Escalating diplomatic “disillusionment” surrounding the US-China relationship has made investors think twice about exposure to the world’s second-largest economy. Geopolitics expert Professor Stephen Kotkin said China, and other emerging markets, may still be attractive to asset owners, as long as they understand the complexities of domestic Chinese politics – and ensure they are paid a hefty risk premium. 

Tensions between the US and China have escalated significantly after the Trump Administration introduced new tariffs and China’s zero-COVID policy heavily disrupted trade and travel between the world’s two largest economies. They have continued to clash since over Taiwan, human rights, microchips and rare earths.

Stephen Kotkin, a geopolitics expert at Stanford University’s Hoover Institution, said officials in Washington DC and Beijing are “disillusioned” about the relationship after decades of efforts to transform China into a liberal, open society have fallen flat.

And they’re not the only ones. Institutional investors, many of whom had been beneficiaries or champions of what Kotkin called the “Pygmalion” approach to engagement with China – a reference to the classical Roman poem in which a sculptor creates a statue of his idealised version of womanhood – are also now feeling disillusioned as the Chinese market is submitted to rising state intervention and a reversal of once-lucrative partnerships with the global financial system.

Some investors call this dynamic “geopolitical risk”. But Kotkin said it should more accurately be seen as simply a re-pricing of the inherent risk attached to investing in the developing world – a risk he says some have clearly underestimated.

“What many people are calling geopolitical risk is just investing in places where the governance is not the same as in your home country, where rule of law is not the same (if it exists at all) and, where transparency is lacking [or] opacity is extreme,” Kotkin told the Fiduciary Investors Symposium held at Stanford last month.

“And for some reason, it was considered normal practice, to invest in those places, and to assume a great deal of risk for which you didn’t get rewarded. But you did do it. And it was known as emerging markets. This never seemed to me a properly understood idea.”

The thesis that emerging markets could yield similar or better returns to developed world markets – without sufficient attention being paid to inferior governance or institutional structures of these countries – was flawed, Kotkin said.

“You were not getting a sufficient premium in my view,” Kotkin told delegates, speaking rhetorically to the broader institutional investor community. “And you maybe were not aware of the scale of the risks that you were undertaking. And now it’s become more obvious and we’re having the repricing.

“Investing in places beyond North America, Europe, Japan, Australia, we’re not advising against that – we don’t give advice on investment. But it’s just how you price those investments previously, but especially going forward.”

Cold war the best of bad options

Notwithstanding the disillusionment felt by diplomats and analysts, Kotkin said geopolitical tensions between world powers was not new and that investors should be realistic that a cold war scenario between the US and China has not only commenced – but is preferable to the alternative scenarios.

“People are against cold war, they say that would be terrible if we went into a cold war with China … [but] you only have a handful of options in geopolitical competition … What are the other options that you would prefer? How about hot war? Would you prefer hot war? I would not prefer hot war. That would be maximal geopolitical risk. I want to avoid hot war,” he said, adding that nobody wins a war given the losses on all sides.

That leaves two options, Kotkin said: appeasement, which he described as “capitulation” and dismissed as “not a good idea” and the “Pygmalion” option favoured by former US Trade Representative Bob Zoellick. Attempting to reform China through engagement and co-operation was well-intentioned but “not going to work”.

“I study geopolitical competition and history, and cold war to me looks like a really good option, because it’s better than all the other options that I know from history,” he said. “So, just learn how to compete, keep it from becoming hot war, don’t capitulate and don’t have illusions about Pygmalion. This is not rocket science.”

He said some analysts and historians had ignored that during the Cold War between the US and Soviet Union there was a “tremendous amount of scientific cooperation”. The standoff was not based on miscommunication or misunderstanding, but a fundamental clash of strategic interests and values which cannot be reconciled. Cold war is the most feasible way to mitigate that tension without escalating to catastrophic conflict, he said.

At the same time, he said China’s success in lifting around 700 million people out of poverty had been built on the back of access to the US economy and consumer. He said there may yet be opportunity for investors in the Chinese market.

But as well as ensuring they are generating sufficient risk premia, he added they face another challenge.

