Publica, one of Switzerland’s largest institutional investors, is reallocating assets away from government bonds into real assets as it dynamically adjusts asset allocation due to ongoing macro-economic instability.

Publica, one of Switzerland’s largest institutional investors, will sell its remaining 2 per cent stake in petroleum over the next few years because it no longer expects the systematic positive risk premia from the allocation.

“The three main reasons why we invested in petroleum were a) positive risk premia, b) it is partly inflation linked and c) the geopolitical hedge,” lists Stefan Beiner, head of asset management and deputy chief executive at the Bern-based fund. “Due to changes in the market structure, the systematic long-term positive risk premia for petroleum is no longer there.”

Beiner adds that he is currently assessing the best exit strategy given low oil spot prices, with a staggered sale as and when the oil price rises being a likely option.

The petroleum allocation will be invested in an increased allocation to inflation-linked government bonds. Together with an existing allocation to precious metals, Beiner hopes this will achieve what the energy allocation no longer does.

The latest shift at the CHF38 billion ($38.3 billion) fund which manages an open portfolio comprising 13 pension funds, and a much smaller and separate closed portfolio for seven funds with no active members, is a consequence of what has become a regular asset liability management process: something Beiner views as essential in today’s challenging markets.

“The macroeconomic situation and the actions taken by the larger central banks has given rise to a need to dynamically steer our asset allocation,” he says.

An ongoing investment theme to emerge from the process has been a move out of government bonds into real assets because of both the enduring low-interest rate environment and darkening economic skies.

“The probability of another market downturn in the next three years is high in my opinion,” says Beiner, who believes that many of the problems blighting the Eurozone remain unsolved. Central banks have bought time for political reform, but not enough has been done, except possibly in Spain, he says.

Publica recently reduced exposure to government bonds by 4 per cent.

It reallocated to private debt, comprising infrastructure debt, where Publica co-invests with Metlife and appointed Hastings as a manager; and private placements, where the pension fund co-invests with Prudential and Metlife.

“Private debt matches our need for duration but we also get a pick-up. It brings an exposure to an additional universe of private companies we can’t access through the public debt and equity markets.”

Another 4 per cent will be taken from fixed income and invested in real estate outside Switzerland, with a further 3 per cent of the bond exposure re-portioned to emerging market government bonds in hard currency.

“Compared to other asset classes I believe emerging markets are less richly priced,” says Beiner.

The fund is currently equally split between internal and external management.

“We try to find the best manager, and only if we think we can do it better than them do we do it in house.” Beiner hasn’t decided if the new emerging market dollar denominated bond allocation will be fully externally, or partly internally managed.

“The internal advantage is cost savings and we have some of the required systems and knowledge already in place. Internal management brings you closer to the market and you can ask more specific questions. The advantage of using an external manager would be not carrying operational risk.”

Publica is also adjusting its equity portfolio.

The fund first implemented equity factor tilts three years ago and works hard to find the most efficient way to get exposure through tilts towards value, minimum volatility and market caps.

“We are now reviewing and enhancing our tilt strategy to diversify and extract greater risk premia,” says Beiner. “This year we will discuss whether to add additional tilts to small cap, quality and momentum – small caps will get most attention.”

Switzerland’s regulatory system, that only sanctions long-only strategies, stopping funds ability to leverage or go short on a look-through basis, has played to Publica’s tilt strategy.

 

 

For a table showing Publica’s strategic asset allocation 2016 click here

 

Strategic asset allocation 2016
Asset class Closed pension plan (weighting in %) Open pension plan (weighting in %)
Fixed income 67 58
Equities 10 29
Commodities 3 2
Real estate 20 11
Total 100 100

 

Two UK local government pension schemes will merge, with a strategy of boosting internal management to 80–90 per cent of assets as well as paring back equity allocations. Funds vying to join the pool will have to “get on the same page”.

On April 1 2016, two of the UK’s local government pension schemes will become the first to pool their assets into a single investment vehicle in a trailblazing merger.

