GLOBAL MACRO RESEARCH DISRUPTION DECADETHINKING OUTSIDE THE ‘INDUSTRIAL BOX’ FOR RESPONSIBLE FIXED INCOME INVESTING

SEPTEMBER 2020

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H •FOR PROFESSIONAL CLIENTS, QUALIFIED INVESTORS, INSTITUTIONAL INVESTORS, WHOLESALE INVESTORS AND LICENSED FINANCIAL ADVISORS ONLY. NOT TO BE REPRODUCED WITHOUT PRIOR WRITTEN APPROVAL.PLEASE REFER TO THE IMPORTANT INFORMATION AT THE BACK OF THIS DOCUMENT.

The 2020s are set to be the most disruptive decade in human history, ushering in the rise of a modern economy and

fall of the industrial

While economic transformations of this nature have taken place in the past, the speed, scale and scope of the changes that

we are experiencing today is unprecedented.

Disruptive changes in technology, society and the environment are driving this shift

Technologies have become fiercely competitive, once abundant stores of natural resources in our environment have been

degraded and depleted, and eight billion people are now driving population density in cities amid rising social change.

Economic incentives are shifting away from favoring industrial companies to those focused on serving the modern

economy, i.e. those that use complex, precision technology to tap into almost infinite data to deliver targeted output using

decentralized but digitally connected supply chains.

Is action by responsible investors creating a false sense of security?

Now is the time to question whether the new developments in responsible investing, such as using ESG indices, are enough

to match the exponential changes underway or whether action remains optimized for prior periods of stability with linear,

incremental change and a limited range of possibilities.

How should we think outside of the ‘industrial box’ in the face of this disruptive decade?

Investors may wish to consider forming a view on the timing of disruption, quantifying the split of assets between industrial

and modern holdings, questioning data sources and underlying assumptions, shifting engagement from a focus on old

industrial challenges to questions posed by the rise of the modern economy, and researching trends which may lead to

disruption in the investment industry.

EXECUTIVE SUMMARY

HANNAH TUCKERHannah Tucker, founder of Balance Point Ventures, explores how fixed income investors

can prepare for a decade of disruption. She researches disruptive changes reshaping the

economy and advises businesses and investors on the implications of these changes as

part of Balance Point Ventures. Previously, Hannah worked with Al Gore at Generation

Investment Management to communicate the investment case for sustainability. Prior to

this, Hannah worked on the launch of PIMCO’s ESG platform. Hannah holds dual masters

degrees from the Wharton School and Lauder Institute of the University of Pennsylvania.

She is a RethinkX research fellow and Climate Reality Leader.

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DISRUPTION DECADE THINKING OUTSIDE THE ‘INDUSTRIAL BOX’ FOR RESPONSIBLE FIXED INCOME INVESTINGDISRUPTIVE CHANGES IN TECHNOLOGY, SOCIETY AND THE ENVIRONMENT ARE USHERING IN A TIME OF

ECONOMIC TRANSFORMATION UNPRECEDENTED IN SPEED, SCALE AND SCOPE. THESE DYNAMICS ARE

CHALLENGING INVESTORS TO CHART AN UNKNOWN PATH. AT THE SAME TIME, RESPONSIBLE INVESTORS ARE

PIONEERING NEW APPROACHES, BUT ARE THESE ACTIONS SUFFICIENT TO PRESERVE AND GROW CAPITAL OR

DO THEY INSTEAD PROVIDE A FALSE SENSE OF SECURITY? AS STEWARDS OF CAPITAL, HOW MIGHT WE THINK

OUTSIDE OF THE ‘INDUSTRIAL BOX’ IN A DECADE OF DISRUPTION? THE VIEWS IN THIS ARTICLE ARE THOSE

OF THE AUTHOR HANNAH TUCKER AND DO NOT NECESSARILY REFLECT THE POLICY OR OPINION OF INSIGHT

INVESTMENT. COMMENTARY FROM INSIGHT INVESTMENT IS GIVEN AT THE END OF THE DOCUMENT.

INTRODUCTION

The 2020s are set to be the most disruptive decade in human

history, ushering in the rise of a modern economy and fall of the

industrial. While economic transformations of this nature have

taken place in the past, never before have they unfolded at the

speed, scale and scope we are experiencing today. These

dynamics are challenging investors to chart an unknown path.

In response, responsible investors have taken action: Investment

decision-making frameworks are now broader than ever before,

accounting for a wide range of environmental, social and

governance (ESG) factors. Capital managed in this way continues

to increase each year.1 But is this progress enough to make a

difference in the Disruption Decade ahead?

1 United Nations Principles for Responsible Investment, ‘What is Responsible Investment?’ (https://www.unpri.org/an-introduction-to-responsible-investment/what-is-responsible-investment/4780.article).

