When members of the Seventh-day Adventist Church built their first hospital, in Battle Creek, Michigan, in 1866 to offer Christian healing, they couldn’t have envisaged how their pioneering idea would flourish. Of the hundreds of Adventist hospitals that have spread across the US, Florida-headquartered Adventist Health System (AHS) runs the most,47 hospitals, 82,000 employees and, most recently, ambitious expansion plans that will result in the system doubling revenue over the next seven years. It’s a growth trajectory that has been supported by an expanding $6 billion investment portfolio where, true to the system’s core beliefs, a holistic strategy benefits the whole organisation.

The overriding purpose of the portfolio is to support the hospitals and care AHS provides in a philosophy encapsulated in its core mission to “Extend the healing Ministry of Christ”.

The portfolio has no return hurdle or mandate to beat the market or peers. Instead, success is measured by the contribution the portfolio makes to AHS’s corporate balance sheet and its ensuing support to the financial strength of the organisation. Viewed through this lens, the portfolio performs very well, says chief investment officer Rob Roy who joined AHS 20 years ago, when it had just $600 million in assets under management. He now points to AHS’s high profit margins, frequent acquisition of new hospitals and AA balance sheet to illustrate his point.

“People say, ‘Show me your investment returns’ but this is not our primary objective,” Roy says.

Just under half the portfolio is invested with seven external managers, some of which run active strategies. The names include Bridgewater, BlackRock, Blackstone and Goldman Sachs.Internally, all investments, bar two tiny allocations to private equity and hedge funds, are in index-tracking strategies. The hedge fund portion is beingexamined relative to cheaper alternative risk premia.

There is no long-term strategic asset allocation with fixed percentages. Instead, allocations are based on a dynamic risk appetite that shifts with the fluctuating needs of the business. The current risk allocation to global liquid markets spans sovereign bonds (30 per cent) inflation-linked securities (30 per cent) global equities (20 per cent) commodities (10 per cent), high-yield credit (5 per cent) and dollar-denominated emerging market sovereign bonds (5 per cent).

“We don’t think equities should always be X per cent and bonds should be Y per cent, plus or minus. This is a rigid approach that doesn’t reflect our support of a dynamic business,” says Roy, who adds that an illiquid allocation wouldn’t fit in the portfolio either. Investing in liquid markets ensures the portfolio is ready to support the business whenever necessary.

The portfolio working for the whole is best encapsulated in one of AHS’s smallest allocations – 2 per cent to private equity, amounting to about $100 million, only about $40 million of which has been deployed so far. Rather than seeking high returns as a primary goal, AHS has invested in two specialised healthcare private equity funds, Ascension Partners and Heritage, where the other limited partners are also healthcare systems. The idea is to invest in new technologies or drugs that could ultimately provide real value to AHS, Roy says.

“It is about finding something to use across the whole organisation that is going to be really beneficial; it is not about maximising investment returns,” he explains.

Growing financial strength – and risk

Portfolio risk is anticipated and measured according to factors such as corporate drawdowns or forecast market volatility, historical data, scenario analysis and stress-testing. Armed with this information, Roy’s 10-strong investment team, which works across the entire portfolio rather than in asset class silos, sets the allocation. It must ensure as high an expected return as possible without endangering the portfolio’s ability to support the business – any losses that force cutbacks on healthcare provision contravene AHS’s mission, Roy reminds.

“We look at how much risk we can take, and how much we are prepared to lose,” he says. “We then build a portfolio that has a low probability, say around 5 per cent, of potentially losing that amount of money.”

The fear of being unable to sustain losses has historically engendered a cautious approach, but this could be about to change. AHS is increasingly able to take on risk because of its growing financial strength, says Roy, who draws on recent comments from chief executive Terry Shaw and chief financial officer Paul Rathbun to describe the shift towards a more confidentategy that is starting to take root in the organisation.

“We are changing the way we think and act – from self-preservation poor, to enlightened rich. It takes times and effort,” he says.

