In long-horizon investing, ‘lock-up’ is a term that attracts much attention and debate. In theory, it would give asset managers a stable capital base for effectively pursuing their long-term strategy without worrying about being forced to sell by redemptions.

This is particularly important given the fact that some of the best returns can be made in times of market distress, which is when asset owners often seek to redeem investments. However, for various reasons, many owners are reluctant to commit to locking up capital (particularly in long-only public markets).

In this article, I review open-end and closed-end structures in the context of some findings from academic research.

Intuitively, in an open-end structure, provision of liquidity to investors (redemption) can have a negative impact on returns; for example, in fire sales that price assets below fair value to meet redemption calls. The empirical evidence clearly lends support to this argument. Roger Edelen, from the Wharton School of Business, in his paper “Investor flows and the assessed performance of open-end mutual funds”, built a sample of 166 open-end mutual funds and concluded that liquidity-driven trading in response to flows has reduced returns of US open-ended mutual funds by 1.5 per cent to 2.0 per cent per year from 1985 to1990.

In a separate study, the US Securities and Exchange Commission’s Woodrow Johnson constructed a proprietary database that includes a panel of all shareholder transactions (just under a million, on 50,000 stocks) within 10 funds in one mutual fund family between 1994 and 2000 in the US. His findings are similar to Edelen’s: the cost of open-endedness is about 1.1 per cent a year.

Johnson further suggested that under the current structure (i.e., no pricing differentiation with regards to trading frequency), long-term shareholders who have relatively small liquidity demand are, in effect, subsiding short-term shareholders who access liquidity. In my mind, this raises the question of whether open-end structures in their current form are fit-for-purpose for long-horizon investors.

It’s not that simple

Now we might be tempted to conclude that – everything else being equal – closed-end funds should, in theory, outperform because they can avoid being forced sellers. Well, unfortunately, not everything is equal here. The lack of monitoring and alignment (in the absence of the threat of redemption) can lead to serious agency costs and underperformance for closed-end funds. Barclay et al found that the greater the managerial stock ownership in closed-end funds, the larger the discounts to net asset value. The average discount for funds with blockholders (shareholders who own 5 per cent or more of the fund’s common stock) is 14 per cent, whereas the average discount for funds without blockholders is only 4 per cent.

Researchers attributed the agency costs to blockholders extracting private benefits – such as receiving compensation as an employee – and blockholders owning companies receiving fees for service to the fund, as examples.

Both structures can succeed

As with many situations in investment, there doesn’t seem to be a universally agreed upon winner of this debate. Both structures could potentially add value and both structures could destroy it if ill-executed. If asset owners can manage to get themselves over the line about the concept of lock-up, and a proper monitoring mechanism is in place, closed-end funds do seem to give managers the highest degree of freedom to turn their skill into better returns.

On the other hand, an alternative to requiring lock-up could be looking for ways of avoiding the cross-subsidy between flighty investors and committed long-term investors, along with providing a better and deeper articulation to asset owners of how long-term strategies should be assessed and measured. This could include a clear articulation of the underlying long-term investment thesis and specification of when the strategy is likely to underperform.

With that, when short-term underperformance inevitably comes around, asset owners are more likely to stay on course as long as the underlying investment thesis remains intact.

 

Liang Yin is senior investment consultant in the Thinking Ahead Group, an independent research team at Willis Towers Watson and executive to the Thinking Ahead Institute.

The University of Toronto Asset Management Corporation (UTAM) manages the institution’s C$8.8 billion ($6.5 billion) pension and endowment assets. Its performance is benchmarked against a traditional 60/40 reference portfolio where key characteristics are passive management in public markets, simplicity and low cost.

Although the reference portfolio comprises only equity and fixed income, UTAM has the flexibility to invest in other assets, such as private equity and hedge funds. These assets are classified under the most appropriate reference portfolio asset class.

Within this framework, UTAM’s new president and chief investment officer, Daren Smith, guides a new six-person, expert investment committee. He has honed a sophisticated, outsourced strategy informed by his prior roles at the fund, which he joined in 2008.

