A lack of appreciation for the lengths of cycles is a key risk for private-equity investors, who can miss the upside if they are too conservative, says Jason Thomas, managing director and director of research at The Carlyle Group.

“If interest rates remain low, there will be demand for higher-yielding assets, which supports higher asset prices. Be wary of calling a top,” he says. “My guidance is not to say you shouldn’t be concerned about the end of expansion. But it can’t be so front and centre that you can’t think of other risks and you pass on otherwise attractive investments. If you were in cash two years ago, you would regret it.”

In 2013, Leon Black, the chief executive of Apollo, one of Carlyle’s biggest competitors, said, “We’re going to sell everything that’s not nailed down,” and prices have risen dramatically since then. Similarly, Alan Greenspan’s warning of irrational exuberance was in 1996, and the market doubled after that, Thomas says.

“Eight years into an expansion, there’s a temptation not to be invested, or to pass on attractive companies,” he says. “But not realising how long cycles can go for is a concern.  You need a balanced approach to thinking about the cycle because risks can be more symmetric than they appear.”

He says Carlyle, a global manager of alternatives with $170 billion in assets under management, typically takes a conservative position, preferring to sell earlier and get liquid earlier, but part of his job is to query decisions constantly, mostly through analysis of data.

Thomas acts as economic adviser to the investment committees at Carlyle. He uses economic data, proprietary and official, to examine the difference between what was expected to happen in the portfolio, and what did happened.

The trick, he says, is managing the tension between over-reacting to monthly data and using inflexion points, month-ahead forecasts, to make decisions.

“We want to step back and see what the idiosyncratic versus systematic portion of the portfolio is,” he explains. “We look at how different our portfolio data is to what we were expecting, plus the prior month’s official data. How our portfolio changed relative to our own volatility and the official data, gives a sense of systemic shifts in economic conditions.

“In private equity, everything depends on the perspective. You can have a compelling case but not have a deal. My role has to be additive and can inform at the outset of the fund; we can look at industries then assess deals as they come in. It helps to contextualise.”

It can also accelerate the sales process, and inform the disposal of assets if there is a belief that a deterioration is not totally priced in.

Against the conventional wisdom

At the moment, Thomas’s view is contrary to conventional wisdom that the current cycle is coming to an end.

“This is not quite right,” he says. “Many economies experienced a pronounced slowdown or full-blown recession in 2015-16, which allows for a sustained recovery today. Everything is going strongly simultaneously; we are seeing recovery from slowdown, it was a dip and we are bouncing back.”

In particular, he says, if the US dollar is not going up – and he doesn’t think it is – then the perceptions of risks in emerging markets may be overstated and Carlyle is more willing to deploy capital there. It has a weighting of about 25 per cent to emerging markets.

Thomas says there is a potential downward adjustment, a real adjustment, to the US dollar, which could be 8 per cent to 15 per cent in a five-year period.

“At the start of the year, the dollar may have been 20 per cent overvalued,” he says. “Investors need to be prepared for a US dollar recalibration down, which is good for the US economy.

“Accumulate foreign assets. The rest of the world is on sale. Buy high-quality companies at reasonable prices elsewhere. There will be a 2 per cent to 3 per cent annual gain over a five-year window, from currency.”

He says part of the reason is the US Federal Reserve has always been so far ahead in its tightening and easing cycles, which has had an effect on the US dollar when it is counter to the rest of the world. In addition, the US is less competitive because the dollar is relatively high, which acts as a constraint on investment and wage growth.

Trump changes not so dramatic

The past nine months, since Trump’s election, has been a test for those wanting to deploy capital.

There was a period of insecurity after the US election last November based on the potential scale of changes in U.S. public policy.

“There was a temptation in the weeks after the election to try and predict policy to an extent that was not practical. Then reality set in, and the scale of the policy changes appears likely to be much less dramatic than people anticipated. Now we are back in a situation where perceptions of the economy and fiscal and monetary policy environment are closer to where they were in November,” he says, pointing out that the Fed may raise rates again in December.

“But they won’t do it for no reason and the impetus is not there now.”

Immediately after the election, Thomas spent much time trying to get his head around the portfolio implications of Trump’s policy promises. For example, the implications of Mexico exposure, mostly through supply chains, and China exposure, along with the implications of tax reforms and potential infrastructure spending, which are ongoing.

