Bert Feuss, senior vice president, investments at the $13.5 billion Silicon Valley Community Foundation, SVCF, explains why diversity is so important, the steps the impact investor has taken to address the institutionalised lack of diversity and the impact on performance.

Q: Why is it important for SVCF to seek diversity in the people who manage your investments?

A: First and foremost, it’s aligned with our values of inclusion and diversity. We started working on this eight years ago. We looked at the diversity of our staff, of our grantees, of our board and of our community. Then we looked at our investment portfolio and it was clearly lacking diversity. And at the same time, if you truly believe that diversification of an investment portfolio across different strategies, different geographies, different points of view and different ideas generates better returns and differentiated returns, then it naturally follows that you would want to diversify your investment managers.

Not only was diversity in line with our values but it was aligned with our fiduciary duty, so we began asking ourselves and our investment consultant, Colonial Consulting, what the barriers were to identifying talented minority and women-owned investment companies. SVCF relies on Colonial for manager research and selection, so we asked them to demonstrate to us that their process for finding managers was inclusive. They began reporting on:

1. How many managers they meet with each year and how many of those firms are women or minority owned
2. How many of those managers are recommended to their clients other than SVCF and
3. How many of those diverse managers are hired.

I would also like to point out that addressing an institutionalised lack of diversity requires intentionality. As we and Colonial delved into this work, it took a while to integrate these practices into our daily routines. For example, Colonial had to modify their databases to capture this information. When they told their staff what they wanted to do there was a lot of support, because their team was already very diverse. There was also some pushback since it was creating additional work. It was an adjustment on both their side and ours.

Then in 2015 they hired a dedicated head of manager equity, Angela Matheny. Because of her outreach, the number of meetings with diverse and women-owned firms shot up dramatically. In 2018 they met with over 515 managers, 202 of which were diverse, compared with 2016 when they met with only 50 diverse managers.

Q: Can you elaborate on why diversity is important to generate returns?

A: As I noted earlier, different experiences and backgrounds drive differentiated return streams. Often too, these newer, smaller managers are still building their businesses so they’re really focused on driving performance. They’re grateful for the opportunity and feel tremendous commitment to do well by their clients.

Q: How did diversity impact performance?

A: So far, Colonial has found that out of 19 managers deployed across their client base, all but four beat their benchmark. The four that didn’t had only missed the benchmark by less than 1 per cent. The ones at the top of the list wildly outperformed the benchmark, by hundreds of basis points. The results were promising. You need managers with different points of view and different life experiences who understand different parts of the world, understand different sectors, understand different geographies. Not just white males who attend Ivy Leagues schools and worked for a private wealth management firm in New York.

Q: What are other people in the investment business doing? Are other firms working to diversify the firms that manage their funds?

A: We definitely have seen a growing interest in this approach over the last few years. Other community foundations and private foundations with similar values have reached out to us. Consultants have also contacted us to understand how we approached this.

Q: What questions do these groups asks? What are their concerns?

A: They often want guidance on building consensus within their organisation to move the idea forward with their board and investment committee. Consultants have told me “Well, we’ve looked and we can’t find these managers,” which Colonial has disproved easily. There are also the concerns around performance, which demonstrates the inherent biases that people have.

Q: Why it is important that the ownership of the firm is diverse, as opposed to just focusing on the staff?

A: We look at the firm’s ownership, because that’s where the profits flow, that’s where the decisions are made. Then it’s also important that the teams themselves are diverse. When we meet with firms we’re always asking them about the diversity of their firm and how they share the returns that they’re earning? Are profits broadly shared across the teams? We want to see aligned incentives and that everyone is participating.

Q: Have you been able to find diverse managers across asset classes?

A: Yes, we have found diverse managers — or Colonial has on our behalf — across all asset classes. And if you look at how our assets are deployed across, say US equities, international equities, fixed income, hedge funds, private equity, it’s pretty well dispersed. Similarly, when you look across African American, Hispanic, Asian or multiple mix of those, and women, it’s pretty well spread out evenly across those groups.

