The OECD has undertaken a stocktake of regulatory frameworks and how they translate into the responsibility and opportunity for institutional investors to integrate ESG factors into their decisions.

The Organisation for Economic Co-operation and Development’s report, Investment Governance and the Integration of Environmental, Social and Governance Factors, allows for a comparison of how different countries and investors are reconciling ESG analysis with prudential, risk-based regulations.

The paper examines how pension funds, insurance companies and asset managers approach ESG risks and opportunities in their portfolios, and the extent to which current legal and regulatory frameworks encourage or discourage them from integrating ESG factors into investment decision-making.

Out of 31 countries in the report, 10 required pension funds to disclose their approach to ESG investing, and five required asset managers to disclose their approach. France had the most extensive reporting standards for institutional investors, requiring information on ESG integration and also on climate risks and how investors’ portfolio construction assists the transition to a low-carbon economy.

The OCED report states that 15 countries and jurisdictions have stewardship codes. It also details the differences among investors in how they integrate ESG factors, how that integration influences investment performance, and their evolving views on good investment practice and fiduciary duty.

The full report is available here

Investment-governance-and-the-integration-of-ESG-factors

The Ontario Teachers’ Pension Plan is “on the cusp of unleashing a whole brand new level of innovation in the organisation that we have not seen in the past 15 years”, chief executive Ron Mock said.

The C$175.6 billion ($132.5 billion) fund was founded in 1990 on a platform of innovation and commitment to excellence and since then it has continued to innovate – in its investment approach, the vehicles it uses, the systems and processes it builds, and the service it gives its members.

“A critical part of our success is innovation. We never stop,” Mock said, speaking at the Bloomberg Investment Summit in New York. He added that innovation is defined in the fund’s values as “having the courage to forge new paths”.

“Because of the driver to innovate and our performance orientation, we are constantly innovating; for example, we started investing in infrastructure in 1999.”

Now the fund is looking to take this culture even further.

“[We’re evaluating] the way we look at and manage our portfolio, our private assets, our real-estate structure – a whole different way of integrating the entire balance sheet,” Mock told the summit. “The other thing we do, we borrow money; a lot of pension plans don’t do that, we employ leverage. And we have to manage liquidity and cash in very special ways.”

The investment team at OTPP is segmented according to specific asset groups or investment disciplines, such as capital markets, global strategic relationships, infrastructure and natural resources, investment operations, portfolio construction, private capital, public equities, and real estate, with offices in London, Hong Kong and Toronto. It uses integrated technology systems and management committees to enable the team to act as one, and manage risk and opportunities at a total fund level.

Value-added decisions are also co-ordinated at the total fund level and portfolio managers are rewarded for maximising value-added returns within the risk limit on total assets, not just their own portfolios.

One of the reasons OTPP is considered an innovative leader is its approach to understanding and measuring risk, and actively managing funding and investment risk together. It is one of few defined benefit schemes to be fully funded, with a funding ratio of 105 per cent, Mock said.

As at the end of 2016, the fund’s asset allocation was 28 per cent equities (public and private), 44 per cent fixed income, 6 per cent natural resources, 26 per cent real assets, 8 per cent absolute return strategies and -22 per cent money market. It has returned 10.1 per cent a year since inception.

OTPP believes in active management, which has contributed 78 per cent of the portfolio’s value above the benchmark over time, and the vast majority of investment management is in-house, helping to keep the expense ratio low, at 28 basis points. Even so, Mock said, external relationships remain critical to the fund’s success.

Talented people for engaged ownership

“We will happily pay higher fees in real estate and private equity,” he revealed. “If doing private equity in other parts of the world, you need to partner with people who are local. If we are getting true value, then we will pay,” he said. But he also stressed that the fund’s long-term process is about engaged ownership.

“In real estate, private equity and infrastructure – a lot of the private stuff we have done – the excess returns have all come from [engaged ownership],” Mock explained. “When we buy an airport, a high-speed train or a downtown office building, it’s our ability to get in…and have the talent to make it work for us that makes the difference. Engaged ownership is one of the keys to all of this and it allows us to go out and employ a lot of things and invest in certain ways that other plans have a more difficult time doing.”