“People had a lot of questions; for example, a border tax could affect a lot of different deals,” he explains.

Hypothetically, he offered the example of a textile manufacturer in China that got most of its retail sales from the US. If a 30 per cent border tax were introduced, it would wipe out the company’s operating profit. But it would also wipe out the operating profit of all its competitors.

“It is unrealistic to think that Americans would no longer have access to low-cost apparel made in China, so it’s a complicated question to consider,” he says. “The good news is that such developments force you to consider the processes in place to assess these types of unconventional risks.”

Back to fundamentals

Thomas says there is much less focus on government policy in his discussions with investment professionals.

“To some extent, the policy focus feels, in retrospect, to have been a bit of a detour,” he says. “Carlyle deployed capital aggressively this year, but on those that had severe policy implications there was a hesitance.”

The discussions are now back to fundamentals, where most of the value is coming from, he says, and Carlyle is deploying capital at a healthy rate – more in 2017 than in 2016 – because of the strength of the underlying economy. The US is rebounding because of energy and industrials, and Thomas can see that in the portfolio data.

“Energy spending/orders for equipment are up 20 per cent in our portfolio. Last year, that was still contracting,” he says.

Norway’s giant Government Pension Fund Global may expand its asset allocation outside the current limitations of listed equity, fixed income and real estate. The Ministry of Finance is reviewing GPFG’s investment strategy while the state also conducts a study of the fund’s institutional peers to compare their progress on environmental, social and governance (ESG) integration with the work of GPFG’s asset manager, Norges Bank Investment Management (NBIM).

The study on ESG integration is being conducted by London-based consultancy Inflection Point Capital Management and is due in October. Meanwhile, the ministry’s strategy review of the NOK7.7 trillion ($990 billion) GPFG will include looking into whether the fund should invest in more diversifying assets, namely unlisted equity, and increase its ability to take on risk away from the governing benchmarks, expanding its narrow tracking error.

As of June 2017, the fund’s asset allocation was split between equity (65.1 per cent) fixed income (32.4 per cent) and unlisted real estate (2.5 per cent). The fund returned 2.6 per cent in the second quarter of 2017.

The review and study are linked, since any adjustment to investment strategy could greatly influence the fund’s ability to beef up its ESG remit, which is mostly focused on active equity ownership of the 9000 listed companies in which it invests. The fund emphasises voting at shareholder meetings, engagement and exclusion; it prioritises climate change, water and children’s rights. For transparency, every investment the fund makes is detailed online.

The review will examine the broader responsible investment landscape and what that could look like in years to come.

“The Ministry of Finance conducts broad reviews of Norges Bank’s management of the GPFG at the start of each parliamentary period,” a ministry spokesperson said. “The current review is in line with this practice. The review and the ministry’s assessments, including the tracking error limit, will be presented in a white paper to Parliament in the spring of 2018.”

Because the review is for the ministry, its authors have a chance to persuade NBIM’s lord and master to expand the giant fund’s strategy. The strategic tension between the ministry and NBIM is well known, since the ministry mandates the limits on NBIM’s investment strategy.

GPFG versus its peers

The study will compare ESG progress at NBIM to that of all asset owners, not just sovereign funds. Leaders that could inspire real change at GPFG include Sweden’s AP funds, which are working towards decarbonising their entire portfolios, and Dutch pension fund managers PGGM and APG Asset Management, which are working to align their investments with the sustainable development goals.

Taiwan’s $124 billion Bureau of Labor Funds, the supervisory body for the country’s labour pension funds, could also be influential. It has just awarded its first-ever foreign ESG mandate, a passive measure worth $2.4 billion.

GPFG has gone further with ESG principles than some of its sovereign wealth fund peers. For example, the Kuwait Investment Authority and Qatar Investment Authority are not galvanised into action by an ESG-minded public and face the same conflict as Norway in terms of needing to balance a hydrocarbon economy with an environmental agenda. However, GPFG has done less than leaders such as New Zealand Super, which is using its current chairmanship of the International Forum of Sovereign Wealth Funds (IFSWF) to push sustainability and has just moved its entire NZ$14 billion ($10.1 billion) global passive equities portfolio to low carbon.

