The best way to tap alpha investing in the energy transition is to buy assets in high carbon-emitting sectors and help them green, a major pension fund’s investment committee has heard.

Mark Carney, vice chair of Brookfield Asset Management and Head of Transition Investing at the manager, a guest speaker at a recent CalPERS investment committee meeting, said an asset’s emissions will be inextricably tied to financial performance in the years ahead, already visible in how low emitting companies within a sector currently trade at a premium.

“Nothing succeeds like success, and value creation will bring imitation,” Carney said.

“Being low carbon is a determinant of companies and countries competitiveness. We will increasingly see this over time.”

Carney dates his epiphany on the opportunity and risk of climate change to when he was Governor of the Bank of England between 2013-2020. Overseeing the Lloyds insurance market, in the grip of rising inflation-adjusted insurance costs due to extreme weather events, plus a steady rise in uninsured losses, opened his eyes to the climate risk coming down the track.

Investors will find the best returns from investing “where the emissions are” and supporting assets transition. He counselled against divestment from heavily emitting industries, arguing it would result in shutting down core parts of the economy in too large an economic adjustment.

A belief already integral in CalPERS approach to sustainability. CalPERS (and CalSTRS) recently voted against a Californian bill that would prohibit the fund from making new investments in fossil fuel companies and would also require both pension funds to divest existing fossil fuel company investments on or before July 2030. “CalPERS does not believe that mandatory fossil fuel divestment is an effective solution to the reduction of greenhouse gas emissions,” said the fund in a statement.

With less than ten years remaining in the global carbon budget (the amount of carbon the world can produce to keep within a temperature threshold) investors need to support heavily emitting industries reduce their emissions. And Carney said the need for capital amongst high emitting industries is paramount.

Many companies are in a transition trap, unable to tap public markets to invest in the transition, and paying large dividends to shareholders. This offers an opportunity for investors like CalPERS, although he said the pension fund would have to commit to owning those high emissions until they started to fall.

He told board members that investors are increasingly committed to asking companies for their transition plans. And the fact that many corporates are only beginning their journey, offers investors even more of an opportunity.

Local opportunities

Investors have other opportunities to tap transition alpha. It is also possible to generate alpha by investing in local solutions, a crucial element of progress. This could include local investment in a new electricity system that transports clean energy, suggested Carney. “Three quarters of our emissions are traceable back to energy. The issue is getting that energy clean.”

In another strategy, CalPERS could consider carving out a specific transition strategy like Canada’s OTPP and Singapore’s Temasek. Both these investors are investing where the emissions are, going “above and beyond” the core opportunity. “The dynamic around getting capital to climate solutions is starting to kick in,” he said.

Above all, Carney urged board members to recognise the scale of the trend ahead. “Clean energy investment is tripling,” he said, adding that the risk of not acting is manifest in every corner of the portfolio.

Risks include property exposed to climate change in the real estate allocation, and investments in companies that have not adjusted their business model to a green economy. He said investors should “pick and choose” investments in fossil fuel groups, mindful of stranded assets and fossil fuel groups paying out more cash flow as dividends or debt repurchases versus spending on investment. “Are they building up expertise? Some of them are,” he said.

Macro risk

Carney told the board that the transition also holds macro significance that carries implications for the portfolio. Transition investment will impact the rate of inflation; the speed of economic growth, job creation and, in Carney’s view, medium- and long-term interest rates. Rates will track higher because of the multi-decade investment boom in the energy transition ahead. This will have ramifications for portfolio construction, managing risk and fixed income portfolios, he warned. “These are considerations to take into account.”

In contrast to the last two decades, investment will rise relative to GDP. He added that the transition to a clean economy will affect every industry, and is on a scale of the industrial revolution but at a speed akin to the digital transformation, taking place over the next quarter of a century.

Regulation will accelerate the transition. Witness policy in Europe where the EU has agreed to ban the sale of new petrol and diesel cars from 2035. “The impact on investment in electric vehicles was almost immediate,” he said. “It drives activity.”

“What happens when California puts in regulation to get emissions down? It’s a big change and old economic models will become uneconomic.” He said that TCFD will become the global standard in climate disclosure and noted that countries the world over are starting to act with purpose.

Countries’ policies to limit emissions to less than 2.5 degrees are progressing, and combined these commitments are getting close to where we need to be. “The expectation is these commitments will tighten,” he said.

Policy will drive the transition via a combination of regulation and subsidies, or support through the tax system like America’s Inflation Reduction Act (IRA) which provides large tax incentives for energy and climate change measures. A national carbon tax is unlikely. Not many jurisdictions have introduced a carbon tax and the coverage is uneven. “The rest of the world is responding to this by trying to level up to IRA as much as possible.”

Other factors are also speeding up the transition. Reshoring trends mean companies relocating production facilities in new jurisdictions have are keenly focused on where their energy is coming from.  “There is no point locking in emissions when they move,” said Carney. Geopolitical risk has also hastened the transition, visible in Europe accelerating the energy transition since Russia invaded Ukraine.

A Just Transition

Acting early and investing in transition opportunities now will help support a Just Transition. As a financial market participant, CalPERS is engaged with what is happening to the community and workers tied to its assets.

Investors can support workers but sighting new facilities in the same place as legacy infrastructure.

Access to raw materials like copper and lithium is a choke point. But he said the west is now focused on this and new resources will be developed. Exploration of these materials is a small component of the overall cost of the transition. “The transition will throw up challenges and we will focus on addressing them,” he said.

BT Pension Scheme Management, the executive arm of the £47 billion ($59.8 billion) BT Pension Scheme (BTPS), believes it has a solution for the United Kingdom’s mature defined benefit pension schemes, buffeted by complex investment risks and dependent on external support from a fragmented landscape of service providers.

Under its new name Brightwell, and in a model visible in regions like Canada, other institutions can now tap into BTPS’ investment expertise and manager relationships in a mutually beneficial partnership that will also boost assets under management as BTPS continues on its own de-risking journey.

The £1 billion DB arm of the EE Pension Scheme has already signed up and Morten Nilsson, Brightwell’s chief executive officer, notes steady enthusiasm since the April launch.