“From an investment point of view, your problem is … understanding Chinese domestic politics. If you’ve made investments there, or if you’ve made investments that are influenced by China, because they’re elsewhere in Asia, or they’re in Germany, or wherever, there are second-order effects from … Chinese domestic politics. Good luck with that proposition. I think it’s possible, but it’s not simple.”

 

APG is considering licensing its new bespoke ESG real estate index to the broader industry, with CRREM compliance a driving factor of broadening its availability.

APG launched a new cost-effective ESG-focused real estate index strategy for pension funds last month and APG head of global real estate investment strategy Rutger van der Lubbe says following the launch the organisation has received many inbound requests about licencing the index.

“This was not originally in our scope but we are contemplating it,” he says.

The index was developed in conjunction with STOXX and includes data from providers including RepRisk, Sustainalytics and CRREM (Carbon Risk Real Estate Monitor).

Van der Lubbe says one of the benefits of licencing would be to increase recognition across the broader industry that CRREM compliance is important, driving compliance and ultimately improving energy use in the property industry.

APG has been involved in other innovative ideas that have been made available to the broader industry, including the SDI initiative, which was an asset owner collaboration with PGGM, BCI and AustralianSuper.

The real estate index strategy built by APG combines data providers and the fund’s own unique proprietary views.

“We wanted to leverage various data providers for the best fit for what we want to achieve,” van der Lubbe says.

“We created our own index with those filters as we believe what clients are after is not available in the public domain at this point in time. We are not aware of an index solution that looks at the criteria like we do, to really embed responsible investment criteria for a passive strategy. We aim to deliver something standout from the market perspective and our own RI leadership.”

The strategy is built on a proprietary process that filters via APG’s exclusion policy, inclusion policy, solid reputation, good governance and CRREM, with van der Lubbe emphasising the CRREM compliance as a unique element.

“It prescribes carbon transition pathways and energy pathways,” van der Lubbe says, adding the guidelines for energy emission and consumption for buildings applies to the present and the years up to 2050.

In its strategy APG reweights securities so it is factor-neutral on a currency, regional and sector basis, to avoid individual tilts that could arise from the five criteria.

The index also uniquely includes APG’s bespoke inclusion policy and whether specific assets meet transition pathways.

APG has about €55 billion ($57 billion) in global real estate assets, the majority of that is actively managed for ABP.

The bulk of the real estate assets are in a globally integrated investment strategy that invests in both public and private assets.

“It is a function of what is out there,” van der Lubbe says.

“The US has a very well developed public real estate market so we have greater share of public there, in Europe it is orientated towards private exposures, in APAC more balanced.

“We are known for an active approach so look for a typical share of control to drive the strategy of the entities we invest and to drive ESG matters.”

This new index strategy will be aimed at smaller clients and is the equivalent to the equities index strategy launched in 2021.

There is consideration of further initiatives to be launched in other asset classes in the future.

“We hope it will drive the industry towards further carbon reduction,” van der Lubbe says.

APG and PSP Investments told investors at the Fiduciary Investors Symposium that unless they embrace technology and innovate, their licence to operate will be under threat. They explain how and why they are embracing technology in all aspects of their investment process and operations.

Asset owners must embrace technology or have their licence to operate questioned by stakeholders according to two large asset owners who are leading the charge on bringing innovative technologies to investment processes in a bid to increase efficiency and outcomes.

Eduard van Gelderen (pictured), chief investment officer at Canada’s C$243 billion PSP Investments, told the Fiduciary Investors Symposium at Stanford last month that pension funds’ licence to operate is under threat if they do not embrace technology.

“I am 200 per cent convinced that investment models will change and will change rapidly,” he said. “If you take a step back and ask what your licence to operate is, ours is to keep the defined benefit system alive and sustainable. I don’t think that is possible if we continue to work the same way as we did before.”

He said that technological changes are happening so quickly if pension funds don’t keep pace and deliver results the general public will start to ask “why do you actually manage our money”.

“So to me that is one of the drivers of why I am so eager to change the investment process and embed the possibilities of technology and to really exploit the technology the best way we can, that is one of the ways to actually keep your licence to operate.”

Van Gelderen was part of a panel with Peter Strikwerda, global head of digitalisation and innovation at APG, chaired by Ashby Monk, who with Dane Rook in 2022 wrote The Technologized Investor, a play on Benjamin Graham’s book the Intelligent Investor, with the subtext that technology is the future of intelligence.

