Funds are looking to increase their allocations to property, with direct ownership of unlisted pooled-property funds the most popular way of gaining exposure, a Top1000funds.com global property survey reveals.

The survey shows funds have an average exposure to property of 9.5 per cent of their overall portfolios and would most likely move funds from equities and bonds to increase exposure to the asset class.

Most of the funds surveyed indicated their allocation to property would either stay the same or increase. While they had long-term plans to increase allocations to non-domestic property, funds still demonstrated strong home bias when it came to property.

Funds that indicated they would increase allocations to property on average would do so by 10 per cent to domestic property, compared to an average increase to non-domestic property of 5.6 per cent.

When it came to investing in property, funds were looking for like-minded investors with long-term time horizons.

“The ideal way to invest in non-domestic property for us as a pension fund would be a non-listed leveraged or very low leveraged fund with a limited number of participants, preferably other long-term investors,” one senior investment staff member told Top1000funds.com.

Conducted in the later part of 2011, the survey garnered responses from 54 funds in 14 different countries representing almost $1 trillion in combined assets under management.

Respondents included Canada’s Alberta Investment Corporation, sovereign wealth funds the Korean Investment Corporation, Ireland’s National Pensions Reserve Fund and Pensioenfonds Vervoer from the Netherlands.

More than 70 per cent of respondents say they plan to diversify into non-domestic property, with the majority seeing little difference in the global approach they take to equities and bonds and the strategy they are adopting in property.

Despite this, property portfolios still have some way to go before they match these diversification goals as the median allocation of property assets was 85 per cent domestic and 15 per cent non-domestic.

The continuing home bias towards domestic property can be seen in the context of last year’s risk-off environment.

The majority of funds consider non-domestic property to be higher risk than the domestic variety. But they also indicated that the rewards were potentially higher in non-domestic property.

Funds also seem more confident about investing in their own backyards. When asked if they had strong knowledge about non-domestic property, the most popular response was “somewhat/neutral”

The vast majority of funds saw the main benefits of investing in non-domestic property as increased diversification followed by increased risk/adjusted returns.

There was also a number of ways funds were choosing to access the asset class. The most popular was direct ownership of unlisted pooled-property funds, with 20 per cent of investors indicating they used or would use this method. This was followed by a fund of listed-property securities or real-estate investment trusts (REITs), with about 14 per cent of investors preferring this method, 11 per cent each going for direct ownership of listed-property securities or REITs and exposure through property debt.

When it came to selecting a manager, funds indicated that they on average ranked investment process as the most important feature followed by experience and performance.

The size of the fund and a consultant’s ranking were the least important criteria for manager selection.

Academics collide on the relationship between environmental, social and corporate governance (ESG), and alpha. One view is there is a clear link that can be uncovered by a deep dive into the underlying factors using a sophisticated operating engine. The other perspective is that the market will price in environmental and social factors, the way it has done with governance. Amanda White speaks to academics with different points of view.

Andreas Hoepner, lecturer in banking and finance at the University of St Andrews in Scotland, says alpha requires a sophisticated investment operating engine to find ESG.

The simple step of taking the ESG data, especially if it is sold to everyone, is usually not adequate to find alpha, he says. But if extra steps are built in, then alpha becomes evident.

“The extra steps are, for example, to look at industry or other types of classifications. ESG factors have a profoundly varying impact on firms, depending on their business model. Environmental management, for instance, has a very different meaning for banks than for oil companies. When you start to build extra steps, you quickly come to some alphas.”

The more competition in the area, according to Hoepner, the higher the level of operating engine needed to identify alpha.

“For example, analysing conventional fundamental accounting information, there is a lot of competition so the engine needs to be highly sophisticated,” he says, referring to the level of information portfolio managers assess in order to find alpha.

Within the field of ESG, Hoepner thinks there isn’t as much need for an engine that is quite as complicated, because there is not as much competition.

“From an investor point of view, when searching for alpha, ESG is a style similar to value investing: you are convinced of a certain type of asset and try to understand where and when it performs best. In the value-investing case, you are convinced by firms with low price-to-book rations, while in the ESG-investing case, you are convinced of firms with more sustainable business processes and a longer term management perspective,” he says. “From an investment-style perspective, at St Andrews we are optimistic that ESG information is not fully efficient as in our research we find many alpha opportunities that cannot be fully explained by transaction costs.”