Perhaps Brightwell’s most compelling service comes in its promise of a coherent, single approach to pension management. Schemes will be able to replace a noisy cohort of actuarial, investment, fiduciary and covenant advisors, plus multiple asset managers, with a single operation.

“We think holistically, and Brightwell can bring all this together under one roof,” he says. “At BTPS we start from our funded position and work through to our liabilities and our covenant and our investment strategy, bringing it all together.”

Nilsson believes multiple service providers create value leakage that is detrimental to pension funds, and although many fiduciary and asset managers argue they are selling solutions they are mostly focused on pushing products.

“There is an acknowledgement from all our peers of the need for something different,” he says. “The challenge is trying to offer something different in a way that the market understands.”

Reducing managers is central to Brightwell’s approach and has been a key seam of strategy at BTPS over the years where the fund has deliberately consolidated its managers into fewer, deeper relationships. These relationships can now be used to offer deals and investment opportunities to others, he says.

Multiple relationships leave many funds struggling to get value for money from their managers and risks pension funds having mandates that are not fully aligned with what they are trying to achieve, he continues.

Nilsson won’t be drawn on Brightwell’s target for assets under management, insisting it is not a volume game. Rather, Brightwell’s guiding rationale is persuading pension funds to work together rather than go through intermediaries and tap into the operational benefits that come with sharing resources.

“This is an opportunity to see how we can work with like minded schemes and find solutions,” he says. “We live in very uncertain times where DB funds need to manage their journey plans. Most schemes are in their end game discussions about what they are trying to achieve.”

Sponsors

Nilsson also believes that Brightwell offers a compelling solution for corporates. Under a buyout model, de-risking DB funds offload tens of billions of pounds of liabilities to insurers who promise to pay employees’ retirement payments at a fixed level.

As schemes seek to complete a transaction with an insurer, they move out of riskier assets such as equities and into bonds.

Nilsson says a buyout is not an option for BTPS given the fund’s size, and capacity in the market. But he also believes corporate sponsors risk losing money in this kind of transaction. He questions the rationale of such large value transfers of returns and surplus from a pension scheme to an insurance company when pension funds could stay in control, benefiting their sponsor.

“A buyout is expected to lead to double digit returns for insurance companies. Buyouts also mean you are taking money away from sponsors that could otherwise be invested in the UK economy – or wherever they operate.”

In a reflection of employers’ concerns that the surplus will be trapped in schemes as funding levels improve, Brightwell has set up a vehicle whereby a pension surplus can be given back to the corporate sponsor.

Integration

Brightwell won’t pool or merge client fund assets like the LGPS model and the team will work with different trustee boards. The DB section of the EE Pension Scheme has outsourced its CIO function, but Nilsson says a larger scheme might equally benefit from having its own CIO and internal team.

Either way, client funds will be able to tap into BTPS’ own investment office in a virtual extension of their own team, accessing Brightwell’s expertise to find the best solutions, design mandates, select managers and implement strategy.

Brightwell will approach investment through the lens of understanding client funds’ funding position, liabilities, how longevity hedging fits with investment strategy and the best way to lock down cash flows on that journey, tailored and specific to them but which will also reveal alignment between BTPS’ objectives.

Cash flows

Brightwell will pay particular attention to how client funds can maximize and lock in cash flows better, providing certainty on what flows they are trying to match. Part of this involves ensuring funds tap a healthy illiquidity premium for their illiquid assets (an allocation which, for many pension funds, has growth relative to their size since last year) and are able to sell illiquid assets in the secondary market.

“Depending on their cash flows, the asset mix for many DB funds has become more illiquid and this is now a central focus area,” he says.

The UK government is banging the drum for pension funds to invest more domestically, but Nilsson says BTPS is already heavily invested in the UK – and wants to be. Closed DB schemes will never want to hold large amounts of local venture investments because it doesn’t fit with their maturity profile but BTPS offsets this by increasing exposure to the UK through investments in corporate credit, direct lending, infrastructure, and income generating property.

“DB and DC funds are different,” he continues. “If you are a 20-year-old saver in a DC scheme you have lots of capacity for risk and should grab it, but the DB sector is different. The government is eyeing trillions of pounds in DB schemes to invest at home. We have appetite to invest in income generating local assets, but high risk illiquid investments wouldn’t suit these schemes.”

Brightwell will also help client funds invest in the transition, supported by BTPS’s expertise where prize transition assets include King’s Cross station, “a brown asset that is now net zero and has also made a tonne of money.”

“UK pension funds also hold a lot of gilts. If the government transitions and helps pension funds achieve their net zero goals with the right return that is perfect,” he concludes.

 

After years of waiting, AP7, Sweden’s SEK 900 billion ($84 billion) DC state pension plan, has just completed an inaugural investment in real estate, marking a leap forward on the road to building a strategy that is less correlated to the equity market.

New regulations in place since the beginning of the year finally permit AP7 to invest up to 20 per cent (up from 10 per cent) of its assets in alternative, illiquid investments. A new allocation to infrastructure and targets to double private equity are in the offing following the fund dipping a first toe in real estate with a stake in a multi-use development in Stockholm.

“We have asked for this for a long time. If you manage investments with a time horizon of 40 to 60 years and 100 per cent of the fund is required to have daily liquidity, of course it will cost you in returns,”  says Johan Florén, chief ESG and communication officer at the fund.

The move is indicative of the gradual evolution of strategy at the fund which has had to adopt a creative approach to diversification because of its regulatory confines. It’s main life cycle product comprises a small allocation to fixed income (primarily Swedish exposure) with all the remainder in equity in a full throttle approach.

The majority of the equity exposure is in a global market cap ACWI allocation where diversification comes via stakes in some 3,000 global companies spread across all sectors and regions. Over the years AP7 has added diversification via paring back on global equity, introducing some factor exposure and increasing the allocation to small cap, emerging markets and a private equity allocation, explains Florén.

