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The World Economic Forum (WEF) and its research partners believe that asset managers are in a good position to help mitigate some of the world’s most challenging risks.
The World Economic Forum advises asset managers how to mitigate systemic risks — including climate change — and improve their risk-adjusted investment returns.
In late May, the Forum and Mercer, the human resources consulting firm owned by Marsh & McLennan, released a white paper – Transformational Investment: Converting Global Systemic Risks into Sustainable Returns – that identifies six systemic risks of global import. It also provides a governance framework to enable the asset management industry to address and proactively mitigate these risks and translate them into opportunities.
The risks are described in the report as “complex, interconnected, and systemic,” representing “the most challenging global investment issue of our time.” They include the following:
Climate change and the need for governments and business to adapt and to protect populations from its impact; geopolitical stability and the implications of rising global inequality, populism and interstate conflict; near-zero and negative interest rates and their long-term implications for investors; technology advances and the risks and opportunities associated with them, including the growth of cyberattacks; water security and the ongoing exposure globally to a decline in the quality and quantity of fresh water; and demographic shifts caused by aging populations and major migration events.
WEF believes that identifying investments that can effectively tackle these challenges will require collective action, long-term thinking and targeted investment along the lines of $6.27 trillion per year, with $2.4 trillion annually devoted exclusively to climate change related investment. The report asserts that the asset management industry is fully capable of meeting these objectives.
“Members of the institutional investment community have the collective power to champion long-term thinking, constructively tackle complicated problems, and bring positive changes to our economy, society and the planet – all while pursuing attractive risk-adjusted investment returns,” says Rich Nuzum, president, investments and retirement at Mercer.
As evidenced by several case studies referenced in the report, such strategies are already underway. For example, the New Zealand Super Fund (NZSF) decided three years ago that markets were underpricing climate risk and that ignoring climate change in investment decisions constituted taking “undue risk.”
In 2017, NZSF fund managers decreased the fund’s passive equity exposure to climate risk (which represented 40% of the fund) by reallocating NZD 950 million in passive investments away from high-carbon exposure companies. As of June 2019, carbon emissions intensity in the NZSF’s portfolio was 43% lower than its original benchmark portfolio, and exposure from reserves was 52% lower. What’s more, NZSF fund managers now actively seek transformational (and profitable) investments in sectors like agricultural technology, wind and solar energy generation, waste management, and technology platforms.
According to Nuzum, it is important to keep in mind that transformational investors are always aiming for strong and positive investment returns. “When they invest in renewable energy, for example … they expect to make more money than a traditional investment would,” he says, adding that such investors are “reducing their risk and, by doing so, improving their long-term expected returns.”
Noting that measurement around ESG issues is very limited, to date, Nuzum elaborates that these types of investors can only succeed if aided by collective action and the pooling of knowledge. “We have an entire industry built around reporting quarterly earnings, but there is no equivalent standardization yet for ESG reporting,” he says. “Collective action is critical to address the ESG measurement issue and, ultimately, to mitigate ESG‐related risks.”
Converting Risks to Opportunities: A 6‐Step Approach
The report provides a six-step governance and decision-making framework that offers a pathway for investors to become experienced in translating risks into opportunities (such as sustainable returns), while imposing discipline through holistic risk management.
The six steps are listed under the action headings: understand, collaborate, design, invest, transform and monitor.
The first step – understand – asks that asset managers not only prioritize global systemic risks trends that affect their investment objectives but also comprehend the overall impact of these trends on the funding entity, objectives and beneficiaries.
The second step – collaborate – advises asset managers to coordinate with similarly situated organizations that are concerned about the same risks and opportunities. These include industry groups and financial system leaders with whom they can partner, so that global systemic risks can be better addressed through the pooling of collective capital; examples of such collaboration include the efforts of the Organization for Economic Co-operation and the International Forum of Sovereign Wealth Funds.
The third step – design – advises asset managers to clearly state their transformational fund policies, processes and systems. Alignment of investment beliefs with risk considerations requires appropriate oversight, as well as incentives for investment managers and teams to keep stated goals on course.
The fourth step – invest – entails the need to build and regularly update processes based upon risk research and scenario analysis. This involves the adoption of strategic asset allocation, sustainability/thematic investing practices and the establishment of a stewardship policy.
The fifth step – transform – calls for the creation of target portfolios designed to deliver benefits. This may entail recasting the roles or mandates of investment managers and investment teams to meet new types of metrics and targets. It may also involve considering investment in innovative structured instruments.
The sixth and final step – monitor – asks that asset managers carefully apply their learnings in transformative investments over time, to improve their policies and processes. Data updates and enhanced technology, along with effective feedback loops, can only help to improve risk management of investments that aim to reduce global systemic risks.
Three developments are critical to advance transformational investment, the report concludes: (1) measurement conventions to assess the impact of global systemic risks on portfolio and stakeholder outcomes; (2) identifying and matching transformational investment solutions with long-term investors; and (3) encouraging intermediation with governments to establish policies and best practices that protect long-term investors and reduce political risk associated with transformational investments.
Transformational investment practices, says Nuzum, are important on two levels: “From an asset owner perspective, they won’t be able achieve their investment objectives long-term without addressing these systemic risks; from the perspective of civilization, these are risks that are all about how society functions and have to be addressed.”
Katherine Heires is a freelance business journalist & founder of MediaKat llc.
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