Strikwerda said APG was innovating across the business with focus on “pockets of value” including portfolio construction, responsible investment, investment decision making, client services, and efficiency with all aspects of the business now “highly data driven”. (See Portfolio managers 3.0: APG’s digital future)

“Over the last 10 years I have been involved in close to 100 innovation initiatives from very small to very big,” he said. “What we do in our innovation approach is we merge business, IT and data knowledge together. One of the key implications of working with data is you need to make it ‘business owned’ and bring the capabilities together in the same teams.”

He said of the 100 initiatives investigated only about 20 per cent survive with a very systematic approach taken to innovation.

“We kill about 80 per cent of those innovations,” he said. “It’s not by luck we stumble into things, innovation needs discipline. Investors need to get mature in that, they need to learn how to do that, and that takes time.”

Strikwerda said investors need to embrace a change of mindset in order to succeed in innovation.

“In a normal operations environment you have KPIs and control mechanisms. When you want to innovate you approach that differently, you want to take risks, make mistakes and pivot from those, a learning ability is key to be able to innovate.”

Monk, who is the executive director of the Stanford Research Initiative on Long-Term Investing noted within funds management most of the technological evolution comes from within the industry – from funds managers or custodian banks – but there was little embracement of start ups.

“A lot of the technology we see in this industry emerges from this industry. We are sitting here at Stanford and the students here are looking for problems to solve. Why not the $140 trillion problem of pension funds?”

APG’s Strikwerda says the fund does occasionally work with startups and has also tapped into the Stanford ecosystem.

“We invest in some venture. Every now and then we take a stake in a company but we do it for strategic reasons, not from an investment perspective,” he said.

The investment in Entis, an AI-powered data science platform, that is a foundational data provider for the Sustainable Development Investment Asset Owner Platform is a good example.

“We also do some co-creation working on specific problems I find that interesting because we learn a lot from that and do a lot of knowledge transfer,” he said.

But APG’s experience demonstrates how difficult it is for large, slow-moving, regulatory-burdened asset owners to operationalise good ideas.

“There is a big difference between a nice idea and something that will fit all our rules and regulations that we need to comply with in order to operationalise something,” he said. “You can’t just put something into a process where you run billions of euros in transactions. There is a real challenge there. To really scale it up it has to be proven before we can really apply it at scale. In between is the question do you want to put in some small efforts to get it going, that is difficult because it is still pension money, you can’t gamble with that. It’s not easy.”

Monk noted with large scale investments like technology – which can be up to $150 million – the business case for value creation from that has to be clear.

Van Gelderen says in making that business case it is important to focus on the individual asset owner’s mission.

“When we think about new technologies and advanced analytics we are keen to be very precise on where the most value for us is,” he said. “We try to team up with strategic partners so that we can rely on some of the technology they can bring to us and we can piggyback on what they do, that’s an attempt to keep the cost low.

“If you think about the business of asset owners, everyone feels it’s a scalable business, but the reality is very different. If you take the biggest cost drivers, human capital and technology, both are actually growing at 7-8 per cent. That is something boards don’t like to see, so they ask you to make very clear decisions on where you spend it and the value add and how you operationalise it. We do it with partners.”

The board and management changes at PSP over the past few years have been an opportunity to focus more on technology.

“There was a sense of urgency and we need to think about it, the topic came up over and over again,” he said. “The Canadian model has been extremely successful over the past 20 years but that is no guarantee for the next 10. The good thing is I do have the support from the board to look into innovation and how it applies to our investment processes. It is still small scale but the successes have been adopted, and we need to give it room to grow.”

Strikwerda says it is important that investors realise that “more data is not the goal”.

“Like the saying more money more problems, it is also true that more data more problems. You need to be very concise and focused on where you put your money,” he advised, adding that problem is magnifying with technological advancement. “The problem is growing day by day because the data and technology available is growing so fast and with generative AI it is tremendous. Spending your money wisely and having capability to make those decision is key.”

He said APG continuously has conversations with its board on how the investments in technology could be translated into alpha.