Bert Feuss is senior vice president, investments, at the Silicon Valley Community Foundation, the largest community foundation in the world. According to its 2017 Annual Report, SVCF has $13.5 billion AUM.

Sampension, the DKK325.6 billion ($47.5 billion) labour-market Danish pension fund has found a rich seam investing in AAA-rated Collatorised Loan Obligations (CLOs) where it earns a pick-up from traditional fixed income in loans with low default rates. These specialist vehicles invest in a pool of loans issued to companies and use them to back a series of bonds of varying degrees of safety. They are also the types of structures that rocked the financial system in 2008.

Anders Tauber Lassen, head of credit at the fund, won’t divulge the exact size of Sampension’s AAA allocation that sits alongside, rather than in, the pension fund’s €3.4 billion credit portfolio due its different risk profile. However, he explains that building out the CLO portfolio is done on an opportunistic basis, timed around the market when spreads are wide compared to other products.

“We think that AAA CLO paper is one of the most attractive, low risk assets out there at the moment and we feel quite comfortable taking this type of risk,” he says.

Rather than default risk, he says the real risk of CLOs is structural and related to complexity.

“It can be volatile from a market risk perspective but the likelihood of a default in a AAA CLO is very low.”

Moreover, he believes CLOs performance in the financial crisis and senior CLO paper traded at a discount, was more a consequence of the liquidity crunch due to the subprime crisis, than a malaise in the underlying deals. Visible in Sampension’s “high teen” CLO returns after the financial crisis, he says.

“In 2009, CLO’s were deemed among the worst products in the world, but our allocation had good returns over the cycle.”

He attributes much of the success to the structure of CLOs, arguing that although technically they are a securitisation, they are more an asset management product given the fact CLO specialist managers buy the loans off banks and parcel them into tranches for investors. In this way the loans behave like any ordinary fund, with the manager trying to make the portfolio perform.

“This is very different to a bank taking rubbish assets off its balance sheet, stuffing it into a vehicle and selling it off to unsuspecting investors,” he says. It makes Sampension’s CLOs allocation a hybrid mix of internal and external management with the bond-part of the allocation managed internally, but an asset manager behind the CLO tranches.

Wider portfolio

Half of Sampension’s €3.4 billion credit portfolio is investment-grade, although investments don’t have to be listed or publicly rated. The other half is in higher yielding and more risky structured credit, subordinated CLO tranches and emerging market debt – though here he notes that last year’s battering has left lukewarm enthusiasm for jumping into emerging markets if the fund can find value in developed markets.

This structure gives the whole portfolio a risk profile that sits between equity (with the more aggressive, high yield and emerging market allocation closer to private equity and alternatives) and non-credit fixed income.

“One part of the portfolio is more stable than the other; it is there for extra risk and extra return.”

It is this split that he believes gives the entire portfolio its edge.

“Many pension funds’ allocation to credit is a one-eyed giant, only there to take higher risk exposure. We think that it is a missed opportunity not to seek out lower risk opportunities.”

Investment grade opportunities

It’s this belief that is driving another strategy. Sampension is also tapping illiquid, investment grade private assets partnering with banks in club syndicates, asset managers and even doing some deals directly on its own balance sheet. The idea is that the illiquidity risk is balanced by the quality of the asset, he explains.

“When you go into something that is illiquid you sell your stop loss option, but that option has less value if it is investment grade, as the likelihood of something going wrong is a lot smaller. That makes it a good place to take illiquidity risk.”

Senior commercial real estate loans are one example. “This is getting less appealing because property is expensive, but there is good value in private financing products generally.”

Bank disintermediation due to capital rules is fuelling opportunities which particularly suit large investors like Sampension, he says. And although illiquid, investment in this space isn’t necessarily long duration with typical maturities of five years. “There are spreads above the EURIBOR curve north of 170 basis points for investment grade risk if you know where to look.”

In fact, working with banks on private co-investment facilities currently takes up most of Tauber Lassen’s time. With his banking background and experience working on the sell-side, it is an area in which he feels particularly comfortable.

