Over the last decade, listed equity managers have grown used to demands from major institutional clients for proof of their management of environmental, social and governance risks. Listed debt managers are growing accustomed to the same demands. Now major asset owners are turning their attention to getting a clear view of the ESG risks embedded in the unlisted assets within their portfolios.

This can be particularly challenging in the traditionally opaque world of private equity.

The Future Fund, Australia’s A$134.5 billion ($101 billion) sovereign wealth fund, first introduced a system to assess the capacity and commitment of its managers around ESG issues in 2015. At a recent gathering, Future Fund head of ESG, Joel Posters, shared how the processes and protocols were implemented, particularly with regards to managers operating in private markets.

As a first step, the Future Fund evaluated its more than 100 investment managers to identify those that required critical attention. There were three criteria: whether ESG moved the dial in terms of the performance of the investment; how much influence the Future Fund had in making demands of a particular manager due to the size of its investment; and the duration of the investment.

“We recently put down an investment of $1.1 billion for the privatisation of Port of Melbourne,” said Posters, speaking at the Responsible Investment Association of Australasia’s (RIAA) annual conference, held in Sydney, November 15-16, 2017. “We might hold that asset for as long as the fund survives, be that 10, 20, 25 years. Clearly it’s in our interest there to make sure we manage those ESG issues to the best of our abilities, versus a hedge fund manager we have a relationship with that trades in and out of its holdings every week or every month.”

Eyeballing managers

Posters and his team identified 50 managers for priority assessment, a process that now begins whenever the fund adds a new manager, and have conducted periodic evaluations since then. Evaluation templates are tailored to the relevant asset class, and sometimes to the underlying strategy.

“Among private-equity managers, we would have different questions to ask an emerging-market buyout manager versus a developed-market venture capitalist,” Posters said.

The Future Fund does not share its assessment templates with managers in advance and prefers to conduct discussions via face-to-face meetings or conference calls, rather than email.

“I think you get the most honest responses when they don’t know what’s coming,” Posters said. “You can learn a lot more from an investment team if you’re looking them in the eye.”

It is also essential, he said, to have the right people around the table and often that’s not the dedicated ESG team.

“I want to talk to the senior portfolio managers,” he explained. “Those are the people who have to fulfil the mandate, those are the people who are making the investment decisions on a day-to-day basis, and those are the ones who are the most relevant for the discussion.”

Once ESG assessments are complete, that information is incorporated into existing manager evaluations, which are based on a dozen criteria, including track records and fees, as a qualitative overlay. Managers are marked as either above expectations, meeting expectations or below expectations.

“I think if you become more granular than that, it just ends up adding a lot of noise,” Posters said.

Feedback keeps managers engaged

For the most part, the Future Fund’s managers are at least meeting expectations. Where they are not, the amount of risk in a portfolio is taken into account before decisions are made about escalation. For example, there is greater risk tolerance for a US venture-capital manager that is just starting on its ESG journey and investing primarily in cloud computing companies in California, than for the industrial sector buyout manager operating in emerging markets.

Managers are ranked according to performance and advised of their ranking. That feedback loop is important to keep managers engaged in the process, because they want to see how they stack up against their peers.

For managers who aren’t meeting expectations, Posters prefers addressing the issue privately first. If that doesn’t work, the Future Fund has had success raising concerns in collaboration with other investors. In one case, a private-equity manager operating in emerging markets retained an environmental consulting firm to upscale its risk management after concerns were raised with the limited partner advisory committee (LPAC).

Other corrective options include hosting workshops with fund managers, and providing them with tools to screen for ESG issues relevant to their portfolio. Where the Future Fund doesn’t have the leverage to force change, it will reconsider the entire relationship, Posters said.

Renewables bear fruit

While the pre-investment stage is a critical time to communicate expectations around ESG issues, in most cases the Future Fund will have a governance structure in place to ensure it has access to, and influence over, managers throughout the investment period.

“For example, [along with] the $400 million commitment we have towards AGL’s renewables fund, we have two of our infrastructure guys on the board,” Posters said. “Within most of the private-equity deals that we do, we want a seat at the LPAC.”

He said that, while the Future Fund probably has taken on many renewable energy private-equity deals in the past, the space is really coming to fruition now.