“The conclusion is you can’t, you can’t isolate it, unless maybe in quant,” he said. “Any outcome is a combination of technology and human input so you can never say we are only generating this much alpha isolated by technology. So what we did, we reversed it so all our investment teams have a KPI on systematic decision making, which breaks down on using technology and standardised data, because our belief is that will lead to better outcomes.”

The Teacher Retirement System of Texas (TRS) believes AI can differentiate the fund and become a powerful source of success. In a recent board meeting at the $200 billion public pension fund with some 200 full time employees at offices in Austin and London, Mohan Balachandran, a managing director at the fund explained how the investor is already using AI and the opportunity and risk ahead.

“It’s a giant leap forward and we really need to embrace it. In my team we are embracing it and figuring out how to use it and put the safeguards in place,” said Balachandran, whose responsibilities include overseeing a multi-asset program that comprises a $15 billion quant allocation to public equities.

The arrival of OpenAI’s ChatGPT has both transformed and accelerated AI integration, creating a new level of realistic computer interactions with humans. It also heralds the start of AI applications touching multiple areas of life from finance to creativity and language, in contrast to narrower, previous applications of the technology like opensource chess software, StockFish.

Tapping the opportunity

TRS is already using the technology to manage risk and create portfolios. For example, it uses it to identify patterns, and which factors work best in the Japanese market. It also uses it to extract sentiment from transcripts on management calls.

Other public market exposure to the revolutionary technology includes investment in the companies leading the digital revolution, the so-called magnificent seven (Apple, Microsoft, Amazon, Google, Nvidia, Tesla, and Meta). Investment in chipmaker Nvidia, off the back of soaring demand for the processors needed to train the latest artificial intelligence models, has been particularly profitable.

Outside these stocks, all highly geared to AI, TRS is also focused on how AI will affect the S&P500’s other 493 stocks. TRS chief investment officer Jase Auby said that the team are mindful of how much money companies are spending on IT, and noted that many companies have slowed their IT spend since 2000. “It has plateaued in the last 20 years,” he said.

In contrast, Tesla’s Dojo Supercomputer is garnering attention following a positive writeup from Morgan Stanley around its billion dollar impact on the company’s’ market capitalization. Auby noticed that S&P500 constituents increasing mention AI on board calls.

In private markets like real estate TRS is tapping opportunities in data centres, the complex buildings housing giant cables and cooling systems. Elsewhere it applies AI to private markets to create memos and summarise transactions. Opportunities are also coming in private equity and venture.

Balachandran explained how TRS integrates the technology into its own investment processes. The quant team tests signals on a data set, figure out the weights it needs using that data set, and then presents it to the portfolio management team to test if the model is robust.

“Any new signal we bring in we bring in with a small weight and evaluate over a period of time. We look for consistent performance, then start getting more confident.”

AI Integration: data and security

One of the biggest challenges of using the technology is access to data.

“Financial data is very small compared to other data,” said Balachandran. For example, Tesla has vast access to data needed to feed into its autonomous driving models. It has fleets of cars on the road with sensors, gathering the data required to build its models which technicians are constantly improving by tapping new data.

In contrast, investors trying to build similar models face a more challenging data gathering process. Financial market data is noisy and markets are also efficient and constantly change.

“In finance, the market evolves and changes so designing a model is difficult,” he said.

High frequency data can create good models, but he noted that the capacity to execute with high frequency data is more difficult.

TRS is also mindful of the risk of using AI in its investment processes. The pension fund holds information that is confidential like member and healthcare data and other companies’ experiences show what can go wrong. Like Samsung Semiconductor which let its fab engineers use ChatGPT for assistance, using it to fix errors in their source code in a process that also leaked confidential information.

Auby added that TRS has been considering the risk of AI for years. “We’ve been thinking about security in our IT systems for a long time,” he reassured.

Balachandran concluded with a warning of the hype in AI, flagging that only a handful of companies coming out with new applications will do well. The board also heard how TRS expects the speed of AI adoption to accelerate with implications for headcounts at companies.

 

Biodiversity, transition finance and a sense of urgency around climate resilience and mitigation were some of the focus areas of Climate Week 2023 in New York, dubbed the “Burning Man for Climate Geeks”. PSP Investments’ Herman Bril and Stella Y. Xu reflect for Top1000funds.com on the highlights from Climate Week which they attended this year. They didn’t attend Burning Man in 2023.

