Impact investment and its combination of financial returns and social or environmental purpose is beginning to move from fringe to the financial mainstream. It is part of a natural trajectory in the evolution of ESG investment first seen back in the 1800s when Quakers developed screens on slavery and tobacco investments. More recently, investors have focused on corporate social responsibility and today they have an increasing eye on impact combining intention and measurement, delegates at the Fiduciary Investors’ Symposium at Harvard University heard.

Impact investment is growing because the long-held concept that investment should only maximise shareholder value is beginning to fade.

“It is still important and many believe it still has primacy, but there is a reduction in confidence that it should be a primary factor,” said panellist Kim Wright-Violich, managing partner at Tideline, referencing America’s Business Roundtable which recently diverged from its traditional stance. It stated that the country’s large corporations should be run not just in the interests of shareholders, but also in the interests of stakeholders.

Wright-Violich said that the assumption that impact investment resulted in below market returns was also fading.

“Impact can outperform, underperform and it can also meet market rate returns,” she said, noting that impact investment is also increasingly perceived as risk mitigation. “There is less scepticism about what you have to compromise.”

In another trend, she noted “mainstream players” entering the impact market including KKR and TPG bringing real scale.

Panellists outlined how a key risk of impact investment is investment not having an impact.

“If, for example, your impact is to support early-stage tech companies run by women of colour, the risk would be a portfolio of early stage tech companies run by white men from Stanford,” said Shuaib Siddiqui, director, impact investing at the Surdna Foundation, with a mission to build healthy and just communities in the US. Their flagship policy involves helping entrepreneurs of colour access capital.

“As a foundation if we don’t take that risk who is going to,” he asked. “We might have financial success but if there is no impact our investment won’t come to fruition. If our venture fund does not support entrepreneurs of colour the impact is a failure.” Countering this threat involves due diligence around impact “over the life of the investment,” he said.

Panellists noted that despite enthusiasm from the investor community to “be innovative,” “catalytic” and “change the way capital flows” most investors shy away from impact. Another challenge is measuring impact. Impact return figures are difficult to measure and unlike financial returns can’t be compared and contrasted.

Some investments easily align with impact. Others are more complicated, and the impact is nuanced. For example, some clean energy investments could reduce a carbon footprint but at the same time destroy jobs. Alternatively, a polluting industry setting up shop in a low-income area would have an impact on jobs, but bring unwanted environmental consequences.

Panellists also suggested that measuring impact increasingly involves managing impact. For example, an investor may exit via an IPO but also needs to ensure preservation of the mission and impact going forward. They also noted how valuations in impact investment are improving as record keeping and data improves. Like private equity and emerging markets, transparency around impact is growing, they said. Elsewhere the UN SDGs help underpin impact in a bottom up fashion.

Consumers increasingly want to invest in line with their values and hold fund managers to account, argued Jill Jackson, managing director of The Big Exchange, a new investment platform in the UK which gives retail investors the opportunity to invest ethically and for impact via the 40 mutual funds on its platform.

“It has involved a great deal of work trying to establish what funds to put on the platform and the role of consumers in impact investment,” she said. “The media increasingly covers companies with bad practices and consumers are asking questions of their fund managers in the retail space.”

Jackson quoted the work of the government-backed Impact Investing Institute, which will conduct research and press for more funds to be allocated to the sector, particularly from ordinary savers. She also noted a “direction of travel” in the UK market driving more transparency.

“The ability to find out what your pension fund is invested in is hard; looking under the bonnet of where funds invest is hard.”

Now the Big Exchange allows investors to see where they are invested.

“Our universe is small,” she said. “We appeal to asset managers to do more impact and do it well,” she said, noting impact needs to chime with a lower risk appetite among retail investors. In another strategy to illustrate impact the Big Exchange has awarded impact medals to the best funds on its platform.

“People can see the real market leaders,” she said.

The Curious Quant series, hosted by Michael Kollo, is a discussion between technically-minded professionals in the financial services, technology and data science fields. It carefully examines the application of new data and new methodologies to common problems in financial markets. The aim is to promote better discussions about these emerging areas, and a better understanding of new technologies.