Strategy at the combined £10.5 billion ($15.2 billion) pension fund will centre around the need to manage volatility and risk, and around developing in-house expertise, says Mike Jensen, chief investment officer of north-west England’s Lancashire County Pension Fund (LCPF), which is merging with the London Pensions Fund Authority (LPFA).

April will bring to conclusion a two-year process during which both funds have shaped new fund architecture comprising a single, regulated investment company.

“Most of the assets from both funds will transition to the new pool from day one, although the allocations that are more difficult to pool, like direct property, infrastructure and some credit portfolios, may stay in separate funds for now. Over time, the allocations will then be streamlined and mandates that overlap may be amalgamated,” says Jensen, adding that he is currently in discussions with other local authority pension funds about joining the pool, either as partners or fiduciary clients.

The existing asset allocation at the two funds will carry into the new pool until the results of triennial valuations which are due later in the year. After this, Jensen anticipates slow repositioning under one strategic umbrella, with strategy remaining focused on reducing the equity risk in favour of real assets over the medium term.

“There won’t be any big changes in allocation or looking at the funky stuff. We just need to pay those pensions.”

LCPF’s assets are currently split between a 45 per cent equity allocation, a 25 per cent credit allocation divided into four separate buckets of senior secured debt, emerging market local currency debt, special situations and opportunities, and long-dated secured debt, with the remainder split between real estate and infrastructure.

A key aim at the new fund will be boosting internal management. Jensen wants to run between 80–90 per cent of total assets in-house in a process already well underway at LCPF, which has its own credit, property and private equity team recruited from the private sector.

It’s a strategy based on cost saving, but Jensen is also convinced that an internal team brings direct access to a quality of advice many of the UK’s local authority schemes still lack. Any of the new funds vying to join the LCPF-LPFA pool will have to “get on the same page” regarding in-house management as well as the need to reduce their equity allocations.

Jensen believes that few pension funds have accepted the new reality of lower returns, with many expecting that another uptick in equity markets and bond yields is just around the corner.

“A lot of funds think this period is a blip and a specific response to the financial crisis because they have been sold that story by their investment advisors and the market as a whole.”

He says an over-reliance on the equity markets has introduced large-scale risks when their underlying responsibility “should be to pay pension liabilities rather than shoot for high capital returns”.

When Jensen joined LCPF in 2009, progressing from a career as a fixed income and currency trader, 73 per cent of assets were invested in equity.

The new fund will continue to pare down its equity allocation in favour of “real assets”, of which infrastructure, for its income and inflation-proofing characteristics, will grow in importance.

“We will be able to make a much bigger play in direct infrastructure. So far we have been limited by the size of our team and assets under management,” says Jensen.

Jensen is well positioned for the push, with a series of infrastructure investments under LCPF’s belt, most recently its minority equity stake in EDF Energies Nouvelles’ Portuguese wind assets, plus two other direct infrastructure deals in the pipeline.

The fund has also learnt from losing out when infrastructure mandates went to other pension funds. AustralianSuper won the stake in London’s King’s Cross development, and Canadian pension fund manager Caisse de dépôt et placement du Québec and Hermes Infrastructure bought the government’s 40 per cent shareholding in Eurostar for £585.1 million ($851 million) last year, when both Universities Superannuation Scheme and LCPF lost out.

“We will look at larger-scale individual projects and to partner with other large-scale investors. Rather than bid against other investors, we want to establish relationships,” he says.

However, Jensen warns infrastructure doesn’t always mean inflation-proof returns.

He believes that there is often “assumed inflation protection in infrastructure and property” that is “not always the case” since property rents and utility infrastructure, particularly, can carry unexpected inflationary risk.

Hedging against inflation is also challenging, as the UK government only issues inflation-linked bonds that are based on retail price inflation, yet UK local government schemes are required by law to link benefits to CPI. “It is currently difficult to manage basis risk,” he says.

