MSCI’s long-awaited decision to include China’s A shares in its Emerging Markets and All Country World indices will affect more than $1.6 trillion in funds that track the MSCI Emerging Markets Index.

One large institutional investor, who has had a long-term commitment to onshore Chinese assets, says that although the Chinese economy faces serious issues, it has achieved a scale that makes its eventual integration into global financial markets a foregone conclusion.

“This should be a significant stepping stone to the real prize – inclusion into major global fixed income indices,” the investor says. “Foreign inflows in the onshore Chinese government bond market have the potential to counterbalance domestic capital outflows, which would improve onshore financial stability.”

MSCI is including 222 China A large-cap stocks, which will make up about 0.73 per cent of its Emerging Markets Index.

Remy Briand, MSCI managing director and chair of the MSCI index policy committee, says the expansion of the Shanghai-Hong Kong Stock Connect program has been a game changer for the accessibility of China A shares and contributed to inclusion’s approval.

Before making the decision, MSCI conducted an extensive consultation that included a large number of asset owners, asset managers, brokers and other market participants.

“International investors have embraced the positive changes in the accessibility of the China A shares market over the last few years and now all conditions are set for MSCI to proceed with the first step of the inclusion,” Briand says. “MSCI will reflect a higher representation of China A shares in the MSCI Emerging Markets Index when there is further alignment with international market accessibility standards, sustained accessibility within Stock Connect is proven, and international institutional investors gain further experience in the market. MSCI is very hopeful that the momentum of positive change witnessed in China over the past years will continue to accelerate.”

MSCI said in a statement: “This decision has broad support from international institutional investors with whom MSCI consulted, primarily as a result of the positive impact on the accessibility of the China A market of both the Stock Connect program and the loosening by the local Chinese stock exchanges of pre-approval requirements that can restrict the creation of index-linked investment vehicles globally.”

Combined, the Shanghai and Shenzhen exchanges make up the second-largest sharemarket in the world, after the US, but China represents only about 1 to 2 per cent of the world’s stock indices. The country generally is under-represented in investors’ portfolios.

In the last couple of years, the inclusion of China A shares has been delayed, due in part to investors’ concerns about the liquidity and replication risk that may result from potential renewed voluntary suspensions in trading of mainland Chinese companies on the local stock exchanges.

MSCI says international institutional investors welcome the expansion of Stock Connect and view it as a more flexible access framework than the current QFII and RQFII regimes. They also welcome the decrease in the number of suspended China A shares, but still consider the number high, compared with other markets. Investors encouraged Chinese authorities and exchanges to consider additional measures to address the issue.

During the consultation, the vast majority of institutional investors approved the proposal to include large-cap shares that are not in trading suspension. Many also recommended that MSCI include China A large-cap shares of companies that already have in the MSCI China Index equivalent shares trading in Hong Kong. Doing so meant an increase from the original 169 China A shares to 222.

Last year, when MSCI delayed China’s inclusion in the Emerging Market Index, Briand said investors had indicated they wanted further improvements in accessibility. This included the ability to move funds in and out of China and clarity on stock suspensions.

MSCI will launch its China A International Large-cap Provisional Index today, followed by additional global and regional provisional indices, including the China and Emerging Markets Provisional indices, in August 2017.

The $140 billion Teacher Retirement System of Texas is working successfully with its hedge fund managers on a new compensation structure that promises to “radically realign” the fees the fund pays. Speaking at his last TRS board meeting, departing chief investment officer Britt Harris explained that TRS hedge fund managers are taking up the so-called 1-or-30 model.

Under the model, TRS pays hedge fund performance fees only after managers meet an agreed upon hurdle rate. Managers can earn whichever is greater – either a 1 per cent management fee or a 30 per cent cut of the alpha or performance after benchmark.

“We get at least 70 per cent of the alpha, gross, after a hurdle rate; we’ve approached 22 managers and 17 or 18 are on board,” said Harris, who is leaving to become CIO of the $40 billion University of Texas Investment Management Company, UTIMCO, also based in Austin, Texas.

Under the model, in years when the fund underperforms, the management fee gets paid back to investors from the following year’s performance fees.

It’s a switch from the industry practice of charging investors 2 per cent of assets and 20 per cent of profits. Given TRS’s respected status among peers, it could set a precedent. Indeed, the fund has pledged to “lead the industry in improving terms for better alignment in a low-return environment”.

Hedge funds will have a place

Investors withdrew $106 billion from the $3 trillion hedge fund industry last year, in the largest annual outflows since 2009, data provider eVestment states. Yet Harris, who briefly served as chief executive at hedge fund giant Bridgewater Associates – of which TRS bought a minority stake in 2012 – believes hedge funds still make up an important part of the TRS portfolio when markets get more challenging.

“We haven’t needed hedge funds,” he said. “The market has gone pretty much straight up for eight years and, in general, hedge funds haven’t performed that well. There will come a time when we will need hedge funds, when markets go in the other direction. But right now, hedge funds are losing assets and are open to better compensation structures. We are collaborating with them to make sure that happens.”

