Investors are preparing for the future and the inevitability that ‘winter is coming’ by reducing exposure to risky assets, the delegates at the RFK Compass Investor Conference heard.

Steve Moseley, head of alternative assets at Alaska Permanent Fund, said they were “selling most of what we can, and trimming our portfolio”.

“I have no idea what will happen in the future, but am prepared for it anywhere. We are selling most of what we can, and trimming our portfolio. We are cautious of our deployment pace like others,” he said. “We are reducing overall exposure to riskier assets and building exposure tactically to those assets we think will outperform in a down market.”

Head of private equity, Bureau of Asset Management office of the New York City Comptroller, David Enriquez, said cycles were a permanent part of the market.

“When we look at our private equity portfolio, we need to be consistent in our pacing and not pull back at the wrong time, or pile in when it is frothy,” he said. “We are looking at what we lean in to and also whether we are over-exposed to, for example, a good to great strategy.”

Enriquez also advised that it was important to analyse operational capabilities.

“When the recession hits, that’s where things will shake out. A lighter touch operational approach might add value at the upper right end; but in a declining market other approaches may weather a recession better.”

Enriquez believes that emerging managers present one of the best opportunities going forward.

“We have a 10 year limited partnership structure, a carry point fee structure, and mix it together will have a permanent deal flow of spin off teams. That’s what we are seeing, it’s a great opportunity for institutional investors.”

Barry Volpert, chief executive of Crestview Partners is sure that “winter is coming”.

“This is the longest economic expansion we have experienced in our careers. As a GP we don’t know when the downturn is coming but there are a lot of warning signs. There is a lot we can do in anticipation of a downturn, the most important way to prepare is to realise things that are mature and successful and de-lever everything else.”

Volpert said it was inevitable there will be a downturn in the next investment period, that is the period that investors are committing funds to now.

“Levered beta has worked out well the past 10 years, but it is very unlikely to work out well the next 10 years. Investors should think about how well the GPs implement the strategies you have hired to implement.”

Moseley said that everything Alaska Permanent does is in line with preparing for the future.

“Everything we do is intended to address what might or might not happen in the future. We think knowing things will be more difficult in the future so we have done a few different things. We have taken a position that paying fees is a good thing, and there is a positive correlation between the fees we pay and the returns of our GPs. So we have invested directly in GPs in a couple of cases. Those contractual cash flows are so valuable and especially in a down turn.”

Enriquez said NY City was focused on diversity in its due diligence with managers.

“We have a supplemental DDQ asking for fairly granular data such as detailed head count and it’s a requirement,” he said. “We require you to address the topic, our boards will hold you to it and when come back years later they will hold you to it.”

He says just asking the question as a large institutional investor has been constructive.

“We have seen movement in the industry and change in recruiting practices. We don’t have specific targets, but GPs need to understand that asset owners are focused on this and it’s really important.”

Chrissie Pariso, senior portfolio manager, private equity and head of the women and minority manager program at the corporate pension of Exelon Corporation, said allocators do have the power because they have the capital.

“Just asking the question will create change,” she said. “To increase diversity you have to look further than Harvard and Stanford – we need to look in different places.”

Pariso said her fund is looking to increase its women and minority manager program, which is now $3 billion across 24 managers.

Four US state treasurers are among 11 investors to sign a joint investor statement on corporate disability inclusion, and are urging others to get behind the cause.

The investors, worth $1 trillion, believe companies must to do more to include people with disabilities in the workforce and are urging their portfolio companies to adopt best practice.

Hosting a conversation with the treasurers of Connecticut, New York, Illinois and Oregon, Ted Kennedy Jr, chair of the American Association of People with Disabilities, urged every investor at the RFK Human Rights Compass conference to sign the investor statement.

“If we are not looking for these opportunities we are not living up to our responsibilities,” the Treasurer of Oregon, Tobias Read, said. “If we are not seeking them out then we are not doing our jobs.”

The treasurers discussed how including people with disabilities is not just the right thing to do, but a business edge. A recent report by Accenture showed that companies that promote disability inclusion are four times more likely to outperform their peers.

The report identified 45 companies as standing out for their leadership in areas specific to disability employment and inclusion and found that they had on average 28 percent higher revenue, double the net income and 30 percent higher economic profit margins than their peers.