The 10-year anniversary of Principles for Responsible Investment (PRI) coincides with the recent adoption of two major agreements by the global community, represented by the United Nations – the UN Resolution Transforming our world: the 2030 Agenda for Sustainable Development and the Paris Agreement on climate change. Looking back and looking forward, what is the relevance of PRI for achieving a more sustainable economy, and what is the relevance of these agreements for PRI? Kris Douma is director of investment practice and reporting at PRI

In late 2015 the United Nations adopted a resolution “Transforming our world: the 2030 Agenda for Sustainable Development”. The resolution commits UN member states, organisations and affiliated organisations to pursue 17 sustainable development goals. Parties to the UN recognise the need for partnerships. The recent “Paris Agreement” to combat climate change also mentions the importance of partnerships and the private sector.

Because of its affiliation to the UN, the PRI is almost directly addressed. As the leading global initiative to promote sustainable investment, the PRI is one of the UN’s main partners in achieving the sustainable development goals.

The preamble to the six principles for responsible investment states, “We also recognise that applying these Principles may better align investors with broader objectives of society”. This clearly indicates that the principles were developed with the expectation that responsible investment contributes to the “broader objectives of society”, recently redefined as sustainable development goals. Therefore, it should be asked what this means for the current process of evaluation of the principles and the PRI agenda for the next 10 years.

The conviction that the principles will contribute to these broader objectives is based on a number of assumptions. The assumption behind Principle 1, ESG integration in investment policy and decisions, is that it will ultimately affect the cost of capital, lowering the costs of capital for sustainable businesses and increasing the costs for non-sustainable businesses.

The lower costs of capital for sustainable businesses will lead to a competitive advantage. In the long run, sustainable businesses will therefore “crowd out” non-sustainable businesses. It seems logical to ask whether this is indeed the case. Longitudinal research by Robert Eccles, and metastudies by Deutsche Asset Management and others show that good corporate social responsibility performance by companies leads to lower costs of capital, but research is inconclusive as to whether responsible investment is one of the drivers of this phenomenon.

The assumption behind Principle 2, ESG integration in active ownership, is to improve the risk–return profile of the businesses in which institutions invest, through a process of engagement to highlight the materiality of ESG issues and convince businesses to adopt more sustainable products, services and processes.

Research about the effects of integration of ESG issues in shareholder engagement shows a positive but limited effect, partly diluted because an investor may voice different messages to investee companies through their ESG experts on the one hand and their mainstream portfolio managers on the other hand, thereby creating a lack of alignment between the execution of ownership and investment decisions. So there is definitely room for improvement.

The principles dovetail with fiduciary duty, which recognises that ESG issues can be material and should therefore be considered by investors if they are to fulfil their obligation towards their ultimate beneficiaries.

Though fiduciary duty has been used as a reason not to look at ESG factors, a recent PRI study and the US Department of Labor decision last year brought clarity to this issue. Not taking material ESG issues into account may even be a breach of fiduciary duty.

However, the underlying assumption still is that the ultimate beneficiaries define their interests as purely financial.

With growing concerns among global citizens about the negative externalities of financial markets, is it still correct to assume that the interests of beneficiaries are purely financial? Although research is scarce, there have been surveys showing that beneficiaries have a wider definition of their interests that includes sustainability, ethical considerations and future wellbeing.

There is one other assumption that has largely remained implicit. While other codes, like the UN Global Compact, OECD guidelines and IFC standards provide desired outcomes (no child labour, lower greenhouse gas emissions, waste reduction, freedom of association, etc.), the assumption of the PRI is that, for financial institutions to contribute to “broader objectives”, it is sufficient to agree on the principles and implement procedures and processes.

At PRI, while we would like to say that all of our nearly 1500 signatories are vigorously incorporating the six principles, we know this is not the case and that much more work is needed. But some signatories have, for example, already taken on a strategy of explicitly decreasing their carbon or even wider environmental footprint and structuring their portfolios to create a positive ESG impact.

With companies globally moving towards more sustainable business practices those investors are likely to be cutting edge and potentially stay ahead of the curve, which also makes perfect sense form a risk–return perspective.

After ten years of vibrant activity under the umbrella of the PRI, we should ask if the assumptions behind the principles still hold in today’s fast-changing world.

And if not (sufficiently), how can the PRI be adapted to the sustainability challenges put forward by the sustainable development goals? Addressing these questions is not an easy exercise and requires input from signatories, academics and stakeholders. Does this exercise lead to a change of the principles? It is too early to provide answers. But we are prepared to ask ourselves these challenging questions.