 

When it comes to the relationship between ESG and alpha, Hoepner highlights the impact of specialist skills, pointing to the 2010 Journal of Business Ethics paper, The performance of socially responsible mutual funds: the role of fees and management companies by Javier Gil-Bazo, Pablo Ruiz-Verdu and Andre Santos.

The study found that in the period from 1997 to 2005, US socially responsible investing (SRI) funds had better before-fee and after-fee performance than conventional funds with similar characteristics, and the differences were driven exclusively by SRI funds run by managers who specialised in SRI.

Further, funds run by companies not specialised in SRI underperformed their matched conventional funds.

“The research found some very interesting outcomes. Specialist funds are clearly better than conventional funds, and non-specialist are worse than conventional funds,” he says.

Hoepner says this highlights a key failing of current investment thinking in that there is a clear mismatch between ESG skill and finance training.

This is also something that asset owners are discovering in their own approach to ESG integration.

 

The CalPERS case
The investment office of CalPERS, for instance, now has set implementing ESG as a strategic goal and its board is committed to this.

But Anne Simpson, director of corporate governance at CalPERS, recently said that it won’t work unless it can get the F – as in finance – into ESG.

Hoepner believes there are inadequacies in using only financial accounting data in financial analysis, as corporate accounts are conceptually an estimation and they are more relevant in the valuation of some companies, such as Fedex, than other companies that trade at large multiples of their book value, such as Amazon.

He believes it is also important to assess non-tangible factors, such as management quality, and this is an opportunity for assessing whether alpha exists.

“There is an enormous opportunity to incorporate intangible factors in a responsible way in financial markets,” he says. “You speak to people in other industries such as engineers or computer scientists and they say it is obvious that intangible factors affect consumer decision making and so performance. Just financial economists have possibly believed their own theories of the hyper-rational homo economicus in the consumer and also the analyst a little too much.

“We are very optimistic ESG alpha exists, but you can’t get ESG from one nice, level approach. But if you combine ESG metrics with very sharp statistics you can find alpha.”

One of the faults, according to Hoepner, is that analysts either look at financials and then ESG, or ESG and then financials.

“I think there’s way too little of both together. If you focus on one, then you miss the other. Bringing the two drivers together can be powerful,” he says.

“It is important to compare ESG investment to other styles when you want to do financial analysis, otherwise it is treated like a step child.”

Hoepner points out that when it comes to portfolio and strategic decisions, there is more to it than just alpha – client loyalty and the universal owner hypothesis come into play, and trust becomes very important.

 

What is relevant will be priced
Unlike Hoepner, Rob Bauer, professor of finance at Maastricht University School of Business and Economics and director of the European Centre for Corporate Engagement, thinks that markets have already priced in some of the relevant ESG information.

“By simply buying good ESG companies, you do not necessarily make good returns in the long run,” he says. “Especially, information on G (governance) is properly priced to a large extent. It might not be at that stage yet for E and S, but I strongly believe that market participants are gradually pricing the relevant information pieces, and they certainly will in the next decade. So there will be no information advantage.”

Bauer points to the study by Harvard academics, Lucian Bebchuk, Alma Cohen and Charles Wang: Learning and the disappearing association between governance and returns.

The study looks at the relationship between returns and a governance index, constructed on the basis of 24 governance provisions that weaken shareholder rights. During the 1990s there was a clear governance-returns correlation, which then disappeared in subsequent years.

The paper provides evidence that the existence and disappearance of that correlation were due to market participants’ learning to appreciate the difference between well and poorly governed firms.

It found that the disappearance of the governance-return correlation was associated with an increase in the attention to governance by a wide range of market participants; and until the beginning of the 2000s, but not subsequently, stock-market reactions to earning announcements reflected the markets being more positively surprised by the earning announcements of good-governance firms than by those of poor-governance firms.