OTPP makes clear that its people drive its success. It spends much time and money on developing, strengthening and retaining its intellectual capital to remain focused on industry leadership and innovation.

“Our approach to everything is about how we find and partner with the brightest and the smartest,” he said. “If going direct drive is better, then we had better have the staff or partnerships that have been there before. Everything we do is approached through partnerships. If we are investing in Canada or the US, then we can do it direct ourselves, but if we are going to do something in Asia, we look at the best four to five private equity funds there. We have to do that.”

He added that the fund often co-invests alongside the external partner.

About 45 per cent of the fund’s equities allocation is with private-equity partners around the world; OTPP also pays external managers in its hedge fund portfolio.

“You negotiate the best fee arrangement you can without crushing it, otherwise the equilibrium is off.”

Mock would be happy to pay fees to external providers but insists that any partnership structure allows internal staff to benefit from those relationships. If the governance structure of the fund then allows compensation to be “unleashed” he said, “it opens up some interesting future possibilities”.

“When your own staff gets into it and starts to understand it, I would argue, the risk-management capacity in your own organisation goes up,” he explained. “Risk management at the coalface [means] not buying stupid deals, and that’s where your own staff can seriously benefit from [partnerships]. You have to partner.”

OTPP investment innovations:

1992: first Canadian public-sector pension plan to introduce incentive compensation

1994: first pension fund to invest in a sports team – the investment grows over 18 years into a professional sports conglomerate (sold in 2012, earning five times the investment)

1994: first pension fund in Canada to create a long/short portfolio

1997: first pension fund to introduce risk budgeting system for investments

2000: first Canadian pension fund to buy a real-estate company, Cadillac Fairview

2000: first pension plan to post proxy votes on website in advance of annual company meetings

2001: first pension plan to provide a corporate guarantee for real-estate debt

2001: first direct investment in infrastructure and first investment in timberland

 

 

Investment strategy at Finland’s €42.9 billion ($48.1 billion) Varma is shaped by a large hedge fund allocation and a growing risk premia strategy. It’s not a trendy mix but it earned the country’s largest private pension insurance company a return of 4.7 per cent last year.

The Helsinki-based fund combines more than 100 external manager relationships with a 25-strong internal investment team, headed by chief investment officer Reima Rytsölä.

At the end of last year, the portfolio was split between fixed income (30 per cent) equity (44 per cent) real estate (9 per cent) and a 17 per cent allocation to other investments, the bulk of which lay in hedge funds – an uncommon move these days but one that paid off.

In fact, hedge funds have continually proven their worth since Varma launched the portfolio in 2002. Since 2003, hedge funds have returned 6.7 per cent, compared with 5.8 per cent for the overall portfolio. Over a 10-year period, the overall portfolio has returned 4.8 per cent, compared with 5.8 per cent for the hedge fund allocation.

Risk premia

There are a handful of new themes in the works as well. Rytsölä, who joined Varma in 2014 from Finland’s Pohjola Bank, plans to extend risk premia strategies to long-only equities. The fund already uses risk premia as an overlay to traditional cross-asset strategies, he explains.

“Risk premia is a big theme for us and something we have investigated for some time. [However], long-only strategies seem to have a pretty decent risk/reward [ratio] and are fairly cost effective, too.”

He adds that the risk premia strategy will focus on liquid, developed markets.

“The balancing actions required in risk premia investment create a fair [number] of transactions,” he explains. “You don’t want to be in a position where you need to do a lot of transactions when there are large beta spreads, or there is an illiquid market.”

Finnish exposure

Varma’s equity allocation includes a sizeable 35 per cent chunk of the overall portfolio to Finnish equities. Although Rytsölä acknowledges it is a “large proportion”, he counters that the biggest companies trading on Finland’s stock exchange are global businesses, resulting in an ultimately small exposure to Finland. The Finnish equity allocation is actively managed by Varma’s expert internal team.

Add Finnish loans and Finnish real estate in other portfolios and roughly 25 per cent of Varma’s total investments are in Finland – about €10.8 billion ($12.1 billion).

The equity allocation also includes 7 per cent to private equity funds and 2 per cent to unlisted equities through co-investments, bar a few outright holdings, including a Finnish housing company and a forestry group.