“We are trying to outperform the reference portfolio but we don’t make any significant macro bets away from it,” Smith says in an interview from UTAM’s Toronto offices.

With 60 per cent of the portfolio in equities and the strong returns of recent years expected to taper, Smith’s focus is working with the best managers ahead of a tougher climate.

“We are not set up to take significant bets where we would underweight equities based on the view that [these] markets are overvalued,” he explains. “We are about finding best-in-class managers that can outperform over a market cycle and in a downturn, hopefully, preserve more capital than the benchmark.”

Passive US equities, active international

For now, he favours passive US allocations and active international strategies. US shares represent 20 per cent of the benchmark allocation, an area where Smith says outperforming the S&P 500 benchmark with traditional managers is tough.

“We looked at traditional long-only managers in US equity, found the ones we thought were best in class, looked at the fee schedules and didn’t have the conviction that active traditional managers would outperform,” he recalls. [It’s why] a large proportion of our US equity is passive.”

Would equity long-short hedge funds perform any better?

“We’ve evaluated whether these funds can outperform the long-only benchmark,” Smith responds. “The reality, in our view, is that it is extremely difficult for a typical equity long-short manager to outperform a long-only benchmark. They may have a higher Sharpe Ratio and less volatility, but when you look at the returns, we find most of the value tends to be on the long side, and then we find most of that value is gross of fees. Net of fees, a significant proportion of that value is eroded.”

Not much private equity

What about private equity? He explains that any investment in private equity requires conviction that the allocation would outperform not only passive markets but also the next best alternatives, which are more liquid – such as a traditional long-only or hedge fund manager – to compensate for locking up assets for a long time.

“The hurdle for private equity is not the usual benchmark returns,” he explains. It’s an analysis that leads him to conclude: “Plain vanilla US private equity is not attractive and the expected returns don’t appropriately compensate investors for locking up capital for such a long period of time. It’s not an area we are actively focusing on at this time.”

In international private equity, applying the same analysis has led UTAM to favour long-only and extension strategies – an allocation that is 15 per cent of the benchmark.

“We’ve been able to find managers that are traditional long-only or extension managers who have significantly outperformed the relevant public-market benchmark. This is the hurdle an international private-equity manager would need to meet, and so far we have little international private-equity exposure.”

UTAM hedges 50 per cent of its currency exposure from US and international equity allocations, in a strategy that leaves the fund with a 32.5 per cent foreign currency exposure. Smith explains that the fund has been overweight US dollar exposure for the last four years, but now that the US dollar is strengthening, UTAM is sticking much closer to the benchmark currency exposure.

“In the past, it was a slam dunk to be overweight the US dollar because the dollar was undervalued and had a risk-reduction benefit for a Canadian investor. It is rare to have something in a portfolio that both reduces risks and is expected to add value.”

Opportunistic in private credit

As equity markets challenge investors, so does private credit. UTAM’s opportunistic credit portfolio comprises strategies including direct lending in Europe, Asia and the US, credit long-short hedge funds, an allocation to mortgages, and a mandate with a special situations Asian manager focused on non-core bank assets and non-performing loans.

“We try to go after different opportunities created by dislocations in the market. In many cases, this has been where banks have retrenched or pulled out of the market,” Smith says. “The objective of this portfolio is to deliver 8 per cent plus net returns with as little risk as possible. If we have to take more risk than we are comfortable with to get to 8 per cent, we will drop the 8 per cent objective.”

The direct lending space has become “less compelling” and UTAM is not re-upping with most of its direct-lending managers, he says.

Uncorrelated returns come from an absolute return portfolio set up in 2011, in an allocation that targets returns of cash plus 4 per cent with low volatility and no market beta. UTAM allocates to nine managers, 70 per cent of which run equity market neutral/low net strategies, with the remainder in global macro.

“Only a small sub set of hedge fund strategies are appropriate for this mandate, because there is traditional beta in most hedge fund strategies. We would argue your typical equity long-short hedge fund manager would have a beta north of 0.3 or 0.4 to the market,” he says.

