Global pension assets grew by $4.8 trillion last year, at a rate of 13.1 per cent on the year before. It was the largest growth rate in the 20 years of the Global Pension Assets Study.

In the 2018 report, Willis Towers Watson’s Thinking Ahead Institute covers 22 pension markets (known as the P22) with combined assets of $41.4 trillion, about 50 per cent larger than a decade ago.

The fastest-growing markets, in US dollar terms, have been Hong Kong (8.1 per cent), Chile (6.3 per cent) and Australia (5.9 per cent).

The report shows the entire universe of asset owners’ holdings to be worth $131 trillion. This includes mutual funds (including exchange-traded funds), pension funds, sovereign wealth funds, endowments and foundations, and insurance funds; however, the study covers just pension assets.

The seven largest markets for pension assets – Australia, Canada, Japan, the Netherlands, Switzerland, the UK and the US – account for 91 per cent of the global total. The US is still by far the dominant market, with $25.4 trillion in assets, making up 61 per cent of the P22’s total.

The assets of the top 300 pension funds account for 43 per cent of the total, with the top 20 funds representing 17.4 per cent of total assets.

The study also reveals the continued growth of defined-contribution funds, with DC now accounting for nearly half of all pension assets (49 per cent), up from 33 per cent a decade ago.

In terms of asset allocation, the report shows that a 60 per cent global equities/40 per cent global bonds reference portfolio would have returned 16.4 per cent in 2017.

The average asset allocation of the P7 is equities (46 per cent), bonds (27 per cent), other (25 per cent) and cash (2 per cent). Australia, the UK and the US have higher weightings to equities than the other P7 countries, at 49 per cent, 47 per cent and 50 per cent, respectively.

In the last decade, the home bias in equities has been reduced. Across the P7, domestic equities as a portion of total equity allocations have fallen from 69.7 per cent in 1998 to 41.1 per cent in 2017, on average.

In the two decades of the study, the allocation to real estate, private equity and infrastructure has moved from 4 per cent to about 20 per cent, and defined contribution has grown by 7.5 per cent a year, compared with 4.9 per cent growth in defined benefit.

The report concludes that the biggest missed opportunity in that time has been in stewardship, with asset owners not taking advantage of their ability to influence corporations.

The P22 countries are: Australia, Brazil, Canada, Chile, China, Finland, France, Germany, Hong Kong, India, Ireland, Italy, Japan, Malaysia, Mexico, the Netherlands, South Africa, South Korea, Spain, Switzerland, the UK and the US.

 

Top five markets by size

US $25.4 trillion
UK $3.1 trillion
Japan $3.0 trillion
Australia $1.9 trillion
Netherlands $1.6 trillion

 

 

 

Europe’s pension funds are neglecting their duty to ensure that the sustainability preferences of their beneficiaries are “proactively sought and incorporated” in their investment decision-making, the High-Level Expert Group (HLEG) on Sustainable Finance states in its 2018 final report, Financing a Sustainable European Economy.

As an indication of this dereliction of duty, the report states that only 5 per cent of European Union (EU) pension funds have considered the investment challenges climate risks pose for their portfolios.

A central theme running through the report is the need for financial institutions to engage with clients and beneficiaries on sustainability, to re-establish trust in the financial sector. This would also result in better directing of capital towards the real long-term needs of the economy and its citizens, the authors state.

The report’s recommendations, hailed as “a manifesto for far-reaching change”, follow on from an interim report published in July last year. They will inform EU policy on sustainable finance in the years ahead, with important implications for long-term investors.

The financial industry is a key to the EU meeting the ambitious sustainability targets it has set by pledging to cut greenhouse gas emissions by 40 per cent by 2030. That commitment will require an estimated €180 billion ($224 billion) of committed, stable financing annually.

Duty first

Investors’ duties to their beneficiaries are already enshrined in key EU financial services directives and regulations but they do not factor in sustainability to the level required, the report states.

“Pension funds should ensure that they have a sound understanding of the broad range of interests and preferences of their members and beneficiaries, including ESG factors,” it reads.

