Outperformance in the current investment climate requires departing from the crowd.

“Fortune favours the bold,” says Kristin Magnusson Bernard, chief executive of Sweden’s AP1, the SEK420 billion ($41 billion) buffer fund, in an interview from her Stockholm office, at her desk despite peak holiday season in the Nordics.

“Holidays, for me, have become an on-off thing this year.”

Don’t’ be passive

A renowned active investor, the team is constantly making assumptions, building scenarios and playing out the different ways strategies might perform.

It is shaped around an active approach to allocation focused on the global equity portfolio alongside active fundamental equity investment. Here the focus is on AP1’s Nordic small and large cap portfolio. The approach also extends to unlisted equity investments where AP1 owns companies in infrastructure and real estate and where Magnusson Bernard argues AP1 is actually the “most active.”

The team often meets every day – otherwise they get together at least three times a week – to discuss exposures.

“We check-in regularly, share analysis and the best way to execute,” she says. “We are always making decisions about the portfolio. Often it will result in nothing changing,  but even when we decide not to change anything it still constitutes an active strategy because we have made a decision.”

Going out on a limb

When going out on a limb, she stresses the importance of ensuring positions are sufficiently constrained so they remain a learning experience rather than risking performance.

“When you have strong views, it’s best not to have too few; don’t let them get too large so they pose a risk, and you get your fingers burnt.”

Formulating strong views and daring to act on them should also be cushioned by ensuring the investment team can always reverse a decision if it goes wrong; able to turn back when going out on a limb backfires.

Indeed, she is quick to own recent mistakes.

“We definitely stayed in the transitory camp over inflation for too long; we learnt something there,” she says.

One of them, ironically, includes the realisation that getting the big calls wrong doesn’t necessarily preclude performance.

Last year AP1 posted its strongest returns (20.8 per cent) since it was founded in 2001 despite believing inflation would be short-lived. The fund has just posted half year results of -9.4 per cent after expenses. AP1 targets a 3 per cent return after expenses in real terms over rolling ten-year periods, and 4 per cent in real terms over 40 years.

 Risk proofing

The majority of the portfolio is invested in listed assets making it more difficult to navigate market volatility.

Still, risk proofing strategies have included reducing the equity allocation by 10-15 per cent compared to last year and paring back on duration in the fixed income allocation.

Last year 61.4 per cent of the portfolio was in equity divided between global (42.9 per cent) and Swedish (18.6 per cent) stocks,  22.9 per cent in fixed income and 25.6 per cent in alternatives.

Other market downturn-busting strategies include taking maximum advantage of the strong dollar to reap the benefits of the exchange rate in light of the fact so much of AP1’s assets are in dollars, yet all liabilities lie in Swedish krone.

AP1 has an active hedging strategy whereby it is legally bound to hedge at least 60 per cent of the portfolio, she continues.

“When the dollar is strong this could mean up to 40 per cent of the portfolio is unhedged; if the dollar is weak, it could mean 80 per cent is hedged. It’s a powerful lever for us.”

She also believes the correlation between fixed income and equity is best explained by high inflation, suggesting the moves in tandem will continue for as long as inflation remains elevated.

“During times of high inflation, we have seen this correlation between equity and fixed income before,” she says.

European energy crisis

The outlook for the European economy is mixed. On one hand, economies face a herculean challenge reducing their dependency on Russian energy alongside high sovereign indebtedness.

“This makes it very difficult for the ECB to bring down inflation,” she says.

On the other, she notes that the European labour market is strong and the continent is also buoyed by a new-found political unity at the highest level as nations coalesce in support of Ukraine.

“If the ECB can get inflation under control, these positives will become more apparent. You could argue European equities have been oversold; many investors are starting to look at going back in although progress on inflation will be a factor here.”

That said, she doesn’t believe markets will stabilise until it is clear how much rates are set to rise, nor is it clear how assets will react to rising rates after ten to fifteen years of economic policy shaped around low interest rates and asset purchases.

