A G20 group, chaired by Michael Bloomberg, has released its final recommendations for company disclosure of corporate climate risk, shifting the onus for reporting from the sustainability department to the boardroom.

The Financial Stability Board (FSB) Task Force on Climate-related Financial Disclosures (TCFD) calls for increased governance that will bring climate change onto the board agenda.

The 32-member task force, which includes Jane Ambachtsheer of Mercer and Eloy Lindeijer of PGGM, calls for climate-related information to be integrated into the mainstream financial reports of companies. This would make climate risk a key corporate agenda item and would allow information to be accessed in a consistent and comparable way.

The TCFD structured its report around four areas: governance, strategy, risk management, and metrics and targets. The group’s other recommendations include disclosures that would help investors understand how their investee companies assess climate-related risks and opportunities.

Investors and the companies in which they invest need to consider their long-term strategies and the efficient allocation of capital, the TCFD states.

“Organisations that invest in activities that may not be viable in the longer term may be less resilient [during] the transition to a lower-carbon economy; and their investors will likely experience lower returns,” the report states. “Compounding the effect on longer-term returns is the risk that present valuations do not adequately factor in climate-related risks because of insufficient information. As such, long-term investors need adequate information on how organisations are preparing for a lower-carbon economy.”

The TCFD was launched by Michael Bloomberg and Mark Carney, chair of the FSB, at the COP21 climate conference in 2015.

The climate research provider institutional investors use, CDP, has committed to adopting and implementing the report’s recommendations across all sectors. In 2016, nearly 6000 companies disclosed environmental data through CDP.

CDP says addressing climate risk is a path to outperformance, with companies on its “climate A list” outperforming the market by 6 per cent over four years. Jane Stevensen, engagement director at the research provider, says mainstreaming corporate climate risk information is a key recommendation of the report.

“Despite broad recognition that issues related to climate change represent major risks to companies around the world, disclosure about those risks has been lacking. Making this a board responsibility will change that,” she says.

The recommendations will be fully incorporated into CDP’s platforms for the disclosure cycle of 2018, so businesses disclosing through the research provider can be assured they are adhering to the TCFD’s guidelines.

CDP will continue to work with investors and companies to ensure market adoption of the TCFD recommendations and support mandating disclosure over time.

“We are strong advocates of mandating and enforcing universal company disclosure to obtain consistent, comparable and high-quality information [from] companies who resist voluntary norms,” Stevensen says. “We believe policy intervention is necessary to drive the cultural behaviours and action required. This should be taken into account by the governments of the G20 as they consider how to respond to the TCFD’s recommendations.”

Chair of the the Institutional Investor Group on Climate Change (IIGC), and chief executive of PKA, Peter Damgaard Jensen, said greater climate-related financial disclosure is crucial to secure more complete, meaningful, reliable and consistent data across all companies and sectors.

“Given their importance at the top of the investment supply chain, large asset owners and asset managers also recognise they have an important role to play in driving the swift and widespread adoption of this framework,” he said.

IIGCC is a forum representing 138 large investors across 11 countries with more than $21 trillion in assets.

A premium for long-horizon investing has been quantified for the first time. A study from the Thinking Ahead Institute’s long-horizon investing working group puts a figure on the value add of eight building blocks of long-horizon investing and highlights the importance of governance in harvesting that premium.

The group’s study report, The search for a long-term premium, states that there is a net premium available by accessing return opportunities and limiting the drag on returns. The five strategies that provide opportunities for long-horizon investors are active ownership and investing in long-term oriented companies, liquidity provision, capturing systematic mispricing, illiquidity premium and thematic investing. The three that lead to lower costs are avoiding buying high and selling low, avoiding forced sales, and lowering transaction costs.

The report argues that depending on an investor’s size and governance arrangements, a premium of between 0.5 per cent and 1.5 per cent a year is available via these building blocks.

Tim Hodgson, head of the Thinking Ahead Group 2.0 at Willis Towers Watson and co-author of the report, says the premium exists but is hard to achieve.

“The key reason investors are not harvesting the long-term premium is because their governance is not up to it,” Hodgson says. “It requires a change in mindset and skill set.”

Worth the costs

For most investors, there will be some incremental governance costs required to implement these eight strategies. The group identified these costs as 15 basis points for a smaller asset owner and about 8 basis points for larger owners. However, the return gain for these actions is larger – estimated at 65 basis points for smaller asset owners and 161 basis points for larger owners.

