Ilmarinen, Finland’s third-largest pension fund, will continue to decrease its allocation to government bonds and investment-grade credit, primarily in Europe, in a strategy designed to protect the fund’s fixed income allocation from any interest rate move.

“I don’t see any value here at the moment,” Ilmarinen chief investment officer Mikko Mursula explains. “If interest rates begin to move up, it will mean capital losses for the longer maturity government bond portfolio. We have had quite a short duration in our fixed income portfolio for some years already.”

The €37 billion ($39 billion) fund now allocates 42 per cent of assets to fixed income. Its investment-grade credit comprises allocations that fall between government and corporate bonds and includes investment in state-owned enterprises and local government debt.

Ilmarinen has just posted a 4.8 per cent return for 2016, in a year marked by two distinct cycles: share prices fell initially, yet picked up towards the end of the year, helping to lift the whole portfolio.

“The market is not the easiest at the moment. But then, we always say this. It is never easy,” Mursula says.

He first joined Ilmarinen in 2000 and has held roles as head of equities, listed securities and tactical asset allocation. In 2010, he left to spend five years working for a Finnish asset manager before returning to Ilmarinen as CIO.

“It was good to go and see the world from an asset manager’s perspective. Being back on the buy-side is a bigger responsibility,” he says.

Looking outside of Finland

The plan is for assets taken out of fixed income to go into diversified equity and real assets instead. The bulk of Ilmarinen’s real-asset portfolio lies in real estate, which returned 6.4 per cent in 2016.

Most of the fund’s real estate assets (80 per cent) are in Finland, primarily in Helsinki’s metropolitan area. Efforts to increase the real estate portfolio from today’s 11 per cent of total fund assets will primarily target foreign opportunities.

“The current ratio is 80/20 local vs foreign real estate and this will change to 70/30 or even 65/35,” Mursula says.

Investments will focus on office space in Central European cities, including Brussels, Berlin and Frankfurt, as well as the US, where he favours residential and office properties.

He will continue to avoid the UK market, having put investment in UK real estate “on hold” after Brexit. The plunge in sterling, “pressure” on the market and uncertainty going forward are reasons to be wary.

“There are so many open questions about Brexit for investors,” he says. “We don’t know the time schedule or what will happen in the end.”

Less exposure to European equity

Mursula is also reducing the fund’s exposure to the European equity market as he works to boost equity overall.

Ilmarinen has a home bias in this asset class, with 30 per cent of its listed-equity portfolio in Finnish companies. The remaining 70 per cent is diversified between the US, Japan and Europe but the fund has already begun diversifying equity risk from Europe to the US and emerging markets. About a third of the overall portfolio is in listed equity.

“We used to be heavily concentrated in European listed equity and have been moving more investment to the US to diversify our risk. We will continue doing this,” Mursula says.

The majority of US equity investment is passive, using index funds and exchange-traded funds. In emerging markets, Mursula prefers active managers.

“In the past couple of years, there have been more index funds in emerging markets but we still believe the more undeveloped a market is, [the greater the] need for active investment.”

Eighty per cent of Illmarinen’s assets are managed in-house. The 20 per cent that is outsourced includes a portion of the active listed equity allocation in emerging markets, but also in Japan and the US.

Private equity, which accounts for about 5 per cent of assets, and the fund’s small allocation to alternative credit, are also managed externally. The fund uses more than 100 managers or funds across equities, fixed income and alternatives but doesn’t use consultants to manage its managers.

“We have a dedicated in-house team doing manager selection. This includes performance analysis in a strict and real-time process,” Mursula explains.

Fee negotiation becomes critical

He says fees are more important than ever in today’s low-yielding environment, and he carries out “case by case” fee negotiation with each manager.

Listed long-only equity managers tend to be flexible about fees, particularly if investors consider a large ticket size, he observes.

Fee negotiation with hedge funds and private equity managers is more challenging and he thinks many managers in these asset classes are struggling to justify high fees with poor performance.