“This was our strategy to diversify the portfolio and reduce risk,” he says. “We reduced the global equity portfolio with the aim of lowering volatility a little, but also keeping returns at the same level. We hoped the risk adjusted return would improve.” Between 2010–2022 the equity fund has returned 415 per cent compared to 5.5 per cent returns in the fixed income allocation. The equity fund made a –9.9 per cent loss in 2022

Less leverage

The ability to diversify will also impact AP7’s use of leverage, accelerating a strategy to gradually reduce leverage over the years. At the end of 2022, the net equity market exposure amounted to 115.5 percent of the fund capital, in contrast to earlier periods of much higher leverage. In 2010 AP7 applied 50 per cent leverage to the equity portfolio and Florén  says the fund now targets leverage of around 25 per cent over the long term. “We have gradually taken it down,” he says.

The ability to invest more in illiquid assets also supports AP7’s sustainability ambitions. The lifting of restrictions will allow the fund to boost its allocation to green real estate and infrastructure.

AP7 has changed its own internal regulations to allow it to invest more in green bonds, highly rated state-owned companies and supranationals like the world Bank and EIB. Investments in green bonds increased to SEK 9.2 billion ($0.87 billion) in 2022, corresponding to 10 per cent of AP7’s fixed income portfolio with a target to increase this to 50 per cent by 2025. These types of bonds yield slightly higher returns than Swedish government bonds, partly because they are not as liquid.

Under its sustainability strategy,  AP7 has also began work on a new transition portfolio, targeting this portfolio account for 10 per cent of the equity fund by 2025. The actively managed allocation seeks to increase holdings in certain companies compared to the index. The idea is that the increased weighting and focus via an active ownership and increased stake will boost corporate transition.

“We are more likely to do good as active owners in a company with high emissions that has a longer transition ahead of them, than in a company that is already best in class,” says Carl Fredrik Pollack, responsible for sustainability integration in asset management.

Illiquid implementation

AP7 still hasn’t finalised processes around implementation and how best to access more illiquid assets, continues Florén.  Its first investment involved partnering with AMF in a joint venture.

“This is definitely one way we will do it,” he says. “But there is no final decision and we are looking at different ways.”

AP7 will likely approach infrastructure investment it in the same way as private equity – aka investing small amounts over a long period of time to avoid concentrating risk in a particular life cycle. “It can be hard to have high quality investments if you invest a lot quickly,” he says. “We will do it over a number of years, step by step.”

He also sounds the possibility of AP7 going into the secondary market to get more diversification over time. Although AP7 can invest up to 20 per cent of its assets in illiquid investments Floren says the fund will likely invest between 15-20 per cent over a number of years.

“Everyone is very enthusiastic about it and we don’t see any big risks since we don’t have a strict timetable. We are looking for good opportunities and will take it step by step.”

Costs

AP7’s outsourcing strategy means the internal team design strategy but select managers to deliver. “We look for the best there is when we do our procurement, in particular around asset management.” Although he says the fund might need to slightly boost its headcount to invest more in alternatives, there are no plans to abandon its outsourcing philosophy and hire a new team.

Similarly, Floren says the fund is determined to keep its investment costs low. Management fees for the AP7 equity fund (0.05 per cent) and the fixed income fund (0.04 per cent) remain unchanged in 2023, in line with policy.

“It’s well known that these investments can be more costly, but we are not going to raise fees and 5 basis points in the equity fund will remain. This fee is a clear condition that we must consider – cost efficiency will remain a priority even in new assets.”

The attempts by multiple Republican states to restrict where US pension funds can invest is symptomatic of bad governance. Top1000funds.com takes a deep dive into the quagmire of US state pension funds to assess the impact of partisan politics on the ability of CIOs to do their jobs. The analysis highlights the need for improved practices around delegated authority to prevent the politicisation of investments. 

So much has been written about the rise and fall of ESG investing. But as an active participant in the global investment industry, and a non-American, it is extraordinary to observe the grandstanding efforts by US politicians, collapsing their vote-grabbing job functions with their roles as stewards of long-term capital.  

The obvious and stark mismatch between the two-year political cycle and the long-term nature of pension investing is at the core of this problem, which also highlights the ignorance of the politically elected in managing pension assets. It’s no wonder best-practice pension management is complicated and difficult to attain. 

The convoluted governance structures of US state pension funds, where elected officials are also trustees of the pension money and in some cases the sole trustee, is the complicating issue. And according to some governance experts, it’s the source of the problem. 

The anti-ESG movement has been played out through comical headlines and quotes, one example being Montana’s Attorney General Austin Knudsen: “Montana’s a northern state. It gets really, really cold. We can’t heat our homes with rainbows and fairy dust.” But the impact is being felt by the investment staff whose jobs are to maximise the best financial outcomes for the beneficiaries of the pension funds whose money they manage.  

The now-famous Montana letter, signed by 21 state Attorneys General and sent to 53 of America’s largest fund managers and financial institutions, argues that the investment industry is following liberal principles of woke capitalism for illegitimate reasons and contravention of fiduciary duty.  

According to Roger Urwin, one of the world’s leading investment governance experts, their fundamental thesis is a strawman fallacy.  

“It is the knocking down of an investment thesis that hasn’t been put forward in the first place,” he says. “But it is symptomatic of something we should respect in the investment industry that is that the politicisation of investments has become a systemic risk.” 

The biggest risk is the legitimacy of the pension fund mission. 

 Shooting a moving target 

The problem with the investment industry arguing either side of the ESG war is the fight is not about investments. 

“My problem with the ESG wars is it’s like looking into the sun, that’s how stupid it is,” says David Wood, senior researcher at the Social Innovation and Change Initiative at Harvard Kennedy School, who has educated many pension fund trustees through the Initiative for Responsible Investment at the Kennedy School.  

“My problem with the ESG wars is it’s like
looking into the sun, that’s how stupid it is.” 

 “What is the point of talking about the ESG wars as an investment style when it’s not what has motivated the attack?” Wood says. 

It can be difficult to understand the arguments. One example of the complexities is in the state of Oklahoma which according to US Energy Secretary Jennifer Granholm is already the fourth-largest generator of renewable energy of all the 50 US states, with enough wind, solar, and energy storage capacity to power all of the state’s households, two times over. While it’s traditionally been a big fossil fuel state, clearly clean energy is a big part of its future. 