 

 

Michael Kollo is a seasoned investment professional with a deep passion for the pragmatic discussion and application of quantitative models to solve problems. His PhD in Finance is from the London School of Economics where he lectured in quantitative finance in addition to Imperial College and at the University of New South Wales. He has created models and led quantitative research teams at Blackrock, Fidelity and Axa Rosenberg in the UK before more recently moving to Australia where he established the quantitative team for the $50 billion industry superannuation fund, HESTA. Kollo is an experienced speaker, author, mentor, a keen student of philosophy and more recently, a podcaster. The Curious Quant is a series of conversations with market leaders, deep thinkers and practitioners who deal with the wonder and frustrations of these models and who are on the front line of AI innovation.

Air Canada, the pension fund for Canada’s flagship carrier, is preparing to manage external assets in a bid to let other pension funds and institutions tap into its top decile performance and 65-strong expert internal team, currently managing 80 per cent of the C$21 billion portfolio. The pension fund’s investment staff have transferred to a new entity, Trans-Canada Capital (TCC), now readying its legal, compliance and best practice pillars for take-off.

It’s a new approach designed to boost assets and grow Air Canada’s internal expertise as the closed fund carries on its own de-risking journey.

“We have been in gradual de-risking phase for many years. Managing external client assets is a new business line for the company and will help maintain and grow the team which is interesting from Air Canada’s point of view,” says Vincent Morin president, pension investments at TCC.

The final phase of the process involves transferring assets held under Air Canada’s pension master trust to a limited partner fund structure from which Air Canada’s pension fund will buy units, also offered to third party clients. TCC hasn’t begun a marketing push yet, but six investors have already shown interest, one of whom has just committed to investing in the fund’s internally managed C$1 billion multi-strategy hedge fund.

“As well as continuing with great returns for the pension fund, if someone wants to chip in and invest alongside us in any of our portfolios, they can now access the exact same strategy that has put Air Canada pension plans in surplus,” says Morin who won’t put a figure on the size of external assets TCC hopes to manage until the structure is right, but hazards it could hit C$10 billion in 10 years.

Transformation
It’s a remarkable transformation from when Morin and his senior vice-president Nelson Lam, who heads up equity and alternatives, joined the fund 10 years ago. A time when tight budgetary constraints due to Air Canada’s rocky finances and $4.2 billion pension fund deficit (when the fund’s AUM was only C$10 billion – there is now a C$2 billion surplus) left them working off laptops with a skeleton, mostly part-time, staff.

They set about replacing the wholly outsourced 60:40 portfolio with an active liability-driven strategy that aims to hedge 100 per cent of the fund’s interest rate risk (in sight, but not completed yet) and uses leverage to enable an allocation of up to 140 per cent. The 40 per cent allocation to risk assets comes via a reduced public equity exposure, and a diversifying allocation to private markets, hedge funds and recently added liquid alternatives.

One of the biggest changes was the introduction of derivatives. Less liquid than the US market, finding bank counterparties in Canada’s derivatives market was tough – as was convincing the board to authorise trading swaps, says Morin. “We now have ISDA’s with 24 different counter parties.”

Liquid alternatives
Last year TCC reduced its public equity allocation from 20 per cent to 10 per cent in favour of a new allocation to liquid alternatives. Comprising emerging market debt, high yield bonds and listed infrastructure, the allocation diversifies away from equity but also allows TCC the liquidity to be fleet-of-foot in times of crisis. Although the fund has traded liquid alternatives on a tactical basis before, it has never been in the fund’s strategic allocation where it now accounts for 5 per cent.

TCC will use some leverage to obtain exposure in liquid alternatives, explains Morin.

“We can use derivatives in emerging market debt and bonds to access the market. Alternatives, including liquid alternatives, can be expensive and using derivatives is a cost-effect way to access them.”

TCC will also use active management to improve returns, but only in niche corners of the liquid alts space where Morin and Lam believe there is enough value to make it cost effective compared to the fees of accessing the beta of the asset class.

“The challenge here is that using derivatives involves mark-to-market. In this way liquid alternatives are like equity, but they have a less risky profile because these asset classes are mostly bonds,” says Morin.