The fund’s approach to active management is targeted; for example, Rytsölä has withdrawn from all active management in US equities, “because of the relatively poor performance of external managers” at adding value. Now the fund prioritises “straightforward passive, externally managed US equity portfolios”.

“We work on the basic principle that if the market is inefficient or illiquid, active management, either internal or external, can create value. But you really do need to know the market to add value. That is why we do the Finnish market ourselves. It has illiquid features, so active management makes sense.”

Mulling the current investment climate, Rytsölä is encouraged by opportunities in emerging markets, where he believes key economies are in good position to withstand the tailwinds of US monetary policy.

“Emerging markets will be affected by US monetary policy and whether the Fed tightens more than the markets have anticipated; they are sensitive to dollar liquidity,” he says. “At the moment, it looks fairly good. Emerging market economies are in better shape to take tighter Fed policy than they were in 2013.”

All emerging market allocations are outsourced in active strategies and the fund does not hedge its local currency exposure in emerging markets, although it does hedge its dollar-denominated risk.

Hedge funds

Varma’s hedge fund allocation is about 15 per cent of its assets, in a portfolio designed to create better returns than fixed income but with a lower risk than equities.

“We do realise it is an expensive asset class but the fixed income market is running out of steam and a decent return is difficult,” Rytsölä says. “The credit spreads are so tight and interest rates are so low, the future running yield is not that good.”

Initial investments were in funds-of-hedge funds, but this has since evolved into direct investments with single manager funds; about 90 per cent of Varma’s hedge fund investments are direct, with the remainder in funds of hedge funds.

The portfolio is diversified across several managers and strategies, including macro, statistical arbitrage, event-driven, long-short, opportunistic credit and fixed income arbitrage.

Manager selection and all the 45-odd relationships are run by Varma’s three-strong team. It involves “a lot of travel” to the US and Europe, reflecting the portfolio’s North American and European bias, and global reach.

“It is difficult to capture these kinds of opportunities ourselves,” Rytsölä says.

 

ESG integration

The hedge fund portfolio also stands out for its environmental, social and governance (ESG) integration, where manager governance and transparency have become crucial investment criteria.

Indeed, ESG is another big theme at the fund, which has measured the carbon footprint of its investments and in 2016 published its first climate policy, targeting carbon reduction across asset classes. In that year, the carbon footprint of Varma’s listed equity investments declined by as much as 22 per cent. There were also carbon footprint reductions in corporate bonds (-25 per cent) and real estate (-8 per cent).

This result was achieved by focusing on low-emissions industries and avoiding emissions-intensive industries such as energy and mining. Climate change mitigation is the focal point of Varma’s responsible investment.

Over the next five years, Varma aims to reduce the carbon footprint of listed equity investments by 25 per cent, listed corporate bonds by 15 per cent and real estate by 15 per cent.

The fund is also part of the UN Principles for Responsible Investment working group promoting responsible hedge funds. The group has launched a due diligence questionnaire to help these funds focus on ESG factors.

“Varma’s goal is to actively promote the responsibility of hedge funds through international collaboration,” says Jarkko Matilainen, the fund’s director of hedge funds. “Managers must now pay even greater attention to responsibility aspects.”

The fund recently produced its first integrated annual report and corporate social responsibility report.

“We have done a lot in ESG integration but there is still a lot to do,” Rytsölä says. “It is a step-by-step process.”

A more structured approach to managing risk in its equities exposure has led Danish fund Lønmodtagernes Dyrtidsfond (LD) to introduce four style buckets for equities – from pure beta through to pure alpha – and a dynamic allocation approach that allows movement between the buckets depending on market conditions.

The fund has also partnered with other Danish pension funds – Sampension and the Medical Doctors’ Pension Fund – in an innovative approach to managing fees. In its passive bucket, it has co-invested in mandates that its Danish pension fund peers have already set up. The mandate with Sampension is a targeted index fund that cuts off the smallest 25 per cent of companies in the index. With the Medical Doctors’ fund, the mandate is an emerging market index fund with an environmental, social and governance overlay.