This doesn’t mean AHS will change tack, pile into active strategies or up its equity allocation but it may increase risk by adding leverage. As the risk budget grows, the investment team will have two choices with the current allocation. The fund could take more risk by selling safe assets like bonds and reinvesting in riskier markets, but Roy believes this makes the portfolio less efficient. He would rather use leverage embedded in derivative instruments to allow him to increase the allocation to what AHS already holds, in a strategy that boosts risk exposure but also retains efficiency.

“Think of it like this,” he says, drawing on a cooking analogy. “When you have your favourite recipe for chocolate-chip cookies and more people come over to your house, to make more, you don’t just add eggs. You make more using all the ingredients.”

Although the internal allocation tracks indices, Roy doesn’t describe the strategy as passive. The investment team actively sets the risk budget and builds a diverse portfolio to reflect it, in a never-ending stream of decision-making.

“Our research team drives the planning and measurement of risk with internal and third-party systems, and our portfolio implementation team plans and executes any trades necessary to manage the portfolio within these parameters every day.”

Moreover, constant decision-making is required to support a business in flux, evolving global capital markets and the instruments to access them.

“Think about the liquidity in global inflation-linked securities and how that changes the dynamics of our portfolio; think about the rise of ETFs and ensuring the most cost-effective ways to implement strategy here, or how trading technology and execution costs are now massively different to 10 years ago,” he says. “The work never runs out.”

 

Stewardship alpha

Although some of AHS’s seven asset managers run active strategies, none were selected based on their expected ability to produce traditional alpha, as Roy observes managers’ ability to persistently outperform the market is mixed. Instead, AHS chooses managers on their ability to provide solutions, not just products. It’s the value they bring beyond simply deploying capital, like advising on team structure, technology architecture, governance, and quantitative research. There is little turnover in the mandates and the idea of a large manager roster requiring hiring and firing fills Roy with amazement.

“Some peers have 100-plus managers and I wonder how they can truly be partners,” he says. “I just don’t understand that.”

Unmotivated by beating benchmarks, it’s not surprising AHS sees alpha in a completely different light. Stewardship alpha, as AHS calls it, comes from within and is achieved when the whole investment process comes together in a sensible, efficient and robust process. It involves a thorough understanding of risk, strong governance and a workplace where employees can excel.

“If we can show up every day to execute and improve upon our process, then we are creating a huge value for AHS,” Roy says. “We try to spend our time and resources on developing the major elements of our process, rather than on smaller decisions like manager selection, security selection or macro-guessing.”

The Future Fund plans to keep investing in private equity, on the back of a benchmark-beating return for the year to June, which was assisted by a strategy of moving into riskier asset classes.

On Wednesday, Australia’s sovereign wealth fund posted a return of 9.3 per cent for the 2017-18 financial year, outpacing its 6.1 per cent target. This result pushed its funds under management up to $107 billion.

The 12-year-old fund also exceeded its 6.6 per cent benchmark targetover 10 years, delivering returns of 8.7 per cent a year over 10 years.

“During the year, we slightly increased the level of risk in the Future Fund, balancing our perspective on the more positive near-term outlook with the longer-term risks that remain,” Future Fund chair Peter Costello said. “The short-term outlook is for a continuing period of sustained synchronised growth. But over the medium to longer term, a number of risks remain and continue to evolve.”

The fund has been adding risk since March, and in the year to June 30, 2018 the fund added 7.4 per cent across listed and private equity with private equity increasing from 11.6 to 14.1 per cent of the portfolio.

Costello added that inflationary pressures might be imminent in the US and with global interest rates normalising, there may be downward pressure on asset prices.

There was a $2.5 billion increase to private equity over the last three months, taking the total portfolio weighting for this asset class from 12.8 per cent to 14.1 per cent.

Future Fund chief executive David Neal partially attributed this shift to the stronger US dollar.

“One thing I would point out is that private equity is always in US dollars,” Neal said. “One reason the allocation has increased is because the US dollar has strengthened, so just, mechanically, the allocation goes up.”

Neal said the Future Fund would continue to invest in the private equity space.

“It provides us with an exposure to the parts of the economy and markets that you can’t necessarily access through the listed markets, and the opportunity to access additional returns through the application of skills,” he said. “But you have to be careful who you trust your money with in this space.”

Relying on private equity values going up without “operational improvements” was not an option, Neal said.