“Our analysis also revealed that US GDP could get a boost of up to $25 billion if more persons with disabilities joined the labour force,” the report said.

New York State Comptroller Thomas P. DiNapoli said the Accenture report provided the justification to urge the top 49 companies in his portfolio including Apple, McDonald’s, Nike and Twentieth Century Fox, to report on their inclusion of people with disabilities.

“We need to include the disabled in our definition of diversity,” he said. “We began this in January and as we’ve found in every other engagement, it may take time but we’re going to get there. It’s important we don’t do it alone.”

Of the 49 companies NY Common Fund reached out to, 11 replied.

“We then followed up with the remaining 38 and there is now a roadmap for them to meet our expectations of what it means to be an inclusive workplace regarding disability,” he said. “Investors need to do follow up. We can give them the formula for what we expect and how to do it.”

Connecticut State Treasurer, Shawn Wooden, also supported collective action on the issue.

“One of the most significant things is that we are moving more collectively to organise our capital to bend the needle,” he said.

“As institutional investors we need to lead by example. There needs to be collective action and persuasion in getting the view out.”

Michael Frerichs, Treasurer of Illinois, said it was important to ask questions but also to give some preferences, for example by giving extra points in RFPs to companies that display diversity and inclusion.

Oregon’s Read, also said there needed to be a process regardless of who was in office.

“We need to make sure this is not dependent on who sits in the treasurer’s chair,” he said. “We have changed our investment beliefs to say diversity is a material factor. Just by making that statement we have changed who comes to see us.”

The treasurers also said it was important to look in their own backyards.

“One action we can easily take is to look at our own team and what we are doing regarding disability inclusion. How explicit are we about diversity and does that include disability? We can update our own executive order regarding diversity and ask more questions about our own profile.”

Kennedy Jr also highlighted the Disability Equality Index as an effective benchmarking tool to score businesses on their disability inclusion policies and practices.

Wooden said there was power as an asset allocator in just asking the questions to corporations regarding inclusion.

“We have said no to managers based on ESG issues including inclusion,” he said.

 

“Our goal is to build a more diverse and inclusive investment industry culture with a specific focus on current CalPERS and CalSTRS external investment managers and staff,” enthused Ben Meng, CalPERS CIO speaking after the recent 2019 CalPERS and CalSTRS Diversity Forum.

The two California-based pension funds, with a combined assets under management of $580 billion, invited over 400 attendees from academia, business, and investment to Sacramento to explore the connection between diversity, human capital and performance, touching particularly on how diversity and inclusion drives value both in investment management and corporations.

In a series of engaging keynotes and panels, the forum celebrated best practice and new research and gave participants tangible next steps on how to increase diversity within their workplace and fresh momentum to push the diversity cause.

“The Forum is an opportunity for investment professionals to come together and collectively address a challenge that we as an entire industry face,” said CalSTRS CIO Chris Ailman.

The investment industry’s lack of diversity remains a critical issue, not only morally but also for its own long-term success, given the wide recognition that diversity of thought leads to better risk adjusted outcomes and better investment decisions.

Yet Ailman, who oversees a strategy that includes around $12 billion AUM with emerging managers (equivalent to around 10 percent of the fund’s externally managed assets) and an internal headcount whereby half of CalSTRS non-administrative investments staff identify as ethnically diverse – important since around 50 percent of assets are managed internally –  insists the diversity message is getting through to the industry.

“I’m not seeing any fatigue, just the opposite,” he said, crediting particularly the efforts of the CFA Institute’s Diversity & Inclusion project.”

As a unique addition to this year’s event, the CFA institute led workshop sessions focused on giving participants the chance to work with their industry peers to generate and share ideas around improving diversity and inclusion in their own firms.

Similarly, Meng and his team also note continued progress.

“While we cannot speak for the whole investment industry, the external investment managers we talked to in preparing for the forum seem more concerned and engaged on diversity than they were two years ago. Managers are developing and implementing new diversity and inclusion initiatives and increasingly using data to better determine what is working and what is not,” he said.

 

Leadership from the top

 

Leadership from the top is a key solution to solving the diversity problem, said Meng.

“Commitment to diversity and inclusion from senior leaders fosters an inclusive and respectful culture, increasing the pipeline at all levels.”

