If you believe what you read in the media, a massive shift to ESG investing is taking place. This shift to focusing on environmental, social and governance factors promises to enhance investment returns while making the world a better place. Is this true or fake news?

I am proposing a simple test to answer this important question: carefully study how asset owners tell their value-creating stories to their stakeholders. Unless these stories are clearly credible, the ‘shift to ESG investing’ is just another case of investment-industry hype triumphing over reality.

Why focus on the behaviour of asset owners? Because regardless of whether they are pension, endowment, or sovereign wealth funds, asset owners have a fiduciary duty to create value for their stakeholders. Collectively, they sit on top of the financial food chain and where they go, others follow.  How can we assess whether their value-creating stories are credible? My January 2019 Ambachtsheer Letter to clients answers the question: by using the Integrated Reporting Framework (IRF) promulgated by the International Integrated ReportingCouncil (IIRC) in December of 2013. While the original context of the framework was value creation in the corporate sector, the Letter shows it is an equally powerful guide in the asset-owner sector.

Why is the IRF so powerful? Because it requires asset owners to explain clearly why they exist and what value creation means for them and their stakeholders. It further requires them to:

  • Explain how their governance structure and processes contribute to the organisation’s efforts to create value
  • Explain the business model used to create stakeholder value and the types of capital at their disposal (e.g., financial, human, IT, physical, natural) to get the job done    
  • Explain the risks and opportunities that must be addressed
  • Report the actual value-creation that has been achieved, focusing especially on longer timeframes
  • Explain the strategies and resource allocations that will be employed to create value in the years ahead, and the associated challenges that will entail. Think this through not only at an organisational level, but also across organisations (for example, how asset owners’ decisions collectively affect the financial markets, capitalism, and the environment).

Looking through this lens, it will quickly become clear whether an asset owner is serious about creating stakeholder value or is faking it. For example, have the implications of ESG action really been integrated into the asset owner’s governance structure and processes, its business model, and how it describes its risks and opportunities? If that is the case, its reporting will include clear explanations of how the organisation assures its own ongoing board effectiveness, how ESG dimensions are integrated into its business model and risk/opportunity assessments, how it assures its human and intellectual capital are fit for purpose, and how compensation structures are aligned with intended outcomes.

Can asset owners be persuaded to incorporate the frameworkinto how they tell their value-creating stories? Early responses to my integrated reportingproposal, from chief executives of leading asset owners, are promising. Here are six:

  • “A nice reporting framework for asset owners….and for asset managers, too.”
  • “Great idea, the concepts of integration and story-telling are super important to us.”
  • “We would be forced to address our strategic challenges if we adopted the [IRF].”
  • “Use of the [IRF] would create greater asset owner comparability across organisations and across time.”
  • “The [IRF] initiative is sound and asset owners need to lead if we are going to hold our investee corporations to this standard.”
  • “I am on board to implement what you propose…but will need to bring my colleagues with me.”

The IRF looks like an idea whose time has come. It forces asset owners to address their strategic challenges, including how the ESG factors are integrated into addressing them. Are you and your organisation on board to join the move to an IRF? If so, I would love to hear from you.

Keith Ambachtsheer is director emeritus of the International Centre for Pension Management, Rotman School of Management, University of Toronto, and president of KPA Advisory Services. He is the author of four books on pension management.

Erik Carleton, director of pension investments at Rhode Island-based Textron, estimates asset managers send him a couple of email pitches every hour. They are straws cast to the wind, rarely taking root in the $10 billion investment portfolio for the aerospace and defence group’s retirees. Only the odd one attracts his attention.

The bulk of Textron’s assets under management are invested in line items, where the pension fund adopts a manager’s strategy because it likes it and neither has, nor wants, any influence over how it is run. But an important 5 per cent of the portfolio is invested in bespoke strategies designed with managers to give Textron particular access to the capital markets and latitude to be more creative. Often with neither history nor tangible track record, these strategies require seed funding. Industry giants like BlackRock and State Street rarely approach small asset owners with niche ideas that need developing or invitations to seed new products that will only ever harvest a couple of billion in assets under management, observes Carleton’s boss, Textron CIO Charles Van Vleet. So when one of those straws cast his way combines a good idea with a chance for Textron’s input, Carleton sees an opportunity to shape the structure, cut fees and gain first-mover advantage.

It happened when New Jersey-based Palisade Capital Management’s managing director Jim Marrone approached his long-standing associate Van Vleet with a convertible bond strategy.

“Charles and I knew each other in previous roles and had kept in touch over the years. We have always had a mutual respect for each other’s approach to solving pension fund-related problems,” Marrone recalls.

It made for an informal first pitch of the strategy back in 2013 when Marrone, on a chance visit to Providence to see his son, caught up with Charles for a chat.