“With convincing long track records, managers can stick to their existing fee structures,” he explains. “Now, lots of private equity and hedge funds are suffering from a lack of performance and track record and we are seeing the fees come down. But it is not just about fees. Managers struggling with performance are also finding it impossible to get new investors on board.”

Hedge funds account for 2.9 per cent of assets at Ilmarinen. Most of the allocation is managed in-house by “a significant hedge fund team” in a strategy that brings transparency and cost-effectiveness. The team focuses on catching market inefficiencies and mispricing in equities, foreign exchange, commodities, volatility and illiquidity premiums.

“There are some sub-asset classes or risk premiums that it is difficult to access in-house, one example of this is insurance risk,” Mursula says.

He says his investment team prides itself on a “flexible and fast” decision-making process shaped around the freedom to act decisively, within a framework the board sets annually.

 

What is leadership? Gianpiero Petriglieri, associate professor of organisational behaviour at INSEAD, will conduct a masterclass in leadership at the Fiduciary Investors Symposium, exploring how and where people become mindful, effective and responsible leaders.

In a conversational meditation on leadership, Petriglieri will ask delegates to contemplate what they think leadership is, how to recognise it and whether it matters.

“How did we end up where we are, with distrust and disillusionment with leadership?” he asks from his Fontainebleau office. “One thing I will ask people is, ‘Do you know why people trust you?’ People’s trust is the main thing you need as a leader.”

Petriglieri will open the conference with a session that explores two related questions – a broad social query and another more personal one.

The first question concerns the nature of leadership, what it is, and how one gains it and loses it. Determining who gets to lead and who doesn’t is never easy to do when people keep moving around.

The second query will dig deeper. Despite copious investment in leadership development, Petriglieri says, organisations claim to suffer from a shortage of leaders. And those who do lead often struggle to connect with potential followers, facing resistance and mistrust.

The session shall reach beyond superficial models and tales to address the key questions: What makes a leader in our times? What does it mean to lead well? What does it take for an individual?

Petriglieri’s interests bridge the domains of leadership, identity and learning. He is particularly concerned with the development of leadership in the age of “nomadic professionalism”, in which authenticity and mobility have replaced loyalty and advancement as hallmarks of virtue and success.

In this context, he contends, a narrow focus on the acquisition of new knowledge and skills is inadequate to develop competent and trustworthy leaders. His research casts a light on the psychological, social and cultural functions of leadership development.

His innovative teaching methods provide an example of how to perform those functions purposefully for the benefit of individuals, organisations and society at large. In addition to his academic background, he has the unique perspective of being a medical doctor and has practised as a psychoanalyst.

INSEAD has been rated the number one MBA school worldwide by the Financial Times for the second year in a row. Petriglieri directs the school’s management acceleration programme – which is its flagship executive offering for emerging leaders – and the INSEAD initiative for learning innovation and teaching excellence.

The Fiduciary Investors Symposium at INSEAD, Fontainebleau, will delve into these issues of leadership, organisational design and governance, alongside investment themes. Incorporating the school’s esteemed academic faculty, the program will explore business excellence alongside investment topics of risk management, environmental, social and governance integration, and illiquid investments.

Other faculty who will speak at the Fiduciary Investors Symposium include:

  • Macroeconomics – Ilian Mihov, Professor of Economics, dean of INSEAD, the Rausing Chaired Professor of Economic and Business Transformation
  • Digital disruption – Peter Zemsky, Professor of Strategy, deputy dean of INSEAD, the Eli Lilly Chaired Professor of Strategy and Innovation
  • Societal progress and the evolution of capitalism – Subramanian Rangan, professor of strategy and management, Shell Fellow in Business and the Environment, Abu Dhabi Crown Prince Court Endowed Chair in Societal Progress
  • Governance – Ludo Van der Heyden, academic director of the INSEAD Corporate Governance Initiative, professor of technology and operations management

 

The Fiduciary Investors Symposium will be held at INSEAD, Fontainebleau, France from April 2-4. To access the program and to register click here.