 

Kris Douma is director of investment practice and reporting at PRI

To better manage downside risk, the second-largest UK local government pension scheme has a plan to gradually alter its equity allocation.

Through the course of this year the UK’s £15 billion ($21 billion) Strathclyde Pension Fund will cut its equity allocation in line with its growing maturity and changing risk appetite.

New allocations will go towards diversifying assets in long and short-term enhanced yield to better manage downside risk.

Strathclyde is the UK’s second largest local government pension scheme and provides pensions for more than 200 Scottish employers, from local authorities and service providers to universities and charities.

In what Richard McIndoe, head of pensions at Strathclyde, calls a “step change in our maturity to do with public sector austerity” and “a big change in cash flow”, Strathclyde will gradually reposition. It is a theme common to many other local authority schemes, which are similarly having to balance the jump in people drawing pensions with a drop in contributions.

“We have a gradual plan to reduce our equity allocation and diversify across new asset categories. The pace won’t be dramatic. More a repositioning over time,” says McIndoe, speaking from Strathclyde’s Glasgow offices. He has been with Strathclyde since 1996, becoming head of pensions in 2003.

This year Strathclyde will shave 10 per cent off its current 72.5 per cent strategic benchmark equity allocation in favour of enhanced yield strategies, extending the equity paring to 20 per cent within three years and more going forward.

Within the context of a reduced equity exposure, Strathclyde will actually increase its allocation to global and emerging market RAFI indices from the current 7.5 per cent to 13.5 per cent of its total equity allocation.

The RAFI rationale, which weights companies according to their economic footprint based on fundamentals rather than market capitalisation, has grown in favour at the fund, explains McIndoe.

“The intention was always to increase our allocation to RAFI over time.” Strathclyde is also repositioning to be more equally weighted across US, European and Asian equity markets and maintain, but reduce, the UK bias.

“Historically we had a higher bias to the UK market, but this doesn’t hold good anymore,” he said.

As part of this strategy, Strathclyde will limit the weight of any one stock to a maximum of 5 per cent of the FTSE All Share index with the aim of reducing stock-specific risk.

Recent turmoil in FTSE heavyweights RBS and BP showed the danger of individual stocks affecting the index as a whole, said McIndoe.

Funds from the equity reduction will be re-portioned to a shortlisted multi-asset credit mandate with a value of around $430 million, and private debt investment opportunities focused on mid- to large-cap corporate lending, also with a value of around $430 million.

Going forward, Strathclyde will also grow its direct investment portfolio, begun in 2009 and a source of pride for McIndoe because of its impact, or “secondary return” characteristics, such as the new housing that has risen in view from his Glasgow desk.

Born from opportunities created by the financial crisis when pension funds stepped into the loan market vacated by banks, the portfolio includes local investments that will impact Strathclyde, like direct company loans, green infrastructure, social housing and university research, as well as global opportunities. So far the allocation is capped at 5 per cent of the fund, but when this ceiling is reached McIndoe expects it will be increased.

It is via the direct investment portfolio particularly that Strathclyde has applied ESG criteria in a more proactive, bottom-up strategy.

ESG is well established across the fund. Examples include the private equity portfolio, run on a “fund of funds” basis, managed between two Principles for Responsible Investment (PRI) signatory institutions, Pantheon and Partners Group; its UK direct property manager, DTZ Investors, is a PRI signatory and the property portfolio subscribes to the GRESB (global real estate sustainability benchmark).

Now McIndoe is planning for more “engagement, directness and means” to apply ESG which he says has historically been handed to external managers in a “hands-off” approach. Strathclyde will apply “more pressure and ask more questions itself”, particularly around the living wage and child labour. The fund has also employed engagement agent Global Engagement Services. “As a result engagement on responsible investment is now better informed, better focused and more productive,” he says.

McIndoe is characteristically sanguine and unflappable ahead of the challenge of downside risk and today’s difficult market conditions.

“Nervous markets can be uncomfortable short term and put you on your back foot. But being on the back foot creates opportunities and can be more profitable. We will live with what comes.”

