GPIF, pushing the boundaries of sustainability investing
When Hiromichi Mizuno, executive managing director and chief investment officer of the Government Pension Investment Fund (GPIF) of Japan, was reappointed effective October 1, asset managers and other stakeholders were pleased.
After all, Mizuno would not have been easy to replace considering the significant reforms, some of which are rather radical by Japanese standards, which he has been instituting and implementing at the GPIF since assuming the position in January 2015.
Although not unexpected, at the very least Mizuno’s re-appointment was seen as a signal that the reforms he had been implementing to modernize the GPIF will go on.
At most it also indicates that the GPIF will continue with its proactive approach to integrating environmental, social and governance (ESG) reforms into its investment strategy and process. Something that can be very powerful in terms of moving the needle in the industry considering that the GPIF is currently the world’s largest retirement scheme with US$1.6 trillion in assets under management (AUM). Of this amount, 50% is in equities and 50% is in fixed income.
The immediate impact for asset managers is that the GPIF’s continuing focus on ESG integration means they have to comply with tougher evaluation criteria when it comes to bidding for GPIF mandates.
In a speech before the Hong Kong Investment Funds Association 13th Annual Conference on November 1, Mizuno announced that beginning this year the GPIF has required asset managers to show how they have integrated ESG into their respective investment analysis and risk budgets.
With this new requirement GPIF is effectively making the asset managers accountable for how they integrate and utilize ESG as part of their investment process. By making the asset managers accountable, the asset owner is also strongly pushing the boundaries of sustainability investing, not only in Japan, but in the global asset management industry as well.
In addition, GPIF will also require its asset managers to engage more closely with their portfolio companies and/or portfolio sovereign issuers on ESG related issues.
This means the asset managers have to look more closely at how the companies they are investing in on behalf of the GPIF are integrating ESG into their own corporate and management processes.
Effectively it’s a domino effect with GPIF pushing the asset managers into ESG integration and the asset managers, in turn, pushing their portfolio companies in the same direction.
While these requirements are more common for European and US pension funds, this is probably the first time that an Asian asset owner as big as the GPIF is making such a bold move.
Such a move is likely to push other Asian asset owners in a similar direction, a move that could raise issues on whether the universe of available ESG-compliant assets is big enough to meet the expected increase in requirements.
Mizuno appears determined to pursue the ground-breaking move saying: “Over the years, our asset managers have been telling us: `We have a sustainability officer or we have ESG analysts.’ But when we asked the portfolio manager, how do you use ESG data? They said: `Ah, we look at it.’ That’s no longer good enough. We urged our asset managers to have meaningful and explicit inclusion of ESG factors into their investment analysis.”
While the global asset managers who already have well developed and integrated ESG strategies and processes in place may not have any difficulty in complying with these requirements, it remains to be seen whether the medium-size and boutique asset managers would be in a position to comply quickly.
Fiduciary duty, systemic risks
To understand how seriously GPIF takes ESG investing it’s worth revisiting the old debate on whether ESG investing is a fiduciary duty of asset managers.
The debate was highlighted again last month when the International Monetary Fund (IMF) issued a report which concluded that investors are increasingly putting money into companies with good track records on ESG issues although there is no guarantee that ESG-focused companies will outperform their non-ESG focused counterparts.
The IMF’s October 2019 Global Financial Stability Report, however, stated that the performance of “sustainable” funds is comparable to that of conventional equity funds and suggests that investors don’t necessarily need to sacrifice returns when they make investments in ESG-focused portfolios.
Also, a recent survey commissioned by NN Investment Partners indicated that 52% of investors surveyed still believe that an ESG-focused investment strategy will have a negative impact on the portfolio’s performance.
The GPIF strongly believes that bringing ESG investment into their portfolio is a pro-fiduciary duty and that failing to address ESG risks is actually against their fiduciary duty.
“If you are managing money for a young guy, and you have to return the money to your customer within the month, of course, you don’t take climate risk into your analysis. But if you are managing money for 20 to 30 years, I think you should,” Mizuno says.
Mizuno argues that for asset owners like GPIF who serve multi-generational clients and have investment time frames of 20 to 30 years, ESG risk factors have to be an important part of their investment strategy.
“I’m very skeptical how anybody can argue that ESG are not relevant risk factors for that investment time horizon. Because of that, for GPIF taking ESG into our investment portfolio management is a pro-fiduciary duty. We think failing to integrate or address these issues is against our fiduciary duty,” Mizuno says.
“A lot of people challenge me, saying ‘oh but there are some scientists who disagree with global warming’. And I say feel free to bet on the other side. But I think this industry is trying to stay on the fence by saying because this is not proven yet, we will remain sitting on the fence. Or taking action may be against fiduciary duty,” he adds.
GPIF has concluded that ESG factors are relevant and systemic risks need to be addressed as part of their fiduciary duty.
On the issue that ESG integration is less relevant to investors with a shorter investment horizon, Mizuno argues: “If you are an equity investor that excuse is not acceptable because the value of the stocks should represent the discounted value of future cash flow regardless of your investment time horizon. That is what investment theory says.”
“For most of the long-term pension funds and asset owners, we agree these are relevant risk factors. Some see ESG as an attribute to the alpha generation while others talk about ESG as systemic risks. We see ESG as systemic risks to our portfolio for the long term,” Mizuno says.