LD is relatively small, with DKK43 billion ($6.5 billion) and collaborating with peers on mandates with external managers is one way it can innovate around fees, chief financial officer Lars Wallberg says.

Collaborating with peers who have gone through the process of mandate design and manager selection allows the fund to reduce costs and time spent on external managers. LD has a clear focus on fees, with a total cost – including administration, management fees and trading fees – of 0.5 per cent of assets.

“Co-investment in passive equities, where we are buying a proportion of the assets, is a very attractive way of investing,” Wallberg says. “We are investing in something that the other pension funds have set up themselves. It’s a win/win; it reduces our costs and we can benefit from the fact our colleagues found the manager and set up the investment guidelines, and we are comfortable the manager is capable. There is no reason for us to set up a fund ourselves. There are significant economies of scale for both of us regarding costs and set up.

“You need to be open and precise as to what your objectives are…Every fund will make their own allocation based on risk profile but there is no reason every fund should invent everything for itself. The risk allocation and monitoring [are] unique to a fund, and should be kept close, but keeping managers to yourself is a losing game. It is more relevant to share knowledge of good managers and spend time on your strategic portfolio.”

In addition, smaller funds benefit from having a collaborator with which to discuss investments.

“We are a very small organisation,” Wallberg says. “In equities, for example, we have only one person monitoring it, so we like collaboration. Our colleagues are more than welcome to invest in our mandates; the firm believes in collaboration.

“For large and growing pension schemes, internal management reduces costs, but for us it is not a strategic opportunity. Ten years ago, we were fully self-managed but identified outsourcing as key. We can be agile in changing allocations, can call managers and reduce or increase mandates at very short notice, and can exit asset classes. It’s easier to call an external manager and reduce by half the mandate. If you had to call internal staff and say to colleagues they’re now managing half the size of the mandate, they would wonder about their jobs.”

 

From active management to a more varied approach

Like the innovation around management fees, the new approach to equities arose out of a focus on risk management within the equities portfolio.

The fund has traditionally emphasised active management but since the beginning of the year the equities portfolio has been separated into four parts: pure beta, beta plus or factor investing, core alpha and special alpha.

Pure beta is in global developed equities as well as the index funds with slightly higher tracking error, where LD co-invests with its Danish pension peers. On top of the pure beta risk bucket, LD has added a beta plus basket, which is a factor investing strategy with a high weight to value, but also a tilt that can be changed. This was also done with Sampension. The core alpha bucket holds the existing active managers within developed and emerging markets. Finally, special alpha is where managers with significant tracking error reside. This includes Danish equities. The fund has reduced its allocation to domestic equities from 25 per cent to 10 per cent over the past few months.

The four new risk buckets allow for a dynamic approach to equities and the exposures to each bucket can be dialled up or down depending on whether alpha or beta is dominating the market. Since the beginning of the year, about 20 per cent of the equities portfolio has changed from active to passive.

“We have seen a quite significant twist in the overall equities portfolio,” Wallberg says. “We reduced the core alpha bucket a lot as well and have increased the beta exposure significantly. We now have about 45 per cent in beta and beta plus, and 55 per cent of equities in the alpha-generating buckets. This is a significant change.

“It allows us to be more precise about when we take a pure beta exposure, when we take factor-based exposure and when we are getting return from fundamental stock selection. We have to have the discipline in ourselves between the mandates. But we hope it will help us achieve our goal of minimising losses in down markets. We can forgo excess return as long as we mitigate losses in down markets.”

Wallberg says LD had previously achieved “quite a lot of excess return” from equities but it had a large tracking error because of the allocation to Danish equities. The first step in this more structured approach to managing the equities exposure was to reduce tracking error and the volatility of the portfolio. The added benefit was to reduce costs.

The next step will be to work on how to manage the individual parts of the portfolio separately.

“We are finding the right risk metrics to identify the action/inflection points to initiate a change in the allocation; this is a work in progress,” Wallberg says.

In the next few weeks, Wallberg will be leaving LD to start a new job as chief executive of Norliv, which is an association with 300,000 members who are all customers of Nordea Life & Pensions.

He’ll be responsible for the association’s endowment, with a portfolio that invests partly in Nordea Life & Pension and partly in discretionary investments. The majority of returns from the fund are distributed to members as a bonus, with 20 per cent going to a charity focusing on mental health for workers and those in early retirement.