“When we invested $400 million in AGL’s renewables,” he told the conference, “it wasn’t necessarily about the fact that it was renewable, it was about the fact that it was a brilliant opportunity.”

Improving monitoring and reporting is an ongoing exercise. For the Future Fund, part of that effort includes signing up to the Global ESG Benchmark for Real Assets, to guide its relationship with infrastructure and property managers.

“We want to receive information about ESG that moves the dial,” Posters said.“But we don’t want our managers to have to report to us in a different way than they’re having to report to the 20 other investors on exactly the same issues.”

First State Super’s focus

Joining Posters for the RIAA conference panel on ESG in private markets was First State Super head of research Ross Barry.

Barry said First State Super has processes in place similar to the Future Fund’s for assessing the performance of its external managers in listed markets; however, the challenge of assessing ESG compliance in private equity makes the fund cautious about how it allocates to the sector. Since private-equity funds are typically blind pools, First State Super has a zero allocation to it in its socially responsible investment options.

Even so, First State Super was eager to explore what it could do in private equity in a manner that was aligned with ESG practices, so it turned to impact investing.

“We wanted to have one piece of the portfolio that was skewed towards finding things that had a very strong, positive social, economic or environmental impact,” Barry said.

First State Super worked with alternatives manager ROC Partners to become a direct shareholder in companies and other assets that promise to have a positive impact.

Barry addressed concerns that impact investing requires asset owners to take a haircut on returns, saying that there is enough deal flow for the platform to offer a well-conceived, diversified and compelling return proposition for members.

“The opportunities have to present a compelling reward for risk, or they just get filtered out along with everything else,” Barry said. “There are enough really clever, smart things that people are doing, that employ people, provide affordable healthcare and affordable energy, and

The board of administration of the $350 billion California Public Employees’ Retirement System (CalPERS) has opted for a steady-as-she-goes approach to strategic asset allocation, selecting from four candidate portfolios the one that most closely resembles the system’s current investment mix.

As part of the asset liability management (ALM) process that CalPERS conducts every four years, the board was presented with portfolios labeled from A to D offering different asset allocation mixes and long-term risk and return characteristics.

At its meeting on December 18, the board opted for Portfolio C, requiring minimum adjustments to its existing policy. The chosen portfolio has expected volatility of 11.4 per cent a year and an expected annual return of 7 per cent, which supports a board decision to reduce to 7 per cent the discount rate applied to the fund’s liabilities.

The new portfolio will come into effect on July 1, 2018.

The expected return of the selected portfolio was calculated using a so-called ‘blended’ return – a combination of a short-term (1- to 10-year) estimate, based on CalPERS’ own investment office projections, and a long-term (11- to 60-year) estimate based on actuarial forecasts, with an allowance for fees.

The other portfolios considered offered lower expected volatility but also lower expected returns, which would have required a further lowering of the discount rate and a reduction in CalPERS’ funded ratio, which stands at about 68 per cent. The investment team advised the board that adopting a portfolio with an expected return of 6.5 per cent a year would have immediately reduced the funded ratio to 64 per cent, increasing the burden on participating employers to make up the shortfall.

Other portfolios that promised higher returns would have eased that burden on employers but also would have exposed the fund’s assets to greater risk.

In a statement, the chair of the CalPERS investment committee, Henry Jones, said the selected portfolio “represents our best option for success while protecting our investments from unnecessary risk”.

CalPERS chief executive Marcie Frost said the portfolio selected took into account employers’ concerns about funding pension liabilities but balanced those against managing portfolio risk to avoid “leaving the fund more vulnerable during an economic downturn”.

The CalPERS investment office recommended the portfolio, and three of the fund’s investment consultants supported its selection.

Wilshire Associates noted that while the other candidate portfolios represented “efficient expressions of the approved capital market assumptions (CMAs) subject to basic and appropriate constraints”, the selected portfolio had two distinct advantages: it would allow the fund to maintain its 7 per cent discount rate, and as the most similar to the current portfolio it would make implementation more efficient, “with limited transactional activity and related costs”.

Pension Consulting Alliance deemed the selected portfolio appropriate for meeting CalPERS’ longer-term 7 per cent assumed rate of return, said it incorporated several of the fund’s key investment beliefs, and called it “a cost-effective solution when compared to the alternatives”.