The mechanism for sharing risks via fees in the pension industry is weak, says Fiona Trafford-Walker. Asset-based fees don’t reflect managers’ ability, and clients don’t get enough of the benefit of scale. So how should managers be paid?

Those who know me well call me Fee, and so I do get a few wisecracks every now and again about “flat dollar fees” and so on. So when Amanda approached me to write this piece on fees, my first thought was “Can I please write about something else?” I have been talking about fees for a long time!

I first actively hopped on the fee soap box in 2009 after I became incensed following a phone call from a fund manager telling me they were laying off 20 per cent of their staff (post GFC) but that I didn’t need to worry, as those staff hadn’t had anything to do with the investment process, so their departure wasn’t going to hurt client performance.

My first thought was, “Why are clients paying for them in the first place then?”

So I wrote a client paper in September 2009 called Managing Investment Management Costs and Aligning Interests in which I stated:

“The purpose of this note is to provide some thoughts on current fee structures used to reward investment managers and align them with the interests of clients and to propose some alternative fee structures that we think would better align the interests of a client with those of the investment managers used. Importantly, we strongly believe that clients should be focused on net risk-adjusted returns to members … Readers might think that this is simply a missive aimed at reducing fees. It is not – it is about paying the right amount for performance. In some cases, this may mean higher fees to some firms if they perform well for clients. In others, it is an appropriate mechanism for pushing out the weaker performers and strengthening the investment manager universe over time.”

I still think that today – in a pension/superannuation fund world, the funds (and the members and sponsors) are the ones that provide the capital and take the risk in allocating to external fund managers.

They deserve to be rewarded for taking that risk with better returns, and high-performing fund managers deserve to get paid fairly for adding value.

But the mechanism for sharing in general is weak – asset-based fees have little linkage with the manager’s ability, clients don’t generally get enough benefit of scale and there is not usually a penalty for under-performance other than termination of the relationship.

This is the case in Australia and in many other countries. Unfortunately, ad valorem fees remain the norm, and performance fees have also not been well-enough aligned as a general rule (the base fee is not low enough, and in many cases the “sharing” of alpha is not really what sharing is all about).

At the same time one of my industry colleagues in Australia, Ken Marshman at JANA, had come to a similar conclusion so we worked together to develop the Frontier/JANA fee principles, which were launched in 2010. (Ken is now the chair of the industry superannuation fund, REST which has A$37 billion in funds under management and two million members.)

The aim of these principles was to assist institutional investors in negotiating investment management fees.

We didn’t intend for these to be prescriptive and emphasised that negotiation should always remain the means by which buyers and sellers of services should come to agreement.

Many Frontier and JANA clients formally or informally adopted these principles or some variation thereof.

I know many other funds also started to think more about fees and fee structures, and modest progress was made. But not enough.

So here I write, six years later, pretty much saying the same thing despite the aforementioned modest progress.

And yet the future looks different, with the following important differences that will affect the years ahead for global investors generally and Australian investors specifically.

1. There is a reasonable prospect that medium-term returns will be much lower than we have seen since the Great Moderation began in the mid-1980s. The investment objectives set by pension funds will be harder to achieve, and so all are looking at how to continue to meet those targets with various investment ideas, but also by looking long and hard at what it costs to manage their portfolios. For funds that outsource money management, investment manager fees are the largest components of that cost by a long way. This has now become a business issue for many funds, so it’s on the agenda for boards, chief executives, chief investment officers and internal investment teams. This elevation to the board is one of the main differences between now and six years ago.

  1. 2. As the Australian superannuation industry has grown, there has not been enough capture of that scale through reduced costs. We also know that fund manager margins remain very, very high (and if anything, many have expanded since the GFC), especially when compared to any “normal” industry. This desire to capture the benefit of scale is now a significant focus at many funds.

3. There is also now an implied regulatory imperative to bring down fees charged by superannuation funds here in Australia. Signals from the Australian Securities and Investments Commission (a key regulator) and more formal statements from both sides of government, as well as a decision to immediately implement a Productivity Commission review of the “efficiency and competitiveness” of the superannuation system that had been proposed for 2020, are all part of this focus.