Tracking error under scrutiny

One of the biggest restraints on ESG integration at GPFG is a tight 125 basis point, or 1.25 percentage point, tracking error. Returns are measured against a benchmark from the Ministry of Finance, which serves as a general limit for market and currency risk in the management of the fund. The benchmark comprises an equity index based on FTSE Group’s Global All Cap stock index and a bond index based on various indices from Bloomberg Barclays Indices.

ESG proponents argue that investors need to make sizeable bets, rather than just tweak an underlying index; a small nudge on a benchmark weighting doesn’t show much conviction. Also, for GPFG, entire asset classes are still off limits, making good ESG ideas around asset allocation and fund design difficult to realise. NBIM is allowed to invest the fund in unlisted companies that intend to seek a listing but, unlike peers such as Singapore’s GIC and the Abu Dhabi Investment Authority, GPFG has never been allowed to venture into private equity.

“In 2011, the ministry considered unlisted equity investments in the GPFG in the white paper to Parliament,” the ministry spokesperson said. “Although it decided not to open up for such investments, it did pledge to revisit the topic based on the experience with unlisted real estate and possible developments in unlisted markets and new research. The ministry has announced that it aims to present a new assessment of investments in unlisted equity in the white paper to Parliament in the spring of 2018. The assessment will be based on expected risk and return, and whether Norges Bank can be expected to obtain comparative advantages within such investments.”

The Ministry of Finance only gave a green light for the fund to invest in real estate in 2010. Three years later, it broadened this to include Asia and the US.

The first-ever publicly released review of California Public Employees Retirement System (CalPERS) board investment consultants has revealed a high satisfaction with the consultants’ honesty, integrity and competence, but much lower satisfaction when it comes to them recommending ways to control fees and costs and proactively bringing new investment opportunities to the board’s attention.

Eleven of the CalPERS board of administration’s 13 members provided responses to a 16-question survey, assessing the consulting firms in three main areas: strategic analysis and recommendations, communication and responsiveness, and overall performance.

Of the consultants included in the evaluation, Wilshire Associates consults on general pension investments, Pension Consulting Alliance consults on real estate investment and on general investment and responsible contractor program issues, and StepStone Group consults on infrastructure.

Private equity consultant Meketa Investment Group was excluded from the evaluation, given its limited tenure in the 2016-17 fiscal year. It was hired in March this year after PCA resigned as private equity consultant in the middle of a five-year contract.

CalPERS budgeted $43 million to spend on consultants in the 2016-17 financial year; about $20.2 million of that was for investment consultants. It paid about $896 million in total external investment management fees, which was a 3.7 per cent decrease on the year before. Reducing fees and costs is a priority for the fund.

In the survey, directors were invited to assess each consultant using a basic five-step scale, where a ranking of five meant a director was “very satisfied” with the consultant’s performance, four meant “satisfied”, three meant “neutral”, two meant “dissatisfied” and one meant “very dissatisfied”. Each consultant’s results were presented separately, and individual directors’ assessments were not revealed.

While the survey revealed general satisfaction with the consultants’ performance in most areas (see table), in two areas there was markedly lower satisfaction, and, indeed, board members explicitly expressed dissatisfaction. However, no directors expressed “extreme dissatisfaction” with any of the consultants.

Two expressed dissatisfaction with Wilshire – which has been a consultant to CalPERS for more than three decades – on the consultant’s performance in recommending ways to control or reduce fees and costs, while one expressed dissatisfaction with Pension Consulting Alliance’s performance on the same measure in real estate, and two expressed dissatisfaction with the firm’s performance on general investment and responsible contractor program issues. Two directors expressed dissatisfaction on StepStone’s ability to control or reduce fees and costs in infrastructure investing.

The CalPERS’s board was also relatively dissatisfied with its consultants’ performance on identifying new investment ideas and approaches and bringing them to directors’ attention.

One director assessed Wilshire’s performance as unsatisfactory in this respect, two assessed Pension Consulting Alliance (real estate) as unsatisfactory, one assessed StepStone as unsatisfactory, and three assessed Pension Consulting Alliance (general Investment and responsible contractor program) as unsatisfactory.