“So we do focus on organisations that have a strong history and skill base in adding value to businesses, growing businesses and [making] operational improvements to businesses,” he said.

“We can’t simply rely on values continuing to go up without operational improvements, so that’s a large part of risk management in the private equity space.”

 

 

Climate change poses risks across industries, governments and countries. Pension plans such as OPTrust – with their large, global investments – are not immune to these risks.

As a long-term investor, our role at OPTrust is to look decades into the future to identify challenges and opportunities that could affect our members’ retirement security.To ensure plan sustainability, we must better understand the risks climate change poses. The transition to a carbon-neutral economy will be increasingly disruptive and we need to be ready to adapt. Waiting for governments and regulators to act will take too long. The impacts of climate change are already being felt. That is why investors need to build climate risk into their investments, starting now.

We recently issued our Climate Change Action Plan. Among other things, the action plan commits us to: determineour exposure to industries, geographies and companies that are most exposed; engage with companies on improved performance on ESG factors; and demand better disclosure of the information investors need to properly price climate change-related risk.

We have already made some progress in our climate-change journey. With our 2017 Funded Status Report, OPTrust became one of the first pension plans to report according to the recommendations of the Task Force on Climate-related Financial Disclosures. We have also issued a white paper calling for a standardised climate change disclosure framework.

Through a G7 initiative and groups such as Climate Action 100+, Canadian investors are working with others around the world to develop common standards and encourage corporations to curb greenhouse-gas emissions.

As a global pension citizen, we believe we must use our voice to influence organisations to better manage climate risk. Currently, 7.6 per cent of the OPTrust portfolio is invested in renewable energy and green real estate. This is our direct investment in the transition to a lower-carbon economy, and these are our guiding principles:

Change happens through influence. Fossil-fuel industries are going to be with us for the foreseeable future.We use our ownership position to promote better practices among our investee companies, which has a far greater impact than divestment. We have engaged 235 companies on climate-related issues, leading to improved climate risk reporting, climate-aware boards and emissions reduction.

Measurement matters. We are focused on developing and using measures and tools that accurately support pricing climate change-related risk.

Market forces can promote sustainability. Our job is to prioritise sustainability by balancing sufficient investment returns with appropriate amounts of risk. We don’t believe regulation will happen soon enough. Market forces will be the more effective means of keeping us adaptable so we can thrive in a changing climate.

Innovation has a role to play. Successful investing requires an emphasis on assessing and understanding a constantly changing environment. We understand the importance of having an innovation mindset and recognise that new technologies will be key in better understanding climate change risks and opportunities. The increasingly rapid pace of change is foundational to how we think about climate change.

Work continues

OPTrust is prepared to face these challenges.

Our approach will evolve over time and the same must happen at other companies for them to adapt to the evolving landscape. Companies must be agile to manage climate risk.

 Canada is a global leader in so many respects. We can be even more so by working collaboratively with other global investors to improve understanding of climate-change impacts. One example is to bring together climate scientists and investors for thoughtful debate, to assess and analyse how climate risk exposure affects investment portfolios.

We want our plan members and the broader community to know that addressing climate change constitutes good business and contributes to value creation and plan sustainability.

 

Hugh O’Reilly is president and chief executive of OPTrust. He will be speaking at the Fiduciary Investors Symposium at Stanford University, September 30-October 2, in a session covering innovation and technology in pension fund portfolios. The discussion will be chaired by Ashby Monk, executive and research director, Stanford Global Projects Center. More information is available here. Note: the event is open only to asset owners.

 

We are all familiar with the claim that private equity significantly outperforms public markets. Any survey coming out these days indicates that investors expect private equity to trounce public equity this year and in the years to come. Using data from Burgiss, widely regarded as the most comprehensive and accurate database of private equity fund cash flows, we look at recent PE performance and the bill that came with it.

The metrics

We first need to choose a performance measure. We opt for the Public Market Equivalent (PME), currently the best tool for comparing the performance of private equity and public equity. This measure compares an investment in private equity to an equivalently timed investment in the public market.

Second, we need to choose a public market index for comparisons. At its origin, PME came with the S&P 500 Index as the benchmark. For now, let’s keep with tradition, and use the S&P 500 as our public market comparator.