[Responsible investment] continues to increase each year. But is this progress enough to make a difference in the

Disruption Decade ahead? HANNAH TUCKER

THE DISRUPTION DECADETHE 2020S WILL MARK THE RISE OF A MODERN ECONOMY AND FALL OF

THE INDUSTRIAL.

The starting point is a place familiar to us all: the industrial economy based on the extraction

of concentrated stores of physical resources; produced and processed with combustion

engine machinery into generic commodities at mass scale, just-in-time; to then be

distributed along centralized, hub-and-spoke supply chains run by people in trucks, ships

and planes around the world; to finally be owned and disposed according to income level.

The destination is unchartered. While key features are still taking shape, many are becoming

clear: we are now increasingly harnessing complex, precision technologies to tap into

almost infinite and diversified flows of physical and digital resources; to be produced locally

and on-demand into personalized products and services; which can then be distributed

across physically decentralized but digitally connected supply chains run by cloud-

computing software; to finally be used, tracked and recirculated across blockchain-enabled,

subscription service platforms.

The shift from one system to another is comparable to the move from hunter-gather tribes

to agricultural settlements that took place 10,000 years ago and to the even greater shift

from agricultural settlements to industrial cities that began 150 years ago. The key

difference is that today’s transformation is playing out at an unprecedented speed, scale

and scope.

WHAT ARE THE DRIVERS?

To answer this question, we must appreciate the technologies underpinning the economy

and the nature of society and the environment surrounding it. Here we find disruptive

changes at all levels pushing and pulling the economy in a new direction.

Figure 1: The economy in context

ENVIRONMENT

SOCIETY

ECONOMY

TECH

ENVIRONMENT: Conditions at the start of the modern economy are dramatically

different to those at the start of the industrial era 150 years ago. Then, natural

resources were not only abundant, but also regenerated readily in the context of a

stable, mild and moderate climate. Now, key natural resources are depleted and

degraded owing to overuse, while also are increasingly subject to volatile, hot and wet

climate conditions.2

2 Global Footprint Network (https://www.footprintnetwork.org/); United Nations Sustainable Development Goals, 13: Climate Action (https://www.un.org/sustainabledevelopment/ climate-change/).

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SOCIETY: In 1870, the global population was just under 1bn people, many of whom

lived in crowded, manure-filled, agricultural towns. Today, in 2020, we are nearing 8bn

digitally connected people concentrated in dense megacities, benefitting from a 30x

rise in social development3, which can be gauged as a community's ability to produce

energy per capita, to organize, to exploit information technology and to defend

themselves.

TECHNOLOGY: At the start of the industrial economy, ground breaking

developments centered on combustion engine machinery. Today, following 50

years of Moore’s law,4 we have complex, precision technologies, including

automated Cloud-computing, digitalized solar and storage systems as well as

genetic sequencing and engineering. While these technologies are not new, the

strength of their relative competitiveness in terms of cost and capabilities is.

Figure 2: Exponential cost declines have accompanied an exponential rise in the

performance of complex, precision technologies5

1990 1995 2000 2005 2010 2015 20200

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100US$4,400/gp US$300m/sequence

US$600/sequence

US$1,480/gflops

CRISPR/Cas9becomespossible

US$12/watt

US$0.47/watt

US$656/KWh

US$159/KWh

US$0.01/gp

US$0.03/gflops

Inde

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�� Computing performance �� Data storage �� Solar �� Batteries�� Genome sequencing �� Genome editing

THOSE WHO MASTER THE CHANGING ECONOMIC INCENTIVES STAND TO WIN

Disruptive developments in society, the environment and in technology are changing

economic incentives. For example, new environmental conditions mean the costs and risks

of sourcing industrial resources (e.g. coal, oil, fresh water, corn, soy) are rising, while those

associated with modern resources (e.g. sun, wind, water flow, data, DNA) are falling.

On social dynamics, people are now demanding more products and services and higher

quality ones, whether that means more immediate, personalized or social media worthy.

On technology, the integration of complex, precision technologies into numerous processes

has given rise to modern capabilities, including machine learning, cellular production,

robotaxis and others.

These capabilities are redefining competitive advantages, while also catalyzing sector-wide

transformations. Those who master them stand to lead the modern economy.

2 Global Footprint Network (https://www.footprintnetwork.org/); United Nations Sustainable Development Goals, 13: Climate Action (https://www.un.org/sustainabledevelopment/ climate-change/).