Private markets
As for the 20 per cent allocation to private markets, the mantra is dynamic and opportunistic. The allocation focuses on real estate, private equity, private debt and infrastructure but has no sub asset class divisions, allowing capital to move freely between the four allocations. For example, TCC moved out of its chunky allocation to US real estate debt as the sub-prime crisis unravelled to later re-invest in US real estate funds, from which it then made capital commitments to European real estate following ECB chief Draghi’s assurances on the euro in 2012.

“We can move around the private market asset classes according to the environment and opportunities the market is giving us,” says Lam.

In another example, they point to how the recently boosted private debt allocation will allow the fund to get its capital back faster than it can in private equity – a good thing in today’s market.

“If the market goes down, we can have a return of capital, or coupon, that will allow us to reinvest in distressed assets in the next crisis. We try to be dynamic but it’s hard because selling an asset in this market leaves too much money on the table. It’s great to be able to invest tactically wherever possible,” says Morin.

TCC’s strategy in private markets is currently defined by small ticket sizes (typically around C$50 million compared to C$200 million in the past) in response to high valuations. In another sign of their wary eye on compressed spreads and low risk premiums, they haven’t deployed to core real estate or developed market infrastructure for a couple of years.

“We want to reserve our cash for an opportune time to invest,” says Lam. “We’ll wait until there are distressed sellers.”

In public equity the fund accesses the beta of the portfolio as cheaply as possible using futures or total return swaps. Alpha comes mostly via a portable alpha strategy in niche, long short equity strategies run externally to actively harvest additional value.

“In current markets it’s hard to outperform in large cap, but some sub-asset classes or sectors are proving less efficient so we move tactically where we believe we can add value,” says Lam. It’s part of a $2 billion fund of hedge funds portfolio with 11 managers diversified across strategies including credit, CTA, volatility, global macro, event-driven and emerging market debt.

Hedge funds
It’s no surprise that TCC’s first client, a Canadian fund in the retail space which Morin and Lam decline to name at this stage, has chosen to chip in to TCC’s internal hedge fund allocation. In an asset class where Morin says “size matters” the multi-strategy allocation stands at C$1 billion with a sharpe ratio of over one. It’s guiding pension fund culture is a particular source of attraction, whereby a longer-term view (with up to two, three or four-year positions) is combined with daily and weekly trades.

“When we say longer term there is a caveat,” says Lam. “We are still in the hedge fund industry and the multi-strategy that we manage does have very short-term exposures where we come in and out in a day. However, we differentiate ourselves by also having longer term positions. We think these positions can add tremendous value to the portfolio.”

Managers
The fund uses over 60 managers across public equity, private markets (it also runs a co-investment program within private markets) and hedge funds. Rules of engagement include insisting managers have skin in the game.

“In all the funds we invest in, we want the investment managers to personally invest to a significant degree,” says Lam. If it’s a theme they like they “aren’t shy” of putting in large commitments that can stretch to $200 million.

“If we put in a higher ticket size, we obtain a seat on the limited partner advisory committee. This ensures we get a lot of attention, co-investment rights, fee rebate and preferential terms.”

TCC’s bargaining power is also bolstered by the fund’s ability to swiftly make decisions on deploying capital. Any deal involves internal analysis and external consultants, but the decision rests with the investment committee, chaired by Morin, which meets twice a week, and more frequently if needed.

“We can give a quick yes or no. We’ve made deals within three days in the past and our external managers really appreciate this,” says Lam.

Bob Prince, co-chief investment officer of Bridgewater, says that institutional investors should consider diversification in the context of different economic exposures which could manifest in splitting portfolio allocations to the east and west.

He says that while the west has experienced the longest expansion in history it has also been the slowest and in the next decade there will be low-positive growth in the developed world.
“The western world will have 1 per cent growth over the next 10 years but in emerging economies there will be 6 to 8 per cent growth, and in the Asian economic block 4 to 6 per cent growth,” he says in an interview. “So there are big differences in secular longer-term 10-year growth rates in different parts of the world, without the ability to generate an above trend growth rate in the developed world.”