According to CalPERS website, 44 per cent of the pension fund’s executives are female, 40 per cent of its senior leaders are female and 70 per cent of its team leaders are female. Data collection and reporting, and continued research are also important tools, he adds.

“Asking about human capital topics during the due diligence process for new mandates for external managers sends an important signal from asset owners to asset managers; asking about how the external managers ensure diversity of thought in investment decision-making is important.”

It’s not only leadership. Diversity must be embedded in beliefs, said Ailman who argues that diversity and inclusion must become a core value and “the norm” supported at the highest levels in all sectors of the investment community.

“This same standard should be applied whether examining makeup of corporations or looking for the next asset manager.” However, he does note that diverging definitions of diversity muddy the water. “The definition of diversity is evolving, and no two people have the same definition. Organizations need to identify what diversity means to them. Once this crucial step is complete, organisations can then better focus their efforts and more effectively measure results.” Diversity is a long-term commitment where change doesn’t occur overnight, he concludes.

“We hope that after the Forum, attendees will return to their respective organisations with renewed conviction to move towards a highly diverse and inclusive workforce.”

Institutional investors at the Robert F Kennedy Human Rights Compass Investor Conference in Hyannis Port were excited about the prospect of investing in the decades to come given the progress in frameworks around ESG investing.

Former CIO of CalPERS and now vice chairman and head of strategic partners at Morgan Stanley Investment Management, Ted Eliopoulos, said the crystallisation of the taxonomy, or organisational structure, to invest via ESG considerations was an important development in investment in the past decades.

“The trillions of dollars now moving to ESG, the nomenclature around integration, and more capital thinking about impact points is an enormous and powerful change for good. I’m looking forward to the next decade and decades to come,” he said.

“From an institutional investor perspective, the organisation, taxonomy and landscape around how to think about these risks and returns in a multi-asset investment is now an organisational concept that can really drive the measurement and reporting around financial impact as well as the social impact of these forces. The $35 trillion moving towards this type of taxonomy and framework is stunning to me.”

Similarly, Andrew Collins, director of ESG investing at the San Francisco Employees’ Retirement System talked about the evolution of divestment according to moral or ethical terms to a more robust ESG framework that considers how environmental, social and governance  factors influence the risk return spectrum, and how fiduciaries can’t ignore ESG in how they invest.

“Since 1988, we have had a social investment procedure that governs our program, and five years ago we updated that to be an ESG policy and guidelines. The naming convention is one indication about how thinking has evolved. Back then the guidelines and actions we took were divesting of sectors where there were moral or political objections such as tobacco or firearms manufacturers. In the last five years we have an ESG policy and procedure framed from the context of how E, S, G influence the risk return spectrum and how as long term fiduciaries we can’t ignore ESG in how we make decisions,” he said. “Our journey reflects the evolution of the whole space where people talk about the shift from exclusions to more integrated inclusion of factors.”

Both investors talked about the importance of data and the evolution of the reports they received from external asset managers, such as from private equity manager TPG and its rise fund.

“A lot of people have trouble with the data, but it’s great that so many smart minds are a tackling this problem,” said San Francisco’s Collins.

“The iterative process works and is so important to prove impact is being created and creating a lens to look forward and unpack other opportunities. The more asset owners ask for this reporting the more they will deliver on it.”

Investors are discovering their collective power in asking questions of their external managers when it comes to ESG reporting, and Collins said he is now seeing trustees ask managers why they don’t have impact or ESG reporting.

“We are also trying to measure these things ourselves. We are now seeing same platforms we use to measure performance and risk, integrate ESG into their systems and so we are able to report on these things in concert with one another.”

Collins said when his fund looks across the spectrum of ESG risks, climate rises to the top.

“We developed a six point climate strategy to understand those risks, minimise them and tap into opportunities created by the climate transition. We spent a lot of time saying how can we put in place a thoughtful strategy to manage these risks.”

One of the steps is to be more vocal in how it engages with companies and regulators to talk about climate risk and risk management structures.

It has “ramped up” its shareholder activism individually and through the Climate Action 100 group, which was actually started by CalPERS which on analysis of its portfolio found that 50 per cent of carbon emissions were coming from 100 companies.

That list of companies expanded to 150 systemic carbon emitters which investors collectively are engaging with to reduce emissions. It has been a very effective way of mobilising the investor community to get effective action from companies with around $33 trillion of investor money signed up the Climate Action 100 group.