  1. 4. Finally, there has been much in the press in Australia from various research bodies comparing the costs of Australian superannuation funds to global funds and arguing they are too high. I don’t think they necessarily compare like with like, but the popular press has run with this nevertheless and it’s a hot topic.

So these things are all in the ether and are impacting discussions around board tables here in Australia and no doubt in other markets around the world.

We have already seen many changes – funds are continuing to explore all sorts of options to reduce fees and costs, such as internalisation, disintermediation, renegotiation, co-investments, better capturing of scale benefits and so on.

Some are walking away from managers and products with inappropriate fees and/or terms, others are canning entire sectors with poor-value-for-money prospects and many are deciding on manager shortlists after looking closely at the value for money.

This will no doubt continue apace.

In our own business, we have changed the way in which we report fees and costs to clients in our manager due diligence documents. We now rate managers formally on five key criteria related to fees, prospective alpha and risk-adjusted alpha, the sharing of that alpha, and value for money.

A manager needs to pass at least one of these tests to be rated. No doubt other consultants have taken similar actions.

Good managers have little to fear – I think most clients will still take a value for money perspective and pay for skill in order to meet the investment objectives set for members and sponsors.

But funds will be much more discerning about the firms they choose to work with, about what they pay and, importantly, how they structure the fee.

As I said in 2009, this is a good opportunity for the funds management community to develop innovative fee structures that work for clients and for the managers themselves; however, the window to do this is no longer as wide open as it was.

Funds have already taken charge and are making changes.

 

 

Fiona Trafford-Walker is the director of consulting at Frontier Advisors, Australia’s largest independently-owned asset consulting firm. She is frequently rated as one of the best consultants globally.

 

Analysis of the Willis Towers Watson Global Pension Assets Study 2016 shows a troubled industry responding as best it can to situations it feels are out of its control. But, as Roger Urwin outlines, focusing on greater clarity of goals – and being tough on risk and strong on governance – will serve pension funds well in 2016.

Global pension assets from the 19 most significant pensions markets weighed in at around $35.4 trillion at year end 2015 in the Willis Towers Watson Global Assets Study 2016, equivalent to 80 per cent of their GDP.

They account for around 35 per cent of the institutional assets available to investors in the world capital markets portfolio.

The asset values crabbed sideways in 2015, being up during the year and down a little by the end of the year. But this was a year of a lot of action – you should see it as the “year of the swan” – not much looked different above the surface, but below the surface lots was happening. And this change has been evident in January too.

The study highlighted six “faces of change” with regard to pension funds:

  • the move in pension design towards defined contribution
  • -the pressure for investment talent
  • -the increasingly internal focus to their value chain
  • -governance improvements
  • -increased risk management emphasis
  • -the consideration of sustainability.

The summary here is of pension funds worldwide being a troubled industry that is responding as best it can to situations it feels are outside its control. The fault line is that in most cases the pension funding positions are less than adequate for future security.

Of course funds have managed to meet their obligations so far through obtaining premium returns from riskier assets. But risk has to be managed well and the world economy has to perform better for everything to add up. January has been a further wake-up call that this is a big ask.

The U50 and the six “faces of change”

These issues are increasingly visible and influential, and particularly worth studying with reference to the largest pension funds, such as the “universal investors”, who earn the title by being invested long term in a slice of just about everything investable. When supplemented by a few of the largest sovereign wealth funds, the largest pension funds form the core of a group of 50 universal owners, or “U50”, comprising funds that are around or above the $100 billion in assets. This group has more than $12 trillion of global capital allocation power and so is roughly a third of the size of global pension assets.

The U50 is an interesting focal point through which all but the first of the six “faces of change” can be illustrated. This group is containing costs with more selective use of external firms; that trend is matched by the growth in calibre of their investment teams; their focus on improved risk management specifically and governance more generally has also been clearly expressed.

The U50 are recognising the value of good governance, and some have shown a preparedness to change their ways of operating through targeting organisational design, investment beliefs and risk management. Sustainability is a particularly interesting new area for these institutions. They have to seek to be sustainable as long-term institutions with intergenerational responsibilities codified in their fiduciary duty.