Meketa Investment Group also supported the selection of Portfolio C, noting that all of the candidates set the same 8 per cent long-term allocation to private equity, the asset class on which it consults.

CalPERS’ investment office said the recommended portfolio would protect the fund’s assets from increased interest rate risk more than the other candidates, and would also maintain the current levels of equity risk and expected volatility, meaning the “potential for [employer] contribution changes” should remain the same.

Asset class Portfolio C Actual allocation as at 30 September 2017 Asset liability management (ALM) policy portfolio 2013
Global equity 50% 50% 47%
Private equity 8% 8% 12%
Fixed income 28% 19% 19%
Real assets 13% – –
Real estate – 9% 11%
Infrastructure/forestland – 2% 3%
Inflation assets 0% 8% 6%
Liquidity 1% 4% 2%
Blended return (1-60 years) 7.00% 6.85% 7.09%
Expected volatility 11.40% 11.50% 12.00%
Source: CalPERS

 

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Investors will play a major role, whether active or passive, in climate change mitigation. To enable prudent decision-making, we propose three physically based engagement principles that could be used to assess whether an investment is consistent with a long-term climate goal.

Click here to read the full article. 

The selection of investment managers contributed almost three-quarters of the 168 basis points of excess returns the $146 billion Teacher Retirement System of Texas generated in the 12 months ended September 30, 2017.

Individual manager outperformance added 122 basis points of outperformance as Texas Teachers posted a 12.9 per cent return for the year, exceeding its benchmark of 11.2 per cent.

In a presentation to the fund’s board this month, Aon Hewitt Investment Consulting partner Steve Voss said this was Texas Teachers’ second-strongest rolling one-year return ever, “second only to roughly a 2010 timeframe, when markets were just starting to improve following the crash [and] you had a lot of credit investments that were” excelling.

Individual managers of real-asset portfolios did “exceptionally well”, Voss said, along with private equity managers, directional hedge funds and stable-value hedge funds – “all added value quite notably above their benchmark”.

About 20 per cent of Texas Teachers is invested in real assets, where the managers the fund selected returned 10.9 per cent for the year to September 30, compared with the benchmark of 6.1 per cent.

The bulk of those real assets are in real estate and energy, natural resources and infrastructure.

“Those areas have done exceptionally well,” Voss said, adding that the fund’s investment management division (IMD) has done “a great job of adding value and finding good managers in that space”.

Voss said asset allocation had also helped the fund exceed its benchmark; for example, the decision to underweight US Treasury bonds contributed 49 basis points of outperformance.

There was lost value as well. Over the year, the fund was overweight absolute return strategies, which cost about 14 basis points of value. Overall, however, asset allocation contributed 41 basis points of the total value added for the year.

“The average underweight the last year for US Treasuries has been -2.3 per cent,” Voss said. “The decision IMD has made to underweight Treasuries has had quite an effect; it’s had a half-per cent impact for this past year. That one decision alone has been remarkably additive.”

Voss warned against letting the current low-volatility environment cause complacency to creep in and lull investors into accepting investment risk that might be “greater than one should be taking on”.

“Volatility has been at an all-time low,” Voss said, and for the last three years has been about 5 per cent for the fund’s benchmark portfolio.

“I don’t recall a time…when we’ve seen volatility as low as this,” he said. Looking forward, volatility is expected to be significantly higher, in the 10 per cent to 14 per cent range.

“It’s been a very quiet, low-vol period,” Voss said.

The value of Texas Teachers’ assets stood at $146.2 billion at September 30, 2017, up from $133.2 billion a year earlier. Investment earnings added $16.1 billion to the fund’s value over the period, taking total investment earnings for the fund over the last five years to $54.2 billion, with net withdrawals for the year of just over $3 billion.

Voss said TRS has outperformed its investment benchmark in 14 of the last 20 quarters.

Despite a raft of reforms and changing social norms that reined in much of the asset management industry’s excesses after the global financial crisis, professional investors working in large institutions are still on a good wicket. It’s a great gig if you can get it. But the future of the investment profession as we know it is under threat.