 

The California State Teachers’ Retirement System (CalSTRS), the Florida State Board of Administration and Washington State Investment Board are the lead asset-owner signatories for the Investor Stewardship Group (ISG). This collective of some of the largest US-based asset owners and managers has articulated a set of fundamental stewardship responsibilities for institutional investors.

Among the asset-manager signatories are BlackRock, Vanguard and State Street Global Advisors – three of the largest funds managers in the world.

In addition to the stewardship fundamentals, the group has released a corporate governance framework that articulates six principles it considers fundamental for US-listed companies. They reflect the common beliefs embedded in each member’s proxy voting and engagement guidelines, and are designed to establish a foundational set of investor expectations about governance practices in US publicly traded companies.

The frameworks are long overdue. The US – the largest sharemarket in the world – operates without any stewardship code or agreed-upon corporate governance principles.

Allison Bennington, partner at San Francisco-based investment company ValueAct Capital, another one of the founding ISG signatories, says there is much overlap among the policies of the group’s members, and this helped create the framework.

“This could be useful for the companies themselves. [It] helps companies focus on standard corporate governance terms,” Bennington says. “Directors are accountable to shareholders but we wanted to show we are accountable to our members and stakeholders.”

Aeisha Mastagni, portfolio manager, corporate governance, at CalSTRS, also says it’s important that investors show their accountability to members.

“It’s about their savings and retirement, so we should be accountable,” Mastagni says. “Engagement between investors and issuers has grown exponentially; now is an important time to have this in place. [It’s about] management and board being accountable to shareholders and us as shareholders being accountable to our beneficiaries.”

She pointed to the issue of dual-class shares – highlighted again recently by the Snapchat float, which has three classes of shares, including those available to the public that have no voting rights – as an example of why good principles are essential.

“With dual voting rights, we lose our accountability,” Mastagni says. “We can’t hold the company to account.”

Bennington concurs that the economic interest should reflect the voting interest.

Large role for voluntary codes

Fiona Reynolds, managing director of Principles for Responsible Investment (PRI), says the ISG code is a significant step forward.

“It is a voluntary code, but has some big investors behind it, which I hope means it will gain widespread support,” she says. “Anything that helps investors focus on long-term risks and opportunities is a step in the right direction. We have already seen attempts to wind back parts of [the Dodd-Frank Wall Street Reform and Consumer Protection Act] in the US. If regulation is wound back, then voluntary codes may have to play an increasing oversight role.”

The PRI undertook some research in late 2016 mapping regulation, including codes that underpin responsible long-term investing. The research shows that companies in countries with mandatory, government-led, comprehensive environmental, social and governance (ESG) reporting requirements have, on average, a 33 per cent better MSCI ESG rating than those without. The score indicates better ESG risk-management practices relative to risk exposure.

“We also tested the relationship between voluntary ESG disclosure requirements [and the MSCI ESG rating],” Reynolds says. “We found a small positive relationship (+11 per cent), but it was less significant than with mandatory regulations. So stewardship codes, while not as impactful as regulation, do make a difference. But there [must] be oversight of the stewardship codes, and reporting against them, to make them meaningful.”

Already a global trend
The US has been slow to the party. The first stewardship code was published in 2010 by the UK’s Financial Reporting Council, in response to criticism about the role of institutional investors in the lead up to, and during, the financial crisis.

The code’s 2012 revision clarified the respective stewardship responsibilities of asset managers and owners, including for activities they have chosen to outsource or undertake in collaboration with others. The UK Stewardship Code now has about 300 signatories and is implemented on a ‘comply or explain’ basis.

After the publication of the UK code, other countries established their own. The Netherlands’ Best Practices for Engaged Share-ownership was developed by Dutch corporate governance forum Eumedion; South Africa launched its Code for Responsible Investing in SA; and Switzerland unveiled its Guidelines for Institutional Investors Governing the Exercising of Participation Rights in Public Limited Companies.

One of the most significant launches of a stewardship code took place in Japan in 2014. To date, the country’s Principles for Responsible Institutional Investors is the only country code, apart from the UK’s, to have been drafted by a regulator, Japan’s Financial Services Agency.

