The UK’s Environment Agency has a simple goal: to protect and improve the environment. However, fulfilling this mission is easier said than done. Recent floods across England damaged about 16,000 houses at a cost that could exceed £1.5 billion (€1.9 billion), throwing a spotlight on the agency and the unpredictable challenges it faces. It is no surprise that the agency’s £2.6 billion (€3.4 billion) pension fund, which is part of the UK local authorities (LGPS) pension scheme, has a tilt towards responsible investment. In October, the fund announced its targets for 2020, which include reducing coal exposure in the portfolio by 90% and oil and gas exposure by 50%, as well as a 15% investment in low-carbon, energy efficient opportunities.
With this move, the Environment Agency Pension Fund (EAPF) became the first in the world to run its assets in accordance with the principle of preventing global temperatures from rising by more than 2°. Mark Mansley, CIO of the pension fund and one of the pioneers of socially responsible investment, believes environmental, social and governance (ESG) criteria forms an essential component of any truly long-term approach to asset management. ‘We’ve always been aware of the risks of doing ESG naively. One key aspect is to select good managers who can look at things on a company-specific basis, rather than rely on generalities,’ he says.
Rather than being a marketing gimmick, Mansley believes ESG has been taken much more seriously in recent years. ‘A very positive trend is that people are getting more rigorous about responsible investment and are developing more quantitative, systematic approaches to it.
‘However, challenges will come from unexpected changes and shifts. For example, the oil price drop is a symptom of an accelerating shift to renewable energy, but it is also going to have a knock-on effect on the development of the renewable sector, which people haven’t thought about much yet.’ Mansley has been with the EAPF for the past four-and-a-half years. The pension team is 11-strong, with four people on the investment side. Previously, he had acted as an external consultant to the EAPF. But sustainable investment has not always been at the centre of his career.
‘I started off as an analyst in the bond market. After a decade, I decided to focus on sustainable investment before it was as popular as it is now.
‘I was disillusioned...there is a lot of heat and noise in financial markets, which are very deal- and trading-driven. It wasn’t about investment and creating longterm value for society. At the EAPF, we’re trying to be a real, long-term investor rather than a speculator.’
Over the past three years, according to Mansley, the EAPF has become more disciplined about cash management and has been exploring new asset classes. In 2015, the fund, which outsources all its assets to external managers, cut 6% out of its UK equity exposure and moved it into bonds to derisk the portfolio. This left the fund 52.6% exposed to listed equity and 29.6% to fixed income.
EAPF's medium-term target allocation (two to three years)
As Mansley suggests, though, both equities and bonds are not offering great returns at present. This is why a lot of the CIO’s efforts have been directed towards infrastructure, property, agriculture and forestry, which Mansley defines as real assets. He is targeting a 12% allocation in the next two to three years.
In regards to equities, Mansley expresses some reservations about a lot of passive indices.
‘They’re often flawed. We prefer smart beta and quantitative approaches and have a significant allocation to low volatility. We also have a lot of quite concentrated high-alpha, high-conviction managers who are looking closely at sustainability.’
The most important manager in the last category is Generation Investment Management, the firm founded in 2004 by Al Gore and David Blood.
‘We’ve had a long-term relationship with them. They are a very high quality manager. Their main product is listed equities, but have a private equity and debt side as well.’
What is more, Mansley has a smaller allocation to an environmental technology mandate and has recently appointed a Dutch boutique called Ownership Capital, which takes a private equity-like approach to listed equity investment, as well as the German asset manager Union Investment with its semi-quant strategy.
‘None of our managers held Volkswagen in their funds. They thought the governance was weak andthe strategy was not really sector leading. They looked beyond the company’s obvious reputation.’
Still on the equity side, last year’s biggest change was the shift from its conventional passive to a low carbon passive index – from the FTSE World Index to the MSCI Low-carbon target index.
‘The low carbon index we selected has a target approach. It excludes more companies in the high carbon areas rather than eliminating stocks from all the sectors. What is more, it has a tracking error target of 30 basis points. Within that budget, they are able to reduce carbon exposure between 75% and 90%. It’s been outperforming by 40 or 50 basis points given the low oil price.’
Within this smart beta suite, the EAPF invests in low volatility and value. ‘Improving smart beta is one of our main focuses, particularly our value index, which is passively run. We want to bring in low carbon approach here too, and potentially other ESG aspects as well, notably governance, and make the smart beta even smarter.’
In fixed income, the EAPF again recognised the limitations of indices, where index weights depend on how indebted issuers are. They switched from an index-tracking bond mandate to a buy-and-maintain portfolio. ‘We said to our manager, Legal & General: buy some good value bonds, don’t try to trade them particularly and seek to hold them to maturity. The mandate is focused on sterling credit, with a seven-year interest rate duration and roughly 140 basis point spread.’