The strategy seeks to generate asymmetric returns via liquid, low-beta, low-volatility exposures. It is built around an initial portfolio of 40 to 60 carefully selected US short-duration convertible bonds with three-year maturity or put dates, within a select price range or entry point. It is benchmarked to US high yield but isn’t meant to trade exactly like high yield, as it seeks better upside and downside capture characteristics – when high yield is up, the strategy is up more, and when high yield is down, it is down less. Capital deployment is immediate, and the short duration has advantages in the rising rate environment. It also offers good diversification, using performance drivers that are different from equities, fixed income or real assets.

Van Vleet was quick to see the strategy had a chance of helping Textron meet its 7.5 per cent return hurdle.

The partnership gathered momentum when Carleton joined Textron in 2014 and took the baton for developing the strategy. He had already come across Palisade researching US small- and mid-cap equity strategies, and more niche convertible bonds, and was immediately impressed by the idea.

“It made sense that a shop with expertise in US mid-cap equities and convertible bonds could understand the capital stack,” he says.

Carleton’s enthusiasm for the strategy wasn’t constrained by any limitations within Textron. For example, the pension fund is free to invest with managers with a small AUM (Palisade has $3.8 billion in AUM) and doesn’t have to invest only in tried-and-tested strategies like many institutional investors in the public sector. Nor does Textron work with consultants, another potential constraint when it comes to novel ideas.

“Consulting plays an important role in this industry but tends to have a more complicated path to the intersection of willingness and ability to take risk with new investment dollars,” Carleton says.

Structure

The parties decided on a separate account mandate held at Textron’s custodian that gave trading authority to Palisade. Textron’s initial $30 million seed allocation, since grown to about $100 million, was large enough for a separate account and Textron liked the due diligence around this structure. Carleton explains: “There is an added level of comfort when you are able to seed fund a strategy in a separate account held in trust at the custodian. Plan assets remain explicitly and transparently within our control, even though we turn the keys over to our new partner for trades and execution.”

The separate account model helped with fee negotiation, allowing more latitude for a bespoke fee structure via an Investment Management Agreement (IMA) as opposed to standardised off-the shelf documents. Textron didn’t write anything specific into the contract regarding exit gates or capacity limits.

As Palisade repeatedly analysed the appropriate price ranges and duration to maturity, Textron set about getting comfortable with a product that had no history or tangible track record. The pension fund began to run its own numbers, back-testing selected assets in the short-duration convertible universe. It spent time building a relationship with Palisade and the people who worked there and carried out in-depth due diligence on the manager’s track record in equity and convertible strategies.

Faith becomes trust

That relationship was put to the test. Two days before Palisade’s final pitch to Textron’s investment team and treasurer, Palisade cancelled the meeting. Reviewing the numbers and back-testing, Marrone found an error in how the team was valuing the securities. He had no choice but to call and postpone the meeting.

“I asked for a pass and admitted that we were not ready to present a complete watertight analysis,” he recalls. “I said we needed to work on the strategy for at least another month until we got it right.”

Frustrating at the time, it proved a crucial moment in solidifying Textron’s faith in Palisade’s integrity, deepening the relationship for the long term.

“If we had found that error on our own before we launched, it would have been bad but we could have talked it through,” Carleton says. “If we’d found it after we launched, it would have been much tougher to forgive and that type of misfire can break an otherwise exciting partnership. Faith can sometimes become trust after a challenge, but it’s much cleaner to deal with that before real money is at stake.”

Fees

Although Palisade runs two other similar strategies, because this approach was new, the manager was prepared to discount fees to “a certain level”. Moreover, because Palisade wanted to offer the strategy to other investors seeking the same upside/downside characteristics, it was prepared to drop Textron’s fee when assets under management grew to a certain level. Today, AUM in the strategy stand at five clients with $200 million under management and Palisade has duly cut its fees for Textron.

“About a year into the strategy, I was able to make the call and say, ‘Your fees are coming down,’ ” Marrone says. But fee negotiation is a quid pro quo, and Palisade’s dropping of the fee was balanced by Textron’s awareness that the manager also needed to make some money.

“The Textron team clearly demonstrated that they understood how important client partnerships are to investment boutiques such as ours,” Marrone says. “This resulted in healthy, candid dialogue regarding many topics during the formation of the strategy, including expected returns, asset allocations, risk tolerances and, of course, the fact that we also wanted to make a good return on our own investment in this product.”

There is no sharing of future growth revenues in the model and Textron never pursued if, and how, this model would fit within its corporate plan.

“We are comfortable with what we did agree on,” Carleton says. “We got a material discount to the market for an innovative product.”

