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The choice of benchmarks is one of the most fundamental decisions that investors make, and yet it gets little time or respect in the investment process. I want to explain why benchmark selection matters, and why investors should care about it.

We should start with the most basic idea. All benchmarks are simply portfolios. Like any other portfolio, the assets held, and the weights of those assets, is what drives behaviour. Benchmark portfolios become important only because we believe they have special characteristics: that they act as good representations of a particular market or sub-market. Of course, it isn’t controversial to say that the risk and return characteristics of two portfolios will differ. It shouldn’t therefore be controversial to say that different benchmarks which are trying to describe the same asset class can have significantly different risks, returns, and factor exposures.

What drives these differences? Simply the portfolio construction methodology, as you would expect with any set of portfolios. Different index providers calculate their indexes in different ways, with different approaches. For example, indexes may reflect free float in different ways, which impacts weighting structures accordingly. Each index is designed for a particular purpose and with a different philosophy: each potentially valid, and each with strengths and weaknesses.

The interesting thing about benchmark selection is the degree to which it impacts every other investment decision you make as an investor. All of your decisions will be assessed relative to the benchmarks you have picked to represent each asset class. All of the sophisticated risk analysis that you perform will be done relative to the benchmarks you have picked to represent each asset class. Your very success and failure as an investor will be driven by those decisions as well. It can be amusing to compare the degree of precision with which we do so many of the calculations we use in the investment process, while spending little time examining the underlying benchmark we are using as the measuring stick for those highly precise calculations.

One way that this can directly impact the portfolio is in the assessment, measurement, prediction and allocation of tracking error. Investors want to make sure that they only incur tracking error in places where they believe that tracking error will be compensated. This requires, of course, an accurate measurement of that tracking error.

A second important impact can be in the assessment of value created by managers. There is an incentive in place for managers to try to “game” the benchmark against which they are measured. This is particularly obvious in the fixed income space: a manager who is building a portfolio of riskier credit assets but who is benchmarked against a core type benchmark with safer government assets will be able to generate long-term outperformance simply because of the underlying mismatch of those portfolio structures. This might be attributed to manager skill, when in reality some or all of it is perhaps better classified as benchmark mismatch.

A similar effect can be seen in international equity portfolios. Managers assessed against a benchmark which includes no emerging market exposure may decide to allocate assets to emerging market securities. Since over the long term these securities are expected to provide a higher return, this may benefit portfolio performance, assuming the manager selects the securities effectively. The challenge, of course, is that the owner of capital may incidentally over-allocate to the emerging market asset class unless they understand these actions of their international equity managers. The asset owner may also unfairly view the international equity manager as skilled, when in fact the manager’s performance may be better attributed to an asset allocation decision. In each case the skill and effectiveness of the manager are mis-represented: better benchmark selection would avoid this problem.

A third problem can be particularly important at large organisations with significant investment staff directly employed by the plan. One of the challenges owners of capital sometimes face is being able to demonstrate the value created by highly talented internal investment staff, so that market level compensation can be awarded to those people. This requires careful selection of benchmarks to properly assess each part of the portfolio that these staff are directly responsible for. As these benchmark selection decisions are at the heart of the employment relationship, and direct staff compensation is dependent on accurate benchmark selection, these decisions become truly core to the mission of the organisation.

So what can investors do? The most important thing is simply ask questions about benchmarks. Consultants and index providers should have strong capabilities in this space, and should be able to provide detailed advice to investors on the best benchmark selection policies to adopt. These should be revisited regularly, to make sure that the benchmarks that are being used at the asset allocation and portfolio construction level are sensible, effective, and provide good insight into the portfolio structure that has emerged from those allocations.

Tools are available to help them make this decision, and detailed risk analytics systems can be used to help understand the underlying risk structures embedded in each benchmark. It is not incoherent to compare benchmarks to one another as though they were each portfolios – because that is exactly what they are. Spending a small amount of time validating these important choices can help tighten up each step of the process thereafter. The more effective the benchmark choice, the more likely all of the subsequent analytics are to be accurate. Accurate analytics don’t guarantee exceptional results of course, but they certainly represent a good start.

Ian Toner is CIO at Verus Investments.

Dutch asset manager €473 billion ($575 billion) APG’s recent decision to allocate €75 million ($82.6 million) to its first local currency China fixed income strategy has come with much thought on the potential risks. None more so than ensuring APG’s strict ESG criteria are met and navigating the indebted status of many Chinese companies. It means that all research and due diligence on the allocation, which will span private companies and government-run entities and won’t have any size limits or target particular maturities, will be done in-house rather than with the help of China’s credit rating agencies.

