1 Comment

Collective Investment Trusts 

A collective investment trust (CIT), also known as a collective investment fund, is a group of pooled accounts held by a bank or trust company. CITs operate like other pooled investments in that multiple investors with similar objectives combine their assets into a single portfolio, and investors in CITs assume the same investment risk, with no guarantee from the bank, trust company or any regulatory authority such as the FDIC.

Advantages of CITs

1) Lower overall expenses:

  • CITs are not registered with the Securities and Exchange Commission (SEC), eliminating costly registration fees. 
  • Since CITs may accept investments from only certain retirement plans or other eligible investors to maintain their securities and tax law exemptions, CITs require lower marketing and distribution costs compared to other vehicles. 

2) Quicker to launch:

  • Contributing to the generally lower cost profile, CITs may be quicker and less expensive to launch.

3) Enhanced risk management:

  • By pooling assets, sponsors of CITs may take advantage of economies of scale to offer enhanced risk management for the participating investors than such investors could achieve by investing these assets in separate portfolios. 
  • CIT trustees serve as Employee Retirement Income Security Act (ERISA) fiduciaries to the plan assets invested in CITs. ERISA fiduciary standards require the bank, as trustee, and any sub‐advisers it may employ to assist in the management of the CIT, to act solely in the best interests of plan participants and their beneficiaries as a whole, thereby avoiding potential conflicts of interest.
  • Plan sponsors appreciate that CIT trustees are subject to ERISA fiduciary standards with respect to ERISA plan assets invested in CITs. 

4) Diverse and innovative investment opportunities:

  • By pooling assets, sponsors of CITs may also take advantage of economies of scale to more diverse and innovative investment opportunities for the participating investors. CIT providers are developing more CIT products to compete with mutual funds, despite the CIT space was dominated by indexed and stable-value investment strategies historically.

5) Targeted marketing and distribution efforts:

  • CITs accept investments from certain retirement plans or other eligible investors only. As such, CITs’ marketing and distribution efforts are more targeted than other pooled investment vehicles. 

6) Flexible pricing:

  • Banking regulators allow CITs to offer variations in pricing to different investors, provided that the fees are reasonable and commensurate with the level of services provided. CIT fees are sometimes more negotiable than fees available in other regulated pooled investment vehicles. CIT trustees recognize that ERISA plan fiduciaries have a fiduciary duty to ensure that the fees charged for a plan investment option are reasonably related to the services provided.

7) No disclosure requirements

  • CITs are not registered with the SEC, eliminating extensive public disclosure requirements

8) Reduced investment minimums

  • CIT Providers are waiving or reducing investment minimums for sponsor participation. In the past, an investment minimum of $100 million or $150 million or $200 million in assets could be a barrier.

9) Management flexibility

  • CITs allow for greater management flexibility, such as customizing underlying investments, negotiating fees, adding or subtracting managers.

10) Compatibility

  • CITs are now more comparable to NSCC Fund/SERV®.

11) Improved reporting and transparency

  • CITs have improved reporting and transparency as a result of compliance with Department of Labor (DOL) disclosure requirements under the ERISA. Historically, the lack of detailed expense information posed a headwind to the broader use of CITs, while plan sponsors now benefit from greater transparency on pricing practices in the defined-contribution (DC) market as a result of several DOL regulations governing fee disclosures to plan sponsors and participants.

Key Buying Factors

1) Investment expense/cost of trust services:

  • Investment expense is generally the largest single expense associated with a retirement plan. Lower‐cost CITs provide plan sponsors and participants with the potential for considerable savings as the industry becomes more focused on driving down plan costs to enhance performance.

2) Investment strategies available:

  • The range of investment strategies available in CITs rivals that of any other type of vehicle, at generally comparable (if not lower) costs.

Other key factors to consider include providers’ onboarding process, brand recognition, distribution mechanisms and style, operations and usage of technology and CIT governance.