“If you grow up on the buy-side you have a different skill set. Experience on the other side of the fence is important when you are investing with banks.”

Banks’ priorities include pension fund partners being able to provide drawdowns at short notice and being able to underwrite facilities without “dithering” or having inefficient approval processes, he says. Sampension has been investing in credit since 2000, and Tauber Lassen’s team of four portfolio managers are adapt at explaining any complexities to the board.

Diversity

Sampension’s credit portfolio ensures diversity via a wide range of portfolio products. Rather than stock or name picking, the fund employs most of its strategies in a portfolio format that sweeps in instant diversity.

“On a look through basis we have more than 1500 credits referenced across our portfolio,” says Tauber Lassen. “Diversity is important because you are not paid for concentration risk in general. If you have concentration risk and illiquid assets, you’ve basically sold your stop loss option which is of greater value.”

Around 70 per cent of the credit portfolio is run inhouse and the fund uses 10 managers in all (although in the CLO allocation there are many more). Instead of co-investing in co-mingled funds Tauber Lassen favours managed accounts for the extra control and investment insight they bring. “This gives us overall control of what direction the portfolio is going in, and an ability to liquidate if need be.”

Fees depend on the product, but a typical fairly liquid, high yield investment “can go down to 20bps,” however he notes that from an economies of scale perspective this only works for some managers. In a closed-end fund he says costs can be as much as a 1.5 per cent fee plus a performance fee in a tally that impacts returns.

“With this kind of fee some of the risk premium that exists in direct lending disappears on the fund level. You have to ask yourself if as an investor on a net basis you really did get that extra risk premium for locking your money up for 10yrs or more.”

Credit risk

The current macro back drop is good for credit. It is easy for companies to borrow and the default cycle has yet to hit. When it does, he predicts it will be sector and company specific rather than broad based. But that doesn’t mean the sector doesn’t carry risks. Terms are becoming increasingly borrower friendly, and credit investors need to ensure they are legally protected. And peering further along the credit spectrum he observes more poorly run companies out there, only afloat because of abundant credit.

“These could be default candidates. They are relatively easy to identify,” he says. “There is lots of money being raised, waiting for distressed companies, but we don’t want to allocate there yet. We will wait until things get uglier before we put money into distressed funds.”

Moreover, today’s low interest rates make rotating out of traditional fixed income and stepping out on the risk spectrum more compelling. “I expect that our credit portfolio will grow but it does depend on the quality of investments available,” he concludes.

I chat with Anthony, Director at Verge Labs, on the open-source revolution, how we should frame the conversation around ethics and potentially optimistic viewpoint as artificial intelligence evolves.

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.

Forty asset managers scrambled to offer their services to the UK’s fastest growing pension scheme when it announced plans to invest in private credit last year. To date, the £8 billion National Employment Savings Trust, NEST, the DC workplace pension scheme launched in 2011, has had little illiquid exposure. In the last month, it selected BlackRock, Amundi and most recently BNP Paribas to manage allocations to infrastructure, real estate and corporate loans in a new portfolio targeting 5-10 per cent of assets under management over time.

Applications were whittled down via a screening questionnaire (around ESG, fee structures and agreement of Nest’s terms and conditions), contenders’ responses to an RFP, Nest’s own due diligence and finally, a series of personal meetings. In the competitive world of asset management, working out where mandates are won and lost is informative. For Nest, only those managers able to adapt on fees and help shape innovative fund structures were in with a chance.

Investors typically access private markets via closed end funds with a limited life. Yet Nest sought evergreen, scalable fund structures in one of the unique features of the mandates that has involved hammering out the right structure to balance the liquidity and legal needs of DC savers. Although the trio were chosen a while back, their appointment has only just been made public while the fund structures were finalised.

“These challenges highlight why the DC market has shied away from private credit and why we think this is innovative,” said Mark Fawcett, CIO of Nest who threw down the gauntlet to the asset management community ahead of the procurement process, challenging them to come up with better fund structures for DC investors.