Third, we need to select a sample. There are many types of private equity funds and, therefore, many samples one can choose. We want a recent and relatively homogenous sample that represents most of the capital and, if possible, performs better than the rest. The winner is: North American and Western European funds, classified as equity or real-asset funds by Burgiss. These funds basically do either leveraged buyouts (LBOs) – applied to real estate, infrastructure, etc – or venture capital. In both cases, the payoff is expected to be like a long call option on equity value (due to leverage, or the staging of venture-capital investments). Funds from the rest of the world don’t perform as well and neither do debt funds. We also exclude the most recent vintage years (2016-18) because these funds are young and underperform but they have an excuse (lots of fees are paid upfront). Finally, we choose the 10 vintage years before 2016: 2006-2015. Nice and round.

Our sample includes 2424 funds with a total size of $2.2 trillion. We find that PME as of March 2018 is 0.97 on average (median is 0.98) and total value to paid in multiple (TVPI) or total value distributed, compared to invested is 1.46. Verdict: performance of these funds is slightly below that of the S&P 500 Index.

The cost

What is the bill for this performance? Carried interest charged and latent (i.e., carry due on what is not exited yet) is unknown, but we can proxy for it by observing that 1518 funds are above the usual 8 per cent internal rate of return (IRR) hurdle. These funds have a total size of $1.52 trillion and TVPI of 1.64. Given their TVPI and a carry of 20 per cent of profits, it should amount to $195 billion. In short, we find carry is about 10 per cent of the total amount of money raised.

This computation makes some assumptions but nothing substantial. For example, it conservatively assumes that the funds that are not in-the-money have never been above an 8 per cent hurdle, (hence have not charged carry) and never will be above that hurdle. It uses net TVPI instead of gross TVPI to compute carry and assumes an American style deal-by-deal carry structure. We would expect European-style whole-of-fund carry to generate a similar amount but more spread through time.

Of course, there are more fee sources than carry. Management fees, portfolio company fees, fund and portfolio company expenses all would contribute to the bill – and these are much more difficult to estimate. Let’s keep it all on the low side.

A management fee of 1.5 per cent of fund size for the first five years of a fund’s life is a lower bound. Applied to our sample of funds, this is about $165 billion. Assume one-third of that amount for the following five years of a fund’s life (very much a lower bound), and management fees are above $200 billion.

To this, you would then add all other fees and expenses but let’s ignore all these and stick to the total fee we have counted so far. We have already reached a fee bill of $400 billion for net-of-fees returns slightly below those of the S&P 500 Index.

Change the sample

Rest assured that this estimate is robust with respect to changes in sample construction and assumptions. For example, if we include only US LBO funds (which are the best performers), PME is higher, at 1.04 (about 1 per cent outperformance of the S&P 500 per year). Total size is $773 billion. Funds in the money have a total size of $567 billion and a TVPI of 1.67. Total carry is about $76 billion – again 10 per cent of the money raised. Fees would be at least as much – and performance is close to that of the S&P 500.

Note that any of these investments would have a beta above 1, hence the benchmark should be higher than the sharemarket. We have also ignored any liquidity premia to compensate for ex-ante capital commitments and the illiquidity of the funds. Yet, private equity might bring diversification benefits that we have not accounted for here, and there may be positive externalities such as access to co-investment opportunities, learning about private markets, etc. Finally, these are just averages (if you select better funds, you do better).

Debunking the myth

Where does the myth of private equity outperformance come from then? First, recent history. Private equity funds outperformed the S&P 500 in most years from the 1990s until the mid-2000s. However, this might be due partly to the choice of benchmark. The average US stock outperformed the S&P 500 over this period by as much as private equity outperformed the S&P 500. Hence, private equity did as well as the average US stock before the mid-2000s. As it happens, since then, the average US stock has the same performance as the S&P 500 Index. This means the average private equity fund has returns similar to those of the average US stocks at any horizon.