Social issues have traditionally been viewed as the weakest link in investment analysis. In many cases, the absence of company data and robust regulation has hampered investors’ ability to assess the risks and opportunities such issues present to their portfolios. While some companies have made efforts to provide good quality disclosures, on the whole, investors have had limited information on which to base decisions.

This is changing. A plethora of new initiatives and engagement activity is driving more meaningful disclosure of data on human rights and labour standards by companies and across supply chains. Policymakers worldwide have a renewed enthusiasm for enacting hard laws and soft guidelines to expand the role and responsibilities of companies when it comes to social issues.

The Principles for Responsible Investment (PRI) recently responded to a government inquiry underway in Australia to determine whether the country should introduce its own Modern Slavery Act, which would complement recent legislation on human rights due diligence introduced elsewhere, such as the California Transparency in Supply Chains Act of 2010, the UK’s Modern Slavery Act 2015 and the European Union’s Non-Financial Reporting Directive. Earlier this year, France adopted its own Corporate Duty of Vigilance law, which requires its largest companies to assess and address adverse impacts on people and the planet, both in direct operations and throughout the supply chain.

Beyond national and state-based legislation are a series of soft laws – norms, standards and frameworks – launched in recent years to promote best practice and stamp out the most egregious violations. These guidelines have included the United Nations Guiding Principles for Business and Human Rights, the Organisation for Economic Co-operation and Development Guidelines for Multinational Enterprises and the International Labor Organization Fundamental Conventions.

More for investors

Such changes are giving investors better data. For example, the Committee on Workers’ Capital recently launched its own Guidelines for the Evaluation of Workers’ Human Rights and Labour Standards, which trade unions have developed to help investors scrutinise social issues such as labour relations in the investment chain. Better metrics on the treatment of workers, employee engagement, training and staff turnover can be strong indicators of the health of a business.

Early evidence suggests both the UK and California laws – which require companies to disclose on their websites the efforts they’re making to address risks of human trafficking and slavery by their suppliers – are providing a wealth of new data and insights to help investors better assess the ‘S’ in their portfolios and inform their engagement and integration strategies, while increasing senior-level corporate engagement, transparency and action on social issues.

More action from investors

Earlier in June, the PRI published a collection of case studies showing how investors are making use of this additional information, putting to rest the notion that investors can’t scrutinise social issues. ESG Integration: How are social issues influencing investment decisions? contains examples from a wide range of sectors – from retail to mining – highlighting methods being used to integrate social issues into listed equity investments.

At the same time, the PRI has facilitated a number of collaborative engagements to improve investors’ understanding of human rights risks and supply-chain labour practices. The findings and outcomes from these projects are captured in the PRI’s From Poor Working conditions to Forced Labour: What’s hidden in your portfolio? and Investor Expectations on Labour Practices in Agricultural Supply Chains.

Matt McAdam is head of Australasia for the PRI.

Asset owners play an important role in advocating for diverse and inclusive workplaces at service providers and the companies they invest in, Bloomberg’s global head of diversity and inclusion, Erika Irish Brown, says.

“Everyone is in search of alpha,” Irish Brown says. “What information are investors leveraging to find that alpha? A lot of big pension funds put out [requests for proposals]. What questions are they asking? Are they asking diversity questions?”

She urges investors to think about the positive impact of diversity on their investments, and cites the way the various networks in a diverse workplace might help generate private-equity deals.

Irish Brown, who has decades of experience working for diversity, including as senior vice-president of diversity and inclusion at Bank of America, says when she first started in such roles, all the data points were anecdotal.

Now there is a huge body of work around the outperformance of companies with women in management and on boards, from organisations with great academic backing, such as McKinsey & Co. and Catalyst. There is also a developing movement around the impact of women’s employment, as exemplified by Womenomics in Japan.

“We have spent so much time on making the business case but now I hope you don’t have to do that,” Irish Brown says, adding that she sees diversity as more as an opportunity for investors.

Irish Brown says Bloomberg has always been an innovative workplace with an open and transparent culture. But the financial services and technology industries, in which Bloomberg operates, have not always been inclusive and diverse in their hiring.