The outlook for financial markets has been fundamentally altered by a decade of radically easy global monetary policy in the wake of the GFC. Meanwhile, other forces are reshaping the investment profession as well, including the rise of low-cost passive managers and robo-advisers powered by artificial intelligence, a public image problem, and the changing power dynamic between asset owners and their managers.

Two doyens of the local industry, one from the buy side and one from the sell side, mused on these issues at the 2017 CFA Australian Investment Conference, held in Melbourne.

Mark Delaney is deputy chief executive and chief investment officer of AustralianSuper, which has $130 billion in assets under management, making it the nation’s largest industry super fund. He reflected on how fortunate he was to have begun his career during the heydays of the early 1980s.

“The industry has basically boomed right through the whole 30-year, nearly 40-year, period [of my career],” he said. “What worries me is that I don’t think the prospects look anywhere near as optimistic for the next 20 years.”

Delaney named three reasons for this: “the rise of indexing” at the expense of active management; robo-advisers displacing the CIO’s role in portfolio construction; and the reputational issues facing the investment profession. He warned the gathering of investment professionals that whether they’re in securities selection or portfolio construction, their roles are at risk of being displaced by technology in the years ahead.

“The only response the profession has is to embed itself in the technology,” Delaney argued. “Be better than indexing. Be better than robo-advice. If you’re not better, you’re not going to survive. Technology is coming to investments and, I suspect, it’s going to take a chunk of the market share. A chunk of the jobs, and a chunk of the income.”

Rise of the robots

Colonial First State Global Asset Management chief executive Mark Lazberger joked that Commonwealth Bank’s $218 billion wealth-management arm was already looking into whether artificial intelligence could produce a better CEO than him. But on a more serious note, he said it was increasingly apparent that while technology is becoming a constant and critical part of the industry, few people understand how that will play out for the profession and its activities.

How and when AI is used to automate back-office functions and sort large data sets, and how that feeds into decision-making, represents a big opportunity for the sector and how firm’s embrace these technologies will be crucial to their future success, he said.

Lazberger drew parallels between the current failure to delve into this issue and the failure of the industry 30 years ago to question the motives of those selling portfolio insurance, which is often considered a precursor to the 1987 sharemarket crash.

“All of us need to have… a preparedness to question. What are the reasons? What does this really mean? And fundamentally, what are the consequences of these sorts of changes?” Lazberger said.

He predicts, like many, that technology will change the way individuals think about investing. The challenge for those in investment management firms is to be clear about their own position, and ensure their ongoing relevance.

“That length, complexity and disconnection [from professional to client] concerns me considerably…I’m not saying it’s insurmountable but it is a challenge,” he said. “It only takes a couple of seconds to realise that we’re part of a massively individuated…intermediated value chain.”

Lazberger and Delaney made their comments during a panel titled The Future of the Investment Profession, facilitated by Investment Magazine editor Sally Rose.

Growing pains

The investment conference crowd was keen to hear the pair’s views on how the growing scale of Australia’s $2.3 trillion superannuation industry, and the trend for big funds like AustralianSuper to in-source more of their investment management, is changing the relationship between asset owners and their external managers.

The big four banks are stepping away from vertical integration, selling parts of their wealth-management and insurance businesses, and investment management firms are stepping in. It has been widely reported in the media that CBA has CFSGAM up for sale.

Delaney noted that the uneasy tension between those who gather assets and those who invest the money is always present and said the approach needs to be reviewed as a fund grows and achieves different benefits of scale. This has been at the forefront of his thinking recently, as AustralianSuper has increased its funds under management by almost one-third over the last 18 months.

“In a well-run organisation, where [the investment business and the investment profession] do work in harmony, there should never really be an issue,” Delaney said, adding that there is “no magic number” where efficiencies and scale meet, rather it’s a constant question of adjustment.

“What you do know is, you can’t wear the same shorts you wore as a 17-year-old when you’re 21. They just don’t fit. So you have to change the clothes you buy,” he said. “As long as you change what you do and adapt to the circumstances, you can keep on making money.”

Lazberger agreed with the notion that an ability to embrace change is vital to success. Both Delaney and Lazberger stressed that, in light of the many challenges facing the industry, it is more important than ever that investment professionals act to preserve the industry’s reputation.