For winning infrastructure debt manager BlackRock, the procurement process shows that successful managers don’t necessarily nail complex briefs from the beginning. BlackRock’s mandate today is markedly different to the asset manager’s original pitch in the RFP, said Jonathan Stevens, managing director, head of European infrastructure debt at BlackRock.

“What managers write on the paper may not necessarily be what the client had in mind. What we are doing now is very different to what I thought we’d be doing. It’s been a journey.” Rather than pushing BlackRock’s own skills and expertise, the shape of the mandate has evolved through a conversation phrased around “we wrote this, is that what you are looking for,” he said. “The hope is that the client is generous enough to be open to the fact you haven’t written on the paper exactly what they had in mind because you are going through an RFP.”

For Stevens, key to success has been grasping the different approach DB and DC schemes have to infrastructure investment. The majority of capital BlackRock manages is for DB and insurance clients, who view infrastructure through a liability matching lens. In DC schemes, where a beneficiary may choose to leave the scheme, there is not the same requirement to match liabilities. The membership base might change, or products evolve often driven by a more risk-on appetite, requiring a recognition that infrastructure assets are not homogenous, and that different investors want different things.

“It involved taking a product that initially only worked for insurance companies and DB schemes and adapting it for DC,” he said. As it is, he plans to explore “slightly less fished ponds” and the “granularity” of the market in the hunt for opportunities where Nest’s abundance of cash (the fund brings in £5 billion a year in contributions) makes the biggest challenge getting money into the market, rather than taking it out given retirees are still few.

Nest is planning to invest around £400-500 million across private credit in the first year but that will steadily grow as its AUM swells.

“The Australian superfunds have 30-40 per cent in illiquid assets. I’m not saying this is where we are going to go but we definitely have capacity to have more than 10 per cent in the future,” said Fawcett. “Regular conversations” and “a clear understanding of the pipeline” will ensure money is ready to be deployed. Managers’ flexibility to scale and evolve the mandates over time was another key requirement. For example, the allocation will only be available to people in Nest’s foundation and growth phase funds, but Fawcett doesn’t rule out this changing in the long-term. “What we anticipate is that people will want to invest in private credit through retirement too,” he said.

Fees

Successful managers also had to compromise on fees in return for long-term mandates. Nest is paying a flat fee (the UK government is currently consulting on performance fees in DC schemes) negotiated in a process where the promise of a long-term partnership piled on the downward pressure. “Nest is not a member of the hire and fire squad,” said Fawcett who ruled out the typical cost structures of infrastructure funds as incompatible with low cost DC pension schemes early in the process.

Softer fees in return for the benefits of a long-term relationship requires a degree of trust – and that comes with personal relationships. “You’ve got to figure out the measure of the person and move to a position of transparency and trust,” said Stevens. This also involves being honest about what the asset can deliver, he said. “There is no point me saying I can definitely get you 300 bps and then turn up with 200bps. It’s about being transparent about what the asset class can deliver.”

Familiarity must have helped. Both Amundi and BlackRock’s have existing relationship with Nest. “They’ve worked with us before on different mandates and were most able to structure the mandates. They know what they are dealing with,” said Fawcett. Elsewhere, Stevens stressed the synergy in mission between the manager and owner as another important overlap. BlackRock’s purpose “to help more people enjoy financial wellness” chimes with Nest’s pledge to make a difference in savings outcomes for an ever-growing number of people. “I can’t think of another institution having such an impact on savings and investment culture in the UK,” he said. “This is a phenomenal opportunity for us to help make a difference,” he said.

Regular valuations

Managers must be able to cater to Nest’s requirement for regular valuations. For some assets it will be quarterly, for others monthly and any downward shift in markets will make them even more frequent. The idea is that members shouldn’t be able to arbitrage the funds if they see a valuation mismatch, explains Fawcett. “This was an issue in Australia where they didn’t’ price frequently enough and some members saw stale pricing around the GFC and got out.”