Helping build

A key component of the relationship has been Textron acting as a reference for prospective Palisade clients. It’s in Textron’s interests to help market the strategy successfully – and not just for the lower fee due to more AUM. The pension fund got burnt when it seed-funded a new strategy for a small asset manager that accounted for half the firm’s total assets under management. The investment performed “spectacularly badly” from the get-go and it grew progressively difficult to market the fund to potential investors. The manager also stopped paying much attention to the failing product. Yet Textron was reluctant to pull its assets, lest it cripple the manager altogether.

“Not all these things are successful. Like venture-capital investing, some are and some are not,” Van Vleet says.

Drawing more investors to the strategy also involves a trade-off between capacity and performance, something Textron trusts Palisade will get right. The manager is well versed in running capacity-constrained strategies through its experience in overseeing its small-cap equity blueprints for institutional clients.

“The key purpose in managing capacity is to preserve the ability of the strategy to generate the agreed-upon return objectives,” Marrone says. “We take into consideration trading volumes and liquidity when managing our short-duration converts capacity, just like we do in other strategies.”

Brown M&M’s

“Jim Marrone and Palisade Capital passed the Van Halen brown M&M test,” Van Vleet concludes, referencing the legendary detail the rock group used to write into its contracts with tour operators. In a test to check they had read the contract, the band stipulated no brown M&M’s in the bowl of multicoloured sweets backstage. Any brown M&M’s and they knew the operator hadn’t read the contract and a serious line check of the stage setup ensued.

“Jim built a relationship with Textron by demonstrating time and time again that he had done his homework and had studied and knew the Textron team, plan and fund design,” Van Vleet says. Cue the seeds of success: a lengthy process built not on speculative emails but around people and relationships.

And the brown M&M rule.

Last year proved to be eventful, with volatile equity markets dominated by concerns around geopolitics and central bank actions, despite the strong underlying fundamentals of global economic growth. What can investors hope for in 2019? While our central expectation is for growth to continue above trend, we believe it will slow a little from 2018.

Recent indications of more dovish central bank action over 2019 than was previously forecast, particularly in the US and China, may reinforce equity markets. However, geopolitical issues, some of which we address below, will keep investors on their toes. Against this backdrop, Mercer outlines four themes we believe will be important for investors to consider when building portfolios in 2019.

WHITE WATERS OF THE LATE CYCLE

We see mounting evidence of overextension of credit. Outstanding debt is increasing while quality is decreasing. Covenants are deteriorating and speculative use of debt is becoming more evident. Meanwhile, we expect the ongoing positive macroeconomic backdrop, pro-business policies and business optimism to continue to assist the equity market in the near term (geopolitics allowing). When these contrasting equity and bond market currents meet, there is scope for white-water turbulence.

Investors will benefit from revisiting and stress-testing their strategic asset allocation, to ensure it is fit for purpose and robust enough to take the knocks that the rapids ahead may present. We should all bear in mind that the successful investments of the past are not guaranteed to be the successful investments of the future. Although fixed income assets offered a degree of protection during the last crisis, it is unclear whether that will be the case next time around; however, there are always pockets of opportunity. Mandates in which the investment manager has the ability to rotate between credit sectors are well placed to take advantage of both directional and relative credit trends (multi-asset credit managers are an example of this).

Equity markets have had an artificially low failure rate over a long period of monetary largesse. The most leveraged companies may be at risk of failure. Along with these ‘zombies’ (now a larger proportion of the market than ever and overdue for a reckoning), income-rich stocks – such as utilities – will probably be sensitive to faster-than-anticipated interest rate rises. We believe shares that are increasing their dividends sustainably, year-on-year, may be the best port in a storm for equity investors.

It is also worth considering holding cash now, particularly in places where interest rates are normalising, such as the US. It would be easy to be complacent about the need for inflation protection in portfolios, as none has been needed for a long time, but we encourage investors to be inflation-aware.

WINDS OF CHANGE IN MARKET PARTICIPATION

After the global financial crisis, central banks stepped in for traditional banks as the primary providers of liquidity. If the world’s major central banks proceed with their stated intentions to deleverage their balance sheets, the coming years are going to bring a withdrawal of liquidity. Without another provider of liquidity stepping into the limelight – and it’s hard to see how that can happen without a relaxation of banking regulations – this could be highly restrictive for economic growth. How firmly central bankers are willing to press the brake on economic growth in order to reduce the size of their balance sheets is a key question for 2019 and beyond.

The prevailing wind looks increasingly challenging for public-market investors, with extraordinarily low yields and generally elevated valuations. Private markets, on the other hand, have continued to offer attractive growth opportunities, and constraints on bank lending have also increased the chances for sophisticated investors to lend directly to businesses; however, the level of asset flows into private markets – and the elevated valuations prevailing in certain segments – may be cause for concern.