“…It’s always easier said than done,” Lazberger said of raising the next generation of captive asset managers in the right culture. “If you find that you’re being challenged by your owner, the larger organisations, your partner or whatever, I think all of us as professionals have a responsibility to…meet that whole issue head on.”

Delaney warned that, amid a proliferation of mass-market, cheap products, professional investors have to be able to position themselves “like any luxury product” – with a reputation for quality.

“The whole business model and framework [in which] people thought about investing, I think, needs to change,” he said.

That is why remuneration and incentives are critical because, as Lazberger said, they drive behaviours.

However, Delaney cautioned against the idea of any single remuneration design program being perfect. Rather, it must be a process of continual revision to shape the program to encourage a culture that puts responsibility to the client above all else.

Diversity matters

Another point on which Delaney and Lazberger agreed was the urgent need for the investment profession to improve its gender diversity.

There are only about 10 female CIOs at the top 100 largest asset owners in the country. And a dearth of young women coming through the ranks indicates the imbalance is likely to persist for many years. Only 12 per cent of local CFA charterholders are women.

Still, Delaney says the culture is changing, albeit it too slowly.

“When I first got into investments, it was like an old boys’ private school stockbroking culture, where the people went to lunch and they all knew each other. It was like a gentlemen’s club,” he says. “The world is nothing like that today, thank goodness.”

He believes the profession needs to do a better job of selling its appeal to women.

“It’s inherently interesting. It’s not that demanding a job to do. And it’s well paid. So, I would think everybody would want to do it,” he says.

Lazberger has “an unproven hypothesis” that unconscious biases are disadvantaging women in both hiring and promotion processes.

“When we’re hiring people, we tend to hire people in our own image,” Lazberger says. “And, given that the starting point is very male-dominated anyway, I think that, quite frankly, has actually been quite an inhibitor in terms of seeing organisations – firms small, medium and large – actually make much progress on this issue.”

 

As a journalist, editor and event producer, I’ve got it pretty easy in terms of the risks I face in my job every day. Really, the biggest risks I face regularly are someone not reading a story or failing to turn up to an event. Hardly life threatening. On a really bad day, someone might take offence to something I’ve written and want to sue, but in a 20-something-year career I’ve only come close to that once.

For you asset owners, it’s a different story. Your risks – in the long term and every day – are large and numerous.

We started compiling a list of risks that investors face in their jobs and it’s made me wonder why anyone would ever want to be a large institutional investor and take on the fiduciary responsibility of managing money on behalf of someone else.

From a business point of view, you have to consider operational risk, regulatory risk, compliance risk, technology risk, cyber risk, longevity risk, balance-sheet risk, people risk, key-man risk, behavioural risk, diversity risk and reputational risk – and that’s just for turning up to the office, before you’ve even made an investment.

There’s the strategic risk of managing short-term and long-term risk, the peer risk of looking different to your contemporaries and the managing-up risk of spending too much time looking after the board’s needs.

Once you start investing, the investment risks are overwhelming – you’ve got equity risk, illiquidity risk, tail risk, credit risk, default risk, interest-rate risk, duration risk, tax risk, liability risk, longevity risk, inflation risk, market risk, volatility risk, sequencing risk, structural risk, catastrophe risk, insurance risk, counterparty risk, sovereign risk, project risk, re-financing risk, benchmark risk, index risk, active risk, and in recent times factor risk and climate risk.

If you use derivatives, you have to also consider delta risk, gamma risk and vega risk. Depending on where you sit in the world, currency risk could pose the largest threat to your portfolio; and depending on where your portfolio is allocated, geopolitical risk could be what keeps you awake at night.

Then there’s the one I heard coined recently by the CIO of an Australian fund in relation to Trump’s presidency: WTF? risk.

In these times of continued uncertainty, there’s now also asset correlation risk and the market risk of investments-just-not-doing-what-you-thought-they-would risk.

And finally, if you outsource to a manager, you have to consider principal-agent risk, supply-chain risk, and the manager’s business risk, which includes people risk, process risk and performance risk, along with their operational risk, regulatory risk, compliance risk, technology risk, cyber risk, blah, blah, blah…

It’s no wonder we all need a holiday.

Thanks for being our readers in 2017. We hope by sharing the stories of your peers, and highlighting best practice, we have contributed in some small way to helping you navigate these risks. We look forward to 2018.