Although pension providers must publicly disclose whether and how they include ESG factors in their risk-management systems, they do not have to integrate ESG factors into their investment policies.

The report also highlights the need for Europe’s pension funds to improve their governance around sustainability. It recommends ‘fit and proper’ tests to include an assessment of the individual and collective ability of the members of governing bodies to address sustainability risks and understand the broader stakeholder context.

Governance should also include improved monitoring and assessment of investment portfolios from a sustainability perspective, the report asserts. It states that Investors should “continuously” analyse portfolio holdings with respect to sustainability risks, particularly in investments where they have significant influence. It recommends corporate engagement and investor collaboration and urges investors to avoid “extracting short-term profits at the expense of long-term value creation”.

New tools

Combating short-termism is a recurring theme throughout the report, which recommends new tools for investors. One recommendation is reform of key market instruments, like performance benchmarks and indices, to encourage sustainability. This way, investors will be more able to understand the sustainability characteristics and exposures of the different investments they hold.

“Indices and benchmarks have an indirect but important impact on the orientation of capital but are not necessarily aligned with sustainability objectives,” the report states. “Greater transparency and guidance on benchmarks is needed, to ensure investors use and select benchmarks in a manner that is consistent with long-term investment strategies, that does not impede on sustainability and that helps to drive allocation of capital towards green and sustainable investments.”

The HLEG also calls for improved disclosure from financial institutions and companies on how they are factoring sustainability into their decision-making. It recommends EU implementation of the Task Force on Climate Related Financial Disclosure framework at an EU-wide level. The task force has provided the first industry-led framework with the potential to become a ‘new normal’ of climate disclosure, the report states. Momentum behind the framework has grown; more than 230 companies, representing a combined market capitalisation of over €5.1 trillion, have voiced their support for the task force’s recommendations.

The report also calls for accounting rules to better incorporate sustainability issues, so investors can make clearer decisions on the companies in which they invest.

“The ultimate ambition has to be convergence or integration of financial and sustainability information, which should be subject to the same assurance rigour as audit requirements for financial information,” the report states.

Pressure on managers, consultants

Asset owners do more to incorporate their sustainability priorities in the awarding of mandates, the HLEG recommends. In turn, asset managers need to ensure owners understand the potential risks, and benefits, of incorporating sustainability, “leading to a two-way consideration and integration of ESG factors”, the report states.

Asset managers should have a clear understanding of their clients’ preferences on sustainability, governance and any broader ethical issues. They should also promote their own internal awareness, embedding ESG in internal training and professional development of staff, including management leadership and the board. Sustainability should also be reflected in incentive structures, the report states.

“Asset managers should establish greater consistency and alignment with their institutional clients’ sustainability preferences – and, through that, the interests of their clients’ beneficiaries.”

Investment consultants also have a role in helping deploy capital towards sustainability goals. The report recommends that investment consultants proactively raise sustainability issues to their clients and offer related advice.

Wider recommendations in the report include calls for a definition of sustainability to establish market clarity on the term, and a classification system, or taxonomy, that would give investors more confidence and ease when choosing to invest. This would also help measure financial flows into sustainable development priorities.

The report advises making it easier for investors to invest in green bonds as well. This could be achieved by setting up a European standard for green bonds and an EU-wide label for green investment funds.

 

Key recommendations from Financing a Sustainable European Economy

Introduce a common sustainable finance taxonomy to ensure market consistency
and clarity, starting with climate change.

Clarify investor duties to extend time horizons and bring greater focus on ESG factors.

Upgrade Europe’s disclosure rules to make climate-change risks and opportunities
fully transparent.

Develop official European sustainable finance standards, starting with one on green

Establish a ‘Sustainable Infrastructure Europe’ facility to expand the size and quality
of the EU pipeline of sustainable assets.

Reform governance and leadership of companies to build sustainable finance

Enlarge the role and capabilities of European supervisory authorities to promote sustainable finance as part of their mandates.

