Public pensions forced to play defense on ESG investments

As environmental, social and governance (ESG) concerns become more prominent in public pension plans’ strategies, sponsors sometimes struggle to justify their actions without the benefit of a clear consensus on how to measure ESG success. Board members, in particular, are feeling squeezed between divergent opinions on whether ESG is a core part of their fiduciary duty.

Different investors take different approaches to ESG and its role in a portfolio, and they use different metrics and frameworks to measure success, with competing frameworks being offered by the Global Reporting Initiative, the Sustainability Accounting Standards Board, UN Principals for Responsible Investment, G20’s Financial Stability Board’s Task
Force on Climate-Related Financial Disclosures (TCFD), and International Integrated Reporting Committee, among many others. The continued debate about how to approach ESG investing leaves plans sponsors vulnerable to critics who call ESG a distraction from investors’ core mission of maximizing returns.

The California Public Employees’ Retirement System (CalPERS), which devoted a portion of its January meeting to discussing ESG strategy, is often caught in the crossfires on ESG debates.

“It’s almost ‘damned if you do, damned if you don’t,’” CalPERS board member Richard Costigan said at a recent board meeting. “As a fiduciary, if I focus too much on this, I risk lower returns which opens me up to [criticism]. Now we’re talking about inaction raising the risk of a fiduciary breach. As a trustee I’m sort of stuck in the middle.”

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San Francisco pension resists calls for fossil fuel divestment

The $24bn San Francisco Employees Retirement System (SFERS) resisted calls from activists to divest from fossil fuels, instead approving a more limited plan to identify and engage with the worst sources of greenhouse gas emissions.

SFERS held a special board meeting January 24 to consider divestment, which was supported by board member Victor Makras and opposed by the system’s investment staff and consultant NEPC. In May, Makras made a motion to divest all fossil fuel holdings in its public markets accounts within 180 days. NEPC estimated that the divestment would cover about $500m in assets, or about 4.5% of SFERS’ public equity potfolio.

Investment staff countered with a proposal that would create a separate $1bn “carbon constrained” passive account strategy that aims to reduce carbon emissions by 50% compared to the S&P 500 Index, and take a phased approach to identifying and engaging with the “worst of the worst” companies in carbon emissions. The approved plan would also hire a director of socially responsible investing and partner with other pension plans, including the California State Teachers’ Retirement System (CalSTRS), NYC Retirement Systems and the New York State Common Retirement Fund, on carbon emission reduction efforts.

SFERS board approved the investment staff’s proposal at the meeting, drawing criticism from activist groups in attendance. San Francisco’s investment team prepared a 164-page report in response to the divestment resolution, saying that divestment would not do anything to reduce fossil fuels.

“This cannot be emphasized enough: divestment does not reduce fossil fuels,” Executive Director William Coaker wrote in a 164-page report. “Staff is concerned that fossil fuels are causing global warming. However, divestment does not reduce the amount of fossil fuels; it simply changes ownership.”

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Overuse of credit adds to PE crunch for pension funds

Public plan sponsors, already facing an overheated market for private equity investments, have to contend with a new obstacle in evaluating private equity managers and putting their money to work: the increasing use of credit lines.

General partners (GPs) are increasingly turning to subscription credit lines, which use limited partners’ (LPs) capital commitments as collateral to secure a line of credit from a bank, to fund acquisitions and delay calling on partners’ commitments. The approach began as a short-term tactic that benefited LPs, by giving them more time to meet cash calls instead of forcing them to pony up on a “just in time” basis. But institutional investors say the tactic has been expanded to delay capital calls in a way that could
inflate a private equity fund’s internal rate of return (IRR), making it more difficult for investors to evaluate potential partners and potentially triggering carried interest fees that would not have been warranted if the GPs put their partners’ money to work in a more timely manner.

“It’s like a baseball player taking human growth hormone and steroids — it can make an average player look terrific in terms of home runs, batting average, and slugging percentage,” David Fann, president and CEO of TorreyCove, a private equity and real assets consultant, told MMR. “It can make a mediocre fund look terrific on an IRR basis.”

Pensions are already feeling crowded out of private equity, with soaring demand for funds managed by top general partners. Entry prices for assets remain high, and dry powder has reached record levels — $906bn according to Preqin’s latest quarterly report on private equity, making for a challenging environment for managers looking to put capital to work. Credit only makes their jobs tougher.

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Oregon aims to build world-class investment culture

When John Skjervem joined the Oregon Investment Council as CIO five years ago, he was surprised to find out that the nearly-$100bn system had long been operating with what he called “a skeleton crew.”

The system had been successful, but its small staff, antiquated equipment, and its division into two physically separate offices, all posed long-term risks, according to Skjervem. After making his concerns known, the Oregon state legislature responded this summer by passing a budget that adds 27 positions to the investment division over the next two years, for a new total of 66 positions.

“When I was hired, I was surprised to learn that we were managing a portfolio of such size and such complexity with such limited staff,” Skjervem told MMR.

The new hiring authority will help the investment division build a worldclass investment culture, Skjervem said, even in a relatively small market like Tigard, Oregon (population 52,000), where the investment division is housed. The new hires will create a stronger and more diverse investment staff, and build on previous improvements, like the consolidation of office space and the installation of new technology, Skjervem said.

“It’s like a do-over,” he said. “You get a brand-new office, you get essentially to double the staff, so you get to inject it with the types of people that you think are going to be most energizing and complement the existing staff in terms of diversity and inclusion. It’s really exciting to think about building a culture that’s unique to the Oregon investment division and a culture that people want to be a part of, that’s stimulating and inspiring so they want to come to work every day.”