The Bloomberg diversity agenda is coming from the top. Bloomberg chair Peter Grauer has always been deliberate in promoting diversity and making it a business imperative, Irish Brown says. It’s not an HR-driven set of mandates. Each business has a diversity and inclusion business plan and set of goals, and Irish Brown’s team provides resources to help implement those plans.

The only goal Bloomberg states publicly is that its senior leadership will be 30 per cent women by 2020, and Irish Brown says “we are making progress towards that”.

“We also do employee surveys around engagement. It is not just about representation but also career progression, attrition rates and external hires – it’s the whole cycle,” she says.

Diversity and inclusion also have a profound effect on limiting staff turnover, she says, with employees of a diverse and inclusive culture being more highly engaged and productive.

Data that makes a difference

One of Bloomberg’s key business offerings is data, and through data it also aims to drive change in corporations with regard to diversity.

Last year, it introduced the Financial Services Gender-Equality Index (GEI), which measures gender equity in the financial services industry.

The index uses gender statistics to track how companies demonstrate their commitment to diversity and inclusion by promoting women into management. It also factors in company policies and goals set to maintain and improve a diverse working environment and promote women, including initiatives such as gender-neutral family support.

Product offerings, whether companies publicly support women, and an organisations’ commitment to women’s empowerment – including financial resources and opportunities for women clients – also affect the index.

In 2016, the GEI revealed that the percentage of women on boards in financial services firms (at that time it covered only the US but in 2017 its reach became global) was 12 per cent.

The survey also found that the proportion of women who get stuck in middle management in financial services is greater than at S&P 500 companies in general. This is despite the evidence that having more women in leadership roles has a positive impact on performance metrics and share price.

“In general, financial services companies recognise they need to improve diversity and are putting resources behind it,” Irish Brown says, adding most now have chief diversity officers.

“Through diversity and inclusion, you can attract the top talent, have better decision-making, and create a culture of innovation. As a technology and media company, that is important for us. It also helps us deepen our relationships with clients and become a connector of people and ideas.”

Innovation comes naturally from diversity

Irish Brown says having debate is an important part of innovation, and the fact that diversity is not easy means debate comes naturally. This means innovative cultures are a natural by-product of diverse and inclusive workplaces.

“If everybody’s perspective is from the same education and the problem solving is the same, then you won’t have the discourse and debate,” she says. “When you’re challenging the status quo and the most common approach, ultimately you are able to innovate. Disruption leads to innovation, and diversity is supposed to be disruptive.

“For example, in a 100-year-old bank, the leadership pipeline has existed for a long time and people hire in their own image. Most people are averse to change and that has nothing to do with whether they are a good or bad person. It’s a little more difficult or time-consuming to create that disruption in a way that doesn’t create big backlash or become counter-cultural,” she explains. “But when people experience it, and when they are introduced to a new pool of talent, there’s enthusiasm. It is very much experience based. You have to be a courageous leader.”

Diversity is not enough on its own, however, she says. It’s important that the culture can deal with the diversity and be inclusive.

“You need to be prepared to acknowledge that diverse teams are harder to manage,” she says, adding that diversity, which goes way beyond gender and is embedded in Bloomberg’s business, so that it affects its products. The company scored a perfect 100 per cent score in the 2017 Corporate Equality Index, which is a US-based report that benchmarks corporate policies and practices around workplace equality for lesbian, gay, bisexual and transgender people.

“We have enhanced our offerings for people with disabilities; for example, the screen colour changes, for those who are colour blind. We look at it from a product point of view,” Irish Brown says. “Bloomberg journalists will ask everyone on air about diversity and inclusion, even if they are there to talk about another issue. It is the intent of our people to run with it and engage with it as a business imperative.”

On Wednesday May 17, Bloomberg lit up its offices with giant rainbow lighting to celebrate International Day Against Homophobia, Transphobia and Biophbia. This photo was taken at Bloomberg’s Australian office at One Bligh St.

Left to right: Erika Irish Brown, global head of diversity and inclusion, Bloomberg; Dawn Hough, Director, ACON; Emily Gordon, head of Australia and New Zealand, Bloomberg.