“We won’t rely on rating agencies. In China the output quality of most rating agencies is questionable, which makes it challenging to get an objective measure of the credit risk in the portfolio,” says Sandor Steverink, head of treasuries at APG who believes the manager’s capacity to carry out its own research is one of the reasons it has been able to launch the strategy ahead of competitors. “We analyse the risk of each issuer and create a diversified portfolio with good risk/return characteristics. Since we are used to doing this already, we have a comparative advantage on asset managers that do rely on rating agencies.”

That same capacity will ensure ESG is integrated across the portfolio, a challenging and time-consuming task even with the help of APG’s partner on the ground, $193 billion Guangzhou-based E Fund Management Co which also helps APG run its $657 million China A Shares strategy, launched early 2018.

“The challenge is getting access to ESG data since this information is not easy to find and Chinese institutions are less used to this concept. The availability of data on ESG and the transparency of most institutions isn’t very high so it will take more time and effort to select institutions that full fill our responsible investment standards,” says Steverink who hopes APG will be a catalyst for change. “APG is one of the global leaders in responsible investing and we think that we can contribute to set new standards in China.”

He notes most progress in ESG integration in environmental and climate matters, rather than social and governance, and says APG’s approach draws on the same tools the fund uses everywhere else in its giant portfolio.

“Critical thinking, transparency and asking questions to companies and institutions on these issues are relevant items of our approach globally, and also in China where we are integrating ESG in a similar way as in other countries.”

As for APG’s relationship with E Fund, Steverink says it is also pushing into new and interesting areas like knowledge exchange around pension systems, AI, IT and talent management.

“The cooperation is going smoothly since there is mutual trust and an enormous willingness to learn from each other. It is noticeable that the Dutch and the Chinese have entrepreneurship in common,” he says.

APG’s ‘China Fixed Income Strategy’ is being driven by the asset manager’s conviction that China’s fixed income market will offer some of the most compelling opportunities in years to come as the credit market grows (around 20 per cent annually according to APG estimates) in line with the Chinese economy.

It’s a trajectory that Steverink compares to the introduction of the euro at the turn of the century. He also believes that foreign companies and global institutions will increasingly consider issuing bonds in RMB alongside euros and dollar issuance. The strategy also offers a pick-up in yield from eurozone fixed income where negative interest rates have driven bond yields lower.

“The low yield environment has increased the need and the intensity to search for attractive risk/return alternatives.”

He doesn’t think Chinese fixed income carries undue risk.

“Most of the time the alternatives have a higher risk profile, but the China fixed income strategy has a low risk profile with solid expected returns and also, we see that the correlation with other parts of the fixed income portfolio is very low.”

APG won’t hedge currency risk as a rule, but will offer its clients (APG has seven pension fund clients including ABP, the pension for people working in Holland’s government and education sectors) the ability to hedge if they want.

“In general, we consider the G10 currency markets as efficient and hedge most of this exposure – especially if it is in fixed income otherwise the currency volatility can become higher than the bond volatility,” says Steverink. “In less efficient markets we do not hedge the currency since we like to receive the currency risk premium and the part of the portfolio is limited. China is somewhere in between, but since the allocation to RMB is still small and the currency volatility is low we do not advice our clients to hedge the currency risk to Euro, which is the currency of the pension liabilities.”

The strategy also offers diversification China, despite the further globalisation, still has its own dynamic, which provides diversification in your investment portfolio, because not everything moves in the same direction at the same time.

The new strategy comes with boots on the ground. APG is opening representative offices in Shanghai and Beijing. The portfolio managers are based in Hong Kong.

“In our view, being close to the market and its dynamics adds significant value to the execution of the strategy.”

California’s Governor Gavin Newsom’s recent executive order calling on the state’s pension funds and endowments to invest more in green energy and less in fossil fuels flags more, complicated divestment decisions ahead for CalPERS 13-member board. The Governor can’t order divestment because fiduciary duty rests with the board, yet his drive promises more handwringing and strife in the giant pension fund’s quest to balance the consequences of divestment’s lost performance and transaction costs with responsible investment.

At least that’s what the future holds if CalPERS December board meeting was anything to go by during which members discussed the thorny issue of its approaching 2021 review of six divestment programs across tobacco, firearms, coal, Iran, Sudan and emerging market equity principles, a program that screens companies from the emerging market portion of its internally managed global equity portfolio that don’t meet ESG standards.