Trends of the CIT Market

The potential advantages that CITs offer when compared to other investment vehicles may continue to translate into greater demand. CITs also continue to grow for recordkeeper acceptance and consultant familiarity. Technological advances, regulatory reforms and other changes in the retirement plan investment landscape have also helped to increase the popularity of CITs. Long a popular choice of defined-benefit plans, in recent years, CITs increasingly have become a choice of DC plan sponsors. The CIT universe today covers a much broader array of investment strategies to meet client demands. 

Meanwhile, widespread sharing of CIT information with database vendors has been limited, both in terms of the number of CITs publishing data and the breadth of the published data, although data aggregators, such as Morningstar and NASDAQ, provide coverage of CITs and continue to expand and improve their institutional subscription databases in collaboration with CIT sponsors.

Leave a comment

Investment in Carbon Capture and Storage

Although carbon emissions occupy a relatively small space on the spectrum of environmental, social and governance issues, as more and more countries and companies commit to Net Zero, they are steadily gaining attention from investors. Companies have relied on offsets to help avoid or reduce emissions for decades. Long associated with the “cap and trade” market, they are traded globally in two ways: (a) as allowances among companies to comply with mandatory emissions caps or (b) as part of various abatement initiatives in the voluntary markets. Offsets are generated through carbon-reduction activities across two broad categories: industrial and nature-based. Carbon capture and storage, for instance, are examples of industrial initiatives to remove carbon emissions.

Moral justifications are supporting the decisions to make strategic investments in carbon dioxide capture and storage. Investing in carbon capture and storage plays a significant role in a portfolio of global solutions to climate change in response to The Paris Agreement targets. Drawing on moral claims about protecting economic and energy access, carbon capture and storage capacity should be available to the regions with hard-to-decarbonize infrastructure.

The key question is, where to pursue the strategic investment? There are near-term and long-term considerations when investing in carbon capture and storage projects. Near-term global distributive justice and undermining legitimate expectations, which we favor investing in developing regions, especially in Asia. We also consider long-term climate impacts and the best uses of resources, and so we favor investing in the relatively wealthy regions that have the best prospects for successful storage development.

The investment risks of carbon capture and storage projects include (a) the risks directly associated with the operational activities of carbon capture and storage; and (b) the planning risks inherent in an over-reliance on large-scale, future deployment of carbon capture and storage. As such, generally, the investment risks of these projects are two aspects: general project risk or mitigable risks and hard-to-reduce risks, which refer to the risks that cannot be mitigated in the same way by private-sector actors. The hard-to-reduce risks can only be addressed by governments. 

Financing Models for Carbon Capture and Storage Projects

During the early stages of deploying carbon capture and storage projects, financial support from governments is necessary to mobilize private capital for these projects. In addition to government and public funding, private funding can come from a wide range of investors, especially banks, as they are experts in funding infrastructure projects. There are corporate-finance models and project-finance models: 

  • Corporate-finance model: the corporate-finance model involves a single corporation that develops the project and finances all of its costs. The corporation may choose to implement the project through a subsidiary, which would then be consolidated into the corporate’s financial accounts. Since it has full ownership of the subsidiary, the corporation reaps all the benefits of the project. Still, it is also exposed to all of the risks and liabilities, which can be significant should the project not perform as expected. Such an arrangement makes it possible to raise debt at the corporate level, with the lenders having recourse to all the corporate’s assets in the event the project should not perform. This significantly reduces the interest rate applied to debt, making the latter relatively cheaper. Also, since the project management is internalized, this makes the entire corporate-finance process attractive in terms of cost of capital and speed of implementation. 
  • Project-finance model: a more scalable funding model is project finance. It allows multiple equity investors to participate in a single project. Debt provided through project finance is referred to as non-recourse debt, and it is for this reason that this form of debt is charged at higher interest rates than corporate debt. Under project finance, the project is set up through a special purpose vehicle, with each investor having an equity stake. Capital for the project is raised based on future cashflows, so both equity and debt investors are exposed to any uncertainty in the performance of the project, thereby increasing the investment risk and subsequently the cost of debt. The ratio of debt to equity can vary significantly and will be dependent on the project specifics, availability of capital and the risk profile of the project owners. Some projects may have a very high gearing of up to 85% debt, whilst others will be much lower, at approximately 50% debt.