The results of the board’s assessment were released at a CalPERS board of administration meeting earlier this month. The board’s vice-president, Henry Jones, said the consultants “perform an important independent oversight function on our investing activities”.

“Feedback is equally important to help ensure our consultants are meeting CalPERS’s needs,” he said.

Historically the consultants “sent their own evaluation surveys directly to the board”, he said.

“As recently as last year, feedback was collected manually from randomly selected board members and reviewed with each consultant separately in closed session,” he said.

“This year several enhancements were implemented. The survey is administered by CalPERS; feedback is submitted through an online survey; all board members have the opportunity to offer feedback; and the results are going to be shared in open session.

“Additionally, we have asked the ESPD [Enterprise Strategy Performance Division] to administer the survey as a neutral third party.”

 

Consultant: Wilshire Associates
(general pension Investment)		 Pension Consulting Alliance, Inc.
(real estate)		 StepStone Group, LP (infrastructure) Pension Consulting Alliance, Inc.
(general investment
and responsible
contractor program)
Area of assessment: Number of directors* “very satisfied” or “satisfied” with consultant’s performance
Key Area 1: Strategic Analysis & Recommendations
Q1: Accurately analyzes issues and provides timely and objective information 10 10 9 10
Q2: Makes clear and relevant recommendations re: policies and guidelines 9 11 10 9
Q3: Recommends ways to control or reduce fees and costs 6 9 4 4
Q4: Helps define appropriate risk parameters and identify mitigation strategies 8 9 4 10
Q5: Makes sound strategic recommendations on portfolio structure 9 8 8 8
Key Area 2: Communications & Responsiveness
Q6: Proactively identifies new investment ideas/approaches and brings them to Board’s attention 4 8 2 5
Q7: Produces high quality reports that are clear and accurate 9 8 9 10
Q8: Clearly and completely answers questions raised by the Board 9 10 9 10
Q9: Identifies and communicates with the board on issues of strategic importance 9 9 8 9
Q10: Effectively evaluates and monitors relevant asset class/total fund developments 8 9 8 9
Key Area 3: Overall Performance
Q11: Thoroughly understand CalPERS’ objectives and constraints 10 10 9 10
Q12: Provides independent, unbiased insight and advice 9 9 9 9
Q13: Acts with honesty, integrity, and competence 11 11 10 11
Q14: Works cooperatively to add value to CalPERS 10 10 9 10
Q15: Fulfills fiduciary responsibility 10 10 9 10
Q16: Clearly understands it works for the Board and with CalPERS staff 8 9 7 9
* Eleven of the 13 members of the CalPERS Board of Administration provided responses.
Meketa Investment Group is not included in the evaluation.
Source: CalPERS Board Consultant Review & Evaluation Project Results – FY 2016-17.

Investors play an important role in facilitating corporate collaborations to improve sustainability says a leading Harvard academic in sustainability.

George Serafeim, the Jakurski Family Associate Professor of Business Administration at Harvard Business School suggests that in the absence of regulatory intervention that forces prices to reflect all externalities a possible solution is pre-competitive collaboration by corporations and industries. Because of their long time horizons and common stock holdings, large investors can play a key role in encouraging this collaboration, he says.

An example of this is an initiative of the denim industry in Amsterdam. It has set up the Alliance for Responsible Denim which has a goal of producing denim in a sustainable way by tackling the three main ecological issues: the use of water, energy and chemicals.

Another example is American Beverage’s partnership with the Alliance for a Healthier Generation which sought to limit beverage portion sizes in schools. It released a report claiming beverage calories shipped to schools had fallen 58 per cent after two years of implementation.

In his paper, Investors as stewards of the commons?, Serafeim says there are two characteristics of investors that are likely to engage with companies at an industry level on issues of environmental and social importance, namely a long horizon and significant common ownership of companies in the same industry or supply chain.

The full paper can be accessed here

George Serafeim, the Jakurski Family Associate Professor of Business Administration at Harvard Business School is one of the speakers at the Fiduciary Investors Symposium to be held at MIT, October 1-3.