It is important to bear in mind that each index is an active trading strategy. Thus, different indices perform differently. The S&P 500 is the most famous index but the types of stocks that it holds and trades are not comparable to the types of companies in which PE funds invest. In fact, now that the S&P 500 has been doing well, and private equity returns are in line with those of the S&P 500, we increasingly hear that the S&P 500 returns are driven by a dozen stocks that have nothing to do with PE-type companies. But instead of choosing an index that better resembles PE, most people now choose to use the MSCI World Index for comparisons. This index has had poor performance at any horizon and has lagged the S&P 500 Index, in particular, over the last decade. Hence, most presentations nowadays show that, compared with the MSCI World Index, PE is still outperforming.

Other data providers compute performance using end-to-end net asset value (NAV) internal rates of return. This method takes the NAV of all funds in the sample at the starting date as the initial investment, then uses aggregate cash flows each quarter, and the NAV of all funds at the end date, to calculate an IRR. But this measure is positively biased, as PE investments used to be more often held at cost, while post-2008 NAVs are closer to market value. This methodology also includes funds raised outside the sample period; for example, the performance for the last 10 years includes funds raised in 2003-07. By contrast, we used funds raised after 2006 and thus simulate the experience of an investor starting in 2006 who bought a representative set of funds. Furthermore, an internal rate of return is not an actual rate of return. Consequently, other data providers’ results will be slightly different to those discussed above.

More transparency please

Of course, the above analysis could be criticised for relying on back-of-the-envelope calculations using generic assumptions about fund terms to compute the fee bill. But lack of transparency regarding fees remains a great hurdle for academics and practitioners. Academics would welcome the details necessary to make a more precise estimate.

Ludovic Phalippou is the author of the bestseller Private Equity Laid Bareand is a tenured faculty member of Saïd Business School, University of Oxford.

Neroli Austin is a PhD candidate at Saïd. Prior to commencing her studies, Austin worked as an economist at the Reserve Bank of New Zealand for three years.

 

Australia’s industry superannuation funds have been largely let off the hook in counsel assisting’s detailed closing submission to the Hayne royal commission, which stated that retail funds operated by NAB, Commonwealth Bank, AMP, IOOF, Suncorp and ANZ Bank could be found to have contravened corporation and superannuation laws.

The closing submission – which wrapped up the superannuation industry round of the inquiry – found no breaches of the law by industry super funds, but hospitality-industry fund Hostplus might have fallen below community standards in its retention strategies, which sought to keep low-balance and inactive accounts in the fund, boosting revenue from insurance premiums.

The submission also criticised Catholic Super for failing to prevent the emergence of conflicts of interest and poor monitoring of corporate credit-card use and questioned whether AustralianSuper’s 2017 “Fox and Henhouse” advertising campaign served the best interests of its members.

Hostplus, which at August 2018 had about $34.5 billion in funds under management and just over 1.1 million members, was singled out for its almost 470,000 members with a balance of $6000 or less at June 30, 2017 – just under half of its total membership. It also had just under 300,000 accounts deemed inactive.

Hostplus

Under questioning at the Royal Commission into Misconduct in the Banking, Superannuation and Financial Services Industry, Hostplus chief executive David Elia had agreed that inactive and low-balance members were less likely to be engaged with their superannuation.

Counsel assisting stated in the closing submission that Hostplus “may be engaging in activities to retain inactive members with low balances, which are not in the best interests of those members, and in circumstances where it was in Hostplus’s interests to keep inactive members in the fund for the purposes of revenue raising”. The submission also questioned whether Hostplus’s use of members’ funds for corporate hospitality and as rewards for staff was in the best interests of members.

Catholic Super

Catholic Super drew some heat during questioning for the collapse of its merger talks with Sydney Catholic Super but this did not amount to misconduct or conduct falling short of community standards, the closing submission stated. Catholic Super might have breached prudential standards, however, by failing to have a conflicts management framework in place to prevent the emergence of conflicts of interest, as evidenced by its dealings with a company named Australian Family, the submission stated.

The Catholic Super board paid Australian Family more than $2 million for marketing, consulting and other expenses; the managing director of Australian Family, Paul Clancy, is the brother of Catholic Super’s head of institutional relations, Robert Clancy.

Catholic Super’s insufficient monitoring of corporate credit card use also fell below community standards and expectations, the closing submission stated.