Conventional economic analysis and portfolio allocation techniques tend to be western world-centric but Prince is advocating thinking beyond that.

“How many of our words are in reference to the developed world and currencies? We are not talking about the other half of the world and they are not experiencing what we are talking about. There is an increasingly integrated economic block in Asia which has the same output of Europe and US combined, and two and a half times the contribution. Out of self-defence, they are increasingly independent and have an internal inwardly-focused economic system driven by the monetary policy of China. There are now three major systems – the dollar, Euro and RMB. For an investor, that is fantastic because you’ve just increased diversification by 50 per cent. The problem is the securitisation for those cashflows hasn’t occurred. The question I like to ask is, does it make sense to balance east and west in a portfolio?”
Diversification of cashflows is one of the levers investors have available to them in the current economic environment, and Prince believes 25 years from now investors will have a distinct east/west split in their allocations.

“People have a benchmark centric view of investing, so benchmark weights are the frame of reference of where the money goes, it’s an investor standard for the management of assets. Because of that, the weight of money allocated to the Asia block is lower than its economic share of the world because a much lower percentage of the business cash flows have been securitised and trade in public markets. But there are cashflows, there are lots of businesses that are privately and family owned in China that those cashflows are going through, it’s just not publicly traded,” he says. “Five years ago it was a closed market so you couldn’t invest but they’ve opened up and the west hasn’t grabbed that because of a lack of understanding, a lack of trust, scepticism, and they have just been slow to adapt. Image if the market cap was 50:50? The question is do you wait for that or do you get in ahead of that.”

In Prince’s view, investors can’t avoid investing in China the only question was how to engage.

This strategic positioning in China is a subject he has been discussing with various investors such as the University of Texas Investment Management, in the context that Bridgewater’s raison d’etre is to bet on economic changes via the markets that reflect them.

Prince says investors can view an exposure to an Asia block through three different dimensions : the first is a policy or issues perspective; the second is by geography so investing directly in China, in Asia or the eastern hemisphere, or as a global investor buying companies that do business with China; and the third is the degree of intimacy of the investment, such as investing in a private company and sitting on the board, or through the public market. And investors can buy individual stocks, or buy asset classes, or buy global assets that are exposed to China.

“No one is making you do one or the other, you can choose, but you can’t avoid it,” he says. “Make your choice and go in with eyes wide open and realise you’re going to have risks that you’re not used to having.” Regardless of the access point, Prince says the most important thing is to learn through direct engagement.

“If you make a good investment in China today and it’s only a good investment that’s not good enough. It needs to be an investment that’s also an education process about how that system works and equip yourself for the future for when it really matters.”

Prince says Bridgewater’s own exposure to China is only constrained by liquidity. It is in all of the firm’s alpha strategies and has a share of the global All-Weather product. In addition, the firm has created two China-centric All-Weather products that primarily hold Chinese assets, one for local investors and one for offshore.

“This is intended for our clients to have that type of learning experience,” he said. “It’s designed to be a perfectly good investment return stream lowly correlated, but mostly it’s a great window into China to get your feet wet in a way that is somewhat arms’ length – it has more derivatives and asset class positions – where they can get to know policy and how policy shifts are effecting risk premiums and start to build that understanding.”

MP3 – fiscal and monetary levers

Prince says investors should be looking at diversification through the lens of macroeconomic conditions and cashflows related to the differences in economic regimes around the world.

“Prices tend to move together but over long periods of times the ups and downs net out and what you are left with is the compounded effects of cashflows of these different economic regimes around the world. Hence the east/west division is one way to think about that. Diversification of cashflows, diversification of monetary systems, that very macro diversification is really where you want to be.”

The key to stimulating growth in the western world, he says, is the management of both monetary and fiscal policies. Bridgewater is advocating MP3 which it describes as increasing reliance on fiscal policy coordinated with accommodative monetary policy. Modern monetary policy could be thought of as one version of MP3.

“There’s not much ability to put the juice into the economy if you look at the level of interest rates and how much they can be cut or the level of risk premiums and so how asset prices can be raised through QE, that’s not available. QE has been spent, monetary policies are approaching the end of their useful lives. We need fiscal policy action.”