“It would be much easier for equity markets to find a footing if we knew what rates were going to do; until then markets will remain tumultuous,” she says. Magnusson Bernard was recently appointed a member of the European Central Bank’s Financial Stability Contact Group (FSCG) tasked with helping maintain financial stability in the euro area.

Positively, sky high energy prices are allowing energy companies to invest, sparking tech advances and innovation (she notices a new circularity in building materials, for example) that will ultimately speed up the transition. “If we manage the short-term, I think there will be many sliver linings in the medium-term.”

Team spirit

One of the key learnings from the pandemic was ensuring the wellbeing of the team overseeing such an active strategy.

AP1 uses short-term consultants through the summer to provide extra resources during vacation (and peak times) so people can have time off.  Her holiday is only on-off this summer, but she insists her team take a break.

“You can sprint for a while, but you need to find a way to rest even though markets never stop,” she says.

 

 “Theory envy” is the wistful feeling that economists get from watching physicists explain 99 per cent of observable phenomenon with just three basic laws.

Economists, by contrast, explain 3 per cent of observable phenomenon with 99 laws (give or take). One of those laws, “alignment theory,” suggests that firm performance will be positively affected as the level of inside ownership grows.

For as long as asset owners (pensions, endowments, sovereign wealth funds, etc.) have entrusted funds to external managers for investment, they have worried about principal-agent misalignment, or “rent-seeking” – all jargon for the suspicion that anyone who can benefit from fraud will commit fraud. Behavioral scientists have deconstructed this theory study-by-study, dataset-by-dataset.

Still, alignment theory persists, strongly enough to give rise to a number of misconceptions. Chief among those misconceptions is the idea that if monetary incentives are aligned, asset owners’ and managers’ interests must be too. Scholars would call it the fallacy of the inverse: the fact of one thing is not proof of its inverse. Professionals are blunter. They would call this presumption lazy or naïve.

“Principals”, like asset owners, commonly get what they pay for – but also commonly pay for something other than what they want. This leakage is to be expected, to some degree, because it is not practical for a diversified asset owner to develop perfect pay structures that optimize for multiple objectives at the same time.

What this means for asset owners is that there is no substitute for sound due diligence of asset managers. No fee or fee structure will make up for hiring the wrong manager. This is especially true given the recent lack of clarity in fund labeling around ESG, which has muddled the perception of sustainable investing. Long-term investors are wise to select funds consistent with their underlying objectives, but that requires a deeper understanding.

How do you know a long-term asset manager when you see one?

In addition to a typical due diligence questionnaire or RFP, there are other key considerations that can help determine whether the manager is similarly oriented on long-term goals – or not.

  • Investment strategy: Does the manager’s investment thesis reconcile with the stated investment strategy, particularly related to long-term opportunities and risk?
  • Repeatability: Is the manager’s ability to add value repeatable and sustainable over the long term and supported by a strong organizational culture of long-term investing? Does the manager have the talent and diversity to achieve their investment thesis?
  • Risk management: Does the manager utilize a multi-horizon approach to risk management and has this approach been consistent through periods of market stress?
  • Active ownership and engagement: Does the manager add value through stewardship, active ownership, and engagement, and does this relate to the manager’s investment thesis?
  • Proxy voting: Does the manager use proxy advisors? If so, what is their process and criteria for selecting and using these services?
  • Fees: How are investment management fees aligned with client outcomes?
  • Compensation: How is investment decision makers’ compensation linked to long-term investment performance? Over what time horizon are incentives calculated?
  • External affairs: Does the manager seek to promote long-termism through engagement with policymakers, associations, investors, think-tanks, or other groups? Can these activities be disclosed? Does the manager actively participate in these initiatives or comment on policy proposals?
  • Investor responsibilities: How are investment opportunities and risks related to investor responsibilities (like net-zero commitments or DEI) identified and prioritized? How are sustainability factors integrated into the investment decision-making process?
  • Manager responsibilities: What responsibilities has the manager accepted (e.g., net-zero) in the course of doing business and earning returns for clients?

Of course, contract terms do matter once an asset owner has selected the right asset manager. Both long-term owners and managers can focus more on the long term with fee structures and contract periods that reward longevity, reporting templates that sequence since-inception performance first, and commitments about when to trigger out-of-cycle evaluation.