The importance of investors understanding their tolerance for illiquidity, in a range of scenarios, is heightened. So, too, is the value of ensuring balance with a program of private-market investments that is diversified across vintages, managers, market segments and the capital structure.

Finally, the growth of systematic or factor strategies, such as alternative risk premia or multifactor equity funds (sometimes referred to as ‘smart-beta), shows how demand for simpler, often cheaper, products has been on the rise across a whole spectrum of product types, from hedge funds to indexed equity. Some of this change is being driven by investor concerns about alignment of fees – a topic Mercer has been vocal about.

Active management can add real value, particularly in an environment of change, but it is not appropriate for all investors or for all markets. Where it may not be suitable, a broader spectrum of available systematic and alternative index strategies can probably benefit investors not content with a portfolio construction process set out purely by a traditional index provider.

TECTONIC FRICTIONS IN THE GLOBAL WORLD ORDER

In our 2018 themes, we talked about the risks posed by political fragmentation and the potential for increased protectionist or isolationist policy. Going into 2019, we are asking ourselves whether we may have reached peak globalisation. We doubt that we will see the gains from globalisation over the last 50 years reversed materially, but we recognise that the forces behind globalisation may be fading.

Nowhere is a stalling of economic integration more visible than in the trading relationship between the US and China.

China has grown rapidly in recent years, with the size of its economy increasing by more than a factor of 30 over as many years, lifting more than 700 million people out of poverty. Such significant growth, for such a large economy, is bound to cause friction.

In Washington, the mood towards China turned decisively during 2017 and 2018, with increases in trade tariffs between the two countries dominating headlines. Likewise, the investment implications of the tariff increases have dominated many investor discussions since then and that will probably continue into 2019.

The introduction of onshore Chinese equities (A-shares) into certain MSCI equity indices and the announcement that Chinese bonds will be incorporated into the Bloomberg Barclays Global Aggregate Index in 2019, will provide impetus for investors to consider how best to get exposure to the second-largest economy in the world, and whether they are comfortable being led by index providers. There are undoubtedly risks to consider, many of which will be challenging to assess. We are definitely seeing a shift towards the East.

If global trade reverses direction, another potential impact could be greater divergence in investment returns across regions and countries. This may present a challenge to our view that global investment mandates are generally better placed than portfolios of regional mandates to deliver active returns, so this is a dynamic we will be watching closely.

SUSTAINABILITY GATHERING MOMENTUM

Sustainability involves being aware of what is expected to happen in the broader world in the years to come and what that might mean for you as an investor; it is about understanding the impacts of actions taken today and the potential risks and opportunities they might create.

Investors are increasingly being encouraged, and in some cases forced, by a wide variety of governments and supranational organisations, to adopt a sustainable perspective. The key lodestars are the United Nations Sustainable Development Goals and the World Economic Forum’s risk stewardship, as embodied by the annual Global Risks Report. More widely, The UN Principles for Responsible Investment (UN PRI) Global Guide to Responsible Investment Regulation has identified a number of policy instruments that are supportive of investors considering long-term value drivers, including environmental, social and governance (ESG) factors.

Alongside their support for sustainable return perspectives, these organisations are increasingly requiring investors to identify non-traditional risks in their portfolios. The earth’s climate is changing – and at an accelerating pace. Mercer has engaged with its clients for many years on the potential impact of climate change, and we will shortly be publishing Investing in a Time of Climate Change – The Sequel, along with extended and enhanced climate-impact modelling. We believe this work will be helpful for investors looking to take a broader perspective on risk.

Focusing on appointing managers that have strong ESG credentials (alongside a high investment due diligence rating) could be the most effective and appropriate first step for many investors looking to incorporate sustainability into their portfolios.

For investors sensitive to fees and governance, the next step could be to look at allocating to an ESG-focused index. We believe this has merit in terms of potential risk reduction and that the return prospects over the long term would be in line with traditional approaches.

For unconstrained investors with a higher commitment to sustainability, impact investing through private-market strategies is worth considering.

The ideas outlined above represent our observations on the challenges, opportunities and drivers of change present in the current investment environment. We provide these ideas with the aim of provoking debate and discussion around the appropriate responses to a changing and changeable market landscape. We look forward to continuing this discussion over the course of 2019.

Kishen Ganatra is European strategic research director at Mercer.

 

We continue to live in turbulent economic times and the challenging road ahead that we predicted for investors last year still exists. Investment professionals at all levels have to make tough decisions in a volatile, uncertain, complex and ambiguous (VUCA) world. There isn’t much clear sight of what could possibly happen – let alone what will happen – and we often deal with questions that have no single right answer.

Despite this, there are some general themes I believe investors should be wary of in 2019 that, if not well-managed, could make the journey ahead even more difficult. Here is our list of five key topics investors should think about in 2019.