Hot on the heels of Japan, Malaysia launched its Malaysian Code for Institutional Investors in 2014 as well. It is the second code in emerging markets, after South Africa’s. Other markets that have followed suit include Taiwan, Hong Kong and Singapore. South Korea and Brazil are looking at launching their own as well.

Six of the 14 countries that have developed stewardship codes since 2014 are in Asia, the PRI states. Codes have typically been modelled after the UK Stewardship Code; they set out principles that aim to improve engagement between investors and companies to help improve long-term, risk-adjusted returns.

 

ISG stewardship framework for institutional investors

Principle A. Institutional investors are accountable to those whose money they invest.

A.1 Asset managers are responsible to their clients, whose money they manage. Asset owners are responsible to their beneficiaries.

  1. 2 Institutional investors should ensure that they, or their managers, as the case may be, oversee client and/or beneficiary assets in a responsible manner.

Principle B. Institutional investors should demonstrate how they evaluate corporate governance factors with respect to the companies in which they invest.

B.1 Good corporate governance is essential to long-term value creation and risk mitigation by companies. Therefore, institutional investors should adopt and disclose guidelines and practices that help them oversee the corporate governance practices of their investment portfolio companies. These should include a description of their philosophy on including corporate governance factors in the investment process, as well as their proxy voting and engagement guidelines.

B.2 Institutional investors should hold portfolio companies accountable to the Corporate Governance Principles set out in this document, as well as any principles established by their own organization. They should consider dedicating resources to help evaluate and engage portfolio companies on corporate governance and other matters consistent with the long-term interests of their clients and/or beneficiaries.

B.3 On a periodic basis and as appropriate, institutional investors should disclose, publicly or to clients, the proxy voting and general engagement activities undertaken to monitor corporate governance practices of their portfolio companies.

B.4 Asset owners who delegate their corporate governance-related tasks to their asset managers should, on a periodic basis, evaluate how their managers are executing these responsibilities and whether they are doing so in line with the owners’ investment objectives.

Principle C: Institutional investors should disclose, in general terms, how they manage potential conflicts of interest that may arise in their proxy voting and engagement activities.

C.1 The proxy voting and engagement guidelines of investors should generally be designed to protect the interests of their clients and/or beneficiaries in accordance with their objectives.

C.2 Institutional investors should have clear procedures that help identify and mitigate potential conflicts of interest that could compromise their ability to put their clients’ and/or beneficiaries’ interests first.

C.3 Institutional investors who delegate their proxy voting responsibilities to asset managers should ensure that the asset managers have appropriate mechanisms to identify and mitigate potential conflicts of interest that may be inherent in their business.

Principle D. Institutional investors are responsible for proxy voting decisions and should monitor the relevant activities and policies of third parties that advise them on those decisions.

D.1 Institutional investors that delegate their proxy voting responsibilities to a third party have an affirmative obligation to evaluate the third party’s processes, policies and capabilities. The evaluation should help ensure that the third party’s processes, policies and capabilities continue to protect the institutional investors’ (and their beneficiaries’ and/or clients’) long-term interests, in accordance with their objectives.

D.2 Institutional investors that rely on third-party recommendations for proxy voting decisions should ensure that the agent has processes in place to avoid/mitigate conflicts of interest.

Principle E: Institutional investors should address and attempt to resolve differences with companies in a constructive and pragmatic manner.

E.1 Institutional investors should disclose to companies how to contact them regarding voting and engagement.

E.2 Institutional investors should engage with companies in a manner that is intended to build a foundation of trust and common understanding.

E.3 As part of their engagement process, institutional investors should clearly communicate their views and any concerns with a company’s practices on governance-related matters. Companies and investors should identify mutually held objectives and areas of disagreement, and ensure their respective views are understood.

E.4 Institutional investors should disclose, in general, what further actions they may take in the event they are dissatisfied with the outcome of their engagement efforts.

Principle F: Institutional investors should work together, where appropriate, to encourage the adoption and implementation of the Corporate Governance and Stewardship Principles.