Eliopoulos said that “rainbow washing” was at the heart of the concern for institutional investors and asset managers truly focused on driving these impacts that also achieves a financial impact.

“An investor community coming together on an orthodox set of methodologies is a really important step in how we invest in the next decade or so.”

Impact investors need to start with a problem they are trying to solve, not an opportunity set, according to Tim Crockford, head of impact investing at Hermes Investment Management.

Speaking at the Robert F.Kennedy Human Rights Compass Investor Conference, he said impact investing is about finding the companies that are solving an un-met need through the products and services they are selling.

“Einstein’s quote ‘we can’t solve the problems with the same thinking that we used when we created them’ summaries what impact tries to do, which is to focus in on the companies that are offering solutions to an issue, and in doing so meeting the -unmet need is the opportunity.”

Impact investing came out of the private investment world, where issues were addressed on a community by community basis, but Crockford says in the public markets what becomes apparent is the scale of the problem.

“Impact investing requires a robust and repeatable framework – this frames the discussions we have and the work we do and who we talk to, companies that are genuinely on this mission. Impact allows investors to have their cake and eat it by meeting objectives of returns and having a positive impact on the environment and society.”

He pointed to a number of universal problems, including the problem of financial inclusion where about 1.7 billion adults around the world are “unbanked”.

“Nearly half of these people are based in just seven countries. Access to financial services is a critical step towards reducing both poverty and inequality,” he said.

Similarly reducing water stress was a global problem, and he quoted that by 2025 half of the world’s population will be living in water stressed areas; and the fact 80 per cent of wastewater flows back into the ecosystem without being treated or reused.

“If you can sell a product or service that helps solve this issue, then that will be a massive opportunity.”

His third example was around improving our health and wellbeing and the fact that non communicable diseases such as diabetes, heart disease and cancer kill 41 million people each year, which is roughly 71 per cent of all deaths globally.

“The UN estimates the global financial cost will reach $47 trillion by 2030 if nothing is done. There is a huge opportunity for companies to benefit and offer growth to their shareholders, but also do good beyond that for society.”

Crockford says to make a dent in the sustainable development goals capital from a broader universe than just governments is needed.

“Are companies demonstrating their impact as well as they could? This is one of the challenges we face, but we are also seeing great progress in this area. The solutions lie with companies thinking differently. The SDGs define the problem not the investment universe,” he says, adding Hermes has published a taxonomy which outlines why a company’s products and services contribute to a solving a particular problem.

A major barrier to understanding the legal obligation of pension fund fiduciaries relating to ESG integration seems to be the confusing language that shades the boundary between taking into account or engaging on financially relevant ESG factors on the one hand and promoting ethical or social behaviour for its own sake on the other.  The law however is relatively clear. 

If ESG factors relate to financial performance or financial risk mitigation, taking them into account is not only allowable, but may be legally required.

The legal analysis starts with purpose.  The purpose of a pension fund is to provide financial benefits in the form of lifetime retirement income security.  Accordingly, where ESG factors are relevant to that purpose — financial risk or reward — they are proper components of the fiduciary’s analysis of competing investment choices. 

In that context, they are not merely collateral considerations or tie-breakers.  Indeed, ignoring ESG factors that are relevant to financial purpose, may be a violation of fiduciary duty. 

For that reason it may not be helpful to refer to ESG factors as “non-financial” factors.  This is because if ESG factors are not financial factors, then they cannot be advancing the primary purpose of a pension plan to provide financial benefits in the form of lifetime retirement income. Generally, non-financial factors shouldn’t be considered.  But when ESG factors inform financial performance assessment, sustainability or risk, they are ipso facto financial factors and can be, and where they are known and relevant, must be taken into account by pension fund fiduciaries.

But what about the non-financial interests of the beneficiaries?  What about a plan for the Cancer Society or some other socially engaged enterprise?

One of the hallmarks of fiduciary or trust law is to treat the interests of the beneficiaries as paramount.  But this does not mean pension fiduciaries may exercise their investment discretion to take into account non-economic factors, whether by presumption or even by reaching out and conducting a vote or survey of plan participants. 

By way of example, one cannot presume that a pension fund for employees of the Cancer Society or the Heart and Stroke Foundation can simply adopt an investment policy to exclude investment in tobacco products. 