And yet last month the state’s treasurer put together a list of 13 financial institutions that are prohibited from doing business with the state for engaging in “boycotts of fossil fuel companies” claiming the firms, including JP Morgan and BlackRock, were “beholden to social goals that override their fiduciary duties”. Both firms claimed the treasurer’s claims were baseless and their business practices were “not anti-free market” as claimed. 

By nature, politics is short term and pension investment is long term. Investment professionals at the helm of pension investment management are managing 40+ year financial liabilities to an accuracy of three decimal points. Exploring the complexity of how these two competing time horizons intertwine is difficult and complex. 

A Journal of Finance paper, Political representation and governance: evidence from the investment decisions of public pension funds, found that pension funds whose boards contain greater representation of state officials underperform. It explores three sources of poor decision-making by those state officials: control, corruption and confusion. Among other things, the paper says elected officials may be more inclined towards opportunistic behaviour arising from personal career concerns or the desire to attract political contributions. 

This is certainly the observation from many investment professionals Top1000funds.com spoke to for this article, who noted that the behaviour of the political-elected trustees on their state pension fund boards did not even consider beneficiaries’ interests as an afterthought. 

Many US public pension funds conduct their board meetings in public arenas. San Francisco City, for example, has public comment after every agenda item at its board meeting, and many public funds hire multiple lawyers just to deal with the Freedom of Information Act requests. 

There are many problems with this structure, not least of which is focus. It opens the arena to people with objectives at odds with the beneficiaries and distracts trustee focus. When a trustee is also an elected official it can veer even more off course. 

“Politics and investment don’t mix,” says Craig Slaughter, CEO and CIO of the $19 billion West Virginia Investment Management Board (IMB), a position he has held for three decades. 

He believes recent legislation introduced by West Virginia’s Republican administration to claw back direct control of the fund’s proxy vote marks the tip of an iceberg. Political interference in investment decision-making threatens the fiduciary independence of the retirement plan, he says.  [See: West Virginia CIO fears anti-ESG campaign threatens fiduciary duty]

The new legislation, coming into force in the next 15 months, will increase the level of scrutiny and impose potentially costly processes and hurdles in the proxy voting process. However, Slaughter’s main concern is that this legislation marks the first step on a road that could see the legislature tell the pension fund how to invest its assets. 

One day that could mean ordering divestment of fossil fuels by those that oppose investing in them, but right now he is more concerned the anti-ESG movement led by West Virginia’s cultural Republicans could start to dictate investment strategy that could include forcing investment in West Virginia’s fossil fuel industry. 

“At the IMB we don’t favour or disfavour fossil fuels, we just buy them if they are a good investment and if not, we don’t; but that may no longer be good enough. Whether pro-ESG or anti-ESG, the idea of using other peoples’ money to achieve a political purpose is offensive to me.” 

“Whether pro-ESG or anti-ESG, the idea of using other peoples’ money to achieve a political purpose is offensive to me.” 

The political hurly-burly is impacting state pension fund CIOs’ day jobs in a meaningful way. 

“From an investment perspective I’m trying to use every tool I can to make better investment decisions – any other CIO will say the same thing,” says Andrew Palmer, CIO of the $63 billion Maryland State Retirement and Pension System. “Politicians are taking the ESG bat and hitting each other with it. And that has made the life of people trying to make investment decisions more difficult.” 

“It turns out good risk management is important for banks; that is a governance thing. If you don’t have good safety for petroleum companies, there can be multiple-year impediments for that company. Every fundamental investor I know looks at these issues to make better decisions. That’s ESG. If CIOs think they can make more money by looking at ESG factors they will look at it,” he says. 

Chris Ailman, the long-time CIO of CalSTRS has been dealing with external pressures on investments for more than 25 years.  

“The average teacher works for 30 years and lives for another 30 after that so this money has a 30- to 60-year time horizon. When you think that long-term you think of all sorts of things beyond the balance sheet. You need a lot more information,” he says. “Whatever initials you want to use, these are long-term risks, and they should be disclosed by companies so we can make investment decisions. End of discussion. This is not about political outlook it’s an investment decision. I’ve never thought of them as political, and still don’t. But I am saddened by the fact that people characterise words and suddenly make them good or bad.” 

Indeed, Willis Towers Watson’s Roger Urwin says asset owners worldwide are trying to solve a financial equation, not solve something more pro-social or pro-environmental.  And yet it’s become a political issue. 

The governance conundrum

To understand best practice pension governance, it’s necessary to go back to 1980s Canada, where independence from the United Kingdom was fresh and KD Lang’s career was going gangbusters. 

In 1986, Keith Ambachtsheer was on a taskforce set up by the then-Treasurer of Ontario, Bob Nixon, to reform pension organisations. The resulting report “In whose interest?” recommended two ways public sector pension management could be improved: first, ensure pension deals were intergenerationally fair; and second, that arm’s-length pension organisations should be governed and managed as effective financial intermediaries with fiduciary mindsets. 

“If you are going to create a great pension system there has to be legitimacy and value for money. Governance is critical to both. You have to understand what arm’s-length means, and you have to understand good business to be effective,” Ambachtsheer says, adding clear delegated investment authority is a key feature. 

The outcome of the report, and the implementation of the governance principles it outlined, was the formation of Ontario Teachers’ Pension Plan which has returned more than 10 per cent a year since inception.  

“It can be done right,” Ambachtsheer, a Canadian himself, says. “I look south of the border and shake my head. There are a few US states that have people who understand the principles around what Peter Drucker said and create outcomes that are kind of OK, but they are a [clear] minority. The issue is at odds with the original principles of legitimacy and effectiveness.” 

Similarly, Willis Towers Watson’s Roger Urwin has spent his career advising asset owners on governance and organisational issues – notably Australia’s Future Fund and New Zealand Super, both recognised for their organisational acumen. 

He is working with USS and Sweden’s AP funds, and although he did some work with the CalPERS’ board some years ago setting up their investment beliefs, he has done limited recent work with US funds.  Urwin, whose work with Oxford’s Gordon Clark demonstrated there is a 100 to 200 basis points a year return attributable to good governance, says there are three universal rules of governance: pension funds are fiduciaries; they should be independent; and they should be run as professional organisations. 

“Those three principles take you a long way,” Urwin says. “It looks on the surface in the US as if both the fiduciary and independence principles are being challenged in some funds. 