Expertise in ESG integration was another deciding factor. Amundi’s “high credentials in sustainable property” was “a key feature,” said Fawcett, while in terms of infrastructure debt he wants BlackRock to target assets like renewables and social housing. “We have failed managers based on the way they integrate ESG,” he warned. Elsewhere, he wanted managers with a global capability, successful track record and a “demonstrated capability to execute.” The focus will be on opportunities in Europe and the US, and there is no UK bias. Managers will manage currency risk, a proportion of which will be hedged – harder in illiquid assets.

Rationale

Nest’s move into private credit is a consequence of the fund’s increasing maturity on one hand, and high valuations in public markets on the other. With growing asset under management (forecast to hit £20 billion by 2022) and members as young as 16 there is ample room to take on illiquidity risk.

“We are hitting a scale where we can be more expansive about the asset classes we invest in and at the same time we can see that public market valuations are full. We need to make sure that Nest members can benefit from less liquid assets,” said Fawcett.

Nest is targeting a 1 per cent private credit premium over equivalently rated public debt and although Fawcett notes that the illiquidity premium has gone down, he believes “the right managers” can still earn that premium. “It might be hard in this environment so we are not piling in, but we want to be at the point that when the illiquidity premium expands and where we can deploy more.”

The mandates also boost diversification – notably around accessing floating rate debt. “If you look at public credit it is predominantly fixed rates. For us this is diversifying our interest rate risk as well,” said Fawcett. It is also a timely move. Banks have been withdrawing from the debt markets for a while, creating a gap that is a natural fit with long-term pension investors. Europe’s toughening regulatory environment impacting banks’ ability to lend is also driving the trend.

The move into private credit comes at the same time as Nest begins setting up a regulated investment subsidiary. As well as allowing the fund to use derivatives more widely to manage investment risks, Nest Invest marks the first steps in building in-house investment expertise that will ultimately lead to co-investment and reducing costs further. “At some point we may have a private markets team,” said Fawcett. While some asset managers might see that as a threat, for others it makes grabbing the opportunity to forge a relationship now all the more crucial. “If you look at the largest in-house teams in the UK they all work with in house managers,” concludes Fawcett.

In September 2015, the United Nations General Assembly adopted 17 Sustainable Development Goals with underlying targets to be met by 2030. Target 8.7 commits governments to taking immediate and effective measures to eradicate forced labour, modern slavery and human trafficking and prohibit and eliminate all forms of child labour. I was in New York for the most recent United Nations General Assembly and it was clear that accelerated action is urgently needed to meet our shared commitments. As UN Secretary-General António Guterres says, “a much deeper, faster and more ambitious response is needed to unleash the social and economic transformation needed to achieve our 2030 goals.”

One of my main roles as part of the UN proceedings was to support the release of a report into what specific actions the financial sector (including institutional investors) can take to address modern slavery and human trafficking. ‘Unlocking Potential: A Blueprint for Mobilizing Finance Against Slavery and Trafficking’ is the final report of the Financial Sector Commission on Modern Slavery and Human Trafficking (known as the “Liechtenstein Initiative”), on which I have been honoured to serve as a Commissioner.

Similar to the language used by the Secretary General, the report not only describes the imperative of eradicating slavery, but speaks to unlocking the potential of an estimated 40 million people in some form of slavery today – roughly one in every 185 people. The Blueprint provides a shared collective-action framework under five goals as well as an Implementation Toolkit with practical tools and initiatives for investors, and other financial sector institutions, to play their part in addressing these practices.

The Liechtenstein Initiative is a public-private partnership between the Governments of Liechtenstein, Australia and the Netherlands, the United Nations University Centre for Policy Research (acting as its Secretariat) and Liechtenstein-based businesses, associations and foundations. Over our one-year mandate, we held four consultations across three different continents – including in Australia where we heard from experts across Asia-Pacific. We’ve been considering different ways that the financial sector can accelerate its engagement on this issue: from responsible lending and investment, to financial inclusion and technology, compliance and regulatory regimes, remedy and international cooperation. The Commission brought together experts – as Commissioners and briefers – where the complexities, experiences in the field, financial systems, technologies, data and practices could be explored and potentially deployed.