“The Bebchuk study confirmed the results of the Paul Gompers study in 2003, which found that in the 1990s well governed firms performed better than poorly governed firms. The Bebchuk team redid that report and now finds that good governance (especially information on takeover defences) is fully priced into stocks.

Probably, the same will happen with E and S, but it will take some time to figure out which information is relevant for cash flows and the volatility of cash flows of firms,” Bauer says. “I think it is not clear yet, but it is becoming clearer. In the end, what is relevant will be priced; what’s not relevant is simply not relevant.”

 

Engagement also starts with E
Bauer believes engagement is the only sustainable way of responsible investing.

“There is a need for a collaborative investor community to engage and change practice on relevant issues in both the financial dimension and the ESG dimension. This will then change the valuation of these companies and lead to higher returns.

Both Bauer and Hoepner are previous winners of the French Responsible Investment Forum, which supports promising research and significant academic achievements and is endorsed by PRI.

Jean-Philippe Desmartin, who created the awards in 2004 and who is the head of ESG research at Oddo Securities, says ESG research is scant.

The awards aim to promote in the long-term academic research with finance and ESG in Europe, he explains.

The genesis of the award came in September 2003, when he saw Harvard’s Michael Porter speak at Copenhagen Business School and identify ESG as a key subject for companies.

“He said it was a top-10 issue for the following decade… and there needed to be more professionalism, to deliver academic research not just to show convictions.”

Desmartin believes that in practice integrating ESG is not completely different from other fundamental analysis.

“Analysts want to understand management, products and services as well as financial statements and fundamentals,” he says. “At Oddo, we are convinced from ESG research you can get alpha.”

There are a number of awards, and this year the winners will be announced at the PIR-CBERN Academic Conference 2012, Evolution of Responsible Investment: Navigating Complexity, to be held from October 1 to 3 at York University in Toronto.

Korean corporate pension funds have grown more conservative in their investments, increasing already high allocations to guaranteed-insurance contracts (GICs) and term savings, the Towers Watson Korea Pension Report shows.

The annual snapshot of the Korean pension market found that 93 per cent of corporate pension-plan assets are allocated to principal-guaranteed products, of which nearly 58 per cent is invested in cash instruments.

Guaranteed-insurance contracts are insurance policies that promise a fixed or floating interest rate during the policy period.

Jayne Bok, Towers Watson Korea’s director of investment services, says the research indicates a 5-per-cent increase in allocations to principal-guaranteed products last year, indicating the high risk-aversion among both Korean pension-fund sponsors and members.

Much of this increase was caused by significant mandates, mostly invested in GICs, being awarded to two service providers from defined-benefit plans affiliated to them.

“Last year was a bit of a risk-off environment so the service providers who were doing the asset allocation were more conservative, and putting more into cash and bonds than they were into equities,” Bok says.

“There are restrictions that don’t allow you to invest that much in equities to begin with… But the problem is more the starting point, rather than anything that has happened in any particular year. Any kind of risky environment you could see will trigger the same response. The baseline level of risk tolerance in Korea is basically too low.”

Bok believes this conservative allocation is largely influenced by corporate sponsors’ “cash-reserving mentality”, which finds its roots in legacy severance schemes and recent fierce competition among service providers offering attractive or inflated interest rates to attract new clients.

“As a result, there is also an inappropriate focus on capital preservation rather than on income or return generation, which would be more suitable given allocations should be focused on the ability to pay pensions in the longer term,” she says.

 

Regulation and return-seeking assets
Further encouraging conservative investment approaches are government restrictions on defined contribution and individual retirement account (IRA) schemes limiting investments to return seeking assets such as equities.

This conservative approach is at odds with larger public pension funds, such as the National Pension Scheme of Korea, which is in the midst of a four-year program to double its holdings of international equities.

The country’s sovereign wealth fund, the Korean Investment Corporation, under former chief investment officer Scott Kalb, started a five-year plan to double its allocations to private markets, in particular looking at distressed-debt opportunities and real estate.

Corporate pension funds have, however, taken a safety-first approach, preferring principal-guaranteed products.

These GIC providers in the last year have offered interest rates on principal guaranteed products in a range of between 4.21 and 5.1 per cent, Bok says.