At the end of 2016, the C$30.4 billion ($24.8 billion) private-equity arm of Caisse de dépôt et placement du Québec (CDPQ) was approached to invest in a private-credit fund run by Indian financial services group Edelweiss. The diverse and fast-growing company’s latest fund bought and restructured non-performing Indian bank loans in a highly successful and specialist investment seam. CDPQ was keen.

In fact, Canada’s second-largest public pension fund wanted to extend its involvement with Edelweiss beyond just being a limited partner. As it invested in the fund, it negotiated a 20 per cent equity stake in Edelweiss Asset Reconstruction Company (EARC), the subsidiary managing the bank assets, and a public investment in Edelweiss Group. The deal included membership on EARC’s board and a role on Edelweiss’s investment committee.

“We are very proud of what we did with Edelweiss, where we manufactured a transaction with an interesting risk-return,” says Frédéric Godbout, CDPQ’s senior vice-president and deputy head of private equity. “We can’t control the market, but what we can control is being innovative and thinking outside the box.”

The strategy characterises a portfolio where 11 per cent of CDPQ’s C$286.5 billion ($233.3 billion) in assets under management resides, and where an internal team of 65 deploy between C$6 billion and C$7 billion a year using two dominant themes: emerging markets and non-traditional deals.

The private-equity team has embarked on a concerted push into emerging markets, where a first priority is finding high-quality, local partners with whom to build a solid foundation over the next decade. The team is also actively seeking and manufacturing deals that don’t exist for traditional private-equity funds or investors.

Absolutely adaptable

Flexibility lies at the heart of the strategy. CDPQ can invest in almost whatever way an opportunity demands. It can put assets into funds, co-invest, or go direct; as a direct investor, it can do minority investment. The fund also recently added private credit to its suite of capabilities.

CDPQ, which manages the retirement income and insurance plans for 2 million Quebeckers in 41 depositor groups, can act as a leader on its own or with peers. It can write smaller cheques for $75 million in emerging markets or bigger ones for $1 billion in developed markets. The average investment spans nine years, but some stretch to 20 years, such as its stake in IT services company CGI.

“All these approaches are integral to deploying significant amounts of capital,” Godbout says. “We don’t see the world in black and white, we see it as a scale, and we do everything at the same time.”

All investment comes with an absolute-return mindset that eschews benchmarks to commit “like an owner”.

Such flexibility would’ve been unheard of at CDPQ in the early ’70s, when it first dipped its toe into private equity. Back then, the only direct investments were in Quebec; all overseas private equity was in funds. Today, nearly three-quarters of the portfolio is invested outside Canada and direct investments account for 70 per cent, with 30 per cent in funds. Direct investment will grow further, Godbout says, as will the private-equity portfolio, which returned 14 per cent in 2016. CDQP is in discussions with its depositors regarding an increase in the allocation to private equity, real estate and infrastructure.

 

Relationships give a competitive edge

Along with this flexibility, CDPQ is gaining an advantage over the competition in another striking way. Increasingly, sought-after private companies approach the pension fund directly, long before private-equity firms have a chance to get involved, in search of the added value that comes with CDPQ investment. It happened last year, when France water and waste company SUEZ, with whom the fund already shares infrastructure assets, asked the pension fund to help it acquire GE Water, the water and process technologies business of General Electric. It’s just the type of asset Godbout likes, for its tilt towards global investment trends around water (he also favours logistics and healthcare).

The fact that CDPQ’s long-standing relationship with GE would help negotiate and broker the deal made the fund particularly attractive to SUEZ. Godbout says this ability to leverage CDPQ’s global relationships with companies and chief executives is key to sourcing future deals.

“Our internal management means we have direct access to expert teams spanning from financial services to healthcare,” he says. “We share this with the CEOs of the companies we invest in, and we also introduce CEOs to each other. We leverage our investments for the benefit of all our companies and CEOs.”

It’s a value-add that crops up repeatedly, whether it’s through working with headhunters for investee companies or facilitating corporate expansion – as was the case last year.

Soon after CDPQ and private-equity group KKR acquired insurance brokerage and consulting firm USI in 2017, USI announced plans to acquire Wells Fargo Insurance Services.