Smith notes that at “a point in time”, the absolute return portfolio may have a long market exposure, due to global macro strategies, where managers take directional views. Yet over “a market cycle”, he doesn’t want managers “to have a static bias one way or another”.

Responsible investing

Smith says the portfolio has met all its objectives, outperforming the cash return objective and a customised index.

UTAM has 40 core managers, selected and managed by an internal team of seven. He has expanded environmental social and governance (ESG) integration at the fund and just produced a first Responsible Investing Report. This promises another lens through which to rate managers.

“We’ve developed a whole set of questions and processes to evaluate existing and potential managers from an ESG perspective,” he explains. “We want to know that the manager is aware of ESG risks that are relevant for their strategy and has taken these into account in underwriting. What we ultimately hope is that this makes us better at selecting and monitoring managers.”

At the end of 2014, Campbell Harvey, professor of finance at Duke University’s Fuqua School of Business, in the US state of North Carolina, reported that there were 316 supposed factors reported in top journals and working papers, with new ones being discovered at an accelerating pace – about 40 a year.

Harvey was the editor of the Journal of Finance from 2006-12 and in his first year handled 1275 manuscripts. With the advent of the smart beta tsunami, and the possible combination of these reported factors, how can investors possibly make decisions on where, what and how to use factors in their portfolios?

Luckily, most of the so-called factors can be ignored; in fact, Harvey described many of them as trading strategies rather than factors.

“There is confusion because there are hundreds that I would classify more as trading strategies, some are fleeting,” he says.

So how can investors get their head around factors? And is it possible to identify one that can earn a premium over the long term?

What is a factor, really?

According to Andrew Ang, managing director and head of factor investing at BlackRock, a factor is a broad, persistent source of return, seen across many different geographies and asset classes. To be properly called a factor, says Ang – who is a prolific author and academic on the subject, writing 2014’s Asset management: a systematic approach to factor investing – something must have been persistently rewarded for decades, and have been studied by academics and used in practice for decades.

This narrows the 316 factors Harvey discovered down to about four.

Experts agree that value and momentum are persistent and robust factors and, depending on one’s perspective, the other two are carry and defensive.

More importantly, Ang says, a factor needs as its backbone an economically sensible source of return.

“Is there a risk premium and does it come about from a structural impediment or from investor’s behavioural biases,” he asks.

For $187 billion investment manager AQR, there are two main criteria for identifying factors: robust empirical evidence across many different markets and contexts; and a strong economic theory to support why these returns existed in the past and therefore are likely to exist in the future.

“It’s all about persistence,” Ronen Israel, principal at AQR, says. “It’s important to recognise that the factors we talk about have an economic theory to support them, and you’re not just relying on data and empirical evidence, [quantitative details].”

“We don’t focus on that many factors, there are only a few that fit that criteria, we think, and that’s value, momentum, carry and defensive (or low risk),” Israel says.

Research on fundamental indexation, an alternative to market-cap-weighted indices, was first published in 2004 by Rob Arnott, now chair of Research Affiliates. Fundamental indexation, which uses equal weighted stocks, argues that cap weighting stocks systematically overweights overvalued stocks and underweights undervalued stocks. And for Arnott, the notion that a factor will produce positive alpha because it has produced positive alpha in the past is naïve.

“When Campbell published the paper showing there were 316 published factors, how many of them asked if the performance benefits from a tailwind of rising valuation? Did my factor get more expensive? No one asked that question. So the first robust test is whether a factor produces positive alpha net of valuation change. Nobody [checks] that.”

The second question, Arnott says, is does the factor work out of sample, across different time spans and geographies.

“We go through all of this and try to find factors that have legitimacy across many geographies net of valuation change, and there are very few,” he says, citing size, value and momentum as fitting that criteria.

“We don’t think that low volatility and quality have alpha, but they do have attractive attributes that people value.”