“The fiduciary-duty principle has always started with a financial-first orientation, but essentially sustainability is one of the instruments to secure the financial mandate,” Urwin says. “Sustainability is instrumental to financial outcome. But not everything in sustainability is supportive to financial outcomes. Understanding where those things are inter-related is important.” 

In the US there are some examples of good governance and Utah’s John Skjervem, for example, cites the fund’s governance model as a critical support for his team’s decision making.  

Specifically, the URS board addresses investment matters in executive sessions which limit the “political grandstanding and virtue signalling” that Skjervem says is commonplace at many US public-plan board meetings.  

Skjervem says the URS governance shields the entire program from politics and “non-fiduciary” influences, allowing the team to focus exclusively on hunting for the best risk-adjusted returns without interruption or interference.  He believes this combination of delegated investment authority and multi-level fiduciary oversight is the program’s “secret sauce” and manifests as excellence in both portfolio construction and team culture. [See: Utah Retirement Systems: Why ESG is a waste of time]

But Utah is a rare case, and for the most part the governance of the state pension funds is complicated at best, embroiled in the political sphere. 

“Politicians shouldn’t get involved in the investment policies in pension plans that are properly set up at all,” says Amabachtsheer. “As soon as they put their fingers in, they are offside. One of the big breakthroughs in the Canadian model was that politicians are deathly afraid to meddle – and they should be.” 

“Politicians shouldn’t get involved in the investment policies in pension plans that are properly set up at all.” 

According to Ambachtsheer, turning retirement savings into wealth-producing capital is the narrative that is central to pension fund management. 

“The whole question should be what is the best way for pension funds to do that transformation process?” he says. “OTPP got that straight away. It forces a long horizon, and you understand the businesses you are investing in. If you are a knowledgeable investor, then of course you can call up those companies and ask them about what they are doing. It comes naturally if you have the right narrative. In the US there are some cases where funds have gone off road on that central narrative to a laughable extent.” 

If getting the foundational governance right wasn’t hard enough, now investment practice is moving from 2D investing with a focus on risk and return, to 3D which also incorporates real world impact. 

“It’s going to get more messy,” Urwin says.  

The Thinking Ahead Institute, which Urwin co-founded, encourages investors to look through a systemic lens incorporating social, technological, economic, environmental, political, legal and ethical issues which all have influences on the system in which investments operate. 

“The new phenomenon is the increased connectedness of these things which is speeding up change as well as increasing complexity,” Urwin says. 

Rob Bauer, Professor of Finance at Maastricht University has been studying ESG considerations for more than 20 years and agrees where societal issues and financial institutions there is complexity. He believes a lack of authenticity from product providers has added to the polarisation and politicisation of ESG issues in the US. 

“I needed 20 years to understand what we are talking about here, every day a piece of the puzzle is added,” he says. “Then suddenly these marketing organisations come through overnight and say they are experts on ESG.” 

“I needed 20 years to understand what we are talking about here, every day a piece of the puzzle is added. Then suddenly these marketing organisations come through overnight and say they are experts on ESG.” 

The most complicated governance relationships according to Bauer are where the boards delegate their proxy voting to firms such as BlackRock and Vanguard. 

“These organisations have commercial incentives, that are often conflicting. On one hand BlackRock is saying divest, but on the other hand Texas oil companies are clients of BlackRock. This says it all. How can these organisations engage when they have two different stances?” 

For Maastricht’s Bauer, who also advises many Dutch funds on ESG-related issues, it again comes back to governance.  

“Pension organisations set up investment beliefs and hire organisations to implement. But it’s more like they are wishing for an outcome so they set up beliefs consistent with that. But they have to test the beliefs regularly,” he says. “ESG is a container so broad and complicated, how do you measure preferences?”

Anger over proxy votes 

To get a sense of the level of grievance red-state investors feel about the misuse of their proxy vote, we spoke to to South Carolina State Treasurer Curtis Loftis, beginning his fourth term as sole trustee of the state’s $65 billion fund, the bulk of which is invested in a $41 billion portfolio and separate from the state’s $38.2 billion pension fund which is managed by the Retirement System Investment Commission (RSIC). Loftis insists asset managers fired the opening shots in the now-raging ESG war by misusing institutional investors proxy votes in the first place.    

Most of his anger is directed towards BlackRock, which was mandated to run a passive equity allocation in the state’s portfolio until Loftis began removing BlackRock mandates, most recently re-allocating a final $200 million tranche to Vanguard.  

BlackRock was using South Carolina’s proxy to mandate dramatic changes in energy use, employment practices and looking after stakeholder rather than shareholder interests and that didn’t represent the beliefs of the people of South Carolina, he says.  

“We’ve eradicated them from our portfolio,” he told Top1000funds.com. “BlackRock was voting contrary to our wishes. It’s as if I couldn’t vote and asked my best friend to vote Republican for me, but he voted Democrat, sealed it up and mailed it.”  

Loftis, who was retired for 10 years before he returned to work to take up the role as South Carolina’s banker, managing, investing, and retaining custody of the state’s assets, continues. “This is what happened on a massive scale and it’s appalling, and it fuels the conundrum we are now in today. It’s about getting these asset managers to vote the investment dollars we’ve given them in accordance with the beliefs of the people who own them.”  

“It’s as if I couldn’t vote and asked my best friend to vote Republican for me, but he voted Democrat.” 

Talking to Loftis reveals that taking back control of the proxy voting process is being driven by a deeper grievance than just a belief that the vote was being used contrary to South Carolina’s Republican taxpayers’ beliefs. He believes ESG-minded proxy voting has infiltrated corporate America and is now triggering fundamental change for the worse. Take the gradual move away from shareholder to stakeholder primacy for example. In today’s new world of stakeholder capitalism, companies are beholden to their community, consumers, and special interest groups not just shareholders, yet he believes these groups shouldn’t be a company’s responsibility. “We have governments to keep stakeholders happy,” he says. “It’s tipping the financial house of America on its head in a process that hasn’t been sanctioned at the ballot box.” 

Loftis says the capital markets used to work well. Now a business wanting to raise money must comply with ESG and other non financial stipulations laid down by ratings agencies and banks that insist on a swathe of rules that do not represent conservative ideas. 