F.1 As corporate governance norms evolve over time, institutional investors should collaborate, where appropriate, to ensure that the framework continues to represent their common views on corporate governance best practices.

F.2 Institutional investors should consider addressing common concerns related to corporate governance practices, public policy and/or shareholder rights by participating, for example, in discussions as members of industry organizations or associations.

ISG corporate governance framework for US-listed companies 

Principle 1: Boards are accountable to shareholders.

Principle 2: Shareholders should be entitled to voting rights in proportion to their economic interest.

Principle 3: Boards should be responsive to shareholders and be proactive in order to understand their perspectives.

Principle 4: Boards should have a strong, independent leadership structure.

Principle 5: Boards should adopt structures and practices that enhance their effectiveness.

Principle 6: Boards should develop management incentive structures that are aligned with the long-term strategy of the company.

 

Through the course of this year, Denmark’s Lønmodtagernes Dyrtidsfond (LD) will make new alternative investments to suit its maturing profile. In an interview from the fund’s headquarters in smart Copenhagen suburb Frederiksberg, chief financial officer Lars Wallberg explains that alternative credit is an area where he’s focused.

“We will be looking at different types of direct lending and trade finance in the illiquid, unlisted credit space,” Wallberg says. “Because it has to be an illiquidity that we can live with … we will be looking at five-year maturities.”

LD is a non-contributory pension scheme for Danish people that is based on cost-of-living allowances for workers, granted in 1980. Assets are now about €5.5 billion ($5.8 billion), but will decline by about 25 per cent over the next five years and 50 per cent over the coming 10. The fund is organised like a mutual fund, with one large, balanced unit-link investment option, LD Vælger (LD Discretionary Investments) that accounts for about 90 per cent of assets, along with a number of small, separate funds that members can choose as an alternative to the balanced fund.

LD favours a mix of passive and index investment to keep costs down, but the increased allocation to credit will be active.

“Passive doesn’t work because avoiding defaults in a downturn is key to successful investing in the credit space,” Wallberg says. “Passive investment here is simply too low a standard of risk management.”

Despite the fund’s maturity, it will still allocate 25 per cent to 30 per cent of its assets to equity. However, strategy throughout 2017 will also include continuing to scale down the legacy private-equity allocation.

“We are at the latter stages of our investment cycle and within the next five years the allocation to private equity will be close to zero,” Wallberg says.

Assets break into three groups

Investment falls into three large asset buckets. High-grade bonds, primarily comprising Danish government and mortgage-backed bonds and global inflation-linked bonds, account for about a third of the portfolio, in an allocation that returned 4 per cent in 2016.

“This was quite a good return for a secure investment class and given the low interest rates,” Wallberg says.

Another third of the fund is invested in credit, comprising assets such as senior loans, and high-yield and emerging market credit; this portion returned about 9 per cent last year. Finally, a little less than a third is invested in equity, with the small remainder in alternatives, including a mature private-equity allocation.

Although global equities did well through 2016, Danish shares, which account for a quarter of the public equity allocation, didn’t keep up. The allocation lost 2.8 per cent over the year, a turnaround from stunning gains of 37.5 per cent in 2015.

“The Danish equity market is characterised by around 20 large caps and some of these companies did badly,” Wallberg explains.

One of the worst offenders was the world’s largest insulin producer, Novo Nordisk. Last year, the pharmaceutical giant came under pressure to lower prices in its key US market, and faced greater competition from rivals.

LD outsources all of its asset management to third-party providers and keeps fees low by cultivating deliberate competition among managers.

“Keeping fees down is achieved by conducting public tenders where we ensure a lot of interest,” Wallberg says. “We don’t negotiate directly on fees with managers.”

Exposure to climate opportunities

One of LD’s best performers has been a climate and investment fund that sits in the main balanced fund. The allocation began in 2011, with an initial €100 million investment. It is the fund’s strategy for gaining exposure to climate opportunities that it has struggled to access because of its short-term horizon.