3 World Bank population data (https://data.worldbank.org/indicator/SP.POP.TOTL); Morris, Ian, Social Development Index, available in ‘Why the West Rules for Now’ (2010). 4 Observation by the founder of Intel, Gordon Morse, that the number of transistors on a microchip has doubled approximately every two years, though the cost of computers is halved, implying the speed and capability of computing power will increase every couple of years, while continuing to drop in cost; Investopedia (https://www.investopedia.com/ terms/m/mooreslaw.asp#:~:text=Moore's%20Law%20refers%20to%20Moore's,will%20pay %20less%20for%20them). 5 RethinkX with data from Bunyip Beowulf Cluster Vs. Intel Celeron G3930 & Amd Rx Vega 64; National Human Genome Research Institute; Fraunhofer ISE; BNEF and Benchmark Minerals.

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RE-EXAMINING RESPONSIBLE FIXED INCOME INVESTINGINVESTORS WILL NEED TO MASTER NEW CAPABILITIES AS THE

DISRUPTION DECADE IS ALREADY CHALLENGING TRIED-AND-TESTED

APPROACHES.

Prevailing investment industry practices developed in the past are largely optimized for

periods of stability with linear, incremental change and a limited range of possibilities. They

no longer serve us, however, during times of exponential systems change when the range

outcomes is expansive.6 The bad news is we no longer have a point of reference for what

works and the returns on past-experience are diminishing. The good news is now is the time

for creativity, boldness and adventure.

Will ESG fixed income benchmarks enable us to ride the wave or do they leave us vulnerable to sinking along with obsolete industrial assets?

HANNAH TUCKER

Responsible investors are or can be the pioneers of new approaches. The increased

application of these approaches to fixed income is evident today in impact bond issuance

surpassing US$1 trillion; 66% of Principles for Responsible Investing signatories engaging with

fixed income issuers; and also the adoption of ESG fixed income benchmarks, such as the suite

now available from Bloomberg Barclays MSCI.7 However, in light of the disruption ahead and

what has unfolded in 2020 alone, are these actions enough? Will they enable us to ride the

wave or do they leave us vulnerable to sinking along with obsolete industrial assets?

EXAMINING THE CASE OF INVESTING RELATIVE TO ESG INDICES

A common starting point for benchmark construction is to adjust the holdings of existing

market-weighted benchmarks representing certain issuer types and credit agency ratings

based on ESG ratings. This methodology often excludes issuers below a minimum score,

6 RethinkX, ‘Rethinking Humanity’ (2020) (https://www.rethinkx.com/humanity). 7 Insight (https://www.insightinvestment.com/globalassets/documents/recent-thinking/uk- impact-bond-issuance-tops-us1-trillion.pdf) and Standard & Poor’s Financial Services; UNPRI; Bloomberg Barclays MSCI.

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while tilting weightings towards best-of-class players. In addition, certain activities may be

excluded altogether, such as carbon-intensive processes driving environmental risks or

tobacco sales related to social risks. These weightings and ratings, however, are mostly

backward-looking, offering very little guidance on how issuers are likely to fare in the

Disruption Decade.

This can result in a set of exposures such as the ones represented in the sector breakdown

for the MSCI USD Investment Grade ESG Universal Corporate Bond Index: 7% in industrial

manufacturers and material providers; 8% in producers and distributors of coal, oil and gas;

and 34% in financial companies with issuance largely secured against industrial assets, in

other words, a leveraged play on the industrial economy.

Figure 3: Sector breakdown of the MSCI USD Investment Grade ESG Universal Corporate

Bond Index as at 30 June 20208

F F

�� Financials 34.3%�� Health care 12.7%�� Information Technology 11.1%�� Communication Services 9.1%�� Energy 8.3%�� Consumer Staples 6.8%�� Consumer Discretionary 6.4%�� Industrials 5.4%�� Utilities 2.3%�� Materials 1.9%�� Real Estate 1.7%

While the benchmark provides exposure to companies poised to lead in the modern

economy, such as those in information technology, the relative portion is small given

modern companies are in their growth phase versus industrial companies in their mature

phase. Considering asset prices are a near real-time reflection of the consensus view on the

future, repricing tends to occur in tipping point moments years before assets fall into disuse

in the real economy. As a result, investors maintaining large industrial positions risk missing

their window to reposition, as was the case with the fall of US coal assets in 2011,

Volkswagen and other diesel car manufacturers in 2015, Generic Electric in 2016 and the

airline industry today.

A FOCUS ON IMPACT BONDS AND ENGAGEMENT

Built-in industrial biases are also a challenge when it comes to impact bonds, through which

large industrial companies fund diversification activities. Although these activities are

aligned with the modern economy, they do not safeguard against downgrade or

bankruptcy. The same applies to engagement: while activities have no doubt led to positive

outcomes, at what point does the expected return on industrial assets inadequately cover

risk? In other words, when does engagement switch from fiduciary to philanthropic in

nature?

8 MSCI USD IG ESG Universal Corporate Bond Index Fact Sheet (https://www.msci.com/ documents/1296102/16680544/MSCI+USD+IG+ESG+Universal+Corporate+Bond+Index.pdf /636acdee-e32a-e2d9-dcd6-22ec93b9a7bd#:~:text=The%20MSCI%20Fixed%20Income%20 ESG,trend%20in%20improving%20that%20profile.)