“It was a significant acquisition for USI,” Godbout says. Quick to offer support, CDPQ and KKR embarked on due diligence and helped with the negotiation and financing.

“We get ourselves involved in situations where we can add value, and we don’t need to control a company to have an impact,” Godbout says.

The team gets involved in CDPQ’s roughly 90 direct investments only as needed. Governance is negotiated in line with ownership, but even in companies in which it has a majority stake, the default position is to let managers manage.

“We make sure we have the appropriate level of governance and negotiated rights,” Godbout says. “This gives us the right level of information to make sure we are getting involved only at the right time, for the right reasons.”

Manager selection: beyond performance

Equally important as supporting the direct portfolio is selecting, monitoring and optimising the 30 to 40 core manager relationships that give CDPQ access to more than 2000 companies. Working with long-established general partners, in relationships that trace back to the ’90s for some, is balanced with constant due diligence and review. Nothing is taken for granted. It means one or two new core relationships are added every year, as the same number disappear from the roster.

“We want to make sure managers have a real and differentiated skill-set that complements what we have in our portfolio,” Godbout explains.

The most important criteria in manager selection and retention is performance, but other factors can also trigger changes; for example, a new team or an alteration in strategy that CDPQ isn’t comfortable with.

“It is important to understand not only the performance number, but also how they source deals, their sector knowledge, how they create value and where the manager is in their own life cycle,” Godbout says. “The founders from maybe 10 or 15 years ago might not be there anymore or may be transitioning. We need to know how the second generation is evolving, and that they are in alignment with us.”

CDPQ has also introduced managed accounts, partly to shore up access to market intelligence. These are shaped more around partnership and investor control than straightforward fund investment; they allow a level of interaction and sharing of intelligence that Godbout favours just as much as he does the reduced fee.

Emerging Markets            

Co-operation and market intelligence are fundamental to CDPQ’s commitment to increasing its 2.6 per cent allocation to emerging markets, where strategy is focused on finding partners first and adding deals second. Godbout is encouraged by strengthening partnerships in India and Mexico, where CDPQ’s infrastructure division has created an investment platform with a consortium of local pension funds. But he says finding suitable local partners in emerging markets across real estate, private equity and infrastructure requires patience and a long-term view, particularly given the fierce competition. That patience has to be combined with an ability to be nimble when an opportunity does arise.

“We have to be able to quickly go there, do the due diligence, and then present the opportunity to the investment committee here,” Godbout says.

Of all the investments Godbout and his team have secured in recent years, perhaps CDPQ’s purchase of French healthcare diagnostic group Sebia in 2017 best captures the pension fund’s dominance in the asset class.

“Sebia was a fast-growing business,” Godbout recalls. “The owners were considering selling, and the managers were looking for a long-term partner. We believed we were the right partner.”

CDPQ bought a minority interest in Sebia, which it followed with a majority stake. It then syndicated a portion of that transaction to two other investors: European private-equity firm CVC, and Tethys Invest, the family office of France’s Bettencourt-Meyers family, part-owners of L’Oréal, in a deal CDPQ shaped, controlled and closed.

“We did the full due diligence and brought in partners of interest to the management team; in effect, creating a transaction,” Godbout says. “It is not often that you hear about a private-equity firm benefiting from the due diligence of an institutional investor.”

Providers of multi-factor indices have recently been debating the respective merits of the top-down and bottom-up approaches to multi-factor portfolio construction. Top-down approaches assemble multi-factor portfolios by combining distinct silos for each factor. Bottom-up methods build multi-factor portfolios in a single pass by choosing and/or weighting securities based on a composite measure of multi-factor exposures.

The top-down approach is simple and transparent and investors can control allocations across factors easily. Top-down multi-factor portfolios usually avoid being concentrated in a few stocks because they are typically assembled from reasonably diversified factor sleeves.

The bottom-up approach, in contrast, has been used to concentrate portfolios in ‘factor champions’, emphasising stocks that score highly, on average, across multiple factors. This allows interactions across factors to be taken into account and avoids diluting exposures (such as to value when tilting to high profitability).