“Asset owners will need to spend money, but it’s more than worth it,” Hodgson says. “This paper needs to survive public scrutiny so we have been cautious in our assumptions. If it becomes generally accepted there’s a long-term premium, then any investor with a fiduciary duty will have to consider it.”

The paper outlines the actions and costs of two funds – a small fund and a large one – in harvesting the eight building blocks of long-term value creation.
The smaller fund’s focus was on avoiding costs and mistakes; for example, by reducing manager turnover, avoiding chasing performance and forced sales, and moving some of the passive exposure to smart beta.

The example of the larger fund shows the advantage of having the governance and financial resources to consider all available options for capturing the premiums, including active ownership, investments in thematic exposures and setting aside cash to exploit forced selling.

The paper raises a number of questions regarding how investors would access the building blocks of value creation, and the working group will release a second paper outlining what investors require to implement them. This second paper will also include an examination of the beliefs needed to adopt this strategy.

Hodgson says some of the negatives that have a drag on returns, such as high turnover of managers and excessive costs, are explained in part by behavioural aspects.

The group deliberately does not define what “long horizon” or “long term” is, but it does attempt to say what it is not.

“It’s not having a minimum holding period, it’s not buy and hold; you’re allowed to sell,” Hodgson explains. “My personal definition is a long ‘look-up’ window, so for any decision an investor is making today, they should ask, ‘How will this pan out in 10 years?’ ”

The paper can be accessed here

The-search-for-a-long-term-premium

Sampension, the DKK290 billion ($43.5 billion) Danish labour market pension fund, is re-negotiating terms with its alternative managers in a push for more investment control. It is a strategy encapsulated in the fund’s forestry allocation, where slim returns are pushing chief investment officer Henrik Larsen to reconsider costs and manager relationships, in a process he has already applied to other alternative allocations.

Most timberland funds tend to be closed-end funds with a forced turnover and high transaction costs, Larsen says.

“We are now looking for structures that are more open-ended and give us some control over the portfolio. We give up control if we choose a traditional closed-end fund,” he says.

It underscores a trend at the fund to commit larger sums to alternative investments more tailor-made to fit the portfolio, as Larsen seeks to get closer to the investment process and have more influence.

“We are changing the way with work with funds in the alternative space. Increasingly, we put up the term sheet and discuss issues around structures and segregated accounts, looking at where we can have more influence, concentrate the risk and commit more capital. We’ve done this in US real estate and European commercial real estate debt already. We are now looking to do it in timberland, high-yield bonds and leveraged loans. We want two things: more influence on the investment and more control over our costs.”

Sampension offers three main products. One is a closed, defined benefit fund with a low risk capacity, where strategy is oriented towards fixed income, with only 7 per cent invested in listed equity. Another is a smaller fund that reinsures Danish municipalities’ statutory-linked pension obligations for civil servants, again in low-risk strategies structured to hedge against inflation with allocations to inflation-linked bonds and commodities. But it is Sampension’s third offering – a fast-growing unguaranteed lifecycle fund – that has the most risk capacity and has become, in Larson’s words, its flagship fund.

“This is a lifecycle product, so we invest more aggressively for the younger members and conservatively for those who are older and in receipt of a pension,” he says. “Our strategy is a reflection of the risk appetite and age composition of our members.”

In the lifecycle fund, assets are divided between: listed equity (36 per cent); bonds with low credit risk, including euro-denominated government bonds and other investment-grade and covered bonds (32 per cent); illiquid assets including real estate, timber, private equity and infrastructure (22 per cent); and riskier, high-yield bonds (10 per cent).

Illiquid tilts

Rock-bottom bond yields and the risk of capital losses from rising interest rates have led Larsen to oversee a tilt in the allocation away from bonds toward more illiquid assets. He’s found a particularly rich seam in Danish social housing.

“Danish rental housing under rent control is illiquid, but the cash flows are very secure. Rental income is lower than free-market levels but there are long waiting lists for flats and a very low risk of any lapse in rental income. It is a good substitution for bond risk if you can live with the illiquidity.”

It’s an illiquid exposure that Larsen plans to build going forward.

“We have no problem coping with more illiquid exposures in our portfolio. The only problem is finding suitable assets; this is what has kept us from building up this exposure even more.”

This leads the conversation back to forestry, where Sampension has built up a sizeable allocation in the US, begun in 2002, and emerging markets. However, he warns that this allocation is not always as straightforward as it seems.

“We don’t hold any Danish forestry assets because it is too expensive, and forestry isn’t as low risk as housing because the risk varies according to different geographies,” he says.