How to put them to good use

So, given that those with the experience of studying and making money from factors over many years believe that only very few truly exist, the next logical question is how investors should use them. That, Ang says, depends on the outcome the investor wants to achieve.

“What they want to achieve goes into two buckets – to reduce risk (then use minimum volatility or quality), or explicitly enhance your return (use value, momentum or size),” Ang says. “The starting point is a strategic allocation to complement a portfolio, so you add factors you might want to have or hedge factors you may have unintended exposure to. I’d recommend a multi-factor benchmark for this.”

After that, you might consider tilting around a strategic allocation, he says, adding that tilting also means other considerations, such as concentration and turnover, need to be assessed in evaluating the attractiveness of each factor.

Factors are not only difficult to time, AQR’s Israel says, but when timing is added as an objective, it becomes more difficult to be robust.

“Why bet on factors through different economic environments – you’re trying to bet on two things. That is demanding way too much from the data,” he says.

“Instead, take a long-term strategic view and be balanced – investors are generally underexposed to these ideas. The first order is to get the long-term strategic exposures to these ideas and let timing, and tactical shifts, be secondary.”

Arnott also prefers to get factors as robust as possible and not to play too many games seeking to optimise against fast-changing correlations.

“We try to marry factors with the fundamental index and rely on the fundamental index to create the structural alpha, not the factors, which we think are too unreliable as a source of alpha,” he says.

So while these factor experts might agree there is a small group of factors that fit the criteria of being robust and earning a premium over a long period of time, the definition of each one is not clear.

For example, the underlying concept of value is to buy cheap, and price-to-book is the generally accepted way to implement that. However, Israel says there is no one perfect measure.

“You are trying to capture cheap assets outperforming expensive, in the case of value. But there is no theory to support why [price-to-book] is the only metric to support that. Sales to price, or earnings to price, could be tests.

“Using one particular measure that worked well in one particular time period may not be the best [method] going forward. So applying multiple metrics, while staying true to the concept and basic idea, is a more robust way to do it.”

Arnott agrees that using the generally accepted Fama-French price-to-book definition of value is way too simplistic.

“If you combine sales-to-price, cashflow-to-price and dividends-to-price, which are all robust individually, it will be more robust,” he says. “Investors have a tough decision to make when choosing a manager. [It’s] about who has done the most robust [analysis], and determining whether the capacity is correct and the turnover is not excessive. Ultimately, the proof is the result, but you need a decade of results before you can make a decision.”

Technological triumphs

The advancement of technology has allowed implementation and execution techniques to evolve, which Ang says leads to more applications for those general concepts.

“It’s like writing a play using a quill,” he says of using only price-to-book as a measure of value. “Technology is central to everything we do.”

Israel advises, however, that there are good and bad things that come out of technology advancements.

“If technology leads to more data mining and factors that aren’t truly there, that’s a bad thing,” he cautions. “But that’s not what we’re talking about here. Being able to trade more efficiently, risk management and without unintended risks – they are all good things.

“And measures of crowding rely on data analysts and technology to be able to react to things, they are good things. But don’t deviate from the core economic ideas that are driving these ideas, and that’s not technology.”

So where to from here?

BlackRock’s Ang says the “biggest bang for your buck” is looking at factors in illiquid markets.

“Modelling of a total portfolio in liquid and illiquid markets is a data and technology story and that is totally transformative,” he says.

He argues investors should be holding investment opportunities everywhere they can.

“But if you don’t take a factor view, then just holding private equity doesn’t mean you are diversified from public equities. Both have a large exposure to economic growth,” he says. “We see value in private markets, there are lots of value effects in private equity and also in real estate. If we don’t take a factor view of the whole portfolio, then we might go into periods like in 2008-09 and see the effects of unintended drawdowns.”

So factors can be used to hedge unintended tilts or enhance returns across both liquid and illiquid markets. But as these four experts outline, factor investing is harder than it looks and should be approached through a long-term strategic lens.

The comments from Harvey, Ang, Israel and Arnott quoted in this article are taken from an Institutional Investor Journals webcast, “Factor Perspectives: Separating Factors from Fiction”.