Such solutions are important, and re-writing mandate contracts to ensure better alignment is a worthy goal. But the investment mandate will not simply refocus managers with short-term investment strategies on the long term.

You can use an investment mandate to ensure you don’t turn a long-term manager into a short-term one.  But you cannot make a fundamentally short-term manager into a long-term one with a legal document alone. There is no substitute for sound due diligence.

 

Ariel Fromer Babcock (pictured) is managing director and head of research, and Matthew Leatherman is managing director, head of programs at FCLTGlobal.

While other LGPS pools in the UK have appointed CIOs, risk officers and internal teams, the £56 billion ($121 billion) ACCESS pool has outsourced every aspect of investment decision making and will remain externally managed. It’s now looking for managers as it moves on the pooling of illiquid assets including private equity, private debt, infrastructure and real estate.

ACCESS pool, one of the United Kingdom’s eight Local Government Pension Scheme pools, representing 11 local authority schemes in the east of England, is under the radar compared to better-known sister pools like Border to Coast, Brunel Pension Partnership or LGPS Central. Yet with £56 billion in assets under management and representing 3,400 local authority employers, it is one of the largest LGPS asset pools.

Like others, ACCESS was tasked with setting up operational and investment capacity to allow client local authority schemes, still responsible for their strategic asset allocation, to invest together creating economies of scale, cutting costs and broadening their ability to access alternative investments.

However, unlike most of its peers, ACCESS has forgone building an internal investment capability, mandating instead to a pool operator and wholly outsourcing all investment to managers. Out of the eight LGPS pools, five are authorised and regulated by the Financial Conduct Authority.

Progress

To date ACCESS has pooled £35 billion of its members’ assets via two passive mandates (£11 billion) run by UBS and a selection of active, sub-funds (£24 billion) offering access to equities, fixed income and diversified growth.

Using the administrative service provider Link Fund Solutions, responsible for the overall management of the pool including the creation of investment sub-funds and the appointment of investment managers, ACCESS recently added to its sub fund selection, mandating to BlackRock, Macquarie, Fidelity and M&G and bringing total pooled assets of member funds to around 59 per cent. In comparison, Brunel Pension Partnership now runs around 80 per cent of total member assets.

Next up is a review of responsible investment guidelines and the first procurement for alternative assets, explains Councillor Mark Kemp-Gee, chair of ACCESS’ governing body, the joint committee. Minerva has been appointed as part of the responsible investments review, providing advice on guidelines and implementing these in a pooling environment.

Later this year a further procurement will take place for advice on future RI reporting requirements to provide transparency to stakeholders, monitor adherence to guidelines and inform discussion on ESG/RI matters.

“Our key areas of focus have been both the joint procurement of UBS as the manager of passive listed assets and the process for procuring Link Fund Solutions as operator for the ACCESS Authorised Contractual Scheme (ACS) which houses active listed asset sub-funds,” says Kemp-Gee, adding that ACCESS has benefited from the full engagement of all 11 authorities throughout the challenges of the pooling process.

ACCESS has appointed consultancy MJ Hudson as implementation adviser for the pooling of illiquid assets including private equity, private debt, infrastructure and real estate.

“MJ Hudson will provide support to the pool in selecting individual investment opportunities and investment managers to build portfolios in a range of illiquid assets,” says Kemp-Gee.

In a measure of the benefits of pooling, as of 31 March 2021, savings totalled £42.3 million in a trajectory set to continue with the establishment of non-listed mandates within the pool.

“The creation of the pool has enabled the ACCESS authorities to leverage their collective size,” concludes Kemp-Gee. “Savings have been generated as a result of reduced investment management fees.”

staying externally managed

ACCESS has no plans to run any assets internally. At the start of the pooling journey, all member funds were unanimous that they would outsource all investment to asset managers, he says.

“The ACCESS authorities have several similarities in how they approached investment. These include the exclusive use of externally appointed investment managers and an absence of internally managed mandates. This approach remains unchanged as pooling has progressed.”

