Our lives are touched and influenced by technology daily. And no matter where you get your news from, there is discussion around the jobs that robots and automation will displace. While we might like to think the investment industry is different, reports tell us that 40 per cent of all hedge funds launched in 2015 use artificial intelligence for investment decision-making. Is the role of the human investment decision-maker safe?

First, we are not yet in a world where characters from films such as Terminatoror I, Robotroam the streets or occupy offices. Instead, sophisticated as it is, AI has reached only the first two of four levels as defined by Arend Hintze, assistant professor of integrative biology and computer science and engineering at Michigan State University.

Developments in the field have yet to come up with machines that are “other-aware” or “self-aware” (although there might be some portfolio managers that have yet to reach these levels, too!).

Instead, all AI to date simply uses varying degrees of classification of data – from fairly simple to deeply complex with multiple layers.

This does still create significant advantages for technology relative to humans. The volumes of data that exist today challenge our human abilities; in contrast, the speed with which machines can sort through it all and recognise patterns with accuracy and objectivity is their strength.

However, AI also identify meaningless patterns – it fails to distinguish between correlation and causation and cannot (yet) draw insights from classification. In addition, the perfect objectivity of AI ignores human emotions and motives that may be creating the patterns in the first place.

Today, humans and AI maintain relative advantages over each other. Some might choose to respond to our changing environment by ignoring one or the other. We suggest a better way would be to harness the strengths of each, augmenting or empowering human investors so they perform better or more than they could without technology. In discussing this with portfolio managers across the investment industry, by far the most common response was to do just that.

What might this mean for the investment industry? Building on the comments from portfolio managers, we suggest this might result in:

Smaller investment teams, as machines continue to do more of the ‘heavy lifting’ analysis

A shorter investment decision-making period, as investors are provided with detailed analysis faster

Lower market volatility, as information from new data sources flows through to stock prices more quickly and efficiently

A shift in the shape of investment teams, with data scientists becoming more prevalent and age diversity becoming an issue to consider, as older generations bring experience to complement the younger generations’ ready adoption of technology

Fee reductions for clients, as remuneration-heavy teams shrink in size

A bifurcation in the industry between systematic, AI-related strategies and judgmental strategies, specifically in terms of differences in time horizon. AI struggles to construct a reasonable representation of the distant future, and human portfolio managers of judgmental strategies might gain an easy win over machines by taking an increasingly longer-term perspective.

An increased focus on non-quantifiable factors, such as governance, employee wellbeing and relationships with third parties.

What might be an appropriate response for asset owners? We’d suggest not rushing out to replace your portfolio manager with a machine, but there are some questions to be asked to gauge asset manager readiness for the evolution, such as:

What actions they are taking – how is leadership empowering the analysts through technology?

What insights they are developing – to what extent does their approach come into direct competition with AI?

To what extent are they engaging with the human management of companies to bring about positive change?

We believe the future investment industry will be strongest where machines and humans work side by side, each playing to their own strengths for better outcomes for clients.

Suzanne Lubbe is senior researcher within Mercer’s equity boutique, and co-lead researcher for global and EAFE (global ex-US) equity.

 

Long-term investing has come into sharp focus as asset owners think hard about how best to fulfil their long-term goals and the advantages of being, and acting as, an investor with a long horizon.

In the latest paper I’ve co-authored with Geoff Warren, Ten Ideas to Foster Long-term Investing, we distil our previous work into 10 suggestions, 10 practical ideas, for entrenching a long-term mindset within an investment organisation.

Such a culture can support an unwavering focus on long-term objectives and a capacity for patience, while providing resistance to short-term performance pressures.

Our first paper, What Does It Mean to be a Long-term Investor?argues that long-term investors may be characterised by their latitude and their intent to pursue long-term goals. Ideally this should be supported by a capacity for patience, discretion over when to trade, and objectives and investment processes that are squarely focused on long-term outcomes.

Our second paper, “Organisational Design and Long-Term Investing”, addresses aspects of organisational structure that can support the pursuit of long-term investment opportunities. It discusses four success drivers: investment beliefs, governance, aligned interests, and people.

Central to both papers is the concept that successful long-term investing requires embedding a long-term mindset deeply within an organisation.

The ideas are practical to implement and provide the biggest impact in focusing an organisation on the long term. Some of the key areas and actions are:

Ensure the focus is on long-term information, and jettisoning the wrong kind of information, to drive long-term outcomes.

Manage behavioural flaws that lead to groupthink, herding and a tendency to overreact to short-term losses.