Fuel to the fire
The new horizon the EAPF is moving towards has a precise name: real assets. The scheme launched a real asset portfolio three years ago, which was essentially a way to invest in infrastructure, property, forestry and agriculture. One of the challenges of that mandate, Mansley says, is represented by the strict ESG criteria he imposes on the chosen managers.
‘It’s been quite a struggle to get the infrastructure managers to understand why ESG matters so much. For example, one manager didn’t appreciate why we were not comfortable with investing in a coal port in Australia.’
Mansley admits infrastructure is quite a crowded asset class, but points out that the ESG attitude forces managers to look for niche opportunities.
On the other hand, he has done deals in agriculture and forestry but is cautious on the asset classes because of valuation and ESG reasons.
The other alternative area that Mansley finds interesting is private debt (currently 0.6%, with a target allocation of 5%). Allocation to the Generation IM Credit Fund has risen in recent years, while the EAPF recently found a second fund and is looking for a third and possibly fourth vehicle.
‘Banks have withdrawn from the direct lending space following the financial crisis. Pretty solid companies are not able to get money from banks for expansion and deal purposes.
‘I believe private debt is a better investment than, for example, high yield bonds: you get higher returns, better covenants and less business risk.’
He says these deals can work out surprisingly well. ‘A fund we own lent the money to a firm for its business development campaign, something banks would have never given the money for. The company got the capital, ran the campaign, the business outperformed massively as a result of that and was therefore ready to refinance itself. The four-year loan was refinanced within the first year.’
Within alternatives, Mansley prefers real assets to financial ones (such as hedge funds, absolute return bonds), partly because he says they bring a more evident benefit to the economy. This has not stopped him from awarding a total return bond mandate to Wellington, which he thinks has done OK, but not spectacularly. It is in its early days.
The CIO is cautious about hedge funds and diversified growth funds because of cost and transparency, and has some reservations over the fundamental value driver of these investments.
‘There is a real, fundamental reason to be invested in private debt. With hedge funds, you go down to the indefinable alpha generation skills and short-term trading, which we don’t fully like.
‘Some hedge fund managers essentially run smart beta portfolios with a bit of hedging and leverage. We’re running a smart beta portfolio without hedging and leverage, and we pay much less in fees.’
On the private equity side (3.9% of the portfolio, 5% target), fund selection has been brought inhouse into a targeted opportunities portfolio. In this portfolio, Mansley is picking a small number of funds with the potential to deliver financial performance backed by sustainability. To date, the EAPF has invested in the Generation IM Climate Solutions II private equity fund, DBL Partners III, a West Coast US sustainability-driven venture capital fund, and in Bridges Property Alternatives Fund III, a UK-based property venturing fund.
The age of robotics
In the short term, Mansley is worried by the conflux between emerging market turmoil and low commodity prices. In the long term, though, he believes scientific progress could put the traditional idea of capitalism at risk.
‘I’m concerned about the impact of new technologies, the age of robotics. We’re facing a paradigm where the technological change could undermine a lot of our economic fundamentals and the ability to generate growth.’
He believes one of the main consequences of the 2008 crisis is a massive increase of inequality. ‘Wealth inequality is not sensible from an economic standpoint’.
Mansley notes: ‘Henry Ford thought it was important to pay workers enough to allow them to buy his cars to create a virtuous cycle. If the age of robotics means workers are not working, who is going to buy those cars? As well as low growth, other consequences of this scenario would be continuing very low interest rates and rising social unrest.’
EAPF's alternative picks
Private Equity's top 3 holdings:
- Generation IM Climate
- Solutions II
- DBL Partners III
- Bridges Property
- Alternatives Fund III
Property Fund's top 3 holdings:
- Threadneedle Low Carbon
- Workplace Fund
- UBS Triton Property
- Fund (Jersey)
- Hermes Property Unit Trust
Not only sustainability: Union Investment's view
One of the equity managers singled out by Mansley is the Frankfurt-based Union Investment, Germany’s market leader for sustainability and engagement, with €11 billion of assets under management. Modern Investor spoke with Ingo Speich, the company’s head of sustainability and engagement, to gain a better understanding of its approach to ESG. ‘We’re an active investor, not an activist investor,’ Speich says. ‘We try to engage with a company on a long term and build some close ties with it.’
Speich has a strategy that is not purely focused on sustainability but has a strong engagement aspect too.
‘We have 4,000 meetings with companies every year. The most interesting thing we are
focusing on now is carbon, notably companies’ carbon emissions. COP21 has reached a good deal
on the political level with the involvement of China and the US. But it is still difficult to understand
what the real impact of the deal will be because governments have quite a broad range of ways in
which they can apply it.’
Speich is also looking specifically at the financial industry, which is attracting more activist investors than any other sector (their activity increased by 6% last year, compared with a 1% growth in the average sector) because of its wide range of litigation and regulation risks.