Innovative financing for carbon capture and storage projects includes sustainability-linked loans and green bonds. Sustainability-linked loans are particularly popular despite their recent emergence. Whilst green bonds have supported the deployment of other sustainable infrastructure projects, such as offshore wind and solar farms, issuances of green bonds have accelerated over the past decade and yields of green bonds are now often less than conventional debt. Green Climate Funds and their agencies can provide concessional financing to support the capital needed.

Typically, large companies, such as utilities, will find that corporate finance suits their needs better than project finance. This is because large corporations have two distinct advantages: their ability to use cash flows from other operating activities and use their general creditworthiness to borrow money to fund projects. Smaller companies, which do not have the large balance sheets of corporations will find the project finance structure to be the more attractive and accessible option for funding these projects. Key to their participation in the project finance model will be their capacity to partner up with other investors. Project owners will need to form consortia to raise equity, whereas lenders will come together to provide syndicated project loans on the debt side.

Investor Considerations

Unlike conventional private investments, a material value is placed on carbon capture and storage projects. This can be in the form of a carbon price or a financial reward for carbon dioxide storage. For investors, this value must be sufficient to incentivize investment in carbon capture and storage. Or the value placed on the carbon dioxide captured, transported and stored needs to exceed the cost of the carbon capture and storage projects.

Rather than a quantifiable IRR, the only way to maintain an acceptable return on investment is by reducing the capital required from investors. Also, there are trillions of dollars currently locked up in the private sector across financial markets, capital markets as well as other sources of funding such as sovereign wealth funds. So liquidity is another criterion to consider. 

Leave a comment

Positioning Portfolios for An Environment of High Inflation

Investors should adopt inflation protection as inflation shows few signs of moderating anytime soon and central banks are tightening monetary policy aggressively. Treasury Inflation-Protected Securities (TIPS) can help position portfolios for an environment of higher inflation and lower growth. TIPS protect against inflation in two ways. First, the principal value of TIPS is indexed to inflation. When inflation increased by 7.5% in 2021, so did the principal value of TIPS. Second, the coupon payments of TIPS are also inflation adjusted, with payments based on the inflation-adjusted principal value of the TIPS multiplied by the coupon rate. TIPS also maintain the defensive components of Treasuries, should growth expectations decline.

In addition to allocating to TIPS, investors also need more yield to help protect from diminishing purchasing power, given the negative real yield starting point of TIPS. One solution is to replace the Treasury allocation in a multi-sector bond portfolio with TIPS. The multi-sector portfolio provides a more appealing risk-return profile, in addition to a yield cushion. Corporate bonds and securitized debt boost portfolio yields and are less sensitive to interest-rate risk. The interplay between yields, volatility and the shape of the yield curve could create investment opportunities in rate markets and among securitized assets. Investors should also build protection into their strategic asset allocations, which pertains to the long term.

Moreover, a blend of assets and hedges can overcome these drawbacks and prove worthwhile for inflation-sensitive investors because different asset classes outperform in different macro regimes. Such assets include stocks with pricing power, inflation-protected bonds, inflation swaps, floating rate debt, and real assets like commodity futures, real estate, infrastructure and commodity-linked stocks. A balanced allocation to these assets can increase the robustness and resilience of portfolios and allow investors to successfully navigate the hostile markets inflation may cause. I also recommend considering high-yielding bonds and broadening the horizon. Inflation is higher globally but it varies by region and country. In brief, active management is key in this environment because only active investors can respond nimbly to fluctuations and navigate shifting trends.

Leave a comment

What You Need to Know About Inflation

High inflation and the consequences of attempts to curb it are a top concern for investors nowadays. By hiking rates, policymakers can eventually slow demand to subdue price pressures, even in an environment of constrained supply. However, this process takes time.