“We can’t invest in long-term climate infrastructure like wind or solar energy because these investments may have a 20- to 30-year horizon,” Wallberg says.

Instead, the fund has built an exposure to quoted companies that are developing climate change products and services.

LD’s equity and property investments have gradually reduced by about €3 billion ($2.3 billion) since 2004, due to the fund’s need for liquidity. Yet Wallberg still endeavours to maintain a long-term view in the portfolio, something particularly important to mute today’s noisy politics.

“I try not to be distracted by short-term events,” he says. “You can’t ignore what is out there, but you can’t be too focused on it either. Otherwise, you’d spend all your time discussing politics, rather than investing.”

Asset owners plan to put more pressure on fund managers’ fees in 2017, as they look to control costs in a low-return environment. As a consequence, managers need more innovative thinking around fee structures, according to the results of the third annual conexust1f.flywheelstaging.com/Casey Quirk Global CIO Sentiment Survey.

In an environment where chief investment officers cannot rely on markets to generate high returns, and also can’t control contribution levels, they are looking to what they can manipulate – costs.

In addition to fighting for a reduction in asset manager fees, asset owners also plan to insource more investments in 2017.

The survey showed, in particular, that efforts to reduce costs have put investment fees under pressure and have caused institutions to look for greater innovation in fee structures to align interests.

The chief investment officers of asset owners from 11 countries with combined assets under management of more than $2.2 trillion responded to the detailed survey, revealing their outlook for fees and risk management.

Investors cited low projected returns, along with increasing stakeholder pressure, as reasons for greater focus on costs. Poor manager performance was not a prominent reason for putting pressure on fees.

The clearly preferred means of lowering investment costs was through harder negotiation with external managers, with 77 per cent of respondents revealing this as their favoured option for reducing expenses.

Half of the respondents revealed they already get a discount from external managers, and 15 per cent said they receive a discount of more than 20 basis points. Some respondents said they received as much as a 25 per cent concession on fees. Even so, continued pressure on traditional asset-management fees was clear.

About half of respondents said they would allocate more to passive or smart beta strategies as a way of reducing costs, and 40 per cent said they would in-source more investment management. However, just 17 per cent said they would move out of high-fee asset classes, such as private equity, in an attempt to save.

Fees under heavy scrutiny

When funds did pay premium fees, the most common reasons they gave were limited product capacity and a lack of high-quality substitute managers, followed by strong service and value-add from managers. Tyler Cloherty, senior manager at Casey Quirk, said the top hedge funds and private-equity funds were not under pressure on fees and even had the potential to extend them.

“Investors have diverging appetites, they don’t want to pay more but they need to increase risk to meet hurdle rates. They are negotiating fees on traditional managers and assets and are spending on alternatives,” Cloherty explained.

Tony Skriba, senior consultant at the Casey Quirk Knowledge Centre, said in addition to reducing fees, asset owners are focused on alignment of interests.

“Investors are looking at performance fee preferences as a preferred model, and asset owners think managers don’t have enough skin in the game,” he said.

The survey revealed that performance fees were a focus for investors, particularly the large investors; 60 per cent of investors with more than $75 billion in assets preferred a performance-based structure with minimum management fees. Investors want innovation in fee structures, with a focus on retaining more of the gross value added.

“We are having more conversations in the market about how to think more innovatively about fee structures,” Cloherty said. “For managers, this is about revenue volatility. When we see people moving into performance fee structures, and reducing management fees, it’s usually about retaining clients. But some managers are looking at how to do that on a more systemic basis. This [requires] operational build out, so it will probably go to larger clients and mandates first.”

He said the most likely structure for institutional mandates will be a lower fixed fee with a performance fee on top, while mutual funds may consider implementing fulcrum fees.Casey Quirk said an ideal fee structure would probably be one where “managers get a hit on the downside” as well as benefiting from any upside.

Skriba said: “Managers need to alter incentives to show they’ll bear some of the risk as well as the upside.”

Managing risk – and expectations

In addition to wanting to reduce costs, large funds in the survey are overwhelmingly looking to lower their return expectations, with 80 per cent of funds having already reduced their return targets or planning to do so in the next year.