 

In the largest investment a private foundation has ever made, the $12 billion Ford Foundation has just committed $1 billion over 10 years to mission-related investment (MRI) strategies that earn both financial and social returns.

It’s a change in strategy from one of the world’s most celebrated foundations, which was set up in 1936 by the son of the motor company’s founder, Henry Ford. The shift brings a fresh approach to endowment management and acts as a rallying call to others to follow suit.

Top1000funds.com talks to Xavier de Souza Briggs, vice-president of the foundation’s economic opportunity and markets program.

Could you detail the background to your recent decision to commit $1 billion to MRI, and why the foundation has reached this decision now?

XB: Over the last five decades, the Ford Foundation has made more than $670 million in program-related investments (PRIs) as part of our programmatic work around the world. In addition to our experience as an impact investor through PRIs, we were motivated by the growth and maturation of the impact investment marketplace and by recent guidance issued by the US Treasury. That guidance clarified that private foundations in the US may consider their missions when making investment decisions.

My colleagues, our chief investment officer, chief financial officer and general counsel, worked closely with me and my team to determine the most prudent way to launch an MRI portfolio. Our great board of trustees, especially our investment committee, joined us on this journey every step of the way, asking tough questions and fulfilling their fiduciary duty to the fullest. While we are by no means the first foundation to embrace MRIs, we concluded that the time was right to make a strong statement as to where we see the market moving, to help it get there, and to encourage other institutional investors to find meaningful ways to make a social impact through their work.

Why have you decided to invest in these specific sectors?

We believe these two sectors, affordable housing in the US and financial inclusion in emerging markets, are great places to start for two main reasons. First and most importantly, relevance; both sectors align well with our larger strategy to combat growing inequality in the world. They offer crucial leverage points.

Second, experience; we have a strong history of grant-making and previous experience investing in these sectors. Third, investable opportunity; there are capable funds and fund managers with track records, achieving both financial and social returns, able to absorb significant new capital.

 

Could you outline your investment process? How will you choose and structure investments and how will you assess social value?

Our MRI team, led by a seasoned portfolio manager we are recruiting now, and with the support and oversight of our newly established MRI committee of trustees, will review each potential investment to determine if it meets our financial and social objectives. We will initially focus on the private markets, primarily private equity and real estate, and will invest with specialty impact fund managers with experience in our target sectors.

All investments will be approved by the MRI committee, a sub-committee of the board of trustees. Building on the monitoring practices in place with our PRI Fund, we also will spend time this year developing an impact evaluation and a monitoring framework to ensure that we have structures in place to evaluate, monitor and learn from these investments over time.

What returns are you targeting – financial and societal?

Financially, we are targeting attractive, risk-adjusted rates of returns. That is relatively straightforward. The social returns are a bit more complex, but we hope in time they will be more commonplace. Our goal is to deliver mission impacts directly over the long term and advance the foundation’s programmatic goals.

We hope that through the example of our MRI portfolio ramping up to achieve scale, we can demonstrate how prudent financial returns are possible while creating positive, measurable impact. This type of evidence base will further the development of the impact investment market. We are committed to transparency and plan to share our lessons learned with the field.

To what extent can financial markets advance social good?

Let’s be honest: The financial markets have a long history of driving change but a mixed history, at best, when it comes to advancing social good. Though the roots of the responsible investing movement go back to the birth of stock markets centuries ago, investing to achieve both financial and positive social returns is still a relatively nascent and contested idea for the mainstream marketplace.

However, the reality is that the scope and scale of our social challenges today demand more from our markets and underscore the need to use every tool we have. Also, from a bigger picture perspective, there is a growing interest in aligning our money with our values, both as consumers and investors.

Start with philanthropy, since it is inherently mission driven: The Foundation Center estimates that American grant-making foundations alone collectively hold about $865 billion in assets, while pension funds and sovereign wealth funds worldwide hold trillions.