The HFRI Fund of Funds Composite Index returned 3.2 per cent over the last five years, trailing the 7 per cent to 8 per cent return most US pension funds target. However, Harris does note that some strategies have performed well in the tougher climate, like event-driven and restructuring funds, both of which have “shot forward”.

TRS has been investing in hedge funds since 2001, deploying capital to AQR Capital Management, Fir Tree, GoldenTree Asset Management, MKP Capital Management and PDT Partners, among others. The fund has $10.6 billion in hedge fund investments, accounting for 8.3 per cent of its total assets, and paid $203.5 million in management and performance fees to them, directly or indirectly, in the fiscal year to August 2016.

Focus on fees across the fund

At the trustee meeting, Harris and his team touched on ways to improve the monitoring of fees, relative to alpha generation, across the fund. The fund has previously pledged to customise all its investment strategies where appropriate, to better reflect TRS’s needs than off-the-shelf products could. Harris also noted in his presentation the success of co-investment and principle investing at driving down fees.

“We have $11 billion in principle investments in private equity and real estate,” he said. “Both those portfolios have performed at or above the peer benchmark. On the private-equity side, there are essentially no fees, and on the real-estate side it is a significantly reduced fee.”

Harris leaves the fund in robust financial health after 11 years as chief investment officer.

TRS told its trustees of strong first-quarter results, with investment earnings at “a pretty remarkable” $6 billion for the first three months of 2017, equating to a 5 per cent return for the fund. Performance has been driven particularly by the emerging market equity allocation, where MSCI benchmark returns have come in at 11.4 per cent for the first quarter of 2017. TRS has $14 billion of exposure to emerging markets, or 10 per cent of fund assets.

TRS’s investment team also attributed the strong results so far to “asset allocation positioning”. Namely, being underweight US Treasuries in the stable value portfolio and, therefore, avoiding their relatively poor performance. Strong returns in the high-end core real-estate portfolio also pushed the result northwards, although Harris’s investment team now expects that asset class to slacken off.

“The expected return for real estate has gone from high towards low,” said Harris, who joined TRS when the pension fund was valued at $100 billion. Shortly after his arrival, that value dropped to $67 billion, due to being ravaged by the 2007-08 financial crisis. Today, he leaves with assets under management doubled from that time.

Harris also attributes the strong returns to historically low volatility.

“Market conditions, the volatility of individual asset classes and the correlation between asset classes has allowed us, and other people, to generate these returns at half the risk over this period of time. This will not last.”

TRS’s fund is divided between a global equity portfolio that accounts for 58.7 per cent of assets and a stable value portfolio accounting for 16.5 per cent of assets, half of which is an allocation to US Treasuries. Real return accounts for 19.8 per cent of assets, comprising real estate and other inflation-hedging holdings; while risk parity accounts for 5 per cent of assets under management.

During the two years to the end of December 2016, Japan’s Government Pension Investment Fund, the biggest investor in the world, decreased its domestic bonds exposure by 10 per cent, re-allocating the assets to domestic and international equities.

This has been a relatively quick move away from bonds, considering the extent of GPIF’s bond portfolio and the size of the fund. At the end of 2008, the fund had more than 75 per cent of its assets in domestic bonds, with only 6.6 per cent in international equities and 9.4 per cent in domestic equities.

Since December 2014, domestic equities have increased by 4 percentage points, to 23.76 per cent, at the end of December 2016, and international equities have increased by 3.5 percentage points, to 23.16 per cent of the fund.

The fund has $1.3 trillion in assets. It now invests in more than 2120 listed Japanese equities; the largest holding, by dollar investment, is Toyota, at 188,430,900 shares.

Globally, GPIF has holdings in 2596 companies, with the largest including Microsoft, Verizon, Johnson & Johnson, Exxon Mobil, Facebook, GE, Nestle, Wells Fargo, and Procter and Gamble.

As the fund has increased its allocation to equities, it has also become interested in stewardship. This month, it asked all of its external asset managers to disclose the details of their proxy voting records on behalf of GPIF.

In a statement, GPIF president Norihiro Takahashi, said: “GPIF believes that disclosure of the details of proxy voting records is very much essential for institutional investors to fulfil own stewardship responsibilities in order to deepen corporate governance reform and move its focus from ‘form’ to ‘substance’ as Japan’s Stewardship Code indicates. GPIF shall continue to enhance the mid- to long-term investment returns for our beneficiaries through improvement of corporate value and fostering sustainable growth of investee companies.”

As previously reported, in 2016, all of the fund’s external asset managers exercised their voting rights.

GPIF uses managers rather than investing directly, because its size makes it too influential. It generally limits a stock owning to 7 per cent. The fund has previously stated that its external managers with poor governance will get a smaller part of the cheque.

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.”