For some board members, the review risks opening old decisions that were reached after prolonged discussions at the time. For others – like board member Jason Perez who said his call to look again at divestment strategy has become a “broken record” – it’s an opportunity to revisit decisions that have cost the fund dearly. For example, CalPERS has lost around $3.5 billion of returns by not investing in tobacco since 2001. A decision based on a view at the time (and reaffirmed in 2016) that the industry was about to hit tough times because of lawsuits and a new awareness among young people of smoking’s dangers.

The merits of tracking divested dollars, and the value of data illustrating what the pension fund has missed out on given it has other pressing considerations, is a cause of consternation for some. Some questioned its use, worried it promotes misunderstanding and pressure to “jump back in.”

But for others examining how divestment performs is an important building block in the reaffirmation process.

Counting the cost of tobacco divestment is “ridiculous”, argued Theresa Taylor.

“To me it just seems silly to look at it as a loss,” she said.

Moreover, few other investors seem to follow the same practice. Daniel Ingram, vice president, responsible investment research and consulting at Wilshire Associates presenting the financial impact of the divestment programs to the board said most asset owners don’t monitor financial gains and losses from divestment according to a recent survey.

“The governance around [this] was probably a bit weaker than what we had expected. Not that many do conduct this kind of an exercise. We picked out one or two examples. Divestment analysis does go on, but not on an annual basis.”

In what he called a “philosophical” comment CalPERS CIO Ben Meng urged the board to “stop chasing its tail” and focus on the sentiments, beliefs and driving factors behind divestment decisions at the time rather than judge with hindsight based only on performance outcomes of divested assets. Similarly, board member Eraina Ortega argued it was “overly simplistic” to look at divestment through an outcome lens and not realise “what was considered at the time” particularly around risk factors. Moreover, she pointed out the pension fund doesn’t list “every other investment it hasn’t made” and the losses therein.

How CalPERS re-invests divested money into the portfolio is another, ongoing concern. Money is re-assigned into the global public equity portfolio according to benchmarked weightings.

“The dollars that come out are spread across the whole fund, so we eliminate [for example] tobacco and everything else gets pro-rated up by its existing weight,” explained Andrew Junkin, president of Wilshire Consulting. Yet members referred to an “incomplete analysis” and not having a “handle” on the process, requesting more light on the benefit derived from re-invested funds.

The board also discussed the frequency of divestment reviews. Some urged against the 13-members “micro-managing” divestment decisions on a more frequent scale than the existing five-year deep dive and one-year high level review. It was one of several nods to the extra toil it brings on CalPERS stretched investment team.

“It does take a big-time commitment from staff,” said Kit Crocker, investment director at the fund. Others also suggested the review process might do better to offer insight into lessons learnt, particularly around impact, rather than “assigning staff to bring a bunch more stuff back” or “second guessing decisions.”

“When organisations such as ourselves divest from an industry, a certain organisation or country, what is the impact on the behaviour of those organisations?” asked Lisa Middleton. “Are we actually producing a positive impact by our divestment decisions or are we not?”

Lastly the board heard how divestment is an active decision that therefore should be re-visited.

“Whether it’s [divestment] forced upon you or whether it’s your choice, it’s an active decision,” said Junkin. “In some cases, you can change your mind. You can’t on Iran and Sudan, but you could re-invest in tobacco. As painful and as long as that process was on the single divestment, that, quite frankly is the process that you need to go through on all of these, on a regular basis to reaffirm yes, we want to stay out of that.”

The fraught reaffirmation of past divestments in the years to come suggests one thing: new divestment around fossil fuels won’t happen anytime soon.

Last year’s international climate conference, COP 25 in Madrid, opened to the news that the world’s average temperature is rising so fast we could be on course for 5°C of warming by the end of the century. In Madrid however, there was little in the way of the bold government commitments to cut carbon that are needed to tackle the climate crisis.

This makes 2020 even more critical. Global emissions are continuing to rise at 4 per cent per annum but they must peak this year to give any chance of limiting warming to 1.5 °C and maintaining a relatively stable climate system.

Yet government promises are only part of the story. Much of the world’s wealth is under private control, with global invested capital now totalling around $300 trillion in assets. Those that control this huge pot of capital have a vital part to play too. The choices investors make when it comes to the companies, projects and instruments in which they invest will all play their part in determining future climate scenarios.

Climate risk for investors is getting real

Investor that choose to ignore climate change do so at their peril.