  1. Value creation as a further dimension of sustainability

Yes, sustainability is back again as a top theme for investors. In a recent Willis Towers Watson paper, sustainable investment is described as an unstoppable train. While to some the train is still slow-moving, it has been gathering momentum in recent years with no signs of slowing up. Regulatory pressure, reputational risks and opportunities, and evidence of improved risk-adjusted returns come together with public awareness and media mainstreaming to push sustainable investment up many asset owners’ and asset managers’ agendas.

Over the last year, we introduced a further dimension to sustainability in our work at the Thinking Ahead Institute: the need for organisations to better understand the value they create for stakeholders. There is increasing demand for organisations to provide positive social contributions to maintain their social licence to operate. It is not enough for organisations to focus narrowly on creating financial value without noting the effect of their activity on wider stakeholders (including society and the planet). Understanding what stakeholders value is a critical input for determining an organisation’s vision, strategy and culture, with the aim of improving organisational policies and practices and better monitoring outcomes. In our paper, Connecting the Dots: Understanding purpose in the investment industry, we suggest that understanding purpose and value creation is necessary for investment organisations wanting to maintain their social licence to operate – signalling a shift from economic legitimacy to societal legitimacy based on trust. We believe it is essential for institutional investors not only to understand value creation, but also to report regularly on the value they create, using an agreed upon framework.

  1. Multifactor diversity

At a dinner I recently attended, I was struck by the clear message of the New York City Comptroller’s office on diversity. As an asset owner responsible for about $200 billion, the office has defined a series of explicit policies focused on increasing participation from women and ethnic minorities, with the aim of creating an even playing field. These policies address manager selection, board structure, capital allocated to projects, improved access by underrepresented groups, and decision-makers at the fund. Central to this effort was the assignment of a chief diversity officer (Wendy Garcia), who reports directly to the comptroller and board executives and has influence not just on people policies but also on investment policies.

This is a marker of the dramatic shift in the mindset of many organisations on the issue of diversity. But as noted in my recent article, “Stronger theory: we need deeper thinking on diversity”, the investment industry as a whole is struggling to catch up. Why? Because for too long, both structural and unconscious bias have limited opportunity for individuals who go against the ‘norm’ (those who are non-white, non-male, non-private school educated). Organisations need to be wary of this and employ deeper thinking on diversity, in all of its forms, whilst making a sustained and systematic commitment to diversity and inclusion in all aspects of their business models.

  1. Culture

Over the last year, investment organisations have produced an uptick of activity designed to codify culture. One example close to us is how Willis Towers Watson has used Thinking Ahead Institute research to develop its research team’s culture assessment model for selecting investment managers for asset owners. This is based on three pillars: how a firm delivers value to its employees, how a firm delivers value to its clients, and how leadership provides overarching guidance and oversight of culture. More on this framework can be found in WTW’s paper “Measuring culture in asset managers”. We believe well-managed investment organisations should and will continue to consider this issue more deeply in the future.

  1. Total portfolio approach (TPA)

Asset owners are increasingly conscious of the limitations of the strategic asset allocation (SAA) approach. Large asset owners are showing much interest in the total portfolio approach (TPA) as a potentially better way of working. Central to this revised approach is the improved ability for governance boards to act quickly and tailor portfolios to achieve specific goals. TPA is not yet used widely but has emerged over the last decade and is practised by a small number of large asset owners. CPPIB, Future Fund and New Zealand Superannuation are examples.

We define TPA as an approach in which:

  • There is a continuous and dynamic focus on achieving the fund’s investment goals
  • Decision rights reside with the CIO/executive team, while ownership of the risk budget or reference portfolio resides with the board
  • The portfolio is managed in real-time; all investment opportunities compete for capital at a whole-fund level but only the best ideas get into the portfolio.

This is in contrast to traditional SAA, which is based on a set meeting schedule loosely connected to the fund’s investment goals. Strategy in SAA is updated infrequently as decision rights often reside with the board, whilst the CIO/executive team may have some implementation decisions delegated to them. Additionally, asset class buckets must be filled, with little room for deviation from pre-established weightings.

TPA has a number of advantages over such an approach, including a more dynamic decision-making process, better quality of decision framing and better quality of decision-making.

  1. Better decision-making

Institutional investing is increasingly a team activity and collective decision-making is a skill that can be nurtured. During 2018, the Thinking Ahead Institute conducted research on institutional decision-making, focusing on how a group can successfully integrate individual thought processes, communication patterns, relationships and other aspects of interactions into effective collective decision-making. In our paper, How to choose?, and in our wider research, we explore some tools that investors can use to make more effective decisions together. These tools range from those that improve the quality and processing of decision-making inputs or improve group dynamics for decision-making meetings, to tools that help you make the actual decision.

So that’s our list for the new year. We believe a focus on these topics will serve you well in 2019.