Extend the evaluation horizon by rewarding the right behaviours for both internal and external managers.

Refocus measurement of performance and progress against objectives and away from historical results.

Slow down the decision cycle. It is often thought that information flow and related portfolio needs should be constantly monitored so as not to miss any opportunities and ensure best-positioning. However, such a constant flow of stimulus merely invites action and draws attention away from the long term. Consider reporting less often, holding fewer and more meaningful meetings and always have an option to do nothing on the table.

No one size fits all investment strategies or organisational structures. Remaining true to strategies and an organisational structure that are fit for purpose is essential to reap the benefits of a long-term approach.

Pay only for sustained performance. The industry standard is to award incentives on a yearly cycle based on performance. Merely awarding incentives over a longer history, say five years, can be problematic. Consider awarding incentives on an annual basis but make vesting conditioned upon sustained performance.

Hire people with an affinity for long-term investing. Easy to say but sometimes hard to do. Consider cultivating people by building a culture that provides a sense of importance and respect and hiring internally where possible to maintain this focus.

The paper provides many practical suggestions that can be used as a ready check list of areas and actions to help organisations embrace and engender a long-term focus.

David Iverson is head of asset allocation at New Zealand Super. Geoff Warren is associate professor of the Australian National University.

Five China-listed companies slated for inclusion in the MSCI Emerging Markets Index were suspended from trading this week, just ahead of a landmark day on which 229 China A-shares were added to the same index.

The suspended companies, which were not added to the index, were Beijing Orient Landscape, China Hainan Rubber, China Railway Group, Shanxi Taigang Stainless Steel, and telecommunications multinational ZTE.

Suspensions are common in the Chinese market, where companies can apply for a halt to trading for weeks or months at a time. However, in some cases, the company gives no timeframe, which is a problem for investors wishing to withdraw investments. As many as 265 listed companies in China suspended trading last July, about 9 per cent of the market, data from fund consultancy Z-Ben Advisors shows.

China’s securities regulator has been trying to supervise suspensions more closely in recent years to help improve investor perceptions of locally listed companies worldwide. For example, the China Securities Regulatory Commission (CSRC) said last year it would pull from its exchanges any Chinese firm whose shares were suspended for more than 50 days. Any offending company would be blocked from reinstatement for at least 12 months.

Suspended stocks have been one of the main concerns of prospective investors in Chinese equities, MSCI’s head of research, Asia-Pacific, Chin Ping Chia, says.

He wrote in May: “In addition to capital mobility restrictions and unequal market access under the qualified investor schemes, investors were uneasy about issues such as uncertainty of capital gains tax, questionable beneficial ownership under the early phase of the Stock Connect program, widespread voluntary stock suspensions and pre-approval restrictions on launching financial products.”

The stocks added to the MSCI index are mostly blue-chip companies, such as oil and gas producer PetroChina, liquor maker Kweichow Moutai Co and auto manufacturer SAIC Motor Corp, and represent a broad spectrum of industries, including banking, airlines, metals and mining, technology hardware, construction and engineering, and oil, gas and consumable fuels.

The 229 China A-shares will make up just 0.39 per cent of the overall emerging market index. MSCI says the inclusion may mean about $22 billion of capital inflows for these shares, an estimate based on $13.9 trillion of assets benchmarked to MSCI indices as of December 2017.

Years in the making

MSCI has been in discussions with Chinese regulators and global investors for nearly four years on whether to add these A-shares to its index. Its decision is, therefore, a symbolic victory for the Chinese government and global investors have welcomed it.

“This decision has broad support from international institutional investors with whom MSCI consulted, primarily as a result of the positive impact on the accessibility of the China A market of both the Stock Connect program and the loosening by the local Chinese stock exchanges of pre-approval requirements that can restrict the creation of index-linked investment vehicles globally,” MSCI wrote in a statement.

MSCI managing director, and chairman of the MSCI index policy committee, Remy Briand, says the expansion of the Stock Connect program and increased investor accessibility are essential for inclusion of A shares in MSCI indices in the future.

MSCI has not given a timeframe for the full inclusion of A-shares but says they will make up about 45 per cent of the emerging market index at that point.

The A-shares market is one of the biggest in the world, trading more than 3000 stocks.

Respecting human rights is still not business as usual, but there are indicators of movement in the right direction. A report released in April shows that more companies than ever are committing to taking steps to address gaps in their human rights management, and the role of public benchmarking as a catalyst for this change should not be underestimated.