Climate Week NYC completed its 15th year as the world’s largest global climate event alongside the UN General Assembly, bringing together a global nexus of policymakers, academics, investors, and corporate leaders.

The New York Times dubbed this year’s summit as a “Burning Man for Climate Geeks”, referencing the week-long large scale desert event in Black Rock City, Nevada that emphasizes decommodification, civic life and leaving no trace on the environment. Contrary to the recent flameout at Burning Man from climate-induced flooding, the mood in NYC was reservedly optimistic with an undertone of urgency. Our team spent a hectic but energizing few days navigating a dizzying array of 400 sessions, workshops, and dinners, where discussions likely signpost many topics that are expected at COP28 in November.

What is clear more than ever before is that Climate Week is not just about climate. Just as the theme of Burning Man this year was “Animalia”, celebrating the animal world and our place in it, Climate Week NYC kicked off with the Taskforce on Nature-related Financial Disclosures (TNFD) publishing its final recommendations to guide companies in disclosing their dependencies and impacts on nature, following the adoption of the Global Biodiversity Framework (GBF) at Montreal’s COP 15. Discussions around geopolitical risks as well as geo-economic policy measures impacting energy accessibility, affordability and sustainability also took center stage, reflecting that a geopolitical lens now also impacts investment decisions and risk management. Domestic election cycles, polarization of ESG in the US, and the need to detangle ESG from culture wars were also recurring themes.

This year Climate Week followed a historic stretch of weather extremeness which culminated in California Governor Gavin Newsom announcing his intentions to sign the California climate disclosure bills into law. The Glasgow Financial Alliance for Net Zero (GFANZ) also launched a consultation on its work to further refine the definitions of its transition finance strategies and support financial institutions to invest in real world decarbonization Paris-aligning strategies. Development in climate technologies from solar to EVs and nuclear fusion may accelerate mitigation efforts, but blind spots remain, ranging from grid expansion and permitting to emerging market green transition investment gaps. Discussions around the role of AI and its ability to unlock vast potential for renewables, specifically around advance prediction capabilities and automation capability, further supports the narrative that Moore’s Law is still relevant and will be for the coming years.

Several sessions also highlighted the significance of climate mitigation through Internationally Transferred Mitigation Outcomes (ITMOs), reflecting a significant milestone for the Paris Agreement. ITMOs are a mechanism for countries to sell emission reductions to other countries or companies to use toward their own targets. Recently, the South American forest nation of Suriname announced plans to become the first country to sell carbon credits, an innovation which can bring much needed financing to developing countries to accelerate clean energy transitions. The United Nations Conference on Trade and Development (UNCTAD) recently called for urgent support of developing countries to attract investment in clean energy as much of the growth in renewables investment since 2015 has been concentrated in developed countries. The choices developing countries will make as they progress will shape climate risk for all and should be viewed as a matter of urgency for the investment community.

At the same time, more focus is needed on adaptation and to build resilience for the future. As the climate crisis deepens, climate resilience defined as the capacity of interconnected social, economic and ecological systems to cope with a hazardous event, trend or disturbance, responding or reorganizing in ways that maintain their essential function, identity and structure – will increasingly come to the forefront as we face more frequent and severe weather events.

Two consecutive years of brutal weather – one scorchingly hot, one gloomily wet – at Burning Man should serve as an allegory that the systems-based world we belong to is careening towards a tipping point. Research published last year in Science suggests that the risk of a tipping point accelerating climate warming is now likely to happen in the 2030s. Separate analysis of the planetary boundaries concept, which presents a set of nine planetary boundaries within which humanity can continue to develop for generations, shows that six of the nine boundaries have been transgressed. As long-term effects of interactions among variables are difficult to forecast, panelists emphasized the need for more up-to-date and relevant scenario models for the investor community and to shift away from long-term linear models to shorter-term realistic ones. It is worthwhile for investors to delve deeper into the themes highlighted during Climate Week, as they will undoubtedly shape the conversations at COP28 in Dubai later this year.

Herman Bril is head of sustainability and Stella Y. Xu is senior director, ESG investment research at PSP Investments. 