Marisa Hall is a director at the Thinking Ahead Group, an independent research team at Willis Towers Watson and executive to the Thinking Ahead Institute.

 

Mark Walker, CIO of the UK’s £21 billion ($27 billion) Coal Pension Trustees (CPT), is building a strategy markedly different from what most UK defined-benefit funds do. While most funds of this type focus on de-risking and matching liabilities, Walker is securing cash flow and prioritising income-generating assets.

Walker says these strategies, coupled with CPT’s still large allocations to risk and illiquidity, reflect its unique structure.

The pension fund hasn’t had any active members for the last 25 years; it paid out about £1.4 billion ($1.8 billion) in pensions last year and needs to generate a return of 2-3 per cent above RPI a year to continue to do so for the two pension pots it manages: British Coal Staff Superannuation Scheme and the Mineworkers Pension Scheme.

“If you can find me an amortising, 50-year, inflation-linked contractual income bond that currently yields 7 per cent, I can go home and sleep well at night,” says Walker, who joined the fund a year ago from Univest, Unilever’s internal pension investment organisation, swapping the consumer business’s global culture for a more traditional pension fund environment with just 35 colleagues.

 

Free thinking

New approaches in CPT’s equity allocation include investing more in China, in a more granular approach, fine-tuning a new bond portfolio to provide liquidity when needed, and dropping the market capitalisation benchmark.

He hopes the latter will help CPT focus more on where it can make money in the future, rather than what made money in the past, and facilitate swifter and more flexible decision-making.

Most importantly, he wants to free-up thinking within the investment team, replacing decisions based on whether portfolios are over or under weight with decisions based on whether an investment meets the fund’s strategic objectives.

“I hope this will introduce a different way of thinking and enable us to focus on future change and positions aligned to the objectives,” he says.The challenge is ensuring that trustees can still measure whether the investment team is doing a good job.

For the China strategy, CPT’s two funds are reviewing external investment managers for a possible onshore listed equity allocation in China, where Walker says many companies are not as represented in the global market cap indices as their value suggests they should be.

CTP already has a “decent” part of its private equity allocation in China, he says, where the pension fund invests with about five general partners, with the help of adviser JP Morgan, but listed exposure has been in the offshore market to date.

Walker seeks managers with strategies that are diverse, who are familiar with institutional money and equipped with a deep understanding of the retail and momentum-driven Chinese market and local regulation.

“We want to invest in quality companies with good and sustainable cash flows, taking account of ESG considerations,” he says.

Equity accounts for roughly 45 per cent of assets under management in both CPT schemes, of which about 35 per cent is listed public equity. The fund has gradually reduced its equity allocation in the last five years, to fund illiquid allocations and benefit payments.

CTP has only a small bond allocation because of its return focus and absence of a liability management approach. But Walker is thinking about ways to add more lower-risk assets without compromising return objectives, thus the new bond portfolio – a liquidity tolerance allocation. It would comprise Treasuries, high-quality credit and higher-yielding, shorter-duration assets that the CIO would be prepared to sell (or wait on redemption proceeds from) to pay cash flows over 3-5 years if “everything else was going down”.

“The idea is to create a portfolio to provide liquidity when we need it, not a portfolio to provide lots of value relative to a benchmark,” he says.

Some of this allocation might come from partly restructuring the existing multi-asset credit portfolio into shorter-duration, cash-flow focused bonds. He would also contemplate selling equities to build this portfolio if that could be done without compromising on the overall objectives.

“We will only take money out of equity to increase our liquidity tolerance if equity has done well,” he says.

Walker expects to start restructuring allocations with CPT’s existing fixed income managers via segregated mandates that combine different elements.

“We want a manager that has the right approach to adding value but also provides security of cash flows when we need them. Because we might have to sell to fund cash flows, it also has to be a mandate that can go to zero in some circumstances.”

Under the broad heading of ‘liquidity options’, he is also looking at borrowing or leverage.

 

Illiquid shake-up

CPT is also paring back its large allocation to private debt, which stands at about £3 billion-£4 billion, or 15-20 per cent, across the two funds.

“We still have a big exposure to private debt, but in 2019 we are slowing down loans within the private debt portfolio,” he says. He describes the market as more difficult and says areas the fund is avoiding include covenant-like loans, where more money has been flowing.

“The risk/return equation is not as favourable, although it is still a very attractive income-producing asset class,” he says.

That said, he does plan to increase exposure to the higher-yielding illiquid space or special situations and might realise value in the property portfolio, a big piece of the fund’s illiquid exposure, to take advantage of opportunities in credit and the higher-yielding illiquid space.

“We will have a little bit of additional capital if we can realise some value in the property portfolio,” he explains. “In a measured way, we are thinking how we can reduce exposure to UK commercial property to provide us with more capital for higher-return or income-generating opportunities.”