In 2017, backed by three large investors and civil society organisations, the Corporate Human Rights Benchmark (CHRB)produced the first publicly available assessment and ranking of the human rights performance of 100 of the largest extractives, apparel and agricultural companies.One aim of the benchmark is to create competition among companies to take action on human rights management and create a race to the top.

April’s Progress Reporton the benchmark shows the race has started.

Law firms, specialist consultancies and advisers such as Norton Rose Fulbright, Freshfields Bruckhaus Deringer and ERM are witnessing increased demand for human rights support. Companies are aiming to improve their absolute human rights performance and their ranking in relation to their peers.

CHRB is one of many initiatives trying to improve the human rights performance of companies and we are seeing a ripple effect. The rise in companies submitting human rights reports has increased four-fold, from 13 in 2015 to 52 in 2017, the non-profit Shift Project states. Meanwhile, the number of corporations now reporting on their public commitments to avoid modern slavery in their supply chain has ballooned to more than 5000. The cherry on top came last October, when Coca-Cola released its first stand-alone human rights report, aligned with the UN Guiding Principles Reporting Framework (UNGP) and partly driven by its position in the first benchmark. Thisincreased disclosure is crucial for accountability and for understanding corporate performance on human rights.

Dangers of inaction

Investors would be wise to note the perils of investing in companies that are nottaking steps forward to address gaps in human rights management or that refuse to make adequate disclosures. These companies could risk a reduced share price and restricted access to capital due to reputational damage and regulatory backlash.For corporations that neglect to tackle human rights,the threat of exclusion from specific funds looms.Issues such as modern-day slavery, worker safety and freedom of association not only have huge impacts on the rights of affected people, but can be material to financial performance.

Despite the obvious risks of not disclosing human rights information, 28 corporations were cited in the CHRB report for not meaningfully engaging, failing to respond to both a $5 trillion investor coalition and CHRB, and not yet participating in the 2018 benchmark engagements. Kraft Heinz, Macy’s, Under Armour and Hermes were among these companies, which also recorded some of the lowest scores in the 2017 benchmark, demonstrating a lack of transparency and no public commitment to managing human rights risks and impacts.

Still a distance to travel

Human rights are not new, the UN “protect, respect, remedy” framework is not new, and the UNGPs are not new. But the tragedy of Rana Plaza five years ago, and a litany of subsequent human rights abuses linked to businesses, demonstrate just how far there is to travel before respecting human rights is business as usual. While there are some ad hoc legislative approaches, such as the UK’s Modern Slavery Act, respect for human rights is largely not a mandatory requirement for businesses. Benchmarks can create positive competition, allow investors and consumers to make informed choices about how to allocate capital and spending power, and provide government with an understanding of the need for further and more powerful legislation.

The 2018 benchmark will launch in November and will bring international scrutiny onto those companies that have failed to respond to societal expectations by not improving their human rights performance. We encourage companies not yet engaging on human rights to pick up the pace, improve disclosure and start moving in the right direction, as the voices demanding change will only get louder the longer they are ignored.

Dan Neale is the program director at the Corporate Human Rights Benchmark. Click here to download the Corporate Human Rights Benchmark: Progress Report.   

 

 

 

Last year, the Massachusetts Pension Reserves Investment Management Board called in executives at one of its longest-serving and most skilful hedge fund managers for a chat. The pension fund’s analysis of all its active managers involves factor and return decomposition, in which performance is broken down to see if it is attributable to factors or other persistent biases or tilts.

The $71.9 billion, Boston-based Mass PRIM staunchly pays active management fees only when strategies show true skill and can’t be replicated or bought cheaper elsewhere. Alarm bells rang when the returns from the hedge fund in question tallied closely with returns gained through a two-year exposure to US Treasuries.

“The manager ran a long-short equity fund; it wasn’t being paid to buy bonds,” chief investment officer Michael Trotsky says with a wry laugh.

Of course, the hedge fund wasn’t buying two-year Treasuries and executives were as surprised as Trotsky by the correlation. Subsequent analysis revealed that it was attributable to private equity firms buying a swathe of the hedge fund’s top holdings and the fact that general partners tend to snap up public companies when interest rates are low.

“When two-year Treasury yields go down, you are more likely to see more of this activity because buyout firms use leverage,” Trotsky explains. “A handful of public equity holdings were being privatised and that explained the correlation.”

Data analysis is king

Trotsky, an engineering graduate who started his career at Intel in California before moving into finance, is naturally drawn to data and statistical techniques. He loves the kind of unexpected patterns the data in PRIM’s principal components and factor decomposition analysis brought up and values their contribution to spotting important trends. In this case, how the shrinking number of public companies is starting to bleed into unforeseen corners of the portfolio. But Trotsky also recalls the story specifically to illustrate the weaknesses of statistical tools, along with their strengths. Data can throw false positives, so it should be used only as a starting point for analysis and always be combined with human judgement, he warns.