Financial sector institutions have extensive and influential relationships across all business sectors, so their role is critical if we are to eradicate modern slavery and human trafficking. The prevalence of slavery is a systemic failure, not only in protecting human rights but of economic proportions. The profits from illegal exploitation are privatized by a few, whilst the costs are socialised. Bad actors gain an unfair (and illegal) competitive advantage over firms with good labour practices, and if left unchecked this can perniciously reset procurement and contractor costs. With complex supply chains and commodity markets, it becomes difficult to know what the “true cost” of production is.

When investors and banks begin to misprice these illegal labour costs (that is, where they become “normalised” yet hidden in the system), it has knock-on impacts to valuations, profit forecasts, and share price expectations that may reinforce or exacerbate exploitation.

An estimated $150 billion each year is generated globally from illegal labour slavery, making it the third most profitable criminal activity. Whether it’s by profit margin or volume, make no mistake – slavery is a business – and it channels its earnings through the financial system, and its products into markets and supply chains. There are good reasons to believe that the risks of vulnerability to modern slavery and human trafficking are actually increasing. This is all the more reason why collective action that includes the broad financial sector is urgently needed.

Addressing illegal and forced labour requires improving market information, so it is clearer to banks, investors and insurers where the risks lie. UN-backed Principles for Responsible Investment signatories are committed to integrating human rights considerations into investment decisions and into their engagement with companies. Investors can, and should, use their leverage in these situations to address slavery, which is undeniably illegal, everywhere. As modern slavery risks can be obscured by layers of outsourcing, subsidiaries and opaque ownership structures, we must work together as a sector to make risk mapping and due diligence real, routine and effective.

This is not just a risk management issue however. The UN Guiding Principles on Business and Human Rights places the victims first. When exploitation is identified at or by companies in an investment portfolio, the victims and survivors should be the focus. In most cases, a multi-stakeholder response will be required to ensure investors divesting or companies exiting a supplier relationship does not put people in a more vulnerable situation. Banks identifying victims whose credit records have been hijacked are also stepping up to play a role in supporting survivors. At the launch of the Blueprint at the UN, the Commission launched the ‘Survivor Inclusion Initiative’ with a coalition of leading banks and survivor service organizations.

Survivor leadership needs to be central to addressing modern slavery and human trafficking risks. Survivors can help guide and direct financial sector institutions to a more nuanced understanding of how and where modern slavery and human trafficking money laundering risks may arise. We encourage institutional investors to engage directly with survivors, to understand their experiences, and to see them as leaders and partners.

Reducing and eliminating slavery also requires addressing root causes. The lack of access to financial products and services heightens risk to modern slavery and human trafficking. It is estimated that 1.7 billion people and 200 million micro, small and medium enterprises currently lack adequate access to financial services. Women make up 59 per cent of the unbanked, and women and girls make up 71 per cent of the estimated global modern slavery population. Through targeted investment in innovation, such as digital platforms and data innovation, we can catalyse change in how the system operates, and the outcomes it produces.

We cannot end modern slavery and human trafficking on our own as investors, but modern slavery and human trafficking will not end by tinkering at the margins – we must bring this issue from margins into the mainstream. By engaging in ‘Finance Against Slavery and Trafficking,’ investors can learn more about the specific role that they can play in making slavery a thing of the past and help achieve the Sustainable Development Goals.

Anne-Maree O’Connor is the New Zealand Super Fund’s head of responsible investment and served as a commissioner for the Financial Sector Commission on Modern Slavery and Human Trafficking.

Apologies for the sound here, this interview was recorded using Skype and occasionally the quality drops.

I chat with Michael, Chief Data Scientist at Neuberger Berman, on using alternative data sets to improve insights into portfolios, deep diving into specific companies and industries and how these sets allow us to look at the world in a richer and more immediate fashion than ever before.

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