Prices reflect the interaction between supply and demand: when demand outstrips supply, prices must rise to re-equilibrate the economy. In fact, supply-side constraints are beyond the purview of monetary policy. In other words, many of the forces pushing prices up are beyond central banks’ control so they cannot solve these issues by changing interest rates. What they do is to slow demand such that even in an environment of constrained supply, price pressures abate, which means tightening monetary policy to slow growth to a rate consistent with the ability of the supply side of the economy to keep pace.

Once rates rise, it takes time for the economy to feel the effect in full. Higher policy rates will not translate immediately into lower demand, slower growth and an easing of inflationary pressures; however, as this year progresses, we can expect growth to slow, bringing inflation gradually lower.

As part of the growth slowdown, consumers will increasingly spend on services rather than goods. Another part of the upcoming rotation is a natural re-equilibration in an environment of higher prices. Since demand for goods has been robust and goods trade has been particularly impacted by supply-chain disruptors, goods price inflation has soared. Food prices, in particular, have risen largely due to high crop prices. 2021 was particularly a bad year for supply, as weather limited planting in many regions and interfered with the growing season. This has made services comparatively affordable and thus more attractive.

However, the shift from goods consumption back to services may take longer than expected. While airlines, hotels and restaurants make headlines, nearly half of the gap in services demand is for medical services. Some of this is likely to be from postponed elective procedures, which could rebound sharply when people feel more comfortable resuming daily life. However, people may take it longer to reach that point.

Prices do not have to fall for inflation to decelerate. Inflation measures the rate of change in prices rather than the price level. Importantly, inflation is not just a one-time change in prices, but a persistent increase. Even if prices simply rise at a slower pace, inflation will turn lower. This means that over time, goods prices and services prices will converge and that inflation will eventually fall below services inflation. Pushing goods prices inflation lower will make a big difference in overall inflation, though it will not solve the problem entirely.

One of the biggest categories of services inflation is how the consumer price index captures the cost of housing. Housing is the part of the economy most sensitive to monetary policy. Mortgage rates in the US have soared and housing prices have risen over the past few years so affordability is extremely low. Subsequently, mortgage applications have fallen sharply and sales of homes, both new and existing homes, have turned down. This suggests that home prices are likely to slow their rate of increase, which should eventually bring services inflation lower too.

To understand ongoing increases, it helps to look at inflation on a month-over-month basis. Doing so eliminates past price rises from the equation, so investors can focus on what is changing now and in the future. The best way to monitor progress toward the outcome is through a broader assessment of financial conditions. Measures and indicators such as lower equity prices, wider credit spreads and higher Treasury yields all work to slow demand by transmitting monetary policy from central banks to the economy. The current financial conditions indicate an economic slowdown is in motion and will in turn bring inflation lower. The key question over the medium term is how aggressively central banks will tighten policy once evidence of slowing growth mounts. Inflation tends to lag the cycle, staying high even after growth slows. If central banks remain aggressive during that interval, the risks of a recession rise sharply.

Leave a comment

Climate-Focused Portfolio Approaches

Investors gain confidence that an equity or corporate bond portfolio is invested in companies that are helping to address climate risk. To support a transition to a net-zero carbon economy, climate-aware investors monitor the carbon impact of the companies in their portfolios. However, climate issues are complex. A purely quantitative-driven process that rewards companies with lower carbon emissions is likely to prove inefficient.

A carbon footprint is the total greenhouse gas emissions (GHG) caused by an individual, event, organization, service, place, product or business activity, which is expressed as carbon dioxide equivalent. A carbon footprint measures the negative impact of a company’s operations on the environment. Some providers, such as MSCI, have created a range of carbon footprint metrics that compare the carbon characteristics of a portfolio with a benchmark.