6 RethinkX, ‘Rethinking Humanity’ (2020) (https://www.rethinkx.com/humanity). 7 Insight (https://www.insightinvestment.com/globalassets/documents/recent-thinking/uk- impact-bond-issuance-tops-us1-trillion.pdf) and Standard & Poor’s Financial Services; UNPRI; Bloomberg Barclays MSCI.

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THINKING OUTSIDE THE ‘INDUSTRIAL BOX’HOW MIGHT RESPONSIBLE FIXED INCOME INVESTORS CONTINUE

TO BUILD ON MOMENTUM, WHILE ATTUNING DECISIONS TO THE

EXPONENTIAL SYSTEMS CHANGES UNDERWAY IN THE DISRUPTION

DECADE? WHILE THERE ARE NUMEROUS POSSIBILITIES, THE FIVE STEPS

PRESENTED BELOW OFFER A POTENTIAL STARTING POINT:

1 Form a view on timing

Over what timeframe do you expect the economy to transform?

(a) 10 years? (b) 25 years? (c) beyond?

2 Know your exposure

What percent of your assets are in industrial versus modern holdings? How does this

weighting compare to your views on timing? If there is a mismatch, where is it

possible to shift exposures? What hedges make sense?

3 Question data and assumptions

What is the basis for risk premium calculations? Do they consider tail events related

to environmental, social and technological disruption? Where are you sourcing risk

premium data? For example, do the source providers leverage satellites and sensors

to understand climate risks, such as the impact of intensified flooding on real estate

valuations? When evaluating political risk, are you examining public sentiment

expressed on social media platforms or reverting to outdated polls?

4 Shift focus of engagement from old industrial challenges to new modern ones

So often we engage on known challenges, for example, reducing carbon emissions.

Are we overlooking new challenges where investors can have a greater impact?

For example, the food system is shifting to one where software programs are

designing foods based on taste and texture, while integrating novel ingredients

made possible by genetic engineering. Those foods are increasingly manufactured

and distributed autonomously without human labor. Are companies considering

the implications of modern food in collaboration with investors?

5 Research modern financial platforms

The financial system is changing in line with the modern economy. Yet investors

largely remain with familiar investment platforms, discounting new ones as years

away. Yet, US municipal bond issuers are already beginning to circumvent banks to

issue directly over blockchain.9 Now is the time to research and track modern

platforms to avoid unnecessarily limiting our investment universes.

A final chicken-and-egg question: Who should step outside the industrial box first? Asset

owners or asset managers? A great skill for the Disruption Decade ahead is having both the

ability and willingness to pilot and pioneer together, rising to the challenge of stewardship

on an uncharted path.

9 Forbes, ‘Berkeley’s Blockchain Microbond Could Spark A Muni Market Revolution’ (December 2019) (https://www.forbes.com/sites/debtwire/2019/12/19/berkeleys- blockchain-microbond-could-spark-a-muni-market-revolution/#1afa031059fd); Alpha Ledger (https://www.alphaledger.com/company/)

A VIEW FROM INSIGHT INVESTMENTDisruption has always existed. The ‘industrial revolution’ changed entire economies and the

advent of major new technologies created fundamental shifts in society. While investors

certainly face much disruption over the next decade, disruption itself is never a straight line:

it will occur differently across sectors and countries.

Regulation and demand are drivers of change but also difficult to predict. We anticipate

Europe will be faster to adopt stricter environmental rules than other regions, but there will

still be a critical role for many industrial companies, such as steel manufacturing. Many ‘old’

industrial companies remain essential in the ‘new’ modern economy.

It is not clear how disruption will transpire; what is seen as modern today will change in the

future. This tells us that investors can’t model for every risk event and impact. There are

inherent uncertainties when investing, and this includes ESG risks and opportunities.

Therefore, a more complete risk assessment that goes beyond a review of financial factors

is so important, and this involves getting to know companies directly.

Engagements, which build relationships, help investors to appraise the strengths of

companies in dealing with emerging challenges that cannot be quantified precisely. ESG

data and understanding thematic issues like environment, technology and society, will

remain important, but forward looking potential is limited without information from

companies actively confronting these emerging disruptive forces.

It is an exciting and challenging time to be a responsible investor. Nascent food technology,

financial innovation and clean energy will be important for investors to understand, but they

don’t have to mean a fundamental shift in asset allocations or research methods. It will be

critical to have the appropriate tools, processes and systems in place to manage the

emerging changes so that investors can take advantage of new epochs ahead and manage

the transition risks smoothly.

Joshua Kendall Head of Responsible Investment Research and Stewardship Insight Investment

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