He says both the Bank of Japan and the European Central Bank have already recognised that monetary policy is at the end of its usefulness and are “handing the baton to fiscal policy”.

So what is MP3? Prince describes MP1 as interest rate driven monetary policy, where borrowers are induced to spend. MP2 is essentially quantitative easing and MP3 involves direct spending by the government in the economy which is supported by the liquidity of the central bank.

“That’s where we are headed,” he says. “Europe, Japan and Switzerland are on MP3. The US and the UK are close to done on MP1 and MP2, rates could be cut a little bit but they are going to MP3 next. China still has all three available and a lot of MP3 fuel because they coordinate monetary and fiscal policy anyway.

“We are headed to a world where the existing reserve currencies are going to low growth, low inflation, zero interest rates but lots of liquidity to avoid a down turn. MP3 is the bazooka you have to fire which brings into play government involvement in the management of the economy from a cyclical standpoint, which is a much messier approach.”

“When we talk of MP1, MP2, and MP3 what we are really talking about is the levers to manage the variations in growth around the trend,” Prince says. “If we have a downturn how do I reverse it, if I am below trend how do I get back up, and if I’m above how do I get back down. It’s the wiggles/cycles that are being managed but they don’t change the long-term productivity path.”

Through history the lack of independence of central banks in relation to government has been a source of inflation mismanagement, Prince says.

“When Tony Blair became prime minister of England the first thing he did was to establish the independence of the central bank, literally the first day in office. And real yields on UK gilts fell 50 basis points. The credibility of an independent central bank was something that was accepted. For 250 years the Bank of England was not independent and a decision was made it would be better if they were. There has been a huge wave over the last 30 years of establishing an independent central bank, and that has been a big contributor to low inflation because they all have inflation targets. If you’re worried about inflation it makes total sense to have independence because you’re going to do politically unpopular things. But today they couldn’t get inflation if they tried, the system is sluggish and now it’s like why would we have an independent central bank, why not have the government coordinated? It’s a function of the conditions at the time, we want inflation now,” he says. “At the end of the day it is probably better to have government and central banks coordinated but only if it is done well. Abuse of that is bad, that’s why we had inflation and why the central banks became independent because government had too big a role.”

Bridgewater focuses on three sources of spending as a template for understanding the economy: productivity, long term debt and short term debt.

“We’ve been in an economic expansion for 10 years, it would be easy to dive into that but it would miss some really important things to be thinking about, particularly as institutional investors have to have their head on the 10-year picture,” he says. “It will be the compounded effects of the next decade that will have a bigger impact than reactions to the boom bust cycle that we are used to over the past 50 years.”

He says the convergence of the cyclical conditions to the secular conditions will be an important driver of how things play out over the next decade.

“This convergence will be an important part of the next 10 years. It’s the combination of productivity and the long-term debt cycle that gives you your long-term trend growth, and the short-term debt cycle that gives you the wiggles around that. We are now at the tail end of a 10-year economic expansion on the short term debt cycle, which has been an outperformance of that long term trend growth rate, but we are coming to the end of that. That thing is running out of gas and there is going to be converging to the long term trend growth rates which are going to be fairly low in the developed world, but not necessarily low in other parts of the world,” he says.

“Because you’ll have very big differences in these secular growth rates, that will have compounded effects over the next decade which might be more important than how we think about monetary policy and the next interest rate change and all that kind of stuff.”

Prince says the mission at Bridgewater is to understand the economic system and how it relates to markets and then respond accordingly and “so wherever that takes you is where we go”.

“Our existing process is actually positioned pretty well to what I described, as if you approached it from a long term secular view even though our process is looking at what is the next shoe to drop. Our systems are continuously processing long term and short term elements. The short term elements are somewhat subdued now so naturally the longer term elements are more dominant in our positioning at the moment, and that comes and goes naturally as a function of the shifts, last year it was the opposite.