The return targets of the respondents varied from 2 per cent to 8.5 per cent, and 31.5 per cent of respondents revealed they were not confident of meeting this target in 2017. A further 42.6 per cent were uncertain of reaching this return target.

The conexust1f.flywheelstaging.com/Casey Quirk Global CIO Sentiment Survey also looked at risk-management techniques and found a heavy reliance on internal systems at most institutions.

While about 40 per cent of respondents did use one or more of BarraOne, MSCI, FactSet or tools provided by external managers or consultants, about 46 per cent used internally developed tools for risk management instead.

The funds are using a variety of risk-assessment techniques, including attribution against a benchmark, and a combination of conditional value at risk, standard deviation, volatility assessment, drawdown risk, sector exposures and tracking error.

Falling equity markets were cited as the biggest risk to investors’ portfolios in 2017, followed by geopolitical risks and rising interest rates.

Casey Quirk is a management consulting business specialising in investment management. It was bought by Deloitte last year.

 

It’s difficult sticking to long-term investment strategies when the political landscape is in a state of flux. Yet now, more than ever, investors need to stay focused on the long term and ignore short-term distractions. The latest report from data provider MSCI, 2017 ESG Trends to Watch, urges investors to act with vigilance and assert their influence as “owners rather than traders of an asset” in the year ahead.

“The year ahead has the potential to test institutions and portfolio companies that espouse a long-term orientation,” say report authors Linda-Eling Lee, global head of environmental, social and governance research at MSCI, and Matt Moscardi, head of financial sector research.

“The temptation to time the market in response to, or in anticipation of, real or rumoured events could prove too powerful a distraction for many. But for investors committed to the long term, 2017 may be the year to differentiate themselves from the pack and orient towards future decades.”

Owning the long game will combine with other key trends throughout 2017. More investors will mitigate their exposure to the physical risks of climate change, and push for improved stewardship from Asian companies. There will also be a jump in the adoption of the UN Sustainable Development Goals as a framework for investment, while China and India will continue to transition to low-carbon economies.

Short-termism and anticipated deregulation

The prospect of a new wave of deregulation is one area that could tempt short-termism from companies and investors. But policy is forged by forces that unfold over more than one election cycle.

Companies seemingly poised to benefit from softer regulation will, in fact, limit their sustainable growth trajectories because they will be hit by competitive disadvantage and the consequences of more lax governance in the long term. Lee and Moscardi ask: Will penalties be eliminated if regulation is relaxed? What will the long-term costs be when regulation is reinstated?

A mooted beneficiary of deregulation is US coal, a worry for those who have divested their US coal assets. Yet coal suffered because it couldn’t compete with cheaper gas, which many US utilities now use.

“What will the new (US) administration do to bring back coal? Will it stop fracking?” Lee asks. She concludes, “It will be difficult for coal to be resurgent.”

Investors also have the option to reduce, rather than divest, their coal assets; many have chosen to reweight their holdings to have exposure to the whole energy sector.

“The reweighting approach doesn’t require a take on timing.”

 

Physical risks will take prominence

Despite such concerns, Lee and Moscardi predict the risk focus will shift away from regulation in 2017.

“The regulatory focus obscures the more fundamental risk: weather patterns can impact assets in a physical way,” they state.

This year, investors should increasingly look at the impact of the physical risk of climate change on asset values. The experience of the US insurance market explains why. Many US homeowners have moved to government-subsidised insurance because private insurers will no longer bear the risks of an increase in the intensity of storms, or the rise of sea levels, on their own.

“Sea levels are rising. That is a fact,” Lee says. “Investors need to address these changes, regardless of who is at the helm in the US.”

Physical risk is definitely on the mind of France’s €36.3 billion ($41 billion) Fonds de Réserve pour les Retraites. The fund, which was created in 2001 to build reserves for the country’s public pension system, kicked off 2017 by identifying the risks arising from climate change in its portfolio, including physical dangers.