While other pools have appointed chief investment officers and risk officers, ACCESS’s internal team comprises just five full-time staff sitting in the ACCESS support unit providing program and contract management support. Elsewhere, five part-time staff provide technical leads, drawn from ACCESS member funds. Neither the joint committee nor the support unit have FCA authority. Strategic oversight and scrutiny responsibilities remain with the individual pension funds as does all decision-making not only on their individual asset allocation, but on the timing of transfers of assets into the pool.

In contrast, the investment team at Border to Coast numbers around 50 people today managing some £30 billion in active equity and fixed income. Recruitment and building internal investment capacity at Midlands-based LGPS Central includes hiring investment team members from the region’s graduates in a bid to build investment expertise outside London’s dominance. To date, three of the eight pools have established internal investment capability in passive equities and government bonds.

 

 

Japan’s GPIF feels the heat of see-sawing global equity markets in its latest quarterly results while the latest annual review reveals a shakeup in global active equity allocations in search of more manager diversification.

Global equities led declines in the latest quarterly return at Japan’s ¥193 trillion ($1.4 trillion) Government Pension Investment Fund. The world’s largest pension fund has just posted its second consecutive quarter losses in two years following a drop off in global equities, in stark contrast to last year when it raked in the benefits of soaring global stocks.

GPIF lost 1.9 per cent during the quarter, equivalent to around $28 billion, with global stocks down 5.4 per cent compared to a fall of 3.7 per cent in Japanese equities. On the eve of the pandemic plunging equity markets wiped out $165 billion from the fund’s assets in another example of the see-sawing impact of its giant global equity portfolio.

CIO comments

The latest results follow on from comments made by the fund’s chief investment officer, Eiji Ueda, in his annual review of FY2021, published in Japanese in early July.

Ueda said that GPIF plans to restructure its active overseas equity manager roster, adding managers to reduce concentration risk and boost diversification.

Last year, increased market volatility negatively impacted the ability of the fund’s actively managed equity funds to deliver alpha compared to benchmarks, resulting in all seven incumbent managers underperforming. GPIF, which holds the majority of its equity investments in index tracking strategies, ended the fiscal year with ¥4.7 trillion in active global equity, down from ¥5.7 trillion the year before.

Poorly performing active managers will have been on the sharp end of  new fee structures introduced in April 2018 by previous CIO Hiromichi Mizuno. Set up to better align GPIF interests with its external managers, the agreements boost the potential revenue windfalls external managers can expect if returns exceed the benchmark, while offering only passive fees for poorer returns.

Ueda, a former co-head of Goldman Sachs’s Asia-Pacific division, took over from Mizuno in April 2020 at the same time as new President Masataka Miyazono also took the helm. In the annual review, Miyazono highlighted the various factors causing turmoil in the global economy and influencing financial markets, including Russia’s invasion of Ukraine, the continued ripple effects of the Covid-19 pandemic and the US Federal Reserve’s interest rate hikes to combat inflation.

Portfolio split

GPIF’s portfolio is split between bonds and equities, with a slight bias to bonds.

As of June 2022, 25.65 per cent of the portfolio lies in domestic bonds, 25.70 per cent in foreign bonds; 24.12 per cent is in foreign equities and 24.53 per cent is in domestic equities.

The GPIF has a general target of keeping its basic portfolio evenly allocated into these four asset classes on the back of continued rebalancing. The fund’s allocations to alternatives currently hovers between 1-2 per cent well below a permitted 5 per cent of total assets invested in alternatives.

In the latest quarterly results, foreign bonds returned. 2.7 per cent thanks to the dollar’s gain of almost 12 per cent against the yen. Given that over half of GPIF’s assets are invested overseas, the yen’s depreciation since March has helped support the portfolio.

 

Investors interested in ESG should be aware of the intensity of the commitment and develop their own deep expertise and impact-weighted accounts, according to ESG pioneer and academic, Professor George Serafeim.

“There are no shortcuts for investors,” he says, “and many of those proxies will end up being disappointing for investors. They reflect the intentions, efforts and aspirations but not the outcomes that will eventuate.”