“It is difficult to raise capital if you don’t have a high ESG score,” he says, describing a new landscape where corporate America, a reliable conservative partner, is now in the grip of “a hard left ideology”. 

Perhaps the fact that ESG isn’t the result of a democratic process – and wouldn’t, he says, pass through Congress if presented – angers him most.  

“ESG is changing a country and culture but without having the government permission to do so,” he says.  “It’s created a veneer of governance that we don’t think is even legal.”  

The guardians of South Carolina’s pension assets managed by RSIC are also preparing for change. The ESG Pension Protection Act, passing through South Carolina’s legislative process and which Loftis expects to be ratified either this year or next, would require the retirement system consider only “pecuniary factors” when making investment decisions. Although this is consistent with the perspective RSIC currently takes when managing the portfolio, the bill also requires the state’s retirement system to exercise shareholder proxy rights for shares that are owned directly or indirectly on behalf of the system.  

Negotiations over the bill have required substantial involvement by chief executive of RSIC Michael Hitchcock.  

“I’ve spent a significant portion of my time over the past year working with the legislators on ESG legislation,” he says.  

A process during which, like other CIOs interviewed by Top1000funds.com, he articulated his biggest fear is an outcome that decreases the availability of investment opportunities in a way that impacts returns and leads to increased contributions. HIs goal has been to keep the focus on RSIC’s obligation to earn an investment return that helps fund benefit payments for the retirement system’s 600,000 beneficiaries. 

“We are not woke, or anti-woke,” he says. “We are anti-broke.”  

CIOS hitting back 

Florida’s Republican Governor and US Presidential hopeful Ron DeSantis, the anti-ESG camp’s biggest hitter, has signed into law a bill that prohibits and seeks to punish all ESG considerations in the state’s investment decision-making, spanning all state treasury and retirement plan funds. It requires Florida State Board of Administration, guardian of $232.5 billion including the $181 billion Florida Retirement System, to only make investments on pecuniary factors and prohibits, amongst a raft of other restrictions, banks integrating ESG factors into their lending criteria.   

DeSantis said the legislation would protect “hard working pensioners” against “woke” asset managers and “joyriding ideology” and said he believes Florida’s legislation, which follows on from Florida State Board of Administration divesting the state’s pension investments from BlackRock, will act as a blueprint for other states opposed to ESG, in a multi-state effort.  

“This governor is leading the fight and 20 other states are following his lead into battle,” says Florida’s chief financial officer Jimmy Patronis, who sits on the SBA board alongside DeSantis and Attorney General Ashley Moody as the three government-elected trustees. 

 But the idea that Florida’s sweeping legislation, backed by the campaign’s biggest beasts, signposts the rollout of similar legislation at other pension funds is not necessarily the case. CIOs are also hitting back.  

Like Alan Conroy executive director of $24.3 billion Kansas Public Employees Retirement System, whose testimony highlighting the potential impact on the pension fund contributed to legislators reducing the scope of Kansas’ Protection of Pensions and Businesses Against Ideological Interference Act. The final legislation still restricts ESG but addresses all concerns Conroy raised in testimony. Like the fact forced divestment from ESG-minded managers, restructuring the portfolio and hiring new managers could cost $3.6 billion over the next decade, impacting the already underfunded pension system. He warned that KPERS’s funded ratio could be lowered by 10 per cent due to the combined impact of lost assets due to divestment and increased liabilities due to lower future investment. 

Forced divestment from ESG-minded managers, restructuring the portfolio and hiring new managers could cost $3.6 billion over the next decade,

Other CIOs also complain if anti-ESG legislation in their states went through in its original format it would have a huge adverse impact on their investment organisations, including needing to fire managers, build bigger internal organisations or go passive – all of which have cost, resource and return implications.  

CIOs are also arguing that new proxy rules create an unnecessary layer of administrative complexity in structures that are already highly bureaucratic compared to global peers, that will make them less competitive with private market investments. 

“These requirements could also prevent the system from using commingled investment accounts that often provide a more efficient, low-cost way of investing trust fund assets,” KPERS’ Conroy told legislators. He also sounded a warning bell on new complexities around the term “fiduciary”.  

It’s a similar story in Nebraska, where Michael Walden-Newman, CIO at $40 billion Nebraska Investment Council has resisted an attempt by Nebraska state legislator to introduce legislation banning ESG investment that directly interfered with fiduciary duty.  

“I explained to legislators that Nebraska already states that the investment council is prohibited from making any investment if its primary purpose is for social or economic development benefit,” said Walden-Newman. “Also, that the members of the investment council board and I, as CIO, are fiduciaries under the law, and are bound by that fiduciary responsibility to ensure investments are made for the benefit of the members of the various retirement plans and the general taxpayers of Nebraska. The Legislature chose to not act on the legislation.” 

In Texas, where an anti-ESG bill went through the legislative process earlier this year but was not passed because it missed a key deadline, Amy Bishop the executive director of the $45 billion Texas County & District Retirement System (TCDRS) raised similar concerns with the Senate State Affairs Committee. She warned the proposed bill would impact the organisation’s “ability to maximize returns and have a financial impact on employers” adding the bill would keep the fund from “partnering with some of the best investment managers in the world”. She warned that adjusting the asset allocation could cost more than $6 billion over the next 10 years, causing employer contributions to double. 

How do you right the ship? 

The governance structures of US public plans were set up in the 1970s and are due for modernisation. 

55 per cent of the board members of US public sector pension funds are either appointed through some kind of election process or through ‘ex-officio’ status, requiring board membership by state or local officials. The number in Canadian and European pension funds is zero per cent.  

The important distinction, according to CalSTRS’ Ailman, is that these organisations are trusts set up for a specific benefit. 

 “These are trust funds and they need to be treated that way. We don’t use that word enough and that’s why we’ve lost sight of it,” he says.

“Seeing trust funds being attacked by both sides of the aisle may be enough of a catalyst for us to make some change. These retirement plans are for multiple generations. I have 20-year-old teachers starting this fall and it’s their pension too. Elected officials want to make a statement and so why not use somebody else’s money? It’s too easy for them.” 