Bok points to wage inflation in 2011 as being around 5.5 per cent, based on Towers Watson’s annual compensation surveys, re-enforcing the need to seek better performance than the cash rate.

She expects a rationalisation in fixed-rate products and a gradual lowering of interest rates offered to drive a gradual push to more return-seeking assets.

The pool of $45 billion in Korean corporate pension plans includes both defined-benefit and defined-contribution plans.

 

Guarantees over growth
With funding levels for corporate defined-benefit plans typically around 70 to 80 per cent, funds adopting conservative investment approaches are unlikely to improve these, Bok notes.

Korea adopted a funded pension-plan system similar to those of developing countries in 2005. Bok says the relative infancy of the system also contributes to conservative investment approaches.

“Sponsors and members need time to increase their investment literacy before we can expect to see fundamental changes in their investment behaviour,” according to the report.

Plan sponsors have been focused on whether to adopt a plan and choosing a service provider, with little thought going into the ongoing investment strategy.

“From a chief financial officer’s perspective, if the pension plan costs are less than 1 per cent of your book, you don’t worry too much about how you are going to invest the assets. It is simple to write an insurance contract for a GIC because you then have no worries because someone else is guaranteeing your return,” Bok says.

“So, I can understand why at this early stage of the market we have this kind of behaviour, it is always easier to stick to the current practice than do something different.”

The report reveals that total pension assets grew by 71 per cent in 2011.

Bok says that as this recent exponential growth continues and pension plans loom larger on the balance sheets of companies, it could trigger changes in investment approaches as plan sponsors pay more attention to fees and performance.

Authors Christopher Armstrong from The Wharton School University of Pennsylvania, Ian Gow of Harvard Business School and David Larcker from the Graduate School of Business Rock Center for Corporate Governance, Stanford University, look at the efficacy of shareholder voting.

The study examines the effects of shareholder support for equity compensation plans on subsequent chief executive officer compensation.

Using cross-sectional regression, instrumental variable and regression-discontinuity research designs, the authors find little evidence that either lower shareholder voting support for, or outright rejection of, proposed equity-compensation plans leads to decreases in the level or composition of future CEO incentive compensation.

Click here to read The Efficacy of Shareholder Voting: Evidence from Equity Compensation Plans.

 

Investors are taking an increasingly sophisticated view of their passive equity allocations, aiming to capture the benefits of a range of risk premiums, while also lowering the volatility and improving the risk/adjusted returns – all at a considerably lower cost than active management.

Wyoming Retirement System (WRS) turned to risk-premium mandates as part of a broad-ranging restructure of its equity portfolio that began three years ago.

Chief investment officer John Johnson explains that the investment team decided to target 70 per cent passive allocations across major classes. It was a radical about-turn for the $6.5-billion fund, which previously had a preference for active management.

While reducing costs was a benefit of the move to passive, the fund also had the overarching objectives of lowering volatility and improving risk-adjusted returns.

To this end it looked at how to capture different risk premiums – including size, value, momentum and volatility – through tilts to value and risk-weighted indexed mandates.

“We have ranges, so typically between 50 and 70 per cent will be passive in all of the asset classes, with the idea of trending towards 70 per cent,” Johnson says.

Previously, WRS had actively managed all of its equity investments but adopted its passive-management target when revamping its equity portfolio, which currently stands at 53 per cent of the overall portfolio.

WRS decided to use the MSCI risk-premium indexes, focusing on products that would capture the risk premiums of size, value and volatility.

 

An age of indexes
Large investors are increasingly looking to use these strategy indexes in their passive allocations.

The $42-billion Taiwan Labor Pension Fund (LPF) announced this month that it would allocate $1.5 billion to two MSCI low-volatility indexes tracking global equities and emerging markets.

Other investors to recently adopt MSCI’s risk-premium indexes include St James’s Place and Credit Suisse AG.

MSCI’s New York-based executive director of index-applied research, Raman Aylur Subramanian, says these risk-premium indexes can be used in both active and passive investing.

The multiple risk-premium index mandates can be used to capture a portion of excess return normally associated with active management, leaving active managers to concentrate on stock selection and rotating portfolios to take advantage of market cycles, according to Aylur Subramanian.