He says investors that truly want to get to the bottom of the intersection of ESG and performance need to develop deep expertise, capabilities and knowledge about why the issues are important and develop their own impact weighted accounts that include measurement and valuation.

“In risk, return and impact, the impact is very difficult but then you have this beautiful 3D frontier,” he says.
Serafeim is an innovator and leader in the development of ESG measurement, metrics and impact in the corporate world and has been researching ESG for more than 15 years. Top1000funds.com first published stories on his early work in 2011 and 2012 when he was an assistant professor at Harvard Business School.

He’s now a named professor at Harvard, teaching respected classes, such as “Reimagining Capitalism” alongside Rebecca Henderson, and influencing hundreds of the brightest students in the world. He has become wildly influential in the business world by creating measurable ESG financial data.

measurement and impact

Serafeim sees the evolution of the ESG space for corporates in four clear stages: measurement, analysis, strategy and communication.

Measurement comes first, he says. Whether it is issues relating to climate change, DEI, or safety, corporates need to be able to measure performance. Then that data needs to be analysed, benchmarked and improvement demonstrated before a plan can be implemented based on the analytics to drive performance. And lastly that performance can be communicated.

“None of those four elements were feasible in the beginning,” he says. “There was little attention on measurement, analysis or managerial ability going into this space when I started working. In the last decade or so many business leaders have realised those societal important issues have become business relevant so that cycle of four factors has been unleashed in many organisations. Companies setting targets and trying to improve, reflects the evolution in the space.”

There are no shortcuts for investors

Serafeim has just written a book, Purpose and Profit: How business can lift up the world, where he describes the “magic” atmosphere that eventuates when purpose and profit combine.

“One of the things I describe is that the world we were living in 20 years ago is fundamentally different to now,” he says in an interview with Top1000funds.com

“A couple of important variables have changed as a context of business and as a result investing.”

Critically, technology created an environment where anything can be measured and social media has created transparency unimaginable before now.

“Take for example a large apparel company with tier 3-4 suppliers, 30 years ago we would have no idea about what was going on, now we have twitter.”

He also points out that, in 2022 the employee and customer base have much more choice, and voice.

“When I was growing up in Athens I would go to the convenience store and buy milk and there was only one to choose from, now there is so much choice. It’s the same thing from an employment perspective, you could sit in Melbourne and look for jobs anywhere in the world for zero cost and that choice has blended with a lot more choice in product and labour markets,” he says.

“That has had an impact on expectations and on society. Transparency has enabled choice and choice enabled voice.”

He says this means now corporate value depends on human capital, social capital, and intellectual capital alongside other forms of capital. The cycle of transparency, choice, voice, and value connection have created a very different operating context for businesses than even 20 years ago.

The book describes that evolution and Serafeim believes that all corporate and investment managers need to understand that context.

Development of purpose

Serafeim’s latest book comes from a long line of work looking at the idea of purpose.

In 2016 he wrote a paper with Claudine Gartenberg of Wharton and Andrea Prat of Columbia, Corporate purpose and financial performance, trying to understand purpose in a corporate context and how that impacts performance.

“There were several pieces of work where used the collective set of beliefs idea about the meaning and impact of employees’ work as a proxy for purpose driven organisation,” he says. “We found that in general, private market organisations tend to be more purpose-driven than public. And when they have long-term ownership, or more commitment in their investor base, they tend to be more purpose driven.”

You need to measure the outcomes because at the end of the day that is what matters

Another important piece of the puzzle was the publication in July 2020 of the Impact-Weighted Accounts Initiative at HBS that focuses on outcomes. This looked at the cost of the environmental impact of 1800 companies, bringing together accounting and environmental costs in the assessment of corporate performance. In its first year the project found that of the 1694 companies that had positive EBITDA in 2018, 252 firms, or 15 per cent, would see their entire profit wiped out by the environmental damage they had caused.

“The idea behind impact-weighted accounts is you need to measure the impact, the outcomes, because at the end of the day that is what matters,” he says.

“We took a step back to measure outcomes and to value outcomes in monetary terms, to understand how valuable those outcomes are, and then try to see how we can reflect those impacts through accounting statements so we have an integrated view of performance.