“If they’re giving you the short pass, take the short pass. If they’re giving you the long pass take the long pass. We try to understand the economic system and just fit in with that, so that’s what we are doing. We haven’t made any major changes, anything we will do will be a gradual evolution but our research is about understanding that system and how it is connected to the markets and then evolving an investment strategy that fits into that. If that meant longer term strategies in more illiquid markets that’s what we’d do and then we’d talk to clients about that. We will always try to do what we think will be right.”

 

Large cap US equities is an efficient market and pension funds are better off indexing their allocations, saving billions of dollars in the process, according to new research by CEM Benchmarking.

Analysis of the returns of equity portfolios by US pension funds shows that large cap equities portfolios added zero value, even before costs, and investors would be better off getting beta returns and reducing costs.

The report’s author, Alex Beath, estimates up to 30 basis points could be saved by indexing US large cap equities exposures. That’s more than $8 billion in one year alone across the sample analysed.

CEM looked at the equity portfolios of large US defined benefit plans between 1996 and 2017 with a combined $2.725 trillion invested in large cap equities portfolios (adjusted for inflation to 2017 USD).

“That’s a lot of money you are paying to operate in an efficient market. For 22 years the largest funds in the US have never added value in that asset class. Why would you try to be active in this market?” Beath adds.

Net of fees these large cap US equities portfolios produced returns of between -0.24 and -0.5 per cent. Gross of fees the return range was 0.11 to -0.15 per cent (with 95 per cent confidence).

Part of the reason investors continue to invest in active large cap US equities is they are fooled into believing that their own abilities, in picking managers or stocks, is better than the market.

“Part of it is lack of data and if they do have outperformance over say a three-year period they get a bias and think they’re better at picking managers, but really that’s just valuing luck,” Beath says. “My personal belief is investors shouldn’t be looking at their own results in these asset classes but looking at peers and larger datasets so they can judge these decisions with data behind them and avoid the sample bias they get by just looking at their own decisions.”

While the research found that large cap US equity portfolios exhibit efficient market behaviour gross of costs, and underperform the market net of costs, small cap US equity portfolios outperformed the market gross and net of costs.

The research analysed US defined benefit fund portfolio data of $1.3 trillion of US small cap holdings (2,172 portfolios) which added 1.02 to 1.38 per cent before fees, and 0.35 to 0.71 per cent after fees, over the 22-year period.

“Investors should definitely be allocating their dollars spent chasing alpha to inefficient markets not efficient ones,” Beath says.

The results could have implications for the dollar amounts spent chasing alpha. The funds sampled have an average allocation of 32 per cent to large cap US equities. The total amount of which is unlikely to be redistributed entirely to chasing alpha elsewhere.

The average allocation to small cap US stocks was 6 per cent.

“The total dollars spent chasing alpha could decrease, active budgets could come down,” Beath says. But he also says that investing more in small caps makes sense given the correlations and the opportunity to pick up alpha because of the inefficiency.

“Should they be allocating more? Potentially,” he says.

The funds measured had an average of 3.4 mandates in large cap US equities and 1.8 in small cap US equities, with average mandate sizes of $2.26 billion and $324 million respectively.

Beath says that CEM’s research has shown that there are many asset classes that are potentially inefficient, and that US large cap equities is an outlier.

“Most academics study US large caps but that is efficient. That’s an outlier. In most of our cases we see that markets are inefficient in some way.”

Beath said with regard to equities allocations, an active global ex-US portfolio “makes sense” with a separate US indexed mandate.

According to Beath the difference in performance, due to alpha, between small and large pension funds is very small. There is a difference in performance but it is due to the cost savings of larger funds, not alpha, he says.

“Gross of costs there is no advantage to being large or small when it comes to alpha. After costs larger funds do a bit better – about 7-8 basis points for every 10-fold increase in size. But they don’t show any real ability to pick better managers.”

The funds analysed make up around half of the total defined benefit pension funds in the US.

 

I chat with Sean, senior quantitative analyst at Mine Super, on the scientific process, uncertainty and the changing relationship between academia and the private sector in Australia.

Nothing on this podcast is to be considered investment advice or a recommendation. No investment decision or activity should be undertaken without first seeking qualified and professional advice.