Earlier this year 215 of the biggest global companies reported $1trn already at risk from climate impacts and analysis by the UN-supported Principles for Responsible Investment released at COP25 found that $2.3trn of company valuation could potentially be lost by 2025 as climate policies start to impact. Those that act now will both safeguard against climate related risks and benefit from the growth of the low carbon economy.

Investors need to use their influence as shareholders to speed up the rate at which climate change is tackled. They have plenty of ammunition with which to do so, with reems of data on corporate carbon emissions and environmental performance at their fingertips.

2019 saw data coming in thick and fast to enable investor climate action. At CDP, we released investor research drawing on our bank of data on over 8,400 listed companies to rank the steel, shipping, automobile and consumer good sectors in terms of readiness for the low carbon and environmental transition.

We learnt at COP 25 that 285 companies, with more greenhouse gas emissions than France and Spain combined, have committed to emissions targets in line with what science says is needed to keep global warming at 2°C or below. If met, these ambitions will reduce global emissions by 265 million metric tons, equivalent to closing 68 coal-fired power plant. We also saw further evidence that cutting emissions can cut costs, with suppliers to 125 major corporates reporting savings of $20 billion from cuts to carbon.

It is data like this that investors should use to help drive transparency, engagement and ultimately decide which companies will be part of the future economy.

Investor action equals results

Investors that choose to act on climate data are bringing about real change.

When, in mid-2019, a group of 88 investors targeted over 700 companies – such as Exxon Mobil, Amazon and Volvo for not reporting environmental information they saw a 14 per cent increase in disclosure.

More recently, London based TCI Fund Management Ltd., which manages more than $30 billion used CDP’s environmental data as the basis for writing to companies like Airbus and Moodys, threatening to vote against management, if they don’t improve their greenhouse gas emissions reporting.

Where asset managers stand on climate is increasingly under public scrutiny too, with retail investors and IFAs keen to know which funds are making a positive climate impact, and which are failing to react. Tools such as Climetrics, which provides climate impact rating for investment funds allow any investor to gain insight into investor action on climate change, and modify their portfolio accordingly.

Investors united on climate

Despite their powerful voice, investors in listed equities are of course just one part of the global financial system. The debt markets, banks and private equity funds all have their part to play. As we look forward to 2020, when global emissions must be checked, the whole financial system needs to work together, something which we at CDP will be investing effort and energy in next year.

By the time we reach November’s COP 26 in Glasgow we need to be much further down the road to creating an ‘Ambition Loop’ where bold government policies and private sector leadership reinforce each other.

Investors have no more excuses. They need to act on climate data now.

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Insurance companies usually join forces as Limited Partners in funds or collaborate around commercial mortgage investment. When six of America’s largest insurers got together to set up their own asset manager back in 1998 it was unusual. The fact that manager was focused on socially responsible impact investment across healthcare, affordable housing and SME finance in underserved communities was positively unique.

Today, San Francisco-based Impact Community Capital’s (IMPACT) has around $2 billion invested in communities across the US of which one of its most successful and enduring allocations is a $1 billion investment in affordable and community housing. Via a pooling and securitising strategy IMPACT’s six founders invest in affordable multifamily rental housing, allowing people earning below average income across 40 US states to spend less on rent, giving them more to go on other necessities like childcare, groceries, healthcare and education.

As attention in impact investment grows so the complexity and challenges on the road to good intentions get more airtime. Responsible investment is littered with acronyms that complicate its message and definition, investors worry impact compromises risk and return, that it doesn’t fit with their fiduciary duty to policy holders or beneficiaries, and where to place it in their portfolios. Yet IMPACT and its founding insurers’ proven model shows one way to channel more capital for impact. It’s a success they are keen to share.

“We have this little gem and we want to share it and create more impact but it’s a tough thing to sell because it is unique,” says Michael Moran who leads real estate investment at Allstate Investments, the $89 billion investment division of The Allstate Corporation, one of America’s largest so-called personal lines insurers providing cover for things like property and casualty risk, and one of IMPACT’s six founders alongside Farmers Insurance, Nationwide, Pacific Life, Teachers Insurance & Annuity Association and 21st Century Insurance Company. They have a combined AUM of $760 billion.

The strategy

Impact’s owners rely on the company to originate and manage the investments for their common benefit, a fairly unique arrangement among large insurance companies who traditionally directly manage their real estate investments. Allstate, for instance, outsources the allocation because it’s niche and it can’t be expert in all areas. Other real estate allocations Allstate has, such as a $4.5 billion investment to commercial mortgages and a $2.5 billion allocation to real estate equity, are all run internally by a team of 20. We can’t match IMPACT’s operational expertise in originating, managing and making day-to-day decisions, says Moran.