It has been argued that bottom-up approaches produce additional performance; however, studies that document such increased returns are typically based on selected combinations of factors. They also do not test for significance or robustness, and do not scrutinise risks, stability of exposures, or implementation issues such as heightened turnover. Moreover, in a recent study, researchers have shown that accounting for the cross-sectional interaction effects of factors does not necessarily require a bottom-up approach but can be addressed in a top-down framework.

Here, we’ll contrast the claims of the proponents of bottom-up approaches with relevant findings in the academic literature. First, we’ll review general insights on return estimation and factor models that are relevant for multi-factor portfolio construction. Then, we’ll discuss recent literature that specifically addresses issues with bottom-up approaches.

Does it make sense to account for fine-grain differences in factor exposures?

A key idea behind bottom-up approaches is to account precisely for stock-level differences in terms of exposure to multiple factors. While it is understandable for computational technicians to try to account for factor exposures with the highest possible precision, there are two findings in empirical asset pricing that question the relevance of the type of over-engineering present in bottom-up approaches.

Empirical evidence on factor premia overwhelmingly suggests the relationships between factor exposures and expected returns do not hold with precision at the individual stock level. Indeed, factor scores are used as proxies for expected returns, which are notoriously difficult to estimate and inherently noisy at the stock level.

Rather than trying to determine differences in returns between individual stocks, researchers have created groups of stocks and tested broad differences in returns across these. This ‘portfolio method’ ensures robustness by ignoring stock-level differences and refraining from modelling multivariate interactions. For this reason, studies that document factor premia rely on portfolio-sorting approaches.

Former Goldman Sachs & Co. partner Fischer Black emphasised, “I am especially fond of the ‘portfolio method’ […]. Nothing I have seen […] leads me to believe that we can gain much by varying this method.”

There is ample evidence suggesting that factor characteristics do not provide an exact link with individual stock returns. Thus, fine-grain differences in factor exposures may not translate into return differences.

To illustrate the lack of precision in the relationship between factor exposure and returns, we provide results for fine-grain portfolio sorts. In particular, we first sort into quintiles by factor characteristics (such as book-to-market for value), then each quintile is subdivided into sub-quintiles according to the same factor score. If the relationship between factor exposure and returns were highly precise, the second sort for stocks with broadly similar characteristics should lead to meaningful return differences. To be more specific, even when looking at stocks in the same book-to-market quintile, the distinction by sub- should lead to a positive value premium for those stocks that are more value-oriented (higher book-to-market ratio) within their respective quintile.

Instead, as can be seen from Table 1, the sub-quintile premia are negative in most cases. Especially in the winning quintile (Q5), distinguishing between stocks based on factor scores does not add any value. In fact, for four out of the six factors we analysed, selecting the highest-exposure stocks in the top-quintile leads to lower returns than selecting the stocks with the lowest exposures in the top quintile. In other words, among stocks with high exposure to a given factor (top-quintile stocks), making a finer distinction between those that are most strongly exposed and the rest does not lead to higher returns. This clearly shows that even though the risk premium appears in broadly diversified portfolios, it disappears if we start accounting for differences at the stock level or create narrow portfolios according to precise differences in exposures.

Table 1: Intra-quintile premiums of each factor:

Analysis is based on daily total returns in US$ from December 31, 1975 to December 31, 2015, based on the 500 largest stocks in the US. For each factor, the universe is divided into 5-by-5 double sorting based on the corresponding factor score, forming 25 equally weighted portfolios. The difference in returns between the fifth and first quintiles, from first sort to second sort, across each quintile, is reported.

31/12/1975 to 31/12/2015 Size Value Mom. Low Vol. Low Investment High Profitability
(Q5-Q1)
Q1 (Low-exposure stocks) 0.53% 0.11% 6.23% 5.50% 9.06% 4.38%
Q2 -0.91% -0.31% 4.45% 1.20% 1.11% -3.08%
Q3 -0.77% -0.39% -1.58% 1.58% 1.63% 2.49%
Q4 -1.18% 2.68% 0.25% 0.75% -0.05% 0.93%
Q5 (High-exposure stocks) -0.38% -0.06% 1.62% -0.94% 1.61% -0.28%

 

 

 

Single factor relationships may break down at the multi-factor level

While there is ample evidence that portfolios sorted on a single characteristic are related to robust patterns in expected returns, such patterns may break down when incorporating many different exposures at the same time.