The forestry allocation has also disappointed since the financial crisis because of the ensuing slump in the housing market, its knock-on effect on timber demand, and the broader slump in commodity values.

“Forestry has seen a fairly dismal return for the last 10 years but it is a good structural asset to hold and returns will be higher going forward.”

Equity

Sampension’s unguaranteed fund has three distinct elements to its listed equity allocation. Three-quarters of the portfolio is in a low-cost, global core allocation that is indexed, or running close to the index allowing for some tracking error. Rather than being cap-weighted, the portfolio has factor tilts towards value, low volatility and small-cap shares.

“These are all traditional factors that we hope will give us extra return,” Larsen says.

A second, active equity allocation within the fund is focused on emerging markets and Danish equities, where Larsen doesn’t believe an index strategy would work.

“Emerging markets and the local Danish market are both very concentrated markets with a few large issues; neither of these markets has a very liquid futures market either.”

Of the listed equity allocation, 10 per cent is invested in Danish companies, far beyond any allocation to the Danish listed market in a cap-weighted portfolio.

Smaller but riskier is the third part of the fund’s listed equity allocation. It’s invested in an active neutral hedge fund. Larsen likes this strategy because it makes it easy to ensure money is spent only on active managers who deliver alpha.

“The idea is to separate our core index-linked exposure from a pure alpha exposure for more control. It makes it easier to measure costs, and the value of active management, if you are in a market-neutral equity hedge fund, rather than a blended traditional mandate.”

He adds that it is an allocation he would like to build.

“When we made the decision in 2009 to split our equity allocation into pure beta index-linked and pure alpha, we envisaged that by now the alpha part would be larger. We have been conservative because we haven’t yet been convinced of the capabilities of the alpha products out there. We would take on a larger part if we could find more talent.”

Costs     

With a large, internally managed fixed income allocation and a large, low-cost equity allocation, Larsen is able to keep a tight lid on management costs. Fees at the fund, including indirect costs from carried interest and transaction fees, come in at 43 basis points, on aggregate.

“Investing more in illiquid assets and alternatives will have a tendency to make our investment costs go up; however, we are negotiating for lower fees in these assets. We are also doing more internally, and making more direct investments and co-investments where we can aggressively negotiate on fees…We are open to offers from potential asset managers and this gives us leeway in negotiating fees.”

He observes that managers are still essential when it comes to ensuring diversification, namely by investing further afield in different asset classes and geographies.

“Diversification means external management,” he asserts.

Moreover, searching for direct and co-investment opportunities internally is demanding. Sampension has increased its internal headcount to 30, most of whom are focused on alternatives, particularly real estate. The fund uses six managers in listed equity, four of which run the active allocations, one the index portfolio and one the hedge fund. In alternatives, Sampension invests in more than 100 funds but some managers handle more than one of those funds.

 

 

Having recently concluded an asset liability review that lasted several months, I recommended to our board that the current policy allocation be retained without changes. Our consultant concurred and the board agreed. During my 25 years in this business, this is the first time I can recall that the asset allocation remained unchanged following the periodic review.

There is always a temptation to make changes to produce a new and improved asset allocation, even though the benefit may be negligible or marginal at best. In fact, in my prior assignment at CalPERS, we found that retaining the 1993 policy through 2010 would have produced a higher return and lower risk than the actual policy, with all the changes, during that period.

Our goals for the recent asset allocation review were as follows:

  1. Increase the risk diversification of the portfolio
  2. Increase the yield component of the returns
  3. Reduce costs
  4. Reduce the downside risk to the funding ratio
  5. Avoid unnecessary complexity.

While we knew it would be difficult to achieve all five, we wanted to accomplish as many as possible.

Weighing the pros and cons

The School Employees Retirement System of Ohio is a $12.5 billion defined benefit public pension fund. The level of risk in our portfolio, as measured by standard deviation within the mean variance framework, seemed appropriate for the long-term funding goals. However, in the current environment, the expected return at this risk level is lower than the fund’s actuarial interest rate. Increasing the risk of the portfolio to reach for a higher return was not prudent, as it also would have increased the downside risk to the funding ratio. Lowering the risk was not an option either, as even lower expected returns would diminish funding progress. Therefore, staying at the current risk level seemed appropriate.

Next, we asked whether a mix of alternative assets could produce a higher expected return at the preferred risk level. Our consultant generated some alternatives with higher returns, between 10 and 30 basis points, with marginal increases in the Sharpe ratios.