Allstate is also too big to go it alone in impact where investment in affordable housing is small dollar amounts with loans typically around $2 million. In their model investment is made via closed end funds packaged up into securitisations, providing essential scale.

“By securitising a large number of small loans, we create a small number of much larger securities in a familiar investment structure that allows institutional investors to invest at a sufficient scale ($20+ million). A securitisation allows IMPACT to achieve scale, reach new investors and to recapitalise so that we can in turn make more loans and achieve greater scale,” says Jeff Brenner, president and chief executive at the manager.

“The number of qualified fund managers that offer market returns on a risk-adjusted basis on something that is scalable is very limited. The opportunity set here is very small, particularly when it comes with a clear line of sight on impact,” says Moran.

Launched in 2003, just a few years after IMPACT was founded, the strategy strives for long duration asset preservation that can weather market cycles and fits its founding investors’ income and yield-generating priorities. The debt investment has limited volatility, making it a low-risk proxy for corporate bonds.

“It’s both high yield and low volatility. This is why we like it,” says Moran who declines to name the amount Allstate has invested in the allocation over the years or the returns – other than state the insurer’s repeated investment since 2003 is testimony to the strategy hitting its target market rate returns.

The risks come with any rise in interest rates and its illiquidity.

“Cash flow from affordable multifamily is generally more stable than cash flow from market rate multifamily housing due to occupancy rates that are more stable and the lack of competitive alternatives for renters. On the other hand, there may be limits on a landlord’s ability to raise rents on an affordable multifamily property that don’t exist for market rate properties,” flags Brenner.

But he points to stark figures to illustrate the strength of demand.

“For every 100 extremely low-income renter households, there are only 37 available rental homes.”

IMPACT also specialises in projects benefiting from Low Income Housing Tax Credits, an important and significant part of the total capital stack that provides strong insulation against default. The LIHTC subsidises the acquisition, construction, and rehabilitation of affordable rental housing for low- and moderate-income tenants.

Measuring impact in the allocation is also relatively straightforward because it is tangible.

“We measure our impact on the community in the number of affordable units we create,” says Moran.

IMPACT also produces an impact report quarterly, and on an ad hoc basis when needed, that doesn’t just detail the number of houses built (45,000 to date) but also lists the level of affordability, the degree to which veterans, seniors or those with special needs have benefited, and the properties’ sustainability credentials. The impact priority is to reduce the cost of housing so that people are spending no more than 30 per cent of their income on housing.

Board control

The six founders have seats on IMPACT’s board where Moran, Allstate’s representative, describes the culture as “engaged.” Regular meetings focus on strategy and growth of the business, new funds and investment ideas and the right structures and underwriting approach.

“I can’t imagine a group of investors with more aligned interest,” he says.

Today that support and counsel is honed on helping IMPACT open the platform to new investors outside the six. IMPACT is expanding its team, growing its brand and building an investment approach that has the flexibility to meet different investors’ needs. For example, Brenner is looking at new opportunities in workforce housing for essential workers in inner cities, and different investment vehicles beyond closed end funds like separately managed accounts.

“We think we’ve created a platform that institutional investors will find appealing and we want to leverage it to bring new investors into this sector,” says Brenner. “Beyond our legacy investors, we are having increasing numbers of discussions with investors interested in the space but seeking greater flexibility and more alternatives beyond the typical fund approach.”

The future

Their model doesn’t fix all the enduring challenges of impact investment. Insurance companies are often public or mutual institutions with stakeholders that don’t’ share an impact mission. It makes justifying impact investment, particularly without the recourse to beneficiaries that pension funds have, difficult. They are also big institutions which take time to change.

“For impact investment to become a meaningful allocation for institutional investors, there have to be more opportunities and the breadth of the offering needs to grow,” says Moran. “As much as we see the benefits of this structure and its opportunities, it is going to take time to make it live outside our ownership group and for others to align with it.”

Yet he is also convinced this is starting to change, recently evident in the Business Roundtable’s pressure that large corporations should be run not just in the interests of shareholders, but also in the interests of stakeholders. “There is a shift in corporate responsibility to stakeholders like employees and communities in addition to our stockholders,” he says.

Now progress depends on more investment managers and opportunities to meet this need and opportunity to scale – something IMPACT is ready and waiting to provide.