2022 Perspectives for the Public Sector

Citi Perspectives for the Public Sector 7 A change in mindset Given their scale and long-term investment horizons, public pension funds have historically been in the vanguard of top-down portfolio construction thinking. Their extremely long-term objectives, such as the need to provide public pensions many decades in the future, mean that they must also manage risks associated with investment. Consequently, they have tended to focus on responsible asset ownership. This contrasts with asset managers, which are necessarily focused on the short-term and on bottom-up stock picking and asset allocation. Public pension funds’ long-term focus means that in today’s environment, ESG considerations have become critical to how they construct their portfolios. The largest public pension funds already have sophisticated internal teams addressing sustainability and are often well ahead of the sell side when it comes to understanding ESG issues. The significance of public pension funds (as well as sovereign wealth funds) to ESG investment (and markets more generally) is often underestimated. Unlike hedge funds, public pension funds have low portfolio turnover and are therefore less prominent (and less attractive in revenue terms) for Wall Street firms. However, the scale of public pension plans — estimated at $25 trillion — means that they have the potential to exert a considerable influence on markets over the longer term. The nature of ESG requires a significant shift in mindset on the part of public pension funds. It imposes both new constraints and objectives. Historically, value has been defined in narrow financial terms, such as absolute, or risk-adjusted return. ESG requires a much broader definition of financial value and outcomes. It therefore necessarily creates a tension between short-term financial returns and the pursuit of longer term ESG outcomes: ultimately, the latter should add incremental financial value, but in the short term this may not be apparent. Public pension funds seeking to incorporate ESG factors into portfolio construction face a number of challenges. The starting point for selecting the universe of investable securities today is generally a broad market index such as the S&P 500, which is weighted by market-capitalization. Various financial and ESG filters are then applied to that universe to narrow it down to the desired investment portfolio. Investors and managers are judged on their financial performance and that performance is judged against a market index. But when the target of the investment portfolio is widened to encompass considerations not measured by those market indices, then a size-based index may not be the best starting point to achieve an ESG outcome in a meaningful way — the biggest companies may not be the most relevant to a specific ESG objective. Another challenge is that ESG outcomes are specific to the asset owner and depend on the underlying portfolio, its constituents and the stakeholders involved. Assessing these outcomes can be challenging. The industry is still struggling to source sufficiently granular data to enable it to monitor and manage ESG risks. Most ESG data is provided by companies; there are few objective standards and no clear way of