Australian Super

AustralianSuper’s 2017 “Fox and Henhouse” advertising campaign – which questioned the appropriateness of banks offering superannuation products – was not misconduct and did not fall short of community expectations, counsel assisting found. But this campaign raised questions about whether political advertising was consistent with the intent behind the Superannuation Industry (Supervision) Act, known as the SIS Act, and what benefit consumers stood to gain from the advertising.

The closing submission was more harsh in its criticism of NAB, Commonwealth Bank, AMP, IOOF, Suncorp and ANZ, which could be found to have contravened the Corporations Act and the SIS Act, the closing submission stated. Some of the potential breaches carry criminal penalties.

NAB

A large amount of the submission was directed at NULIS Nominees – the registrable superannuation entity licensee for NAB’s MLC Super Fund and MLC Superannuation Fund. With $76.4 billion and $18.7 billion in funds under management, respectively, these funds represent more than 1.3 million members.

The charging of plan service fees and adviser service fees where no service was provided might have amounted to misconduct, the submission stated, potentially breaching the Corporations Act, the SIS Act and the ASIC Act. This could also be found to be conduct that fell below community standards and expectations.

“By advocating various methodologies in their negotiations with ASIC, including opt-in remediation or ‘fair value’ approach, with the intention or effect of minimising the quantum of remediation to be paid to members, NAB and NULIS acted in a way that was ethically unsound and ultimately delayed remediation to members who, in some instances, had paid fees in 2009,” counsel assisting stated.
NAB was also not “full and frank” with the regulator about the amount of loss to members and the expected remediation, the submission asserted. Chief customer officer, consumer and wealth, Andrew Hagger revealed “both a disrespect for the role of the regulator and a disregard for the gravity of the events in question” when he gave evidence that he “left the door open” for ASIC to ask questions, the submission states.

NAB may also have breached the SIS Act’s requirement that it act in the best interests of members, when it resolved to retain grandfathered commissions for members transferred to the MLC Super Fund in July 2016, and by delaying the transition of members to MySuper offerings so that they continued to pay grandfathered commissions, plan service fees and contribution fees, counsel assisting wrote.

An NAB spokesperson said the bank disagreed with many of the findings and would address them in a further submission by August 31.

“We take our obligations to uphold the law seriously,” the spokesperson said. “Where we get it wrong, we expect to be held accountable. We are also focused on earning the trust and respect of or customers every day, and when we do not live up to their expectations we will make it right.”

Commonwealth Bank

Commonwealth Bank’s inability to move more than 13,000 super fund members to MySuper accounts after January 1, 2014, could be found to be a breach of corporation and superannuation laws, the closing submission continued. And CBA’s open platform, Aventeos, was in breach of the super laws in charging dead customers for financial advice, the submission stated.

IOOF

IOOF might have breached super laws in raiding its reserves to compensate members for a management blunder and engaged in misleading or deceptive conduct in its subsequent communications to members, counsel assisting stated.

IOOF managing director Chris Kelaher was criticised for lacking insight into both the obligations super fund trustees have to their members and why IOOF’s conduct was problematic.

AMP

AMP’s highly outsourced arrangement, in which other arms of the business managed a range of services for the trustee, left the AMP trustee unable to step in and protect its members from fee gouging by various related parties.

Parties with leave to appear now have until August 31 to provide written submissions in response to the specific findings that are the subject of the closing submissions.

The closing comments also raised a range of policy-related issues. The broader public has until September 21 to make submissions related to these.

 

Sweden’s AP7, the SEK490 billion ($53.8 billion) pension fund that manages the default option within Sweden’s premium pension system, will increasingly call out corporations on opaque climate lobbying.

Thwarting the practice – whereby companies publicly support the Paris agreement on climate change but also back trade associations that lobby against it – has become one of the most important strands of the pension fund’s active ownership strategy within its SEK454.3 billion ($50 billion) equity allocation.

Using shareholder resolutions, AP7 will demand transparency on companies’ true positions, how much they spend on climate lobbying and under what circumstances they would leave these powerful trade organisations.

“Right now, we are focusing most on corporate lobbying,” says Johan Florén, head of communications and ESG at AP7. The real danger lies in the role influential lobby groups, backed by corporate sponsors, have in obstructing national legislation, he explains.