To generate this higher return, the consultant included niche assets such as high-yield bonds, emerging-market debt and master limited partnerships with highly constrained allocations to each. In the end, the higher return and higher yield came with higher complexity and less risk diversification, as these assets are all equity-like in their risk characteristics. Also, we didn’t believe they would play a distinctive enough role in the portfolio to qualify as a strategic asset class. We do have exposure to these investments within broader asset classes, but not as a policy allocation.

Because the return assumption has the greatest margin for error, our conviction on these marginal return increases was low. We have higher conviction in the volatility estimate than the return estimate. Deploying new money into these assets at current high valuations in this late-cycle phase was too risky. So aiming for the marginal increase in returns was not worthwhile.

There are two risk-diversifying assets in our mix: fixed income and hedge funds. Hedge funds are a part of our Multi Asset Strategies (MAS) portfolio. Fixed income and MAS have risk contributions that are lower than their weights in the portfolio. All the other assets – public equities, private equity and real assets – are growth oriented, have risk characteristics similar to equities, and have risk contributions that are higher than their weight in the portfolio.

Increasing the fixed income allocation in this environment of rising rates and low expected returns was not promising. Another option was to reduce the 10 per cent allocation to MAS because of its higher fees, but the downside was that we would lose its risk-diversification benefits. In addition, the MAS portfolio has higher net returns than fixed income, with similar volatility. Retaining the MAS allocation improved the efficiency of the portfolio.

Same allocation policy, better efficiency

After assessing all of this information, we decided to keep our existing asset allocation for now. We’ll continue to review it annually; however, we believe we can try to achieve some of our goals by improving the efficiency of the structures within the strategic asset classes.

We are continuing to realign our MAS portfolio by including low-fee options, such as dynamic risk parity and specific liquid alts, without reducing its diversification benefit. Fees are now 1.4 per cent and 17 per cent for the MAS portfolio and we believe we can go lower. We have modified our fixed income structure to include a separate US Treasuries portfolio that can serve as a risk hedge in a market downturn. Allocations to private credit as an opportunistic strategy outside of our policy portfolio also have produced a higher yield than traditional bonds.

I believe we are achieving some of our goals without changing the allocation policy, through better portfolio construction. In this process, we are focusing on defining the role of each strategic asset class in the total fund and aligning the structure with the role. For example, MAS is meant to be a risk diversifier and to generate higher returns than fixed income with similar or lower risk. Our ultimate goal is to refine portfolio construction and management to deliver enhancements when the policy asset allocation may have reached an optimal plateau.

Farouki Majeed is the chief investment officer of the School Employees Retirement System of Ohio.

“Absolute size, by itself, is no indicator of success and achievement, let alone of managerial competence. Being the right size is.” – Peter Drucker, author and management consultant.

 

What is the right size for an investment fund’s internal staff? What are the drivers behind the size of a fund’s front-office operations, responsible for day-to-day investment activities? How big should back-office functions – responsible for governance, operation and support – be in relation to the front office?

To answer such questions, and gain insights into the investment operations of large global funds, CEM Benchmarking undertook a study in 2016 of 26 such organisations with total assets in excess of $2.7 trillion. CEM looked at the full-time equivalent (FTE) headcounts of both front- and back-office staff. The study’s findings confirmed that staffing levels are a poor predictor of total fund cost once external management expenses are included. Further, while our clients often express a belief that the back office should have staffing levels similar to the front office (roughly a 1 to 1 ratio), the findings showed this rule of thumb is, at the very least, overly simplistic and in many cases not useful at all.

For front-office operations, the number of FTE primarily depends on:

Asset size – the more assets funds have, the more front-office FTE they have

Asset mix – the more illiquid assets funds have, the more front-office FTE they have

Implementation style – the more internal management funds have, the more front-office FTE they have.

Within this framework, strong relationships can be seen, and close to 90 per cent of the variation in front-office FTE is explainable through a combination of these factors.

To illustrate the utility of the model, compare the FTE intensity of external active public equity to that of internal private equity. For internal private equity, one FTE would be expected to oversee about $0.2 billion in assets as opposed to about $2.5 billion for external active equity, a 12-fold difference (and this is before considering differences in economies of scale between asset classes, which can be profound).  However, the cost of internal private equity is lower than for external active shares, showing that having fewer staff members does not translate into cost savings.