Over the last three years, AP1, Sweden’s SEK 446 billion ($40.4 billion) buffer fund and one of five backing the income pension system, has only allocated to GPs investing in at least one of the 17 SDGs in its private equity portfolio.

Since 2021, around 15 per cent of the $2.9 billion private equity portfolio has been invested with 16 GPs with funds with sustainable strategies. “All new investments in the portfolio now align with our sustainability objectives,” says Jan Radberg who oversees the portfolio that he says will gradually  increase. “Returns come first, but investments to date have done well and we are encouraged to continue.”

Progress isn’t uniform since the venture portion of the portfolio (around 15 per cent) is taking longer to develop, but in the buyout space he sees good progress in terms of revenue growth and profit. “We haven’t seen too many exits yet, but it’s coming.”

The SDGs smaller investable universe leaves AP1 navigating a market segment with less opportunity or proven managers. “Managers haven’t been working in the sustainability space for as long as in traditional private equity,” he says.  It would make deployment for a large LP with regular pacing challenging, but the strategy fits nicely with AP1’s small, 7 per cent allocation to the asset class.

“[Investing in the SDGs] can be easier for smaller or medium sized LPs with less capital to deploy. However, we can see that the investible universe is growing as many traditional private equity managers are redefining their strategies or adding new business lines at the same time as newer entrants are getting more experience.”

Adding value through ESG

More managers could also move into the space given the returns available for private equity investors that add value by integrating ESG. Especially since private equity investors are feeling the impact of higher interest rates and a tougher business cycle, as well as geopolitical uncertainty.

With the caveat that some businesses are more suited to ESG improvements than others – and it is more difficult to add value in venture – Radberg says GPs are increasingly seeing value from improving sustainability in a company when they exit. “We often see GPs buy small companies that haven’t integrated ESG, and then using ESG improvement as a tool to increase the value in the underlying company.”

Investing in line with the SDGs also reveals important trends in climate opportunities in private equity – they are surprisingly hard to find.

Although AP1 aims to create diversification by investing in as many SDGs as possible, around half of the total allocation to the SDGs currently sits in healthcare (SDG 3: Good Health and Wellbeing). “It is more difficult to find investment opportunities around some of the goals,” he says.

After healthcare, AP1 invest most in climate-related SDGs where Radberg would like to allocate much more. Although opportunities abound in climate infrastructure like solar and wind farms, or sustainable real estate, he says it is difficult to find private equity opportunities in the energy transition space that are pure private equity plays. “Infrastructure is normally longer-term, lower yielding assets compared to private equity, and those kind of assets are not included in our private equity mandate.”

However, he says opportunities in the decarbonization vertical are starting to emerge. “Decarbonization is an interesting space, and we will increase our exposure here over time.”

AP1’s SDG lens has slightly adjusted its regional focus away from the US to more GPs in Europe where LP demand for sustainable investment is stronger. The wider private equity portfolio is split between America (60 per cent) Europe (30 per cent) with the remainder in emerging markets while venture and growth account for around 15 per cent each with the remaining 70 per cent of the allocation in buyouts.

Still, he notes that the number of US managers experienced in the sustainable venture space supersedes other regions, and America has more opportunities in decarbonbisation than other areas. Moreover the supply of investable projects in clean, renewable energy is sure to expand off the back of the climate incentives in the 2022 US Inflation Reduction Act.

He also believes that the number of managers targeting SDGs and impact will could grow if more LPs focus on intentionality. He expects progress in the space to manifest around new KPI beyond just carbon emission targets indicative of the different ways investors can contribute to a a more sustainable world.

Radberg concludes that finding venture capital GPs experienced in sustainable investment is most difficult. “It is sometimes difficult for us to determine what the venture managers are going to invest in and how sustainable these investments will be.” AP1 has a rule of thumb that at least 70 per cent of the investments in a fund must align with its chosen SDG.

“We have to be a bit opportunistic and pragmatic to not limit ourselves too much as we are looking for returns as well. It’s a difficult balance.”

He is also concerned that venture could be hit hardest in a tougher environment ahead. If investors start to see less capital coming back from GPs it will impact their ability to commit to new funds. Some of these companies wont be able to raise money again and will have to restructure or close down, he concludes.