Passive investors can use these indexes to either add value to a traditional passive portfolio or access systematic excess returns at a lower cost to traditional active management.

Aylur Subramanian says that investors like Wyoming can make a strategic allocation but the indexes can also be used tactically.

He cites examples of investors who have wanted to de-risk portfolios by adding volatility protection to their portfolio, without the need to increase allocations to fixed income.

They can then rotate between a minimum-volatility index and a traditional cap-weighted index as market conditions change.

For WRS, the passive part of the equity portfolio was split between a 70 per cent allocation to a portfolio tracking MSCI All Country World Index Investable Market Index (ACWI IMI), with the remaining 30 per cent evenly divided between portfolios tracking the MSCI ACWI Value Weighted and MSCI ACWI Risk Weighted indexes.

“What I really wanted to do was capture all of them [risk premiums] without changing the overall portfolio’s factor exposures,” Johnson says.

“If we went and bought a value risk premium, it could change other factors within the total portfolio. MSCI ran various analyses of the portfolio’s risk factors that we were being exposed to. We had an iterative process of what we wanted to allocate to: initially it was one half to market weight and one half to risk premiums, and then of those risk premiums it was split evenly between size, value and volatility.”

Johnson says that the fund ended up incorporating the MSCI ACWI IMI, which encompasses large mid and small-capitalisation segments of the global equities universe, with a 10-per-cent strategic overweight to small caps as a way of capturing the size risk premium.

WRS did not forgo return opportunities via momentum risk premiums, with Johnson saying that allocations to a passive-market cap-weighted index provides a proxy exposure.

“We chose not to use momentum because it was the least understood factor. I think momentum is actually a very good risk premium to incorporate because it is negatively correlated to the other risk-premium strategies, so is useful in a portfolio,” he says.

“But the way we thought about is that, just like we are incorporating the MSCI ACWI IMI to capture the size premiums, effectively the market cap-weight index is a momentum index by definition because, as companies are getting larger and larger caps, they are being included in the index and you are capturing them on the way up.”

Correlation and keeping it Sharpe
Johnson explains that the passive allocation to a typical market cap-weighted index will capture the typical market beta. Hence, correlation will be 1 and the Sharpe ratio will be around the market Sharpe ratio of between 0.2 and 0.25.

Risk premiums aim to increase the Sharpe ratio that would otherwise be expected from a traditional passive allocation. The aim is to generate a Sharpe ratio of between 0.33 to 0.44, [thus] improving the risk-adjusted returns of the passive-equity allocation.

The remaining 30 per cent of the equities portfolio is actively managed, with two-thirds earmarked for long-only managers, Johnson says.

The remainder will be allocated to an “alpha pool” of five-to-seven hedge fund managers tasked with achieving returns that are uncorrelated to the broader market.

“What we have been trying to do is eliminate direct equity exposure and create more nuanced risk exposures across the portfolio,” Johnson says.

In its active equity allocation there is an expectation that the portfolio will have a lower correlation of between 0.75 to 0.8, with a Sharpe ratio of between 0.5 and 1.5, thus generating a higher return per unit of risk than the broader portfolio, he says.

In the alpha pool, zero (plus or minus 0.5) with a Sharpe ratio greater than 1.5 for the total portfolio, will add “an incremental return per unit of risk for the entire portfolio”.

 

Passivity brings beta
The exposure to risk-premium indexes should only cost 4 to 5 basis points more than the cost of a typical market-cap index, according to Johnson.

The tightly focused approach to active management comes from the investment team’s belief that they should only be paying for more for exposure to areas of the market where there is persistent evidence managers can achieve excess returns over the benchmark.

“If all you are trying to get out of that asset class is beta, then we internally can capture the beta as well as an active manager out there by going the passive route,” he says.

“What we did was that we decided to incorporate the MSCI IMI to capture the size premiums and then allocate 30 per cent, split evenly to volatility and value. So what that did was still kept the overall portfolio-factor exposure very similar to the market-cap index, but it also enhanced the return per unit of risk, which is what we were trying to get to.”

 

The rest of the revamp
As part of its revamp of the overall portfolio, the investment team has strongly focused on managing and ongoing monitoring of the correlations both within an asset class and between asset classes.

