The US case involving the purchase of shares in an Australian bank by Australian investors on an Australian stock exchange has important implications for US institutional investors and their drive to diversify investments offshore, a paper finds.

A white paper commissioned by the Council of Institutional Investors (CII) to examine the impact on institutional investors of the 2010 case, Morrison v National Australia Bank, was released this week. (Click here to download the report.) The case is detailed below.

The paper, authored by Christian Ward and Campbell Barker, lawyers at Yetter Coleman, argues that Congress should grant US investors the right to sue for securities fraud regardless of where shares are purchased.

The paper says restricting the scope of US antifraud protection, an outcome of the case, significantly alters the risk profile of foreign investments.

“Under Morrison, US investors will have no recourse in US courts for fraud by the numerous foreign companies that list their shares outside the US but raise money in the US through the purchase of those shares by Americans,” the paper says.

Globally, there is a clear trend for institutional investors to invest offshore. According to the Towers Watson Global Pension Assets Study, the weight of domestic equities in the pension equity portfolios of the largest seven pension markets has fallen, on average, from 64.7 per cent to 28.1 per cent since 1998.

Of those largest seven markets the US, however, remains the country with the largest home bias to equities.

Disincentive to invest

According to the argument in this white paper, the lack of antifraud protection for US investors in offshore securities may act as a disincentive to invest offshore, which would further buck the global trend, and have diversification implications.

“The lack of remedy under US law may make American institutional investors more wary of diversifying their portfolios, as the purchase of stock on a foreign exchange will not carry the same legal safeguards as the purchase of stock on a domestic exchange,” the paper says.

In the Morrison case, the plaintiffs, who were Australian purchasers of ordinary shares of National Australia Bank, which is organised under Australian law, argued that statements made by bank officials artificially inflated the share prices.

Where it concerned the US courts was the fact that they alleged those deceptive statements came from misleading accounting used by one of the bank’s subsidiaries – Homeside – located in the US.

From a US perspective, in the Morrison case, the lawsuit involved foreign plaintiffs, against a foreign defendant, concerning securities traded on a foreign exchange – a so-called “foreign cubed” or “f cubed”.

The Southern District of New York and Second Circuit Court of Appeals dismissed the action because it involved only harm to foreign investors, and it found the alleged fraudulent conduct in the US was too far removed from the alleged injury.

Transactional test

The Supreme Court upheld the dismissal of the action, but for a different reason.

It adopted a test that focuses solely on the place where securities are purchased and sold – a transactional test.

If a securities transaction occurs on a US exchange or otherwise occurs in the US, the antifraud provisions of Securities Exchange Act apply. But those provisions do not apply if the transaction does not occur in the US.

This paper argues that the transactional test fails to take account of the reality of financial markets transactions in a globally connected economy. For example, both the US and the EU have laws requiring brokers to adopt a “best execution” policy that ensures orders to buy and sell securities are executed to a client’s best benefit. This may mean the execution takes place on an exchange offshore.

“In today’s globally connected economy, investors may have no idea where a purchase order for securities is carried out. Some securities are listed on two exchanges – one domestic and one foreign – and investors will not know through which exchange their transaction is routed,” the paper says.

Soon after this case in 2010 the Dodd-Frank Wall Street Reform and Consumer Protection Act was passed by US Congress.

In the act, Congress responded to the Morrison case by expanding “the extraterritorial jurisdiction of the antifraud provisions of the federal securities laws”, but only in actions brought by the SEC or the DOJ, and not by private investors.

Transnational fraud

In the CII paper, the Yetter Coleman lawyers argue that US investors should have a private right to sue for transnational securities fraud.

Part of the argument is it puts further fiscal pressures on agencies like the SEC, which already operate on tight budgets; and that a private right of action would ease the burden on government agencies, which may not have the resources to address transnational securities fraud even if that fraud significantly harms domestic investors.

Further, it argues that a private right of action results in recoveries that far exceed recoveries by government agencies.

For example, the SEC recovered $40 million for investors defrauded by Enron, but investors recovered more than $7 billion in private suits.

According to the CII paper, the Morrison case has had wide reaching implications in the past 18 months.

For example, even if investors place their purchase from the US with a US broker, courts have ruled that the transaction is not “domestic” if it settles on a foreign exchange.

Similarly a case involving a US pension fund that purchased the stock of a Swiss company on a foreign exchange was dismissed because the stock was purchased on a foreign exchange, even though the US fund placed its stock orders in the US.

It argues that allowing investors to assert claims to recover losses caused by fraud also ensures investors’ confidence in the truth of financial disclosures, which in turn, promotes the efficiency of capital markets.

Yetter Coleman clients include the New York State Retirement Systems and Ohio Public Employees Retirement System.

Carl Hess, Towers Watson’s global head of investment, says the study reflects two investment themes in the past few years: globalisation and diversification.

While alternatives have increased as part of this diversification trend, in part he says, the increase has also been due to “packaging and mainstreaming” of the products.

The average asset allocation to alternatives has increased from 5 to 20 per cent from 2005 to 2011, with a corresponding reduction in equities, bonds and cash.

The US has seen the largest change to its alternatives allocation (5 to 25 per cent), followed by Switzerland (9 to 28 per cent), Netherlands (1 to 14 per cent) and Australia (14 to 24 per cent).

According to the Towers Watson Global Pension Asset Study, the aggregate P7 asset allocation at 2011 was 41 per cent equities, 37 per cent bonds, 20 per cent alternatives and 2 per cent cash.

This contrasts with the 1995 allocation of 49 per cent equities, 40 per cent bonds, 5 per cent alternatives and 6 per cent cash.

In particular the allocation to equities in the UK has dramatically fallen, from 67 to 45 per cent over the past 10 years.

Hess says he believes equities across the globe remain high, and “questions whether bond allocations could be up a bit more”.

“Many funds will be de-risking in the next 10 years,” he says.

Another investment trend has been a reduced home bias in equities, with the weight of domestic equities in pension equity portfolios falling on average from 64.7 per cent in 1998 to 48.1 per cent.

The US still invests the least in overseas equity markets, and Canada has the lowest level of home bias.

Consistent with the defined contribution nature of the market, Australia has a higher than average allocation to equities, while Japan and the Netherlands has a higher than average allocation to bonds.

In the past 10 years defined contribution assets of the largest seven pension markets has grown from 38.3 to 43.1 per cent.

Australia has the largest defined contribution proportion, with 81.1 per cent of the market in defined contribution.

In the UK defined contribution has grown from 8 to 39 per cent of the market in the past 10 years, and in the Netherlands that has grown from 2 to 7 per cent.

Towers Watson’s annual study shows that assets of the 13 largest pension markets accounted for $27.509 trillion, representing a 3.9 per cent rise from the year before.

The largest pension markets are the US (58.5 per cent of the total pension assets in the study), Japan (12.2 per cent), UK (8.7 per cent), followed by Canada, Australia, the Netherlands and Switzerland.

Australia has had the highest growth rate in the past 10 years, followed by South Africa, Brazil and Hong Kong.

Hess says that the global ageing phenomenon will be a key theme for all pension market in the next 20 years.

“That demographic, and the fact they are more conservative with money, will impact markets in the next 20 years.”

From February 1, 2005, to December 31, 2011, the “Global 100 Most Sustainable Corporations” list has achieved a total return of 41.7 per cent, outperforming the MSCI All Country World Index, which returned 29.30 per cent over the same time period.

The list is compiled by assessing 11 key performance indicators (listed below) including linking senior executive pay to remuneration.

Chief executive of Corporate Knights, Toby Heaps, says the Global 100 shows it is now possible to score companies on clean capitalism criteria with a quantitative approach.

He says a minor revolution due to more readily available ESG data, combined with the industry group comparison synthesis his company uses, removes a crucial barrier that has been preventing institutional investors from integrating ESG into their passive strategies.

This year the number one ranked company in the global 100 was the Danish Novo Nordisk, which is the only pharmaceutical company in the list to report the link between CEO remuneration and corporate performance on clean capitalism KPIs.

Chief executive of Corporate Knights, Toby Heaps, says: “The Global 100 companies serve as ambassadors for a better, cleaner kind of capitalism which, it also turns out, is more profitable.”

“Employee turnover” was included as a new indicator for the first time this year.

It is the eighth year annual list of the most sustainable large corporations in the world, and this year the companies were recognised at the Davos World Economic Forum at a private dinner hosted by Corporate Knights and Inflection Point Capital Management.

Heaps says the mission of CK Capital, which provides a suite of products based on the passive methodology, has a seven-year goal to enable $1 trillion of assets to be optimised to clean-cap, volatility-reducing criteria.

Global 100 Key Performance Indicators Definitions
• Energy productivity ($) – sales ($) / total direct and indirect energy consumption (gigajoules)
• Carbon productivity ($) – sales ($) / total CO2 and CO2 equivalents emissions (tonnes)
• Water productivity ($) – sales ($) / total water use (cubic meters)
• Waste productivity ($) – sales ($) / total amount of waste produced (tonnes)
• Leadership diversity – percentage of women board directors
• CEO-to-average worker pay – ratio of highest paid officer’s compensation to average employee compensation (three-year average)
• Percentage tax paid – percentage reported tax obligation paid in cash (three-year average)
• Safety productivity – sales ($) / lost-time incidents*$50k and fatalities*$1M)
• Sustainability remuneration – whether or not at least one senior officer has his/her pay linked to sustainability
• Innovation capacity – R&D/sales (three-year average)
• Employee turnover – total number of employees who leave the organisation voluntarily or due to dismissal, retirement, or death in service as a percentage of the total employee numbers at the end of the reporting period.

For the full list of the most sustainable companies click here: http://www.global100.org/annual-lists/2012-global-100-list.html

It finds that modifying asset allocation to the market risk barometer offers investors the “promising opportunity” to meaningfully enhance portfolio performance across market environments.

To access the paper click below

Risk-based dynamic asset allocation with extreme tails and correlations

Speaking at the 2102 annual meeting in Davos last week, Ackermann, says “we need to stop the blame game and start looking forward”.

Pointing to Spain’s 42 per cent youth unemployment, he says a strong financial services sector is needed to support the type of recovery that is needed and to contribute to prosperity in order to grow the real economy on a global scale.

In a separate session at the annual meeting, chief executive of Citi, Vigram Pandit, pointed out that 400 million jobs need to be created between now and the end of the decade.

The financial services governor’s group, chaired by Ackermann, discussed the economic outlook, regulatory framework and sustainability within the financial sector, as well as look at risk management and the lessons from other industries including aviation and food.

“It is seldom that so few have done so much to so many,” he says. “When you boil it down only a few banks failed the test, the bulk of banks managed the crisis very well and increased profitability and market share.”

So, he says, one of the lessons from the crisis is to single out those that have made major mistakes; the group also thought a more differentiated analysis of the crisis revealed that while banks made mistakes there were also political mistakes and market inefficiencies which helped cause the crisis.

“We now need to pull forces together to make the system more stable without jeopardising the efficiency of markets and the financial of the real economy.”

He said the governor’s group supported reforms in liquidity management, improving market infrastructure, and a system to exit failed banks, but there was also a need for consistent, global rules.

But in his view it is not wise to come up with new proposals or taxes as it would add to instability.

Ackermann says: “on the psychological and political side we are proactive in helping put in place insurance funds on a national or European level, to do something on the compensation level. This is a very emotional issue and we are working in the industry on a proposal.”

World Economic Forum Annual Meeting 2012

Developed by executive recruitment firm, Charles Skorina & Company, the index is calculated by assessing an institution’s investment returns over the past five years, and measuring it against the salary of the CIO.

A basis points earned per $100,000 of compensation is derived and then the CIO’s are ranked by this measure of “performance for pay”.

By this calculation, John Hull, chief investment officer of the Andrew W. Mellon Foundation was the highest performing CIO, with 105 basis points per $100,000 of salary.

Hull manages $5.1 billion and earns $620,000, ranking him 46 out of 50 on Skorina’s list of highest paid CIOs in the US.

The highest paid CIO on this top 50 list is Harvard endowment’s Jane Mendillo earning around $4.7 million in total compensation, followed by Yale’s David Swensen with around $3.7 million.

Endowments dominate the list, with Texas Teachers’ CIO, Britt Harris the only pension fund chief investment officer featuring on the list, earning just over $1 million according to the Skorina data.

Applying the performance for pay calculation reveals Harris generated 29 basis points per $100,000 of salary; Swensen 16, and Mendillo 10.

Skorina says institutional investment boards have been asking him for years to develop a measure of performance for pay and so his aim was to develop a basic, objective and consistent measure.

“Chief investment officers and asset managers measure their service providers every day, but have excuses for why it doesn’t apply to them,” he says. “We wanted to create a simple measure, to create an MER for CIOs. If they think a measure such as basis points per dollar of their salary shouldn’t be used then earnings per share shouldn’t be used, and the S&P and Dow Jones would be defunct.

“You can say that each fund has different benchmarks and measures, but what it gets down to is how much money was made for the institution. An institution will forget about all the other things if you have a negative return.”

CLICK HERE TO VIEW THE CIO PERFORMANCE-FOR-PAY TABLE

To compete with the open market, attract and retain a certain calibre of executive, and compensate them for the peculiarities of being a fiduciary, there is a certain minimum required. At the same time this has to be balanced with communication to beneficiaries, governments and other stakeholders about what is fair, often within tight budget constraints.

Communicating what is value for money, and developing appropriate pay structures as part of this measurement is a challenge.

The ranking of performance per pay of a CIO as measured by Skorina (see the article Do you get what you pay for?) seems crude. It doesn’t consider the working environment, benchmarks, constraints and governance, or responsibilities such as reporting, staff training and motivation, technology oversight and strategic thinking.

Charles Skorina argues none of that matters; that institutions are paying their CIOs to generate a return, and so they can be measured against that return.

To some extent that is true, but life isn’t that simple. At least Skorina is bring the idea of accountability for salary to the fore, and perhaps it is a starting point.

One of the issues the industry is grappling with is an appropriate pay structure.

The 2011 Mercer Financial Services Executive Remuneration Survey in the UK shows across that sector that pay continues to move away from short-term incentives.

Mercer reveals that from 2008 to 2010, base pay for senior positions in this sector rose from 25 to 34 per cent, at the same time, the proportion of long-term incentives at the chief executive level increased from 36 to 46 per cent, with annual bonuses dropping from 39 to 23 per cent.

In the pension industry there is no formula for success, however a number of funds have spent, and are spending an increasing amount of time on this issue and developing their own ideas of performance benchmarking and appropriate compensation.

CalPERS has a performance and compensation committee, and has an elaborate measurement system for its executive pay structure.

The chief investment officer is measured against a variety of short and long-term, investment and organisational, issues. (CalPERS CIO pay structure)

Similarly the Canadian Pension Plan Investment Board has identified executive pay as a key organisational issue – this in the context it employs more than 800 people and manages all assets in house – and has developed a pay-for-performance formula within a risk framework

Keith Ambachtsheer’s paper – How should pension funds pay their own people – provides a case study of CPPIB.

More widely Ambachtsheer identifies executive remuneration as one of five critical pieces of the puzzle if a pension fund is to satisfy its tasks of investing productively, administering efficiently and advising wisely.

To do these well, he says, requires aligned interests with stakeholders, good governance, sensible investment beliefs, effective use of scale, and competitive compensation.

The program, the first of its kind to be aimed specifically at board members of pension funds and other long-horizon investment institutions, looked at the functionality of boards, examining when they get stuck and why, as well as the right way for a board to approach strategy, planning and execution.

The impetus for the program came from the desire of the program’s academic director, Keith Ambachtsheer, to provide help to pension fund boards to overcome areas where they may be dysfunctional, which he believes arise from a desire to implement rather than oversee.

The program asked participants to submit in advance the top challenges facing their boards. This revealed good governance and sensible investment beliefs as the two of the key challenges.

As a result of the program, which is collaboration between Rotman Executive Programs and the Rotman International Centre for Pension Management, a plan was developed for trustees to use as a guide.

The good governance advisory team decided on three key steps to implementing a governance improvement program:

1. Create a current board skills/experience matrix and document board member roles and behaviours.
2. Revisit the organisation’s mission and mandate, formalise board processes and agree on board norms and behaviours.
3. Implement the roadmap through updating board policy documents, through internal board bonding sessions and external board training.

Similarly participants developed a step-by-step guide with regard to sensible investment beliefs and organisation design that included:

1. Investment beliefs should be explicit
2. If you have scale then insource
3. Insource in stages, with public equities first
4. Prepare the ground for the required compensation plan
5. Build capacity for internal management.

The other challenges nominated by the board included robust risk management, effective stakeholder communications, and financial sustainability.

The program will be held again next month, and is already sold out, but to register for future offerings visit www.rotman.utoronto.ca/icpm

The poll found 55 per cent of European investment professionals believe that the common issuance of stability bonds can help alleviate the debt crisis, but only as part of a package of structural reforms, fiscal integration, and a strong common governance framework.

The risk of moral hazard, where some member states may follow poor budgetary discipline with limited implications for their financing costs, is a key concern of CFA Institute members.

More than half of investors also believe the bonds will reinforce financial stability in the euro area and 56 per cent agree that it will facilitate the transmission of euro-area monetary policy.

“Stability bonds” are seen as an instrument to address liquidity constraints and ultimately reinforce financial stability in the euro area.

The poll of 798 investment professionals comes in the context of the European Commission’s consultation on the issuance of “stability bonds”.

The bonds are seen as creating a new way for governments to finance their debt, the European Commission says.

In a Green Paper outlining various potential models for a stability bond, the Commission says that the bonds will potentially offer a “safe and liquid” investment opportunity for savers and financial institutions.

The Commission claims that such a stability bond would be the catalyst for a euro-area-wide integrated bond market to rival the liquidity and size of its $US counterpart.

While a majority of respondents agree that resolution of the euro-area sovereign debt crisis should require common issuance of sovereign bonds, 40 per cent disagree with this strategy.

A common view from respondents is that the stability bonds could bring temporary relief in the short run, but will only postpone the problem and be detrimental in the long term, possibly fuelling the next crisis.

Some respondents believe the long-term negatives would outweigh the short-term benefits, as stability bonds would create further systemic risk, resulting in national sovereign debt crises being replaced with a Europe-wide debt crisis.

There is also a clear consensus among investors, however, on how the bonds should be issued.

Joint and several guarantees would be the most effective approach for the common issuance of stability bonds among member states of the euro area, according to 64 per cent of CFA members polled.

A partial substitution of stability bond issuance for national issuance – in which a portion of government financing needs would be covered by stability bonds, with the rest covered by national sovereign bonds – is supported by 64 per cent of CFA members.

Investors strongly advocate three key preconditions that countries wanting to access stability bonds would have to agree to. These are:

• Significant enhancement of economic, financial, and political integration (supported by 86 per cent).
• Increased surveillance and intrusiveness in the design and implementation of national fiscal policies (supported by 88 per cent).
• Limited access to the Stability Bonds in cases of non-compliance with a euro-area governance framework (supported by 90 per cent).

Agnès Le Thiec, CFA Institute’s capital markets policy director, says the new financial instruments, while helping to solve the euro zone debt crisis, cannot cure structural problems of imbalances in trade and competitiveness, or public debt, in many member states.

“Stability bonds also carry a high risk of moral hazard, and would therefore have to be associated with much more extensive structural reforms, fiscal integration and a strong common governance network,” Le Thiec says.

The consultant, which has outlined economic and financial challenges for investors in 2012, says the scarcity of credit, as well as the reduced role of banks in lending, provides possibilities for investors to build and broaden credit portfolios.

Further, it says that investors need to make some “sharp judgments” on sovereign bond investing, specifically whether they want insurance or investment returns.

Mercer says the macro environment, which will continue to be fast-moving and volatile, will be challenging for stock-pickers, with manager success depending more on overall positioning than bottom-up stock selection.

This will mean investors should expect greater discipline from those we deploy their capital and seek to ensure “agents do not extract unfair rewards”, and active management fees will experience continuing pressure.

According to Mercer the economic uncertainty lends itself to portfolio flexibility, and predicts that more institutional investors will move to a floating strategic asset allocation mindset where the investment strategy evolves and morphs over time.

Mercer says that faced with a challenging and unfavourable economic backdrop, institutional investors should focus on agility, flexibility and efficiency when planning for the year ahead.

Mercer says the key economic and financial challenges for 2012 will be:

• An improving US economy and the continued strength of emerging market economies could yet lead to respectable global growth, though significant downside risk remains. A challenged Europe however poses a very real threat to global economic prospects.
• The Eurozone financial crisis is yet to be played out and the saga will continue as politicians try to implement a blueprint for a fiscally-responsible Europe.
• Further coordinated policy responses from political and financial authorities could ease the sense of crisis in the short-run but could equally raise long-term inflation expectations.
• Focus on “fair capitalism” will increase, including consideration of the rewards for capital versus labour, of principals versus agents and of inter-generational equity.
• The scope for further shocks, from diverse sources, will remain elevated. Even if the gloom of abject growth lifts, the fog of uncertainty is likely to remain.