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Iowa launches unconventional RFP to seek alpha unconstrained by asset class

The Iowa Public Employees Retirement System (IPERS) has issued a request for proposals for active investment management services, saying that it will seek top-performing managers regardless of the manager’s asset class or benchmark.

The $31bn system is looking for a separately managed account that gives the manager full discretion to actively implement their investment selection and portfolio construction process, as long as the investments are primarily comprised of liquid, publicly traded securities. IPERS is also looking for public market investment products that show “persistent risk-adjusted alphas that are uncorrelated with IPERS’ strategic asset allocation, liabilities, and the alphas of other public market products within the IPERS investment program.”

Wilshire Consulting, which is assisting IPERS with the search, said that the unconventional RFP will help the pension fund take a more holistic view of
its public markets portfolio options and identify top-performing managers
across a range of traditional asset class “silos.”

“This search is unique in the way that IPERS is approaching it, which is taking a deeper dive into the excess returns that managers are producing in relation to their benchmark,” Ali Kazemi, managing director at Wilshire, told MMR.
Published by Money Management Report/Pageant Media.

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Investor profile: Washington State doubles down on private markets

The Washington State Investment Board (WSIB) is more committed to private markets than most of its institutional peers, recently allocating nearly half of its $120.4bn in assets to private equity, real estate and tangible assets.

The new allocation doubles down on Washington State’s already aggressive commitment to private markets, widening the gap with other public pension funds, most of whom favor higher targets for global and domestic public equity – asset classes that have offered high returns at relatively low costs since the 2008 financial crash.

CIO Gary Bruebaker acknowledges that Washington State is something of an outlier in its asset allocation strategy, but said the reason behind it is simple – Washington expects private markets to outperform public markets over the long term.

“Our since-inception [1981] return is 484 basis points higher than our public equity return,” Bruebaker told MMR. “Securing the financial future for over 400,000 public employees is the reason we invest in private markets.”

At its September meeting, the board approved a four-year asset allocation strategy that cuts its public equity target from 37% to 32% and uses those savings to increase real estate from 15% to 18% and tangible assets from 5% to 7%. The board left both fixed income and private equity unchanged, at 20% and 23%, respectively, but would have
committed more to private equity if it thought it could realistically achieve those goals, Bruebaker said.

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Money managers willing to play ball in SDCERA’s fee revamp

The $12bn San Diego County Employees Retirement Association (SDCERA) is overhauling its fee agreements by asking money managers to take only an index-level base fee when they fail to outperform the market, in exchange for higher upside when they beat the benchmark. For the most part, managers are willing to chase upside in exchange for sacrificing the safety of a flat-fee structure.

Although SDCERA has traditionally paid a flat-percentage fee to its external managers, CIO Stephen Sexauer has been working to move toward performance incentives since he took the position in the summer of 2015. With mounting industry-wide pressure on costs, and a major nationwide shift from active management to passive management, asset
managers are willing to be more open to non-traditional compensation structures.

“There’s just enormous pressure on management fees – people are using ETFs, they’re using index funds – so managers, to maintain their business, are now open-minded about performance fees,” Sexauer told MMR. “If you randomly called up 20 money managers, they’d all say the same thing. The industry is changing and changing rapidly.”

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Oregon eyes expansion in redefined alternatives asset class

The Oregon Investment Council is planning to hire three new managers in a newly-defined alternatives asset class, seeking to bolster its investment in areas like infrastructure and real assets.

The council, which oversees $95.5bn in assets and plans to nearly double its investment staff over the next two years, has separated private equity and real estate out of its alternatives portfolio. The fund wants to limit the asset class to investments that offer greater investment diversity and are less correlated with broader market.

The new alternatives class, which is underweight a 12.5% target allocation, includes investments like real assets, infrastructure, and timberland, according to spokesman James Sinks. Separating out real estate and private equity, whose valuations are more correlated to market swings, will allow the new alternatives class to provide a better hedge in the event of another downturn, Sinks said.

“This is one of the lessons learned from the global economic crisis in 2008 and 2009, when a lot of pension plans thought they were really well diversified,” Sinks said. “In that particular event, stocks, bonds, real estate and private equity all went down.”

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Public pension funds fret over high-flying U.S. equities

With U.S. stock prices regularly hitting new records in 2017, pension plans are enjoying high returns from their public equity investments. But many institutional investors are beginning to get nervous, wondering when the good times will inevitably come to an end.

A recent Northern Trust Asset Management survey found that 65% of investment managers believe U.S. equities are overvalued, compared to just 30% in the first quarter of 2016. Some pension funds are reacting with cuts to public equity allocations,
others are standing pat, and some are second-guessing their recent shifts to non-U.S. equities.

“There are fewer and fewer managers that think U.S. equities are fairly valued or undervalued,” said Mark Meisel, senior vice president at Northern Trust. “Some people are beginning to reallocate toward European equities and emerging markets. You are seeing some assets flowing that way.”

Despite growing nerves around valuations, institutional investors tend to have faith in the overall U.S economic outlook, benefiting from a longterm investment horizon as a shield from the pressure. Scott Evans, CIO for the $160bn New York City Retirement Systems, attributed recent positive returns to “ebullient” markets, calling the funds’ situation “dicey” and “fraught with risk” at a June 21 quarterly meeting.

“This is as good as it gets, so we should not be complacent,” Evans said.

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