“If we want to have an eco-system that holds managers accountable for all sorts of capital then you need to measure the outcomes.”

Advice for investors

Serafeim says that ESG means different things to different people but the important thing is investors know what it means for them, whether that be divestment, risk, opportunity, a type of investing, or a strategy. But the problem is, because it means different things to different people, people are talking past each other.

“To me, ESG is a collection of issues that over time have become business relevant while at the same time being societal relevant. And over time because they are business relevant they reflect the underlying types of capital that organisations need to be competitive on and at the same time affect impact that organisations have on society. I see it as a framework that is the interdependence of impact and the competitiveness of the organisation. It reflects the risk and the fundamental ways the economy has been transformed and so where the opportunities exist.”

George Serafeim, the Charles M Williams Professor of Business Administration at Harvard Business School is a speaker at Top1000funds.com’s Sustainability in Practice event from September 13-15. Asset owners can find out more here.

The third edition of FCLTGlobal’s report, Institutional Investment Mandates: Anchors for Long-Term Performance provides a toolkit for mandate processes and behaviours to reorient towards the long term, including a rethink of KPIs that asset owners can use to evaluate their managers. The report demonstrates these concepts in reality by giving examples of asset owners and managers using them to good effect in practice.

The re-framed KPIs include portfolio issues like style factors, drawdowns and turnover; business issues like personnel turnover, DEI and client concentration; operational issues such as trading effectiveness and proxy voting assurance; investment risk such as results of simulated stress-testing scenarios; engagement and impact.

A full suite of tools for asset owners to use in assessing and monitoring managers, and aligning their mandates and actions with the long term is in the report including tools such as an onboarding checklist and a manager scorecard.

Examples of long-term mandate practices include those from the Future Fund, GIC, New Zealand Super and OTPP; and on the manager side it names Kempen Capital Management, MFS and Wellington as making progress on long-term behaviours.

Ontario Teachers, the report says, has integrated many specifically long-term provisions into its standard long-only equity IMA including:
• Compensate using longer-term fee arrangements, such as longevity discounts or longer-term performance measurement.
• Report long-term performance before short-term performance in all tables, per a visual exhibit that OTPP created.
• Focus prose commentary on year-to-date performance instead of monthly or quarterly.
• Disclose managers’ active-ownership strategies; and
• Treat succession planning, succession events and investment capacity planning as leading indicators of performance and disclose accordingly.

The report also singles out MFS as a leading manager on long-term mandates when it comes to reporting long-term performance before short-term performance. Instead of beginning with year-to-date, one-, three-, five- and 10-year figures, MFS now begins with the 10-year figure and has dropped the year-to-date altogether. It also has stopped highlighting the three-year figure, which makes a significant visual impact.

As an asset manager Kempen’s practices also include emphasising longer-term performance first in reporting to clients, but also offering loyalty-related fee reductions so client costs decline the longer a client remains invested, and communicating very clearly with clients about how the firm has voted its shareholdings in individual companies through a custom proxy voting portal.

In some less-liquid funds, the performance fees that Kempen pays are backdated with the manager realising those fees in line with the liquidity cycle of the fund.

Kempen is also a multi-manager so it also looks for evidence of a long-term focus in its relationship with external managers, for example as a long-term steward of capital it also looks closely at turnover in its manager selection process.

FCLT has a long history of published research and tools to support long-term alignment between asset owners and managers, dating back to 2015.

In this latest report it outlines some questions for investors to ask as they build a mandates:
• Do the incentives built into the mandate support a long-term relationship?
• Do the ongoing communications concentrate undue attention on short-term results?
• Is the focus on leading or lagging indicators of performance
• Do the mandate terms reward long-term investing and mitigate the common “buy-high, sell-low” pattern of chasing performance?

In addition to a typical due diligence questions FCLTGlobal recommends 10 considerations that can help focus discussions with prospective managers and determine whether the manager is long term or not.

These include everything from the manager’s ability to add value repeatably and sustainably over the long term, whether it is supported by a strong organisational culture of long-term investing, and the compensation of investment decision makers.