It’s a strategy based on Walker’s expectation that property won’t make as much over the next five to six years as it has in recent years. CPT slashed its large exposure to retail property a while ago. The allocation now includes the private rented sector and alternative property, along with an allocation to development.

“Property development is great if the total return is measured over a lifetime and the income is also good,” Walker says. “But developments require capital upfront, and capital upfront is part of our cash flow.”

He also sees good opportunities in industrial property going forward.

 

Lawns and crews are costly

Walker’s eye on capital and operating costs that eat into cash flow, especially in a lower-return environment, focuses on other allocations in the real asset portfolio, too, like the fund’s substantial shipping portfolio, comprising roughly 30 ships across both funds with a total exposure of about £400 million.

“With ships, you need to pay the crew, with properties you need to mow the lawn. Property is good for income, but the net income can be very different to the gross. You may take in £100 million in rents but receive only £60 million because of fees, transaction costs, capital investments and other operating costs,” he explains.

CPT recently drilled down into costs and found private debt and shipping the most predictable allocations, from a cost perspective. He’s found in the special situation debt allocation, where the pension fund invests more in funds, that not all funds distribute income as initially assumed in the team’s expected returns framework, and not all distribute in the first few years.

“Looking at the income tells you a great deal about how the asset works, things we knew but maybe didn’t fully appreciate.”

The shipping portfolio is linked to economic growth and trade, like equities, but with a different level of risk.

“Like equity, ships are linked to the economic cycle and particularly to global trade. But they are an amortising asset – overall, we expect to lose money in capital terms every year,” Walker explains. “However, the income offsets this and at the end of [the asset’s] life, there is scrap value.”

Key to success is understanding the return steams, which can result in double-digit income. This means being across the terminal value of the asset, the forward market for ships and new regulations around sulphur emissions – along with ensuring the vessels are on the sea. Global trade adds another risk, although he notes that even if global trade does “fall off a cliff” chartered rates aren’t close to 2008 levels and don’t have nearly as far to fall now.

 

Sustainability

Walker’s new approach will also bring sustainability centre stage. The fund he previously worked at, Unilever, was considered a world leader in this regard. At Coal, part of the motivation is that CPT’s members and elected trustees worked in an industry that was closed down with little thought for the people and communities left behind, he notes.

“As the world moves towards a lower carbon future, we need to ensure we see a ‘just transition’,” he says. “We must think about financial return opportunities and risk, but given the legacy of our funds, we must also think about the impact our investments and future change will have on people and jobs. I want to bring more of a focus on broad sustainability issues.”

The CHf4 billion ($4.02 billion) pension fund for CERN, Switzerland’s prestigious nuclear research centre, balances a dynamic, tactical strategy alongside long-term investment. CIO Elena Manola-Bonthond runs a careful strategy tailored to fit the fund’s risk appetite.

This strategy takes into account both the market environment and the fund’s liabilities and projected funded status over the short and long term. Only when the pension fund’s governing board has decided the level of risk does the objective turn to maximising returns and determining the asset allocation benchmark, although Manola-Bonthond notes the fund is never 100 per cent aligned to that strategic benchmark.

“By choosing our risk budget, we determine the return we are able to achieve. Yet returns also need to be such that we can close the funded gap over the long term,” says Manola-Bonthond, who trained as a particle physicist but was always drawn to finance. After completing an MBA, she decided to move across to CERN’s pension fund in 2011. She was promoted to CIO in 2015.

“A scientific background is universally relevant in many other kinds of discipline,” she says. “It is the background that trains you to look critically at the data and assumptions.”

She will need all those skills to plug CERN’s yawning funded gap. It sits at just 41 per cent funded, according to international accounting standards, as of December 2017. According to CERN’s alternative methodology, however, it is a healthier 75 per cent, which the fund aims to make 100 per cent by 2041. Doing so will require the equivalent of a 3 per cent average geometric return over the long term.

“This doesn’t mean the annual objective is 3 per cent,” Manola-Bonthond clarifies. “If you fix the return objective in the short term in response to a long-term average, you risk not arriving there. At an equivalent level of market risk, some years 3 per cent is easy to achieve but other years it will be much more difficult.”

In 2017, CERN returned 6.93 per cent, net of external management fees.

Dynamic approach

CERN’s portfolio comprises liquid allocations to government securities, credit and listed equity, with an alternative portfolio of real estate, private equity, hedge funds and a small dose of timber and farmland.

Because the risk level changes, the liquid asset allocation is rarely static. “The same asset allocation at the beginning, middle and end of the year can have a completely different level of risk. Because we focus on the risk, our approach must be dynamic,” Manola-Bonthond says.

