harvard Salata Institute for Climate and Sustainability and former Dean of the Said Business School at Oxford University.

Engagement leads to more companies introducing KPIs; corporate Scope 3 emission reporting often results in companies reporting more emissions than they have and measuring nature-related risks is extremely complex. Just some of the key take homes from Japan’s $1.7 trillion (¥245.98 trillion) Government Pension Investment Fund (GPIF) 2023 ESG Report.

As a universal owner (82.3 per cent of the portfolio is passive) GPIF is exposed to climate and biodiversity risk across the portfolio. Specific ESG strategies include a ¥17.8 trillion allocation tracking ESG indexes and ¥1.6 trillion invested in green bonds. The giant portfolio that is roughly split four ways between foreign and domestic equity and bonds.

Engagement works

The report finds that engagement has led to companies introducing more KPIs to support ESG targets. For example, GPIF found its engagement on climate change and board structure resulted in an increase in decarbonization targets and the number of independent outside directors at companies.

“Analysis revealed that active engagement by asset managers likely made substantial contributions to overall market sustainability, corporate value and investment returns or improved market beta.

We believe both asset owners and asset managers should continue their efforts to achieve more effective engagement activities,” states the report.

Problems with Scope 3

GPIF flags that Scope 3 disclosure will make it more difficult to analyse portfolio emissions over time and states that data vendors and investors tend to overestimate companies’ Scope 3 emissions, often arriving at larger figures for emissions than the companies have.

“It is important for companies to proactively disclose information to ensure that they are properly valued,” GPIF writes.

The report goes on to stress the importance of cost-effective, beneficial disclosures that are not too burdensome.

“We have a high hope for the development of ISSB and SSBJ standards.”

The ISSB standards require companies to disclose material sustainability-related information to help investors make investment decisions based on the single materiality approach.

New climate index

GPIF has moved approximately $20 billion to a new ESG-themed domestic equities index due to concerns over a “large tracking error” with  the former index, MSCI Japan ESG Select Leaders Index which was in place since 2017.

The new index, the MSCI Nihonkabu ESG Select Leaders Index aims “to reduce the risk of tracking error from TOPIX, the policy benchmark, while retaining the basic characteristic of an ESG index including stocks with a high ESG rating.”

As of March 2024, the tracking error of the former index was 2.3 per cent while that of the new index was limited to 1.2 per cent

ESG in alternatives

GPIF has a tiny allocation to alternatives, capped under 5 per cent and currently just 1.4 per cent of total AUM. However, the pension fund insists on ESG integration amongst its alternative managers where a lack of standardization adds complexity. GPIF interviews managers,  requests they answer due diligence questionnaires and uses third-party consultants.

The pension fund references the enduring challenges in measuring emissions in private equity where “only a few” private equity funds report on portfolio companies’ emissions.

GPIF estimates portfolio company emissions using the enterprise value (EV) metric, on that basis “that EV and GHG emissions have a certain degree of positive correlation in the case of listed companies.”

The estimated carbon footprint of the overall private equity allocation was 2.32 million tons in a reflection of the tiny allocation. The carbon footprint of GPIF’s entire equities portfolio was 464.03 million tons. The allocation to private equity industrials had the largest carbon footprint.

GPIF marks a 4 per cent increase in the number of funds in its real estate portfolio which participated in GRESB Real Estate Assessment and says 83 per cent of the funds in the real estate portfolio now use the framework.

Nature dependencies

GPIF documents the challenges of nature reporting and disclosure in accordance with TNFD Framework.

“We feel that measuring nature-related risks is extremely complex and that many unresolved issues remain.”

Using the TNFD, GPIF found  “materials” and “transportation” had the highest nature-related risks in terms of both dependencies and impacts on the domestic equities portfolio, while energy and food, beverage & tobacco were identified for the foreign equities portfolio.

Elsewhere the investor found that research showed that TOPIX companies that have endorsed the TNFD recommendations have better disclosure rates than those that have not.

 

In the past two years, the Future Fund has made around $70 billion worth of changes in the portfolio that its director of research and insights, Craig Thorburn, said can be traced back to stubbornly high inflation.  

The Australian sovereign wealth fund stood at A$225 billion ($149 billion) at the end of the 2024 financial year. In its latest position paper on geopolitics, it outlined its bias towards “owning inflation” as a way to mitigate risks that come with changing trade dynamics, a rise in strategic competition, and growing populism. 

These portfolio changes were made between July 2022 and the end of June in 2024 across multiple asset classes, Thorburn said, and one of the most prominent decisions was to increase gold exposure as a part of the currency mix. 

“We own two currency baskets – a developed one and an emerging market currency basket,” Thorburn told a CFA Society investment conference in Melbourne.  

“One is primarily for diversification benefits; and the other is for a little bit of that, as well as return benefits against the Aussie dollar. 

“We added gold into that mix to ensure that diversification benefit as it relates to our developed-market currency basket, so beyond only, say, US dollars or Japanese yen or euro, we also own some gold as well.” 

The fund also started incorporating commodities exposures in its portfolio, which Thorburn said has been “a material uplift…to deal with this secular inflation driver”.

Some of the changes relate to a reduction in bond exposure, as Thorburn said that asset class’s long-term diversification benefits are not as evident as they once were. The Future Fund has been reinforcing this view with various position papers since 2022, suggesting that bonds can no longer sufficiently offset the equity risks.  

“There are scenarios where we do believe that bonds can provide that diversification benefit – that’s probably in a more benign, or what I would call business cycle recession,” Thorburn said. 

“But unfortunately, there are other scenarios that are very different going forward that we are contemplating.”  

Alternatives such as hedge funds are attractive as diversifiers, which the Future Fund attributed as one of its key return drivers in the last financial year.  

“On top of that, the duration exposure that we hold is actually through assets like infrastructure and property, and we do ensure that they do have that inflation linkage,” he said.  

“In the case of property and infrastructure, one of the advantages – should it be contracted – is that you can actually get that inflation exposure through the contract. 

“It’s not enough to just own those assets. You’ve got to ensure that that inflation pass-through is actually through the contract.” 

While the changes were made in preparation of increasing geopolitical conflicts, Thorburn made it clear that the goal is not to “trade conflicts” but to position the portfolio to not only survive them but also thrive in their recovery. 

“We are not trading conflict. We are not smart enough to do that. In fact, history shows that if you try and do that, you’re probably going to destroy wealth,” he said. 

“I would argue…macro has always mattered, even when it looked like it didn’t. Geopolitics is one of those external factors that has actually mattered, but over the last 30 or so years, probably because of the Great Moderation and the great peace dividend, it looked like it didn’t. 

“But unfortunately, in our view, it [the pronounced impact of geopolitical conflicts] is back.”