While the portfolio turnover of professionally managed long-only equity funds has been declining on average over recent decades, we have found that managers turn over their portfolios every 1.7 years on average (58 per cent turnover ratio). This finding stems from recent research carried out by Mercer in conjunction with the 2 Degrees Investing Initiative and the Generation Foundation under the Tragedy of the Horizon project.

The study analysed over 1,700 equity strategies with at least three years of recent consecutive data. Overall, the project aimed to explore the potentially suboptimal allocation of capital for the long-term due to the limited ability of the finance sector to capture long-term risks within typically short-term risk-assessment frameworks.

An emphasis on short-term outcomes by investors is potentially damaging for beneficiaries since companies may miss out on profitable long-term investment opportunities and ignore longer-term risks by prioritising quarterly earnings expectations.

Moreover, short termism can create time horizon mismatches in the investment management value circle generating concerns over principal-agent issues and a misalignment of incentives, as illustrated below.

Figure 1: The investment management value circle and varying time horizons

 

 

A key implication of turnover for investors is the hidden cost of portfolio transactions including bid-ask spreads, broker commissions, price impact and taxes which can vary in their traceability and magnitude depending on the characteristics of a given investment strategy.

Asset owners are often not aware of the costs their asset managers incur in the process of portfolio management despite the fact that these costs can often be as significant as management fees. The level of turnover and transaction costs can be a useful indicator of whether a manager is implementing the strategy in line with its stated objectives and investor expectations.

Evidence of long-termism

The average turnover of professionally managed long-only equity funds has been declining over recent decades, despite rising overall stock market turnover.

Moreover, institutional investors tend to favor lower turnover strategies, with around 70 per cent of strategies (by assets under management) having a turnover level of less than 50 per cent and just 4 per cent of strategies having turnover of more than 100 per cent.

We also found that sustainable and responsible investment (SRI) funds exhibit lower turnover than non-SRI funds. This is evidence of the philosophical alignment between the SRI and long-term investment movements and highlights the importance of long-termism to evaluating and addressing environmental, social and corporate governance (ESG) risks and opportunities.

Additionally, through detailed conversations with 10 major asset management firms we learned that trading costs and their related impacts are typically an active consideration in portfolio construction.

While there is a recognised trade-off between alpha and trading costs, managers were generally of the view that trading activities will be influenced by return expectations, risk management considerations and transaction costs – all of which are changing over time.

A majority of the managers interviewed had sought to explicitly align a portion of employee compensation with the time horizon of the strategy’s philosophy. In particular, for longer-term oriented, lower-turnover investment strategies, three- or five-year performance targets will often influence the calculation of employee total compensation.

Evidence of short-termism

Notwithstanding the comments made above, approximately 80 per cent of managers turn over their portfolios every three years or less. The average portfolio turnover for the sample was 58 per cent, implying an average portfolio duration of around 1.7 years. This suggests that most managers may not be performing long-term analysis or obtaining long-term research and data regarding underlying portfolio holdings.

Arguably, if investors turn over their portfolios every one to three years, they are unlikely to generate demand for analysis of long-term risks including those related to ESG factors (such as climate change). These types of risk are therefore susceptible to being mispriced.

As expected, quantitative strategies show consistently higher weight and name turnover compared to fundamental strategies. It is important to note that while quantitative strategies may offer lower management fees than comparable fundamental strategies, they may also incur higher transaction costs, raising the bar for alpha generation.

Recommendations

In a diverse financial ecosystem with many different types of investor with varying motivations and goals, there is likely to be a role for both short- and long-term investment practices. Based on the findings of this research project and others before it, it appears the overall equity market is skewed toward shorter-term behavior. While the investment managers we interviewed did not see a strong need for changes or interventions in markets to promote a more long-term orientation, we believe there are many potential drawbacks to short-termism which need to be better understood.

To this end we recommend the following:

  • Asset owners should be explicit about their time horizon in their investment beliefs. Manager monitoring processes should move beyond short-term benchmark-relative performance measures with the aim of assessing progress against expectations over meaningful time periods.
  • Asset managers should be explicit about the time horizon over which a given strategy is expected to deliver and how the time horizon feeds into issues such as decision-making and remuneration.
  • Regulators should consider the merits of broadening fund disclosure requirements to cover transaction costs in order to better inform asset owner-asset manager discussions.