Costs, risks and returns, toted up, scrutinised and measured with that combination of data and human analysis, shape strategy at one of the US’s most successful public pension funds.

For example, look at PRIM’s recent decision to extend a successful equity hedge strategy to 3 per cent of the total fund, up from 1 per cent. Using a put spread collar in the S&P 500 involves selling a market call, selling a deep out-of-the-money put, and buying a put. It gives equity exposure but with reduced volatility in today’s capricious market by altering the returns payoff profile. It’s also low cost, because it involves selling two options and buying one.

“The skill, and success, of the strategy depend in part on how frequently you trade and at what strikes you buy and sell the options,” Trotsky says. He credits the proprietary strategy, which was developed with Goldman Sachs, to his chief strategy officer Eric Nierenberg, who is also an academic, teaching finance at Brandies Graduate School of Finance.

PRIM’s equity allocation has been gradually dialled back since the financial crisis. But at a target 39 per cent of assets under management, it is still the fund’s largest allocation to risk, which it needs to hit a mandated rate of return of 7.35 per cent, recently lowered from 7.5 per cent.

The $5.8 billion hedge fund portfolio has been re-modelled under Trotsky’s tenure, changing from a return-seeking allocation into one providing returns uncorrelated to the equity allocation.

“Last year, we had 1.6 per cent volatility in the hedge fund portfolio. You are not going to find that in many other hedge fund programs,” Trotsky says with obvious delight. It was lower than the S&P 500 and in line with bonds, while the portfolio’s 8.2 per cent return for the year fell between stocks and bonds but provided a better return than bonds at the same risk level. PRIM led peers, returning 17.7 per cent last year, but Trotsky is prouder of the fund’s performance when global equity markets headed south in the 12 months of fiscal year 2016. Many funds posted weak returns, but PRIM was up 2.3 per cent during the period, due to diversification but also because of its hedge fund strategies.

It wasn’t always the case. When Trotsky took the helm in 2010, PRIM was invested in 237 underlying hedge funds, all charging the typical 2 and 20, via five hedge fund-of-funds managers, each charging 80 basis points. It was an unwieldy strategy and this was compounded by the fact hedge funds were doing badly at the time.

“It was the aftermath of the Madoff scandal,” Trotsky recalls. “Every time there was bad news about a hedge fund, there was a 50 per cent chance we were invested in it.”

Trotsky reduced the strategy to one fund-of-funds managed by PAAMCO and introduced a new model investing directly in 28 funds in a managed account program.

“It has brought complete transparency into the holdings, allowing our own data analysis,” he says. “This means we can customise the portfolio to our specific needs.”

It also affords a great deal more control. If something goes wrong, PRIM can shut off trading to the account.

“The assets are ours and ours alone, there are no gates or anything,” Trotsky says, referencing the way managers can halt redemptions. In co-mingled hedge funds, managers often control risk by buying futures or raising cash. Now PRIM manages that risk on a portfolio level without the managers’ input, leaving them to do what they do best and eliminating “a ton of fees”.

Costs, costs, costs

PRIM has cut costs via other strategies, too, like co-investment in private equity and hedge fund replication. But whittling down management fees has brought the biggest savings. It has involved constant evaluation and monitoring of active strategies to ensure the fund is paying fees only for returns that can’t be explained by tilts. Since most of PRIM’s 46 public market portfolios are passive, the analysis applies most in private markets and, particularly, as the long-short equity fund discovered, to the hedge fund exposures.

“We have lots of managers and it takes time, but it is something we do extensively and frequently, and that is ongoing,” Trotsky says.

Counting costs is more important than ever in today’s market, he continues. A nine-year equity bull run has led many investors to take their eye off costs and, in a classic late-cycle tendency, increase active equity allocations. It’s a trend Trotsky has even noticed in PRIM’s own client base. The state employees and the state teachers are the fund’s two largest captive clients, but PRIM has another 100 or so smaller funds that pick and choose investment strategies a la carte.

“We just don’t think it’s the right time in the cycle to [increase active], but some are more focused on returns and past returns, without regard to risk and cost,” he says.

Keeping costs low does have a flip side. Most obviously in the fund’s ability to retain staff. Trotsky recently lost his deputy chief investment officer to a prominent university endowment.

