Allocators

Clean your pension fund

Stockholm (NordSIP) – As any finance student is taught in investment management class, a pension manager’s main duties are the matching of assets’ and liabilities’ duration and the risk optimization for a desired level of return (or vice versa). In practice however, these seemingly obvious tasks can prove challenging. Mats Andersson, former CEO of the Swedish state pension fund AP4, describes for Hedge Nordic how carbon neutralization and implementation of sustainable investment principles in general can help a pension to apply the principles of sound textbook asset management.

“It all started with Al Gore’s movie”, admits Andersson. “As I watched ‘An Inconvenient Truth’, I wondered if it was indeed  possible [that the climate was changing to such an extent] and if so, what I could do about it.” Andersson concluded at first that he couldn’t help; the problem had to be fixed by politics, not money management. In parallel, he started reviewing the way pension funds look at risk and time. At a large majority of pension funds worldwide, managers are evaluated based on yearly performance. The implicit incentive this practice generates does not align with the duration of a pension’s liabilities, which is usually around 20 to 40 years. Assets should be invested with the same time horizon in mind. Three years ago, AP4’s board
gave the fund a unique strategic mandate where evaluation should be made on a 3 to 15-year time horizon. So far, out-performance against the reference portfolio was 200 bps per annum. While is too early to tell whether this can be attributed to the change in time horizon, according to Andersson it makes sense: “the less competition you have, the easier it is to generate returns”, he says.

In turn, this leads to questioning annual volatility as an adequate measure of a pension fund’s risk. “If we can stand volatility”, Andersson proposes, “we shouldn’t shy away; volatility is just a poor measure of risk for a large state pension fund.” Hence the quest for a new metric. Andersson suggests to define risk where there is a possibility of permanent capital loss in the long term. And climate change is just the type of permanent capital loss a pension should care about. Encouraged by his mentor, Laszlo Szombatfalvy, author of “The Greatest Challenges of Our Time” and founder of the Global Challenges Foundation, Andersson decided to take action in 2010. His first step was to survey 10 other large pension funds worldwide to analyse how they approached these questions of risk, time horizon and climate change, but he was disappointed – volatility and one-year horizons prevailed everywhere, and no one considered climate change a relevant issue.

As a result, Andersson went to the drawing board together with his team at AP4. The easiest way was of course to take away all the oil and energy companies from the portfolios, but that represented in effect an undesirable sector bet. Instead, the team worked on a system to minimise the carbon footprint in the S&P500 in a sector-neutral manner. With the help of a consultant, Trucost, the team sorted all the companies and eliminated the worst CO2 polluters in each sector. By doing so, the carbon footprint of the S&P500 was halved without taking any directional bet, and the return was practically the same. In fact, the “decarbonised” index of 350 companies outperformed the S&P500 index by 100 bps. Consequently, the pension fund’s board mandated a 50% decarbonisation of the portfolio, thereby decreasing the carbon footprint by 30%. Over 4 years, this strategy has generated an outperformance of 200 bps over the MSCI World Index. “It may be too short a period to draw any conclusions”, says Andersson, “but it is certainly encouraging and we still haven’t seen the carbon tax, which is expected to generate a certain outperformance”.

Nowadays, climate change is no longer a second thought. Policy makers have carbon footprint at the top of their agendas as everyone recognizes the systemic risk that needs to be monitored and addressed. This is especially true after the Climate conference almost exactly a year ago in Paris, where more than 190 countries have pledged to take action. At the same time as change is happening at the governmental level, institutional investors are pushed into gear. The French government for example, has made it mandatory for anyone managing money to report carbon exposure by the end of this year. “This includes anyone
managing French pension money from abroad, so it becomes a global issue”, underlines Andersson.
In 2014, together with the United Nations Environment Program and its Finance Initiative (UNEP FI), the Carbon Disclosure Project (CDP) as well as the French asset manager Amundi, AP4 became part of the founding team of the Portfolio Decarbonization Coalition, which committed to decarbonising USD 100bn of institutional investment worldwide. “USD 100 billion is a significant amount but it is absolutely feasible. And we hope that by reaching this target, investors can show that a different course of action is possible, where institutional investors’ goals are aligned with, and support the common good,” Andersson stated at the time. After 2 years, the coalition counts 26 members and USD 3.2tr AUM, of which USD 600bn will be put in decarbonised strategies.
In parallel with its environmental push, AP4 has of course invested in sustainability more broadly and taken care of the “S” and “G” in ESG also. In fact, sustainability represents a legal pre-requisite for the Swedish state pensions. “In 2006”, admits Andersson, “I thought it was impossible to maintain returns while being sustainable, but it seemed acceptable to lose some in order to be a good citizen.” Now he knows better – without compromise, it is actually the fiduciary duty of the pension manager to take sustainability into account.
In Europe, he believes, sustainability is taken into account more seriously than among institutional investors on the
other side of the Atlantic, but awareness is raising there also. Sweden is definitely ahead, even if there is still a lot to improve, even at AP4. When it comes to carbon emissions, Sweden has been proactive for a long ti me. In the 90s already, the country introduced a carbon tax of USD 150/ton, which is substantial compared to other countries. This drove emissions down by 30% while the economy maintained a higher-than-average growth. Many Swedish companies are at the forefront when it comes to sustainability, for example with household names such as H&M and Ikea. Pension funds were late adopters in comparison, but they are catching up fast. National politicians are also ahead compared to other countries. For Andersson, there is no need for further regulation to drive the change. The push will come no matter what, also from savers. The more knowledge people have about climate change, the more they will demand to know where their money is invested.
“[For institutional investors] Sustainability will become part of the core business” Andersson expects. “We are definitely beyond the ti pping point”, concludes Andersson, “we moved from millions to billions and now to trillions. Everyone, be it in private equity, long-only, hedge funds, all will have to report on sustainability going forward.” It may be an issue for those who are more short-term oriented, as sustainability is noise in the short-term. Pension funds will progressively be driven to have a more
long-term approach as well. 95% of pensions are still evaluated on a yearly basis and they will have to think this over. For Andersson, all investors managing money with an underlying long-term interest need to find a way to align what they are doing with sustainability. “More than that”, he affirms “it is a hygiene factor and an opportunity to create value at the same time.”
 Picture (c) Thorben Wengert pixelio.de
Kames Capital
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  1. Pingback: The Week in Green (September 29th edition) | NordSip

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