 

Alex Bernhardt is principal and head of responsible investment for Mercer in the US.

Investors are not getting paid for taking on carbon risk according to New Zealand Super, prompting the fund to move its global passive equities portfolio to low carbon. The next step for the fund, as it implements its climate strategy, will be to work out how it will account for carbon risk in unlisted investments and some active exposures including factor mandates.

The NZ$14 billion ($10.2 billion) global passive equities portfolio, which accounts for 40 per cent of the fund, made up 75 per cent of the fund’s carbon emissions and so was an obvious place to start with transitioning the entire portfolio to low carbon.

The fund has reallocated about $695 million away from companies with high exposure to carbon emissions and reserves, into lower-risk companies.

The carbon exposures were highly concentrated in a relatively small number of companies and fell into three sectors – utilities, materials and energy. They accounted for about 83 per cent of the carbon emissions in the portfolio and 16 per cent of the equities portfolio.

By making these changes the fund’s carbon emissions intensity is 19.6 per cent lower and its exposure to carbon reserves 21.5 per cent lower. New Zealand Super expects to reduce the carbon emission intensity of the fund by at least 20 per cent and the carbon reserves of the fund by at least 40 per cent by 2020.

Using a carbon measurement methodology created in consultation with MSCI, the fund divested away from stocks with high carbon emissions and carbon reserves.

MSCI examines the carbon metrics of 8500 companies for scope one and scope two. Scope one is emissions generated directly by the company and scope two are those emissions purchased into the organisation, often through energy usage.

New Zealand Super’s global passive equities portfolio is managed by State Street Global Advisors, BlackRock and Northern Trust which implemented the changes.

The chief investment officer of the $26 billion fund, Matt Whineray, said the weight of evidence shows the market is under-pricing carbon risk, partly given the very long horizon of the fund.

“It’s a risk investors are not getting paid for,” he says.

The belief is that the risks associated with climate change are material and the new low carbon portfolio will increase the resilience of the fund.

The fund used the reference portfolio equity exposure – a combination of the world investable market index, emerging markets investable market index and the S&P/NX50 index – as the starting point for developing an exclusion list. Stocks in the top quartile as measured by MSCI ESG research were not excluded.

Stocks were then ranked by their reserve intensity and eliminated until the desired reserve reduction was met. Then the remaining stocks were ranked by carbon emission intensity and progressively eliminated until the right carbon emission intensity reduction was obtained. Then the remaining stocks within the indices were linearly up-weighted to preserve the proportionality between the three equity indices.

The reference portfolio reserve target was set at a 70 per cent reduction and the carbon emission intensity target was set at a 50 per cent reduction. The new reference portfolio retains 93 per cent of the original market capitalisation.

Separately the fund also excludes stocks on the basis of cluster munitions, anti-personnel mines, nuclear explosive devices, nuclear base operators and tobacco. About 137 companies are currently excluded.

The fund used Bloomberg’s global active equity risk model to calculate the active risk for the equity component of the reference portfolio after the new exclusions lists were applied. At the total reference portfolio level, this is estimated to be about 0.7 per cent of active risk.

New Zealand Super doesn’t typically take conventional active risk in stockpicking, but its active risk is in its allocation away from the reference portfolio into, for example, forests and farms, and also in tactical asset allocation tilts.

New Zealand Super defined its four-part climate strategy in October 2016; it includes carbon footprint reduction, analysis, engagement and seeking new opportunities.

The acronym for the climate process is RAES – reduce, analyse, engage, search (ironically, this was authored by Dave Rae who has since left the fund).

The fund analyses how to incorporate climate risk into the investment hurdle rates, the risk allocation and manager selection process. It is searching for opportunities such as renewables, alternative energy, green bonds and green property.

Whineray says the next step will be for the fund to apply the same carbon measurement to its active equities mandates.

The fund has a number of New Zealand equities active mandates, one active manager in emerging markets and factor mandates with AQR and Northern Trust.

The fund is also looking to understand its climate exposures across the unlisted asset classes.

“We need to get a sense of the footprint, which is hard to do in unlisted because there is less data,” Whineray says. “Then there’s the discussion of what we can do to mitigate or change these exposures. We kicked off with listed equities because it’s where the biggest exposure is and it’s the easiest.”