Hedge fund manager Cliff Asness, for example, observes: “Value works, in general, but largely fails for firms with strong momentum. Momentum works, in general, but is particularly strong for expensive firms.” As a result, “Increasing both momentum and value simultaneously has a significantly weaker effect on stock returns than the average of the marginal effects of increasing them separately.”

This weakening would affect securities favoured by composite scoring methods.

A more drastic failure is discussed in a study where the authors show that, even though the low volatility anomaly exists in the broad cross-section of stocks, low-volatility stocks underperform when considering only stocks that rank well on a composite multi-factor score. Building bottom-up multi-factor portfolios on the basis of factors that have been documented in a top-down framework thus lacks relevance.

Ultimately, engineering multi-factor portfolios under the assumption of a deterministic dependence of returns on security-level multi-factor scores means attempting to exploit information that is not reliable.

Could the backtest performance of bottom-up approaches be over-stated?

A backtest is a simulation of a portfolio’s performance as if it were implemented historically. It is not rare to find strategies that provide stellar performance in backtests but fail to deliver robust live performance. There are several reasons for this. First, backtests are sensitive to the sample period of the tests. This problem arises simply because returns are highly sample-specific. Second, the results of backtests could be contaminated by data mining and over-fitting.

Andrew Lo and Craig MacKinlay wrote in 1990 that, “[…] The more scrutiny a collection of data is subjected to, the more likely will interesting (spurious) patterns emerge.”

Over-fitting occurs when more and more degrees of freedom are added to the model until it might be capturing sample-specific noise, rather than structural information. Over-fitted models tend to fail miserably out of sample. If one generates and tests enough strategies, one will eventually find a strategy that works well in the backtest.

The bottom-up approach to multi-factor investing has opened up a platform for computational technicians to come up with several possibilities for selecting and weighting factor metrics for multivariate composite scores. Such combinations made after the fact exacerbate data-mining problems by introducing over-fitting and selection biases. Knowing that the bottom-up approaches are, by design, prone to selection bias, an important question worth exploring is whether the claims of bottom-up proponents could be due to statistical flukes. A simple way to do that is by adjusting the results for the inherent biases. The discussion below explores this question in detail by summarising results from a recent study published last year in European Financial Management titled “The Mixed vs the Integrated Approach to Style Investing: Much Ado About Nothing?”, by Markus Leippold and Roger Rüegg.

Even though the multiple testing bias has been analysed extensively in the literature, studies claiming that bottom-up approaches provide better risk-adjusted returns than top-down approaches do not account for this issue. Moreover, tests are done on short time periods, such as 15 years, while a reasonable empirical assessment of factor investing approaches requires a substantially longer time period (40 years or more) to account for the cyclical nature of risk factors.

Leippold and Rüegg’s work re-assesses claims that a bottom-up approach to multi-factor portfolio construction leads to superior results. When applying proper checks of statistical robustness, and adjusting for relative risk, they find that there is no such superiority.

The authors account for the fact that there are numerous variations one could employ to conduct such tests and any reported superiority of the bottom-up approach could be the result of picking a favourable combination that happens to work simply due to chance. The authors test a large variety of factor combinations and portfolio construction methods, and compare the bottom-up and top-down approach in each case. They use advanced statistical tools to adjust for the fact that a fluke can easily result in apparently significant benefits if the number of combinations is large enough.

This analysis shows there is no evidence that bottom-up approaches perform better than corresponding top-down approaches. Thus, the findings reported by promoters of bottom-up approaches do not withstand rigorous analysis and could instead be explained by the choice of a particular selection of factors, and failure to adjust for data-mining possibilities.