CIOs and their investment teams are money managers trapped inside the business model of a government entity. 

“These are trust funds and they needed to be treated that way. We don’t use that word enough and that’s why we’ve lost sight of it.” 

“That is costing us money,” Ailman says. “But even that is not enough to make people want to change the governance, because the people who will change it are the ones using it for personal gain. I can’t put my finger on what will cause it to change, but when it does it will spread like wildfire across the country.” 

 

 

Policy makers in the UK are suggesting pension funds invest more at home to support economic growth, but investment executives at the funds say it’s not that simple.

The UK’s defined benefit funds, many in their end game as corporates prepare to shift their liabilities off balance sheet, aren’t positioned to tie up assets in illiquid investments. Moreover, many are still feeling the impact of the largely government induced LDI crisis. Elsewhere defined contribution schemes like Nest, although fast growing and already investing in illiquid assets in the UK, still lack the size to invest for economic growth on the same scale as the Australian DC model.

Policy makers have recently suggested that pension funds should invest more at home to support economic growth. But investment staff at the UK’s pension funds say it’s not that simple.

Nest, the UK’s £30 billion flagship DC fund, growing at around £400 million a month due to contributions from one in three working Britons, is just the type of investor the UK government has in its sights to invest more at home to fuel growth. Speaking on the side-lines of the annual pension association conference as part of advisory firm LCP’s Investment Uncut podcast, Nest CIO Liz Fernando, sounded a warning bell against investors being told where to invest by geography or asset class.

She said Nest already invests some 45 per cent of its assets in the UK and would resist any government compulsion on how it invests – an approach, she warned, that “always ends badly.” She also flagged that it takes time for Nest to put capital to work in infrastructure, where scaling up has been a little slower than imagined although managers are right to be picky on price and terms.

Investment Uncut interviewee Cliff Speed, CIO of £10.3 billion TPT Retirement Solutions, reflected that pension funds looking to the future can’t ignore the lessons of last year’s gilt crisis when the market froze over and it was impossible to trade.

Speed said that the unprecedented volatility in gilts has seen investors build new risk models into their portfolios that incorporate much bigger moves in gilts prices. This in turn has implications for how much they are prepared to invest in illiquid assets, running counter to the government push. Reflecting on the crisis he also noted the importance of diversity of thought and the value of people who think differently – everyone thought last year’s sharp movement in gilts was impossible.

Still, Speed noted that although DB schemes are looking to have less illiquid assets, DC schemes are wanting to build up exposure. “Is there a trade there?” he asked, adding that the barriers for DC schemes to invest in illiquid assets are starting to come down coupled with an awareness amongst participants of the benefits of “slow finance” – aka investing for the long term.

Investing more in the UK for growing LGPS and DC funds may make sense, said John Chilman, CEO of Railpen who said research shows that illiquid investments in DC improves member outcomes.  But he noted that Railpen, an open DB pension fund, already has significant UK holdings in infrastructure assets like windfarms and solar.

Investing more at home is also challenging when pension funds are worried about growth because of high inflation. For example, Fernando, who also had a 25-year stint at USS, said the fund targets CPI +3 per cent net of fees which in today’s high inflationary environment is a reach. Although higher interest rates have led to better nominal returns, most assets currently fail to meet Nest’s return target making a long-term view and diversification central to strategy.

She added that as inflation drops back, Nest will be able to deliver on its target return. Moreover, the fund now has the assets in its tool kit including private credit, infrastructure and renewables to diversify plus its huge monthly inflows help support a natural rebalancing.

The active equities team at CPP Investments has abandoned antiquated investment categorisations, such as style and size, and views companies through a more holistic “domain” interpretation. Amanda White spoke to the global head of active equities Frank Ieraci about the unique insights and organisational structure of the team; and the contributions it makes to the total fund, including capital efficiency, agility and pure alpha.

Frank Ieraci runs a giant hedge fund within CPP Investments. As global head of active equities, one of six investment teams at the C$570 billion Canadian pension fund, he has a mandate to deliver alpha in global public equities markets, and it’s done in one concentrated portfolio.

“We are a long-short, market-neutral strategy, and from that perspective we are very similar to hedge funds,” Ieraci says.

His team of 170 delivers a single C$69 billion portfolio driven by fundamental research, unique insights predicated on a long-time horizon and investment beliefs that have been empirically tested.

“We have a set of investment beliefs in active equities, that are not articles of faith, they are empirically tested facts. We have put the time in to think about what long-term fundamental investing looks like and empirically test what works and what doesn’t, and it’s that set of investment beliefs that really drive the way we structure ourselves and the way we make decisions,” he told Top1000funds.com in an interview.

“We can demonstrate empirically that markets are less efficient when you start to extend the forecast horizon. At approximately the one-year mark you start to see a big difference in both how information is priced in and the speed at which it is reflected in market prices . At about that one year mark it breaks down, publicly available information is not uniformly or ubiquitously priced in, and that trend continues to break down as you push out the horizon. The drivers of returns over the long run are company specific fundamentals. So for individuals who can think and act as long-term fundamental investors there is opportunity to generate alpha.”

He believes the ability to exploit those market inefficiencies is predicated on unique insights, and it’s the proprietary company specific fundamental research that yields a collection of high-conviction, single-company investments that are assembled into a highly concentrated long/short, market-neutral portfolio. An optimization process removes unintended factor exposures.

The active equities team is organised around regions and ‘loosely’ around sectors, that internally are labelled as domains. Unique to its approach is redefining the ecosystems within which businesses operate either through the lens of a theme business model, or value chain.

“It’s not enough to just have fundamental insights, those insights need to be unique,” Ieraci says.

“It’s not enough to just have fundamental insights, those insights need to be unique”

It means approaching investments with a holistic, broader view of business operations and drivers of success and not through the lens of pre-constructed investment criteria such as capitalisation or factors and styles.

“When I was early on in my career I struggled to label whether I was a value investor or some other description,” Ieraci says. “Over the years I have just got to better understand what active security selection, and more specifically fundamental investing, meant. Increasingly we are seeing there is not that much difference between say factors and small cap or mid cap, so why have those distinctions? It’s tough to appreciate why that exists today.”