“The Paris agreement needs strong regulation on a national level,” Florén says. “If we don’t have this, it won’t have any effect, so companies working against climate regulation are a real threat.”

Corporations had a taste of what’s to come earlier this year, when AP7 co-filed a resolution against Australian mining giant Rio Tinto. The UK and Australia-listed company is one of the worst offenders, Florén says.

Although Rio has pulled out of coal, it is still funding lobby groups like the Minerals Council of Australia, which is accused of obstructing climate policy and actively pushing governments to continue to support coal-fired energy.

AP7’s resolution, which was co-filed by the £8 billion ($11.1 billion) Church of England Pensions Board and A$11 billion ($8 billion) Australian pension fund Local Government Super failed but it attracted the support of 18.3 per cent of Rio Tinto’s shareholders.

“It is not hopeless; next year, things might well have changed,” Florén says.

AP7’s crackdown on climate lobbying is already helping drive change at other energy companies as well.

BHP Billiton has released a report laying out ground rules for its continued membership in industry associations and has committed to withdrawing from the World Coal Association over differences on climate change.

This Northern Hemisphere summer, Exxon Mobil left the American Legislative Exchange Council (ALEC), a conservative non-profit group that receives funding from fossil-fuel companies.

“ALEC was moving towards climate denial and Exxon said [it couldn’t] be a member anymore,” Florén says. “That means Exxon has become a part of the engagement process at a micro level, changing attitudes and behaviour. It is very positive.”

Along with shareholder resolutions, AP7’s active ownership includes voting, engagement, dialogue and blacklisting or divesting from companies.

Laggards, which number about 65, are excluded from its index-tracking MSCI All-Country World Index allocation until they change, when they are reinstated.

“We see from the reaction of targeted companies that they are listening and changing,” Florén says. “We have situations where some we have been trying to engage with for years suddenly contact us.”

Strategy: countering gaps in the index

AP7’s assets are split between a large allocation to equity and a much smaller one to fixed income. The equity fund comprises a 96 per cent passive global equities allocation and a 4 per cent allocation to private equity; it uses leverage through derivatives to generate higher returns.

“Because we invest in the whole market, all the problems out there are ours,” Florén says.

New strategies in the equity portfolio include halving the use of leverage from 50 per cent to 25 per cent, introducing factor exposure, and increasing the small allocations to private equity and emerging markets by 1-2 per cent.

AP7 aims to improve diversification and risk-adjusted returns by countering gaps in its index exposure, Florén says.

“The MSCI country index has a tilt to large caps and is underweight emerging markets,” Florén says.

He adds that the fund will also introduce a new small-cap bucket at some stage. Factor exposure will include value, size and quality and will account for about 10 per cent of the equity portfolio.

Climate solutions

Strategy at the fund is also starting to focus more on climate solutions. Last June, AP7 launched two new positive, or impact mandates, for a combined SEK3 billion ($333 million), with Ireland’s KBI Global Investors and the UK’s Impax Asset Management, focused on water and climate solutions, respectively.

The new mandates mark an important step in AP7’s integration of impact investing into its equity manager selection and follow on from introducing a clean-tech portfolio in private equity and green bonds in fixed income.

“Finding managers has been a long and thoughtful process; we have found some of the best performers financially and from a sustainability perspective; we can’t compromise our financial return.” The new managers target returns above the passive portfolio.

SDGs

The new mandates also tie-in with AP7’s ambition to incorporate UN Sustainable Development Goals (SDGs) six and 13, which focus on water and climate challenges. The reality of integrating SDGs into investment strategy has proved a challenge, Florén says.

“The SDGs are the typical global, UN-backed type of sustainability initiative we like. But when we started digging into the 17 targets, we were overwhelmed. They contain all the world’s problems and some of them contradict each other,” he explains.

Rather than develop an SDG portfolio with all 17 categories, AP7’s approach has been to start by picking individual SDGs that it can realistically integrate, and develop strategy from there. Florén also notes that measuring impact remains a huge challenge.

“It’s not just about measuring the litres of water or carbon saved, because this is just a number,” he says. “The real question is measuring the utility to society, to overall sustainable development.”