“Because correlations are not static, they change over time, we need to be constantly vigilant on monitoring,” Johnson says.

The restructure of the portfolio has resulted in a 53-per-cent exposure to equities with a target exposure of 50 per cent and a range of 40 to 60 per cent.

Fixed income is 24 per cent of the overall portfolio with a heavier exposure to credit. Fixed income is split 6.5 per cent interest rates, 11.4 per cent credit and 6 per cent to mortgage/opportunistic.

The investment team also added a global tactical-asset allocation (GTAA) that includes global macro hedge funds, risk parity and long-only global tactical allocations.

“GTAA is a strategy to exploit short-term market inefficiencies [in order to] to profit from relative movements across global markets,” he says.

“The managers focus on general movements in markets rather than individual securities within markets. The purpose for our portfolio is to provide a low-correlated asset that will provide high risk-adjusted returns and minimise the volatility of the portfolio.

Real-return opportunities make up 8.5 per cent of the portfolio, with the balance held in tactical cash.

Investments in private equity were recently approved by the board, and keeping with its overarching view on correlations are included as part of the active-equity exposure, as it is essentially capturing equity returns.

The fund also includes private equity-like structures throughout the portfolio with mezzanine and distressed debt forming part of the credit allocation.

Johnson says the fund has not yet set a target range on the amount of private-equity investment.

Infrastructure (1.5 per cent) and real estate (3.5 per cent) form part of the real-returns stream, as will a planned allocation to a resources/commodities, inflation-linked product slated for launch this year.

The fund should complete its equity restructure by mid-way through this year, Johnson says, with the overall portfolio build out being finalised by the end of the 2013.

 

Norway’s 3496 billion kroner (US$582.7 billion) sovereign wealth fund could suffer significant losses in a range of climate-change scenarios if it fails to hedge its risk by investing in climate-sensitive assets, the release of a confidential report shows.

Norway’s Ministry of Finance recently released an extensive study by asset consultant Mercer on the effects of climate change on the Government Pension Fund Global’s (GPFG) portfolio of investments.

The world’s second biggest sovereign wealth fund has a portfolio that is heavily weighted to the traditional asset classes of equities and bonds.

GPFG is the only one of 12 large institutional investors that participated in Mercer research conducted in 2011 to release the confidential report looking at the specific impact of climate change on each of the funds’ portfolios.

If the recommendations of the report, currently with the Ministry of Finance, were adopted, the fund would make it a priority to increase its allocation to assets such as low-carbon-intensive infrastructure, real estate and private equity with a focus on alternative energy and venture-capital technologies.

The fund currently has no allocation to infrastructure, private equity, timberland, agricultural land and other alternatives.

GPFG has a strict investment mandate that limits investments to financial instruments (mainly listed equities), fixed income, real estate and cash.

The fund has a new investment mandate that came into effect on January 1 this year, but has recently announced it will increase its allocation to emerging markets and decrease its exposure to European assets.

As part of its risk management processes, Norges Bank Investment Management – the fund’s asset manager – has already taken measures to build in climate-risk considerations into its investment decision making.

Since 2009 NBIM has included water among its key risk focus areas (see here).

Based on the current positioning of the fund and its unique characteristics, Mercer grouped potential climate-sensitive assets into three priority groupings:

Priority 1: Infrastructure (low-carbon assets), real estate (improve existing standards and seek new opportunities in energy efficiency), private equity.

Priority 2: Sustainable equity (continue to build on integrating into core processes), energy efficiency (listed and unlisted).

Priority 3: Timberland, agriculture, green bonds and carbon (consider building exposure to a carbon market as it matures and liquidity improves

 

The report recommends that GPFG introduces a climate-sensitive asset-allocation plan over a long-term horizon.

“In particular, develop a plan to cover what asset classes will be relevant and beneficial for the fund over a 1.3.5 or 10/20 time period,” Mercer advises in the report.

“This could include creative leadership in developing approaches to deploy capital to new areas of opportunity where institutional-investment frameworks are still nascent (for example, energy efficiency).”

This multi-asset class process would also take into account various regional sensitivities to climate risk.