On the issue of whether ESG integration affects a portfolio’s performance, the CIOs of major asset owners believe that climate risk has not yet been fully reflected in the current stock market valuations.
The current capital market also does not reflect ESG attribution of contribution to the performance of stocks.
“Using past performance is self-contradictory because you’re talking about a market that hasn’t been able to price it in and you’re trying to prove ESG effectiveness by using past performance. This argument doesn’t stand in my opinion,” Mizuno argues.
Perhaps the most important step GPIF has taken as part of its ESG integration process is the radical change in the structure of the fees it pays to its asset managers.
The new fee structure is substantially different from the old fixed-fee and partial performance-based fee structure, where the asset managers were paid regardless of their investment performance. This means the asset managers get paid a fixed basic fee even if they under perform.
Because of the fixed-rate nature of the old fee structure, the GPIF concluded that there was little incentive for the asset managers to achieve performance targets in excess of return rates that have been set initially.
Introduced in June 2018, the new fee structure is performance-based and drastically reduces the basic fee rate.
Under the new fee structure GPIF lowered its base fee rate to the rate of a passive fund, and eliminated the maximum fee rate. However, a carryover mechanism has been included to even out the amounts of fees paid. In addition a portion of the fees will be held back to ensure that the amount of fees is linked with medium-term to long-term investment performance, according to a statement.
There are a number of reasons for the change in the fee structure.
First, it provides a self-governing process for the asset managers. This means GPIF, as the asset owner, no longer needs to closely monitor the daily trading activities of each asset manager, something they had to do under the previous system with its fixed-fee structure.
In this connection, GPIF is working with the Sony Computer Science Laboratory to develop new technology based on artificial intelligence (AI) that will allow them to monitor the daily trading activities of their asset managers. When the technology is in place, the asset manager will no longer have to generate reports on their trading activities for the GPIF. Rather the AI technology will generate the reports for them.
Second, is to generate cost savings and to increase the amount of actively managed AUM in GPIF’s portfolio. Mizuno says the GPIF has saved US$200 million in managers’ fees since the new fee structure was implemented.
Third, the new fee structure is designed to promote “long-termism” among asset managers. As part of the reforms in the fee structure, GPIF is also terminating multi-year contracts, where an asset manager has to renew his/her mandate every year.
The GPIF will instead give all active managers five-year contracts, instead of one-year contracts. And their performance will be evaluated in terms of average alpha generation over a five-year period.
Fourth, the change in the fee structure is designed to provide GPIF with more chances to increase its actively managed portfolio. Under the old fee structure, GPIF’s active managers have failed to beat their benchmarks.
Passive investment accounted for about 90% of GPIF’s equities portfolio in 2017.
“When I came on board, I looked at the statistics; over the last 17 years never did our active portfolio ever beat the market. But in reality, you can look at the statistics, more than 80% of asset managers (in the world) failed to beat the benchmark over the course of five years. We just decided if we want to include the probability of winning with our active portfolio, we have to give more money to active managers and we need to change the rules of the game,” Mizuno says.
In the fixed income space, a key part of GPIF’s ESG integration involves a concerted effort to promote and invest in green bonds.
The GPIF clearly made its preference for green bonds clear to its fixed income asset managers on various occasions. To help its managers address the lack of liquidity in the green bond market, GPIF has entered into partnerships with seven multilateral development banks including the Asian Development (ADB), European Development Bank (EDB), Nordic Development Bank (NDB), and European Bank for Reconstruction and Development (EBRD). These partnerships are designed to strengthen capital market cooperation to promote ESG integration into fixed income investment.
With the help of these partnerships, Mizuno says GPIF has substantially increased its investment in green bonds and social bonds from US$30 million at the end of last year to several billion dollars.
Another important element of GPIF’s ESG integration is requiring its external asset managers for domestic and foreign equity investments to comply with stewardship principles.
In order to fulfill its own stewardship responsibilities, GPIF continuously monitors the stewardship activities of asset managers, including the exercise of voting rights, and proactively conducts dialogue or engagement with them. The areas covered in the stewardship activities includes: corporate governance structure of asset managers; management of conflicts of interest by asset managers; policy for stewardship activities, including engagement; ESG integration into the investment process; and exercise of voting rights.
Climate change financial reporting
The GPIF also made another move which is expected to surprise asset managers and other asset owners. It has recently issued a report on the climate risk analysis of its portfolio in accordance with the recommendations published by the Task Force on Climate-related Financial Disclosure (TCFD), an influential non-profit organization that works to integrate climate change-related information into mainstream financial reporting.
The report entitled “ESG Report 2018” was actually prepared by Trucost, a prestigious third-party data provider that produces estimates about the hidden costs of unsustainable use of natural resources by companies. The report focuses on climate related metrics that apply most to the issues that are of concern for GPIF's portfolio.
The GPIF’s intention by publishing this report is to set an example for its asset managers by showing them publicly the extent to which it is integrating ESG into their portfolio.
It is also in preparation for requiring the asset managers to show their own climate risk analysis reports when they work on GPIF mandates.
“We disclosed our analysis of the climate risk of our portfolio. Our asset managers over the last four years keep telling me climate risk is a significant and relevant risk in their portfolio. So, this year we expect them to give us their climate risk analysis report. I’m not sure how much they are prepared. But they keep telling for the last four years that it’s a relevant information, a relevant risk factor so they should be ready to give us their own analysis of climate risk on mandate,” Mizuno says.