Elsewhere, Canada’s C$18 billion ($14.1 billion) OPTrust, which manages pension assets for former and current public-service employees in the state of Ontario, has just release detailed analysis of the potential risks to its investment portfolio from global warming. The analysis, prepared by consulting firm Mercer, predicts the fund’s investment returns could improve with modest warming, but will decrease if there is a major impact on global temperatures this century.

OPTrust states: “The physical impacts of climate change, such as extreme weather events and sea level rises, are expected to be relatively limited over the period to 2050. Nevertheless, the post-2050 implications should not be ignored.”

More stewardship in Asian capital markets

Expect increased stewardship in Asian markets through 2017, the MSCI authors state.

In an argument that contradicts conventional wisdom that sustainable investment in Asia lags behind that in Europe, six of the 14 countries that have developed stewardship codes since 2014 are in Asia. The codes, modelled after the UK Stewardship Code, set out principles that aim to improve engagement between investors and companies to increase long-term, risk-adjusted returns.

Progress in Japan has come from investment managers taking a more active role on ESG.

In a survey conducted by Japan’s giant Government Pension Investment Fund (GPIF), 60 per cent of its investee companies reported changes in their interactions with GPIF’s external managers. Elsewhere, Taiwan’s $46.7 billion Bureau of Labor Funds has committed $2.4 billion to socially responsible investments. However, the authors do flag Japan’s ageing working population, which is forecast to shrink 12 per cent in the next 10 years, as a worrying long-term risk for economic growth.

ESG grows up

This year will also mark a shift in the conversation – from how ESG matters to where it matters. Examples of the increasing sophistication of ESG strategies include research from Cambridge Associates showing that they make a stronger contribution to the performance of companies in emerging markets than to those in developed markets.

Barclays research showed strong management qualities are also likely to result in greater fiscal responsibility and fewer corporate credit downgrades.

Research also suggests that ESG and factor exposures have a relationship that can either enhance or interfere with investment goals. ESG can complement some defensive strategies that focus on lower volatility or higher quality companies. Conversely, adding ESG characteristics to a momentum strategy made for a “more difficult marriage”.

Blending factor exposures and ESG is one strategy recently adopted by HSBC Bank Pension Scheme, the fund for the HSBC Group’s UK employees. Its new multi-factor global equities index fund incorporates a climate tilt with the four factors: value, low volatility, quality and size. The fund’s bias is towards smaller, not larger companies. The climate element to the index tips away from exposure to carbon emissions and positively towards green revenue.

Sustainable development goals on the rise

Expect more investors to use the UN’s sustainable development goals as a framework for responsible investment throughout 2017. Relating to challenges around climate, poverty, healthcare and education, the SDGs require an estimated annual $5 trillion to $7 trillion by 2030.

“We will all hear a lot more about SDGs, even though they were not designed with the private sector in mind,” Lee says.

A coalition of European investors has already made an explicit commitment to use the SDGs as the reference framework for an increasing number of investments. Dutch fund PGGM, which manages pension assets worth €205.8 billion, has already invested €10 billion in line with four SDG themes – climate, food security, water scarcity and health – and is targeting €20 billion by 2020.

Transitions in China and India

China and India will continue to transition to low-carbon economies. China is laying the foundations for a green financial system with initiatives including subsidies for loans that finance renewable energy, guidelines from the People’s Bank of China that govern issuance of green bonds, tradeable environmental indices, and a national carbon trading scheme.

“If China is to attract global capital, it needs to meet global standards,” Lee says. In 2017, global investors will be able to take “a serious look” at allocating investment, she predicts.

India is aiming to lower the emissions intensity of its gross domestic product by up to 35 per cent, compared with 2005 levels, by 2030. It also wants to quadruple renewable energy capacity in the next five years. Renewable energy has been deemed a priority lending sector for banks, and the Securities and Exchange Board of India has issued voluntary green bond guidelines.

It’s too early to declare that these economies will take on the mantle of global leadership in the transition to a low-carbon economy. But their transitions make up just one of the exciting trends of 2017.