The report does not prescribe specific target allocations for climate-sensitive assets.

 

Basic framework and scenario forecasting
Mercer’s Climate Change Scenarios Tailored Report takes the basic framework used in its landmark 2011 Climate Change Scenarios ‑ Implications for Strategic Asset Allocation study, which found that climate change could slash up to 10 per cent off portfolios in the next 20 years.

The potential effects of four potential climate-change scenarios ranging from divergent regional action to mitigate climate change, delayed action, comprehensive and coordinated action similar to that advocated by Nicholas Stern, and climate breakdown are analysed.

The cumulative gains or losses the fund could experience are modelled relative to a baseline case, where the fund would achieve a nominal return of 7.3 per cent with risk (standard deviation of return in absolute terms) of 12.1 per cent until 2030.

Mercer found that GFPG could suffer a cumulative loss of approximately 8 per cent of its portfolio by 2030, relative to the baseline, if the current asset allocation was maintained and delayed action on climate change occurred.

Delayed action is the second most likely scenario Mercer forecasts.

The fund could potentially lose between 1 and 2 per cent of its portfolio under the most likely scenario: regionally divergent action on climate change.

Under the “Stern action” scenario where there is comprehensive and coordinated action, the fund is forecast to enjoy 2-per-cent cumulative growth relative to its baseline over the next 20 years. This is primarily caused by lower policy risk positively impacting the returns on most assets.

A cumulative loss of between 5 and 6 per cent of the portfolio is predicted to occur if climate breakdown was to occur.

The report notes that most of the more significant macroeconomic outcomes of climate change would be modest up until 2030, with the effects considerably magnified after 2050.

Built into its analysis is the impact of technology, the physical impacts of climate change and policy changes, what Mercer calls the (TIP) risk-factor framework for examining investment uncertainty around climate change.

Mercer also takes into account the sensitivity of various asset classes to these TIP factors, as well as which regions might be better placed to lead the push to change economies to a low-carbon future.

The report notes that the fund’s portfolio – currently approximately split 60 per cent equities, 35 per cent fixed income and 5 per cent real estate – was reasonably positioned in the event of climate breakdown.

However, it was more exposed to climate risk in the other more likely scenarios of regional divergence and delayed action.

The report recommends that the fund build a process for monitoring climate risk and opportunities, which could complement efforts to gradually build out a hedge against climate risk through diversification of the portfolio.

Mercer also advocates the fund establishing engagement with active managers so that it gains the advantage of being strategically prepared, rather than attempting to enter asset classes late on the back of market events when it would be more costly.

The report notes that listed equity markets were unlikely to price long-term climate risk and were, in fact, more likely to respond to climate related events as and when they take place.

“Against this backdrop, the headline macroeconomic impact of climate change is unlikely to be a driving force behind any changes to beta assumptions for listed equities within our horizon,” Mercer notes in the report.

“Rather, we expect the degree of economic transformation that will take place under the different scenarios to produce varying impacts in terms of sectors and regions.”

 

Uncertainty is risky
Policy uncertainty is also identified as one of the greatest sources of risk, and Mercer advises the fund, which is the second biggest sovereign wealth fund in the world, to engage on both a domestic and international level with policy makers. This engagement activity should form part GFPG’s risk management processes, according to Mercer.

The report also recommends GFPG build into its potential climate-risk hedging activities consideration of which regions will be better prepared to deal with climate change.

The European Union and China/East Asia are identified as regions where government policy is aiming to reduce emissions and attract investments.

In the case the fund does not adopt the recommendations of the report regarding specific allocations to climate-sensitive assets, Mercer advocates GPFG builds proactive management of climate risk into its existing assets.

This would include reducing the operating costs around carbon by improving the sustainability practices and energy efficiency of its real-estate portfolio and consideration of the overall equity portfolio’s exposure to TIP risk factors.

Global equities are the least sensitive to TIP risk factors, followed by emerging markets and sustainability-themed equities.

Norges Bank Investment Management (NBIM), the manager for the fund, was contacted for comment but directed enquiries to Norway’s Ministry of Finance. The ministry did not respond prior to publication.

To read the report click here