The fund uses conditional value at risk (CVaR) to measure and monitor its market risk, which is set at a 5 per cent CVaR risk limit of -8 per cent over a one-year horizon.

“[This means] in 5 per cent of the worst-case scenarios, the average loss would be 8 per cent,” Manola-Bonthond explains. The liquid book is adjusted and tweaked according to the risk, so that more or less space goes to fixed income and listed equity allocations as the risk changes. Moves are guided by a holistic risk budget, rather than individual risk budgets for each asset class.

“Opportunities in the bond market will determine our risk appetite in equity. Alternatively, a reduction in the credit allocation on the fixed income side will give more space to equity,” she explains. “The different parts of the portfolio have to be synchronised. We have to deliver the performance together within the risk parameters.”

In this dynamic and tactical element of the portfolio, Manola-Bonthond’s focus is on a one-year horizon, rather than the strategic long term. Current strategies include remaining overweight government bonds versus credit and private debt.

“Credit is the most vulnerable in the late phase of the cycle,” she says. The reduction in the credit allocation has increased the weighting to European bonds; she is also thinking of increasing the allocation to emerging market local currency debt. To date, CERN’s emerging market debt allocation has been in hard currency, favouring exposure to Eastern Europe, rather than higher-yielding geographies.

“We will have to see how and to which extent we will hedge the local currency exposure,” she says. The pension fund has about 25 per cent of its allocation in fixed income, including private debt.

A dynamic and tactical strategy also plays out in the 15 per cent listed equity allocation, which has been steadily pared back from 20 per cent in recent years. Over the last six months, Manola-Bonthond has reduced the bias to US tech stocks to neutral; she is now doing the same to US small caps. The only passive element in the equity portfolio is US large caps, where CERN invests in exchange-traded funds to obtain sector exposure. This, however, is balanced by actively allocating between the different ETF sectors.

“Active management in this environment can bring real value,” she says.

Her investment team of 10 meets every week to discuss how the different portfolios are evolving; any important decisions are taken collegially by the team in keeping with the global risk budget, she explains.

Alternatives

In the alternative allocation, the mantra is alpha production.

“Private markets are less efficient; the more inefficient, the more opportunity there is to access alpha,” she says; however, she notes that diversifying and preventing correlation are challenges in alternatives. “In our experience, the correlation between an average private equity fund and listed equity is very strong. Nor is it accurate to say that global real estate isn’t correlated with equity – there is a strong correlation.”

She says the only truly diversified component of the alternative portfolio is the 7 per cent hedge fund allocation, made up of absolute return and CTA diversifying strategies, favouring low equity and credit beta.

“We measure the beta of this strategy all day long,” she says. “We are not willing to pay fees for market beta.”

She also keeps an eagle eye out for style drift in hedge funds to ensure that the strategy in place is the one intended. The process requires a level of due diligence that surpasses that for all other portfolios.

“The due diligence in hedge funds really does take time, particularly when we include a new hedge fund in the portfolio,” Manola-Bonthond says. “It is a very important and long process.”

All CERN’s due diligence in private equity and hedge funds is carried out internally. It involves analysing a strategy’s risk in different market environments and understanding the track record in detail.

“Was it skill or luck? What is the market where the strategy will not deliver?” she asks. “The objective is to avoid any surprises. If a hedge fund suffers losses in a given market environment, we want to have expected it through our due diligence process. If the hedge fund performs in a way we don’t expect, we don’t like it.”

In private equity, due diligence involves extensive analysis of past returns to gauge whether they are the result of alpha or something else. Here, Manola-Bonthond is working with an external provider that has developed a methodology for benchmarking and measuring performance.

“The widely used performance measure in private equity – internal rate of return – assumes you re-invest all proceeds at the same rate of return. By you can’t reinvest a distribution at the same level as you receive it as cash. This methodology cleans this part of the process,” she explains.

In fact, the importance and rigour she applies to internal due diligence makes increasing some allocations in private markets difficult. For example, CERN has a small allocation to farmland that Manola-Bonthond likes but isn’t planning to increase because of the need for a reinforced internal team to cover the due diligence of the managers.

CERN’s 7 per cent allocation to private equity, built up today from an original focus on venture capital, targets the best managers, in a bottom-up approach.

“Our view is that it is the skill of the GP – rather than illiquidity premium – that drives the performance in private equity,” Manola-Bonthond says.

The strategy draws on an external adviser to help gain entry and prioritises nurturing and building general partner relationships.

“During a GP’s next [fund raising], we need to ensure we are invited to invest,” she says. “Our strategy is to keep in contact and show interest via a continuous dialogue.”

Manola-Bonthond has no plans to increase the allocation to private equity. For now, strategy is focused on replacing some managers as funds come to the end of their cycles and better opportunities arise, and also on increasing capacity with managers identified as outstanding.