“After six years, she was recruited away to the endowment, which can probably pay her more,” he says. Her departure has also hurt diversity in his investment team. Although 44 per cent (4 of 9) of PRIM’s nine-member board is composed of women, Trotsky wants to attract more women to the investment team and has launched an inclusion initiative with an outside consultant to increase the number of diverse applicants.

PRIM’s 9 per cent allocation to real estate now includes a small non-core element comprising a handful of development opportunities. The core component is focused on top-quality buildings in the US, such as PRIM’s own centre in Boston’s financial district. Overseas exposure comes via real estate investment trusts, which bring geographic diversity and exposure to big-ticket items the fund couldn’t invest in otherwise. In another development, PRIM is also beginning to invest directly, outside the umbrella of its real estate investment managers.

“It’s another way to reduce costs,” Trotsky says. “We can pick property types we think will diversify the portfolio, complement our overall exposure and adhere to our return, risk and cost mantra.”

 

Much has been written about the potential for automation, digitisation and artificial intelligence to reshape the financial system. Institutional investors are acutely aware of this. The PRI’s recent megatrends survey with Willis Towers Watsonfound that investors expect technological advances  to have an “extremely significant impact” over the coming years on the financial markets in which they operate.

One of the disruptors is the emergence of blockchain technology, which has generated substantial hype though the proliferation of cryptocurrencies such as Bitcoin and Ethereum. Amid the speculative frenzy, discussion has mainly focused on cryptocurrencies, rather than the underlying blockchain technology, which has the potential to reshape the investment industry and help solve some of the biggest challenges facing responsible investors by increasing transparency and strengthening shareholder democracy.

Proxy voting upgrades

Of immediate relevance to institutional shareholders are the innovations in proxy voting that blockchain technology brings about. Several financial institutions and central share depositories (CSDs) have been investigating the use of private blockchain systems to implement shareholder e-voting infrastructure.

An early mover was Nasdaq, which launched a pilot project in Estonia in February 2016 to reduce the time, complexity and cost of shareholder voting. The Nasdaq system essentially piggybacks on CSD registers to assign voting rights and voting tokens to shareholders, who can spend them on agenda items.

Broadridge has completed a pilot project with JP Morgan, Northern Trust and Banco Santander using a private, Ethereum-derived blockchain to show how clients could use a distributed ledger to gain daily insight into voting progress.

A recent Oxford University report called for an even more dramatic modernisation of the annual general meeting, with the use of a private blockchain system and smart contracts that would allow shareholders to place proposals and immediatelynotify other shareholders of them so they could exercise their vote. Proxymity, a digital voting system that will launch in the UK in time for the 2018 proxy season, will enable investors to vote in real time, potentially removing inefficiencies such as the need to submit votes days ahead of company AGMs.

‘Blockchain for good’

Blockchain technology also has the potential to give beneficiaries a louder voice in communicating their ESG preferences to asset owners and their managers. London-based CAPITALusM is building a system to provide a direct conduit to fund managers for individual beneficiaries of funds to express their voting wishes. Those managers will, in turn, split their total votes to reflect the preferences of their clients. Also under development are a feature that would allow individuals to delegate their votes to non-government organisations – known as liquid democracy – and a process for proposing resolutions.

While most of the activity in the blockchain space has been motivated by peoplespeculating for profit or cutting business costs, there is an emergent ‘blockchain forgood’ or ‘blockchain for impact’ community, attempting to use it for non-commercial purposes. Humanitarian organisations, United Nations agencies and social enterprises have all launched private initiatives and other coalitions are emerging. Organisations include the Blockchain for Impact Coalition, set up as a conduit for UN agencies to engage with private blockchain technology vendors, the Blockchain for Social Impact project, and the Blockchain for Good think tank.

The European Commission has also put out ‘blockchain for social good’ calls focused, for example, on strengthening financial inclusion, tracking the origins of raw materials in supply chains, and e-voting systems that will help deliver tamper-proof elections.

Real-time tracking of ESG data may also be improved through blockchain. In June 2017, the United Nations Framework Convention on Climate Change stated that blockchain could aid the tracking and reporting of greenhouse-gasemissions reduction and avoid double counting. The convention launched a ‘climate chain’ coalition and called for groups such as Hack4Climate to come up with solutions.

It’s worth noting that many projects within these areas remain aspirational and are not widely deployed, so a healthy dose of scepticism is advised when assessing them. However, with technology disrupting and transforming the economy, society and the environment at an ever-increasing pace, those with an interest in the development of a more efficient and participatory financial market supply chain would be well advised to stay on top of developments in this field.