How to get unique insights

It’s this domain expertise that defines the analysts in the active equities team.

“We believe that domain expertise is necessary, we don’t think about a generalist model. At the same time we don’t need marketing-driven labels such as value or momentum, they have been created to market to clients and it’s not how we think about the world,” he says.

Instead a more inclusive and universal view of a company means they are viewed through mini eco-systems that operate in larger systems.

“We need to understand the business model of each company and the competitive dynamics that exist within the systems within which they operate and become an expert in that to really understand what will be the long-term drivers of success for these businesses,” he says.

That domain expertise is how the analysts are organised. Eco-systems are identified around emerging themes, business models, value chains, and in some cases a more traditional industry definition.

“It could be any of those, and it is any of those. We look at building expertise in that space and from there our fundamental, and in some cases data-driven, research comes in to produce those fundamental unique insights.”

By way of example he says AT&T or Verizon might be traditionally covered by a telecommunications analyst, but at CPP it’s not so narrowly defined.

“You need to understand the parts of the value chain that go left and right of that. For example the handset makers, the tower companies, software, the equipment providers and how that is changing how consumers use their devices, you need to understand the unique partnerships attracting customers. All of these things are part of the value chain, but the traditional analyst is just set up to look at that company in the telcos lens.”

Ieraci says there is a culture at CPP of collaboration and knowledge sharing as an important part “of the way we apprentice our analysts and how we build investors”. But to some extent the need to share knowledge misses the point of how the team is organised and researches companies.

“In the traditional sense you would need to be collaborate across industry analysts to get the full 360 view. But our analyst already looks across industries. We handpick the companies in those domains to create these structures. It’s one person that does all of that. At first blush you might say that seems hard. But I think it’s the opposite. I actually think it is impossible to fully understand A&T and Verizon without understanding the other parts of the business. So when you are separated you actually hinder people from truly understanding the ecosystem and developing those more unique insights that they could develop.”

Portfolio optimisation

The active equities portfolio has a three-to-five year horizon, although it can be longer. Turnover is about 20-25 per cent with a holding period of about four years. One position has been in the portfolio for 11 years.

Consistent with a long/short approach investments can be opportunistic and as a market-neutral approach it is by definition not tilted.

“We do think opportunistically, agility is the important piece of that,” Ieraci says. “We want to operate in areas where there is an alpha opportunity we can exploit through our fundamental research and if we have a unique insight then we will deploy capital there. For example on the long side of the portfolio we could have a big position in India or more in tech than industrials, but that changes frequently because we operating opportunistically.”

The short is used where a company is in structural decline and there’s a view that hasn’t been priced in, or to mitigate the exposures it doesn’t have a view on.

The portfolio optimisation process has three layers that gradually brings the view of risk down from 30,000 feet.

“We start with off-the-shelf risk models we refine for our needs, they have factor exposures including sector, geography, beta, momentum, value etc and that allows us to structure portfolios to neutralise standard factors. Those risk models will get from 30,000 to 10,000,” Ieraci explains. “At the next level we think carefully about the nature of the company and specific exposures that may not be captured in off the shelf factor models. For example there could be an exposure we have where regulation may change the outcome of the company and we want to neutralise it.”

The third layer, he explains is the toughest to get right and a constant area of improvement, looks at emerging correlations.

“It’s where we are trying to identify those situations where there is a lurking correlation that will only present itself when something goes wrong. Covid showed us there were some companies where there was no historical correlation but post-Covid there was. These were out of model risks.  We’re looking to see if there are any early correlations where we can examine them through a fundamental lens. We are experimenting with new data and analytical techniques to identify emerging correlations.”

Research clarity

It’s possible for active equities to manage as one portfolio, because it has a platform that allows the team to think and operate as a long-term investor with scale, certainty of capital, and a sophisticated internal team.

“We know what will matter the most and over what horizon, so we can laser in on those,” he says. “Others are having to consume vast amounts of information and trying to process that in a mosaic, which is impossible to do. I don’t think humans are very good at doing this.”

“We know what will matter the most and over what horizon, so we can laser in on those”

Because of how hard that is people end up taking short cuts like reading other peoples’ research without validating it. “Other peoples’ research has an element of postulating and is not really evidence-based or data driven” he says.

CPP’s active equities research has clarity with the team identifying one or two questions to focus on and get right over the next three to five years.

“We focus solely on that and bring as much evidence as we can to those questions, and don’t rely on other peoples’ research, we do it ourselves. We read it but because we’re not tasked with doing what others do, and having to know everything about a stock at any given time, we can actually can do the work that we think is the most relevant.”

The research process is protracted and detailed with specific research being identified and bought, which in some cases has taken months to negotiate and evaluate.

“Once we have identified the key question we can take the time to do the research and find the evidence and data that can support that,” he says.

The questions being posed are always company specific.

“We are very clear about what specific performance we are investigating. Earnings don’t matter to every company. For some revenue or operating margins or investment capital might matter more. We identify what matters for each company and then we are laser focused on those questions that will drive that fundamental outcome,” he says.

Serving the total portfolio

At CPP, teams are broken into six groups: total fund management, active equities, credit investments, capital markets and factor investing, real assets and private equity.

Like any of the groups active equities delivers alpha, so at the most basic level its commercial imperative is to deliver outperformance to the fund. But as a long short portfolio it doesn’t deliver any other factor exposure.

“We don’t deliver any public market beta, just alpha,” says Ieraci. “So as a result how we contribute to the fund tends to be a bit more simplified in terms of the factor exposure but in other dimensions we can do things that other long-only strategies can’t.”

This means the contributions to the total fund are more than just alpha. The long short positions mean it is a very capital efficient portfolio, using less dollars to deliver the same alpha; and the liquidity of the fund means it is very agile.

“We deliver an agile strategy that can expand and contract very quickly if we need to move capital from a relative value perspective to other parts of the organisation,” he says.

While it doesn’t happen very frequently, Ieraci says the conversations are constant.

“Our CIO, Ed Cass, in partnership with each investment department head, is constantly trying to identify where the best relative value opportunities are , and how would we tactically allocate capital to them. That conversation happens regularly given our size we need to constantly be thinking about how to set ourselves up at any point in time for the next two to three years,” he says.”