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The Greatest Financial Engineering Challenge of our Generation

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Stockholm (NordSIP) – “We, as institutional investors, have violated the first principle of finance,” warned Sony Kapoor (Pictured), Director of Re-Define, at a recent TBLI Conference Europe 2019 in Zurich. “We are putting all our eggs in baskets that are highly interconnected and facing similar structural challenges.” Elaborating on his 2017 keynote address at the TBLI Nordic, Kapoor explained how investors in developed markets can overcome their home bias to channel funds towards sustainable opportunities in emerging markets.

Re-Define is an independent international think tank specialising in financial and economic policy formulation. It advises companies, investors and other stakeholders on the economy and policy developments. Aside from his responsibilities at Re-Define, Kapoor an ex-investment banker, has also been an advisor to the European Commission and Parliament, the IMF, the UN EP, the OECD and the Norwegian government and oil fund.

Structurally Unsustainable Growth and Returns

- Promotion -

“The factors that have driven economic growth and financial returns in developed economies will not be replicated in the next 20 years,” Kapoor explains. “The falling interest rates and rising stock valuations that drove capital gains, the emergence of China, falling corporate taxes, demographic and productivity growth are all in the rear-view mirror.”

At the same time, risks are on the rise. “Political risk used to be an emerging market concern. But Brexit, the Eurozone and Trump are the three most prominent risks we are facing. It is also clear that we are reaching the limits of how much we can destroy the environment to generate returns.”

“For large institutional investors, returns are strongly correlated with the economy.” The implications are dire, but the investment industry is ignoring them, says Kapoor. “Based on their existing portfolios, large institutional investors are looking at 3% in long term expected returns for the foreseeable future, not 7% to 8% as most of the large US pension funds – including CalPERS – use. We are facing potential contingent liabilities worth tens of trillions of dollars and pension deficits that are impossible to finance.”

Opportunities in Emerging Market ESG

Instead, Kapoor argues that investors should shift towards emerging markets (EMs), where so many of the factors hindering developed economies are a boon. “For every rich OECD country that is looking at a demographic decline, there are two or three EMs economies that have a potential demographic dividend. For every rich OECD country close to the technological frontier, there is an India out there where 20%-25% of people still do not have access to electricity.”

“We need to focus on opportunities in the new growth sectors of technology, in fintech and renewable energy and the effect of rising environmental risks and risks in terms of social and governance issues common in the ESG space.” However, sustainable asset allocation in emerging markets can be difficult. “Emerging markets are where these investments yield the highest return, but we are going to have to start focusing on illiquid markets. If a company has already listed in the Bombay stock exchange, it probably does not need our money. The company that needs money is the small family business in Mumbai where the cost of capital – 18% – is so high that they will not be able to finance their project.”

A Financial Engineering Challenge

Home bias and index tracking are stopping Western funds from flowing to illiquid impact investments in emerging markets. “Of the US$ 80 trillion in long term institutional capital, including pensions, insurers and sovereign wealth funds in developed markets, 60% to 80% is invested in Europe and the USA. European institutional investors have less than a 5% allocation in EMs, at a time when EMs already account for over 50% of global GDP.”

Asset managers are also not seeking the best opportunities. “The rise of passive investing has been a major disruptor for the financial industry. Even active investors now benchmark their portfolios against an index. Looking at a wide range of investors, we found that 80% of the money tracks an index, while only 10% is invested in illiquid asset classes, where the best opportunities await.”

Home bias and liquid index tracking are motivated by a lack of human resources, according to Kapoor. “On average, in large institutional investors, one employee is responsible for US$ 2 billion of assets to invest,” he explains. “Norway’s sovereign wealth fund has 500 people managing US$ 1 trillion. The ratio is similar for the Swedish pension funds. Not only do asset managers and asset owners in developed countries not have the time and the capacity to seek out that US$ 10 million promising solar investment in Kenya or India, they are not even talking with the people that do have that expertise,” Kapoor explains. Investing in well-known, liquid and benchmarked markets is simpler and cheaper.

“Even the International Finance Corporation (IFC), a specialised international development bank and one of the most promising impact investors, with offices in 50 countries, a great track record has only deployed US$ 10 billion of capital over the last ten years,” Kapoor admits. His own experience reflects these challenges. “I was asked to deploy US$ 2 billion of impact capital in a short time and quickly realised it was not possible.”

All of these facts conspire to create asset misallocations. “What we are facing today is the greatest financial engineering challenge of our generation. There are pools of capital in geographies and in institutions that are simply not designed to seek profitable opportunities where they are now.”

 A Win-Win Solution

To solve the misallocation problem, Kapoor argues we need boots on the ground. “The solution is not to hire thousands of more analysts for UBS and Credit Suisse but rather to channel the millions of new people entering the local workforces in EMs every year towards solving this problem,” he explains. “That is the only way of making the impact proposition interesting and scalable and impactful for institutional investors, and conveniently for investors, compensation levels in EMs are 10% of what would be expected in Switzerland.”

The solution to the problem is evident to Kapoor. “Whether you want to expand global GDP growth, or want higher financial returns or whether you care about human beings being given opportunities for meaningful employment, the answer is the same: We need investment in these countries to allow their people to be employed productively.”

“We need to do what the ESG community has been telling us to do for ten years. We don’t need to agree with them. We don’t need to belong to them. We don’t need to call ourselves impact or ESG investors. We just need to do the right thing from a risk-return perspective,” Kapoor concluded.

Photo © TBLI CONFERENCE

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