It is one thing to ban tobacco investment by the Cancer Society in relation to its donated funds, since the purpose of those funds is to support the goals of the Society, i.e., to reduce the incidence and impact of cancer.  It is quite another thing for the Cancer Society’s pension fund to adopt such an investment policy for its pension fund.  That’s because the primary purpose of the Society’s pension fund is not to reduce the incidence and impact of cancer, but rather to provide financial income security to its employees in retirement.  

This is not to say that the Society’s main pension plan documents could not be drafted in such a way to impose such limits to achieve the other purpose; but that other purpose would have to be secondary, and it would have to be legally authorized by something other than an investment policy statement.

So how does that legal imperative fit with notions of principles of responsible investment, socially responsible investing, impact investing and broader ESG factor integration?

In situations where ESG considerations are used to enhance financial results or mitigate financial risk, ESG factor integration is not only consistent with fiduciary duty, but arguably is a requirement for proper discharge of fiduciary responsibility.

One significant problem in the discourse about ESG, has been the tendency to think about ESG factors as non-financial factors. 

However significant advances in financial analysis research appears to demonstrate that a recalibration of the usual financial metrics is underway. One study conducted in 2015 that combined the findings of about 2,200 individual peer reviewed studies demonstrated that the business case for taking ESG into account in investing is empirically well founded.

Roughly 90 per cent of the researched studies found a non-negative relationship between ESG and corporate financial performance (predominantly measured by stock returns).  The large majority of studies reported not only a positive correlation with returns, but that the positive ESG impact on corporate financial performance appeared to be stable over time.

Unfortunately, very few of these studies disentangle motive. But they do suggest that integrating ESG considerations into financial analysis results in strong empirical evidence of outperformance. In other words, ESG factors should be considered and used as financial factors.

On the other hand there are a few studies which have looked at investment results where the financial risk and return objectives appear to be secondary to achieving a positive social or environmental purpose. 

Not surprisingly, where ESG factors are not taken into account as financial factors, but for other reasons, the results appear to be less consistent. Investment motivated by non-financial ESG considerations are a mixed bag of values based considerations and moral and  philosophical perspectives, with focal points that relate to many different concerns such as climate, employment opportunity, human rights, or alleviation of poverty, and many include exclusionary perspectives on gambling, alcohol or tobacco. 

Where the motives underlying ESG investment policy are primarily non-financial, it is not surprising that the empirical evidence, although difficult to isolate, provides a less clear-cut picture than it does for ESG integration motivated by financial goals.

Several jurisdictions are now considering or have passed legislation to require pension fund fiduciaries to indicate whether they consider ESG factors, and if so, how.  One good piece of legal advice is never say “never”. 

Pension fund fiduciaries who say such factors are never taken into account may simply be making an admission that they do not fully understand their legal duty as pension fund fiduciaries.  And that is true even where the fiduciary is merely passively invested in mutual funds, including those adopted for money purchase arrangements.  In that case the disclosure statement might be as simple as “We consider the extent to which our investment managers incorporate and engage on ESG factors, as one of many criteria in the investment manager selection process.”

As mentioned above there is no end of confusing language around ESG factor integration to the point that a fiduciary might conclude that a proper purpose is to promote ethical or socially responsible behaviour — when that is rarely going to be accepted as proper for pension fund fiduciaries.

On the other hand, pension fund fiduciaries are frequently able to achieve positive collateral effects by complying with their legal obligation to focus on using ESG factors to achieve financial purposes.

The bottom line is that a proper perspective on ESG for pension fiduciaries is one that sees it as financial insight.  As a result, fiduciaries, fund managers and their consultants should be demanding better and more fulsome ESG disclosure. 

They should also be considering appropriate ways to engage on ESG issues to enhance financial performance or manage financial risk. The motive ought to be to deal with ESG factors just like any other consideration in the financial risk-performance-assessment matrix.

Fiduciaries and their advisors who understand this will no doubt gain more confidence in devising and disclosing appropriate ESG investment policy that first and foremost serves their fiduciary duty to plan beneficiaries.  And who knows, it may also have other collateral environmental or social benefits.

Randy Bauslaugh leads Canadian law firm McCarthy Tétrault’s national pensions, benefits and executive compensation practice in Toronto.