Table 2 presents a summary of the results. Leippold and Rüegg created 78 different multi-factor portfolios using all possible combinations of up to five popular factors (value, momentum, low investment, profitability and low volatility) and three different portfolio construction methods. Only 13 per cent of the possible variations led bottom-up portfolios to have significantly higher Sharpe ratios than top-down approaches, when adjusting for multiple testing. Moreover, when adjusting the top-down portfolios to match the levels of relative risk of the bottom-up portfolios, none of the bottom-up portfolios have significantly higher Sharpe ratios than their top-down counterpart. This finding invalidates the claims of superiority made by proponents of bottom-up approaches.

Table 2: Bottom-up vs. top-down approaches – Sharpe ratio comparison. The table presents the summary of results discussed in Leippold and Rüegg [2017] based on a long history of US stock returns (1963 to 2014).

78 Portfolios

(3 Portfolio Construction Methods * 26 possible combinations of 5 Factors)

 Bottom-up portfolios with higher Sharpe ratio
Number of portfolios Statistically significant at 5% when adjusted for multiple hypotheses
Difference in Sharpe ratio 67 (86%) 10 (13%)
Difference in Sharpe ratio at similar relative risk 35 (45%) 0 (0%)

For investors, it is important to keep in mind the potential data-mining pitfalls associated with backtests. Leippold and Rüegg note: “Given the increasing computational power for conducting multiple backtests and given the fact that financial institutions have incentives to deliver extraordinary results, it is crucial to apply the most advanced statistical testing frameworks. Ignoring the available tools can lead to hasty conclusions and misallocation of capital to investment strategies that are false discoveries.”

While providers are entitled to rely on short-term backtests to support the superiority of their approach, investors would be well advised to consider the findings in the academic finance literature and to use advanced statistical tools when they evaluate the benefits of bottom-up approaches.

Felix Goltz is research director, and Sivagaminathan Sivasubramanian is quantitative analyst, at ERI Scientific Beta.

We are grateful that thought leaders like Keith Ambachtsheer take the time to review the CFA curriculum and provide feedback. His perspective is precisely the kind of input on which we rely to design the curriculum and that will help improve what we teach future investment management practitioners.

Ambachtsheer is correct in noting that some of the data and examples used in the CFA curriculum are dated. Maintaining a nearly 9000-page curriculum is challenging, and it can take five years to revisit a particular reading. To identify the knowledge, skills and abilities that are necessary for today’s and tomorrow’s investment management professionals, we conduct a continuous process called practice analysis. This involves gathering input from practitioners around the globe to guide us in prioritising the areas of the curriculum that need to be revised to ensure that the CFA program maintains its status as the gold standard of investment management credentials.

About five years ago, in response to feedback that the Level III (the final level of the CFA program) curriculum was getting outdated, we embarked on a multi-year project of revamping it. Rather than merely revising existing readings, we completely redesigned the structure and content of the Level III curriculum. Unfortunately, Ambachtsheer reviewed last year’s version of the curriculum, which did not reflect these major revisions. In contrast, this year’s version includes seven new Level III readings that reflect the current practice of investment management; for example, we added in-depth coverage of liability-driven investing, which is particularly relevant to ensure adequate funding for pension plans. We are also adding content in other areas that are of increasing relevance to the practice of investment management, such as ESG, fintech, and goal-based investing.

Over the last five years, the revamp of Level III has been the focus of our curriculum development efforts, sometimes at the expense of doing the regular maintenance on readings that remain practically relevant and structurally sound but that would benefit from updates of data and examples. This is an issue to which we have turned our attention, with the objective of being more systematic in keeping the CFA curriculum up to date.

For the future

Ambachtsheer questions whether the CFA curriculum is future-oriented enough. CFA Institute is more than the CFA program and we rely on more than the curriculum to achieve our mission of leading the investment management industry by promoting the highest standards of ethics, and professional excellence for the ultimate benefit of society. Moreover, the CFA program, like all credentialing programs, is designed primarily to reflect current practice. It is not the primary vehicle for thought-leadership and looking forward, except in areas where we advocate practice, rather than reflect it, such as ethics and professional standards.