For bond investors, the most relevant metric is the weighted average carbon intensity of a portfolio, which measures the carbon footprint of a portfolio in terms of the volume of carbon dioxide emissions per value of sales. This metric is applicable across asset classes. It is simple to calculate. It does not need the market cap or sales data required for other equity ownership-related measures and can be expressed in a score for the portfolio and a score for the benchmark.

The carbon footprint investing approach aims to identify key sustainability issues. One is whether the issuing company’s strategy is aligned with recognized carbon-reduction targets. The other is how the companies are financing their transition to net-zero carbon. It is also important to stay aware of the wider picture and whether conventional analysis adequately reflects reality.

However, a carbon footprint approach does not tell the whole story of the impact of a company. It can sometimes be misleading. For one, a carbon footprint is only a snapshot in time, which cannot look forward to allowing for companies’ carbon-reduction plans. Secondly, it cannot capture the nuances of carbon use. The GHG Protocol distinguishes between direct and indirect sources of carbon emissions; the distinctions depend on whether a company emits the carbon itself as an intrinsic part of its business or as a user of energy or further up or down the supply chain. Moreover, taking bond portfolios as an example, existing carbon intensity reporting tools do not differentiate between carbon footprints from conventional bonds and those from green bonds or other ESG-labeled bonds. These structures raise capital either for specific green projects via a green bond issue, or to support firm-wide carbon-use reduction via sustainability-linked bonds targeting key performance indicators.

Using the carbon footprint approach, companies that have a relatively large carbon footprint might be overlooked even if they are making significant contributions to decarbonization through climate solutions. Many products needed to help curb global emissions over the long term require industrial commodities, such as steel, cement, lithium and cobalt, which are energy-intensive to produce. Similarly, companies with a low carbon footprint might be included even if they rely heavily on carbon offsets. Carbon offsets help make up for the GHGs that an entity produces by allowing it to buy, sponsor or fund a carbon-reduction initiative elsewhere; however, offset projects that are not certified by reliable third parties may not be as effective as advertised.

A carbon handprint, by contrast, measures the positive impact or carbon avoided by using the products of a company. Using the carbon handprint approach, a clean energy company will be judged on the amount of zero-carbon energy generated, while a resource efficiency company is ranked on its ability to save energy for other companies or entities. Products and services that address the physical effects of climate change include drought-resistant crops, coastal infrastructure to protect cities and communities, and smart irrigation systems to improve water use efficiency. Such progress is needed in many areas, such as resource efficiency solutions, clean energy solutions, transportation solutions, agriculture solutions, food waste solutions, and recycling solutions.

The three investing principles for a carbon handprint approach are: (a) search for climate solutions across regions and sectors; (b) make sure that target companies have solid fundamentals; and (c) invest in portfolios that actively engage with their portfolio companies. By assessing carbon handprints, actively engaging with management, and conducting independent research of business fundamentals, investors can obtain the information needed to measure a company’s carbon handprint accurately and convincingly, and create a portfolio of companies with superior long-term return potential that are providing solutions to the biggest climate challenges.

Using carbon handprints to invest in climate-focused companies can also help investors create differentiated portfolios. The MSCI Climate Change Index or the MSCI Climate Paris Aligned Index, are carbon footprint measures. As a result, these popular climate benchmarks look very similar to the MSCI ACWI Index. A carbon handprint index would look very different than the broader equity benchmark.

Climate-aware investors also need to dig much deeper into the business and emission policies of each company to understand whether a low carbon footprint is truly indicative of a good environmental actor. Investors should also be clear about the key milestones as well as the end goal of the carbon-reduction journey of the companies.

Lastly, sustainably reducing carbon emissions means that companies’ strategic plans should aim to reduce their future emissions. Therefore, it is vital to identify companies that have credible climate commitments for the long run. Drawing on independent sources of expertise and transparent climate pledges, such as the Science Based Targets initiative and the Net-Zero Banking Alliance can help differentiate between companies with demonstrable long-term commitments and those who are not yet willing to walk the walk.

%d bloggers like this: