LGS overlays with clean green strategy

The Australian $6.2 billion Local Government Super (LGS) fund has taken an active role in handling its risk, by developing innovative in-house strategies for tackling climate change and equity market risk in its portfolio.

LGS, whose members are municipal employees in the Australian state of New South Wales, is three months into trialling an indexing methodology it has developed that aims to de-risk when key market factors are triggered.

Along with this system the fund has also developed a “Socially Responsible Investment” overlay across all its investments.

This involves applying environmental, social and governance (ESG) principles to both its active and passively managed equity assets, and also an ongoing effort to measure its carbon risk across its entire portfolio.

In addition, the fund is working on ways to hedge climate-change risk across all the asset classes in which it invests.

Its recently launched in-house indexing strategy is another way of attempting to better control risk and also aiming to cut costs and improve returns.

The indexing methodology is a systematic approach that covers a range of indicators in the 12 largest equity markets and looks at matters such as economic growth outlooks, inflation, currencies and bond yields.

If pre-determined triggers are met in a range of these indicators, the portfolio – which represents 5 per cent of the fund’s overall international equities portfolio – is designed to retreat to cash to avoid a potential downturn.

“The model is a systematic process based on indicators that the board has agreed on,” Craig Turnbull, LGS chief investment officer, says.

“Those indicators are cautious at the moment, so the strategy is to move to cash. If the markets stay turbulent or keep falling, as they have been, that strategy will out-perform and if the markets take off it will under-perform.”

Turnbull says the systematic approach has the potential to be scaled up and is used as additional early-warning information the fund uses to make other tactical asset allocations.

The fund offers its 90,000 members six different strategies ranging from high-growth to cash.

At the end of the financial year to June, the fund achieved about a 9 per cent return for the higher growth options and 7 per cent for more conservative strategies.

This is in line with Australian industry averages.

At the beginning of the year, the board looked at its long-term asset allocation and maintained settings it had in place since the last review in 2009.

“The strategic allocation came out reasonably well-disposed to the growth side,” Turnbull says.

“We don’t have a huge allocation to equities, we have a fairly diversified portfolio. We have alternatives assets, property, private equity and private debt.

“But the strategic allocation, because of what we see as good attractive valuations for growth assets, has a reasonable allocation to growth.”

While members can pick different asset allocations depending on their risk profile, the overall fund has 23 per cent in Australian equities and 22 per cent in international equities.

Listed international property investments account for 3 per cent, direct property investments 8 per cent and Australian and international fixed interests 11 and 5 per cent respectively.

The fund has about 10 per cent of its assets in cash and 10 per cent in what it calls absolute-return investments.

Most of this is in private credit, with the largest holding in residential-mortgage-backed securities that involves investment grade borrowers servicing the Australian housing market.

Illiquid investments make up the remaining 8 per cent allocation.

While not prepared to disclose the returns achieved across these particular asset classes, Turnbull says all these asset “sectors” achieved in excess of 5 per cent return. Australian equities, international property and illiquids returned more than 10 per cent.

Its best performing asset was international property that returned 28.4 per cent.

LGS presently indexes 50 per cent of its Australian equities portfolio and 40 per cent of its international equities portfolio. A sizeable portion of its bond portfolio is also indexed.

The fund holds passive mandates with three major indexing houses – Vanguard, State Street Global Advisors and BlackRock.

In 2009 the fund overhauled its active/passive management mix, boosting its allocation to passive mandates.

Turnbull says the approach had performed well over the past two years and this allowed the fund to cut the fees paid to managers.

The consolidation of mandates also reduced inefficiencies between different active managers.

“This core and satellite approach means a bit less overlap between the managers, so you don’t have one guy who is overweight BHP and another guy underweight BHP, so you are paying two active fees but getting index performance,” Turnbull says.

The move to increase passive management has continued the fund’s focus on risk management.

“The passive allocation allows us to very easily control the  objective of keeping the tracking error – or the potential of the sector to vary from the benchmark – down to 1 to 2 per,” he says.

“If we want to use a manager that is a bit more high-risk that is fine but we can reduce his allocation and put a bit more into the passive core and the overall risk hasn’t changed at all.”

If indexing has allowed LGS to better manage its risk, its approach to ESG across its portfolio is setting a clear path for the fund to handle what it sees as a growing risk from climate change.

It uses external advisor Mercer to look at the overall carbon exposure in its portfolio and uses other sustainability consultants to advise on what companies pose a potential ESG risk.

Since 2004 it has not invested in Australian companies that derive more than 10 per cent of their revenue from a range of areas including armaments manufacturing, nuclear energy and uranium mining, and the logging of old growth forests.

An index investor, the fund also looks for ways to mitigate ESG risk, where a company with a questionable ESG record is included in an index it uses.

The fund’s internal investment team will short a particular stock in the index to hedge against its potential ESG risk.

Turnbull cites its recent shorting of News Corp on advice it received about the company’s questionable corporate governance structures as an example of where this policy protected the fund from potential downside risk when ESG issues arose.

Usually between 1-2 per cent of the portfolio is shorted to hedge against ESG risk.

Turnbull says that while the fund may lose in the short-term if a shorted stock performs well, it calculates that over the last five years the policy has added 14 basis points to returns.

“We think this is great because we have reduced our risk to these high-risk stocks and added to returns so everyone is  happy,” he says.

LGS has also looked to apply its ESG principles throughout its portfolio, recently hiring a sustainability expert to work directly with the asset managers it appoints.

“It can be a factor when we make our allocations to managers and the board would not feel comfortable about a manager that was taking on a lot of climate change risk without good consideration,” he says.

“We insist with all our managers now that they at least consider these issues and that they factor them into their investment analysis before they make their decisions. A big part of our due diligence is going through and seeing what managers are doing in terms of taking on board things like climate change risk.”

The fund is also looking at ways it can make specific allocations in each asset class to both hedge climate change risk and take advantage of any opportunities presented by a move to a lower carbon future.

This has included private equity investments in clean energy, a hedge fund strategy that looks at the energy industry in Australia and use of renewables, and a $50 million mandate to sustainable stock-picker Impax Asset Management.

“Our board thinks that some of these issues are so big (that) we should be thinking about top-down strategies as well,” Turnbull says.

“So in each sector we invest in, we think: ‘can we invest in something that will actually be a climate change hedge for us?’ ”