As a leading professional organisation, CFA Institute is committed to lifelong learning. We offer our members, directly or via our network of CFA societies, a broad range of continuing professional development offerings. We are committed to examining issues of critical importance to the future health of the investment management industry and to its ethical practice, through lilications such as the CFA Institute Financial Analysts Journal, and CFA Institute Research Foundation material, along with white papers and research from our teams for advocacy and the future of finance. For example, we agree with Ambachtsheer that sustainability is a critical issue, and we have recently published several pieces on this topic, including Financial Analysts Journal articles on climate risk and a Research Foundation Handbook on sustainable investments. Thanks to the involvement and contributions of influential practitioners and academics such as Ambachtsheer, who sits on the CFA Institute future of finance advisory council, we have the opportunity to identify important trends and create or curate content that will help shape a better investment management profession. These contributions have guided the integration of sustainability content, such as ESG case studies and related materials, into the curriculum.

CFA Institute takes its role as a leading professional organisation seriously. We are committed to ensuring that the CFA curriculum remains practically relevant globally and that we continue to challenge the profession to be future-oriented and focused on the long term. We welcome feedback from all of those who, like Ambachtsheer, support these goals.

Stephen Horan is managing director and Barbara Petitt is head of curriculum and learning experience, at the CFA Institute.

Hiring specific ESG equity managers provides a benchmark for the California State Teachers’ Retirement System to measure the processes and practices its traditional equity managers use to integrate sustainability.

In October 2016, the $225 billion fund issued a request for proposal (RFP) for up to six managers with a specific ESG focus. It already has two existing ESG mandates, with Generation Investment Management ($622 million) and AGF Investments America ($256 million).

CalSTRS chief investment officer Chris Ailman said part of the motivation for hiring specific environmental, social and governance managers was to compare and contrast their mandates with what its other managers do.

“We have some managers giving us lip service on how much they actually integrate this, I’d call them light green,” Ailman said, speaking at the Sustainability Accounting Standards Board annual conference in a session chaired by Janine Guillot, SASB director of capital markets policy and outreach.

The fund expects all of its 225 fund managers to integrate ESG into the investment process, so there was some debate about whether the fund should issue an RFP for a specific ESG product.

“Of our managers, 93 per cent currently integrate ESG into their process in some way,” says Ailman, who is chair of the SASB investor advisory group. “It’s self-certification, so there are some faults in that. The 7 per cent that don’t are quant managers and don’t have those as reliable factors to integrate into their models.”

He says most of the fund’s traditional managers are trained to look at the financials first and then at long-term business risk, which is what he wants, but the fund decided to do an RFP for those that put ESG first and integrate it into everything they do.

“Some of our oldest managers, that we’ve had for 25 years and they’ve been around for 100 years, won’t use the words ESG but when we look at the way they analyse and do deep research, it’s on everything that is E, S and G – it’s business risk,” he says.

In the search for specific ESG mandates, the fund started with 200 ESG products from 100 managers, and quickly whittled that down to under 20.

“We are now at due diligence stage of visiting them and saying show us what you do and prove to me that you ask companies these questions and how do you integrate it into your process.

“I can’t stand when a company says we have a responsible investor and it’s one person. Is everyone else irresponsible? It’s a concern that too many companies have a specific product and then everyone else doesn’t think about it. We want it to be integrated into the investment process as part of the risk due diligence on any company, any investment.”

Internally, CalSTRS has a comprehensive approach to ESG across all asset classes.

It has environmental teams, social teams and governance teams, in separate committees, with one staff member from every asset class as lead and then someone else as backup.

In 2016, CalSTRS made it mandatory for every one of its investment professionals to attend a session on what ESG integration means at the fund.

He wants to have up to 10,000 companies using SASB metrics by the end of 2018.

“I’d like to get the corporate board to care about it and think about long-term operational business risk, and get the standards out there,” he said. “We talk about [ESG factors] as long-term operational business risk; if we use this language, then the CFOs get it and are willing to talk about it.”