Front office predicts back office, with some caveats

The survey did show a robust relationship between the size of the back office and the front office. However, the ratio was close to 2.5 to 1, rather than the often-cited 1 to 1. This single figure hides important findings:

There is a base level of back-office FTE required, regardless of the size of a fund’s assets under management

This base level varies dramatically based on fund complexity and the number of functions a fund chooses to do in house. For funds of lower complexity, the base level is about 20 FTE. For complex funds with most back-office functions performed in house, this number grows to 240 FTE

Once this base level has been realised, about 1.2 back-office FTE is required for each additional front-office FTE, regardless of fund complexity and in absence of any changes to the investment program.

Funds with complex investment programs generally exhibited much higher FTE counts than would be expected based solely on their amount of assets. This increased FTE is a poor indicator of cost-effectiveness because:

The largest cost for most investment funds is external manager fees, with the cost of internal FTEs being relatively immaterial

Performing back-office activities in-house is often more cost-effective than outsourcing.

These more complex funds exhibited elevated headcounts across all back-office functions; however, the increase in information technology support was responsible for more than half of the increase. Based on the data (see charts below), it appears there may be a tipping point at which organisations feel it becomes cost-effective to in-source many back-office functions.

The more complex organisations cited several reasons for insourcing back-office functions, including:

Ability to run more robust and customised risk monitoring

Running complex derivatives programs involving a large number of over-the-counter derivatives.

Economies of scale vary by asset class

Another area of interest was economies of scale in the front office. While these were evident, they varied greatly by asset class:

Strong economies of scale were present in the management of indexed public assets, whether they were managed internally or externally

Weaker economies of scale for actively managed public assets, particularly internally managed active fixed income, for which economies were not significant

No economies of scale in the management of real estate or private equity, regardless of whether these assets were managed internally or externally.

Ultimately, asset size, asset mix and implementation style drive front-office FTE. Back-office FTE is driven by front-office FTE, but with important distinctions for larger, more complex funds, which have much higher staffing levels, relative to asset base, than smaller funds. That these higher staffing levels do not result in higher overall costs reflects the fact external management fees remain the biggest cost driver for most funds.

The findings of this study are of interest to funds that want to:

Plan for growth – how your FTE will grow as your assets under management increase

Prepare for change – determining how many FTE you will need to move into new asset classes or change implementation styles

Understand differences – why some organisations have more or less FTE than others.

 

Michael Reid is vice-president, relationship management, at CEM Benchmarking. Alexander Beath is a CEM senior research analyst.

 

The California Public Employees’ Retirement System has defined its 10-year capital market assumptions, which are the essential input for its four-yearly asset liability modelling (ALM) and, ultimately, for the asset allocation in its reference portfolio.

Determining the capital market assumptions is the first item in a six-step process CalPERS uses to set its policy portfolio in ALM workshops.

This year’s assumptions, which the internal staff presented to the board, showed much lower expected returns and higher expected volatility for CalPERS’ strategic investment classes than those developed for 2013.

As a result, one of the fund’s consultants, Pension Consulting Alliance, advised that “these latest inputs will very likely translate into lower long-term expected compound returns for the range of strategic portfolio options the investment committee will consider during the 2017 ALM process”.

The capital market assumptions the CalPERS internal team proposed, after input from its consultants and other players in the industry are:

Asset class                  compound return (%)           volatility (% standard deviation)

Global equity              6.8                                           17

Private equity              8.3                                           25.5

Fixed income              3                                              6.6

Real assets                   5.8                                          12.6

Inflation                      2.8                                           8

Liquidity                     2                                              1

 

The return estimates the $323 billion fund derived were modest compared with some others in the industry. For example, in private equity, its return estimate of 8.3 per cent is significantly below the projected return assumption of its private-equity consultant, Meketa, which forecasts 9.6 per cent. This is primarily because CalPERS has a lower expected return for global equity than Meketa. Both expect a premium for private equity above global equity of about 1.4 or 1.5 per cent.

All asset assumptions are based on inflation and a real risk-free rate, with assets then divided into three categories – low, medium or high risk premium.

Input from one of CalPERS’ other consultants, Wilshire, shows return prospects across all asset classes have been declining for decades, following the downward trend in interest rates. Core fixed income remains low, and the risk premium for every other asset class is anchored to fixed income.

Once the capital market assumptions have been agreed upon, the process for developing a new strategic asset allocation will begin. As at June 30, 2016, CalPERS asset allocation was:

 

Public equity               51.1%

Income                        20.3%

Real estate                   9.3%

Private equity              8.9%

Inflation                      6.0%

Liquidity                     1.5%

Infrastructure              0.9%

Forestland                   0.7%