The generalised mission statement for these entities is meeting their commitments securely, affordably and sustainably. This makes them keen to make sure that their present strategies do not impair their future outcomes. These funds need to compound their wealth over the long term in a pathway, and not be compromised in any up-front bonfire of scarce resources.

New measures and priorities

A new data point for the study this year explores the carbon footprint of the aggregate pension assets. The pension investment in public equity carried direct ownership exposures to carbon flows (referred to as scope one and scope two emissions) of around three billion tonnes, with the U50 accounting for around a third of this figure. Before any attempt to put context against those measures we should consider this recent availability of the measures themselves.

For carbon, the combination of bottom-up corporate disclosures with top-down asset allocation produces the overall estimate.

Improved “integrated reporting” has generated wider measures from corporations through the imposition of new accounting standards.

Loosely, this is a small part in the inexorable rise of big data. This nascent measurement trend involves assessing something that is low precision but high significance. ESG factors rarely yield precise data, but they are assessable and they are clearly impactful.

The sustainability challenge

ESG as a factor in investing has for a time been a very slow moving, but unstoppable, train. While it has been easy to ignore it in the present, it is hard to discount its future. And 2015 was a year in which a number of the U50 funds resolved not to let sustainability and ESG languish at the bottom of their priority list. Their attention focused on getting the mission, beliefs and strategy in sync with the sustainability challenge.

What exactly is the sustainability problem that ESG is involved with? The centrepiece is externalities. The corporate machine is adept at producing many well-priced widgets but it does so while inflicting some unwelcome spillovers on unwitting parties.

There are two stand-out examples: the use of fossil fuels generates climate change; the governance and human-capital chain of corporations inflicts certain inequities on stakeholders.

A corporation that has a limited carbon footprint and operates with top-quality governance might attract more than plaudits, it might carry a performance or risk advantage over its peers that don’t have these attributes. Of course this all depends on investment beliefs but it is certainly a plausible thesis. In the U50 we see a few funds reaching this conclusion and tilting their capital allocations in this direction.

There are obvious ties with the attention that climate change, carbon and stranded assets are receiving from outside the investment world, which culminated in 2015 with COP21 in Paris. Getting to an agreement of 195 nation states is unique in the history of the planet but the agreement document is dominated by governance, and the lack of binding targets is telling.

Nation states are confronting the global problem of climate change through a local solution – their national policy. That is the way that nation states operate. But as the issue flows from global to local, much of the effectiveness in the solutions gets lost. This is elementary game theory and a version of the “tragedy of the commons”. The nationally determined contributions to carbon reductions are intrinsically local decisions. The policies of the G195 will play their part in carbon reduction but they cannot do the work alone.

Large funds can influence the future

Switch now from nation states in G195 to the asset owners in U50.

Here we have a local problem – a sustainable investment portfolio for one fund – that can be addressed through a global solution. Here the issue flows from local to global because the allocation is to all global assets which is where the risk control is applied. So this can be effective at the single-fund level, although it would be amplified through some collective commitment and action.

Pension funds, as big corporate owners, have increasingly used engagement to influence the corporations they own towards a faster transition to more sustainable futures in particular with respect to lower carbon. These influencing rights and opportunities are gaining traction. But a key conclusion is that pension funds also have the potential channel of global capital allocation to exert a more robust and effective influence on the world’s future carbon budget.

The good news is that there are plausible reasons that funds should capture co-benefits if they do exercise this influence – that is they can expect over time both better performance and positive impacts on climate.

Measurement of the “imprecise but significant” is the catalyst for effective change, as is the goal-setting that goes with it. John F Kennedy put it this way: “By defining our goal more clearly, by making it more manageable and less remote, we help all people to draw encouragement from it, to move irresistibly towards it”.

The wheels of this train seem like they are well in motion.

Ultimately, pension funds need great clarity of goals to act as their north star. They face many disruptions. They will ultimately be judged by the dual outcomes of financial success and legitimacy. The attributes needed for this journey into the distant future remain being tough on risk and strong on governance.

 

Roger Urwin, is global head of investment content at Willis Towers Watson.