If foundations were to take even a fraction of their endowments and put assets into MRIs, this would be a significant advance. But ultimately, we’re going to need every player – governments, foundations, financial institutions and other institutional investors – to step up if we are to meet our financing challenge. We see an incredible opportunity for entrepreneurs, especially those who are at the leading edge of creating businesses that deliver social impact, to be targets of this investing and to scale accordingly.

 

How will your strategy encourage other institutional investors to consider MRI, too?

We want to get more and more institutional investors thinking about how to make the best use of their assets. It is encouraging that many big players are already working on this, both here in the US and abroad – focusing on long-term value investing, considering what meaningful “double bottom-line” investing can mean for their results and reputation.

By sharing our strategy, experience, questions and results, we want to accelerate this clear trend. And beyond our MRI and PRI investing, through our ongoing grant-making to help build the marketplace, we will continue to strengthen market infrastructure, advance public policies to accelerate and deepen market development, and make the practice of impact investing more rigorous, tested and widely understood. We’re supporting standards development, for example, mechanisms for aggregation, performance measurement, matching capital supply and demand, and more – all the ingredients of a healthy marketplace able to function efficiently and flexibly at scale.

What are the biggest challenges around MRI for institutional investors?

First, there is a shortage of high-quality, representative and standardised data. At Ford, we are using our grant-making to support more and better data to help move the market forward. A second challenge is the lack of supportive policies that would help both retail and institutional investors fully and effectively engage.

In other words, there is untapped demand to do this kind of investing. There have been a number of policy wins over the past 18 months, and Ford remains supportive of impact investing policies through its engagement in the US Impact Investing Alliance. There are also longer-term challenges. In order to truly mainstream impact investing, for example, investment professionals and thought leaders who help shape the profession will need to look not only at risk, return and liquidity but also impact. This will require education and culture change, but the stirrings of change are there. There is much to build on.

 

President Donald Trump has been a sugar boost for markets, but he’s not a catalyst for sustainable growth, says Dan Farley, chief investment officer of investment solutions at State Street Global Advisors.

“The drivers of markets are fundamentals, not Trump policies,” Farley told delegates at the Investment Magazine Fiduciary Investors Symposium, held in the Blue Mountains, NSW, May 15-17, 2017. “The Fed is on a path and will raise short rates at least twice more this year. We think earnings growth is key in the US to justify higher valuations and drive stock markets.”

But he warned that equity and bond markets remain volatile.

Examining the impact of the “US’s first Twitter president”, Farley said Trump has been using those 140 characters in a specific way.

“It’s been an effective tool for him,” Farley said. “He’s maintained attention on what he wants, he’s managing the headlines and it’s played into the straight-talking image that he ran for president on. But we need to understand the diminishing marginal utility of this – people are getting used to him throwing out something outrageous – and also how the market distinguishes between the literal and figurative meaning of these tweets.”

Standard & Poor’s research on the impact of Trump’s tweets on the potential default ratings of companies showed that three out of five negative tweets were followed by the potential default ratings increasing the day after a tweet.

Similarly, positive tweets about an industry, by Trump, were followed by some “nice bumps in stock prices” in the sector – for example in the car industry.

But, in the case of both the positive and negative tweets, Farley says, the impact was quick and then started to mitigate.

“This also has a diminishing marginal effect,” he explained. “The tweets have taken on less of an impact than before. This is a short-term issue. “Trump may have been a pop for the markets, but [his tweets are not a catalyst for] growth and sustainability of that growth.”

Influences on allocations now

Farley pointed to economic conditions, including the fiscal expansion happening around the world, and the fact, he thought, that the deflationary concerns have passed. However, he said the populist voting trend has not come to an end and that there is an inane dissatisfaction with the status quo.

“From an active risk point of view, this has all led us to be more risk seeking and we are about 8-10 per cent overweight in stocks, against government bonds on a global basis. There is a positive monetary backdrop, fiscal policy is coming in, and earnings are good. It’s a good environment for equities.”

The main driver of the overweight position in equities at State Street, he said, has been improving earnings sentiment. The biggest risk to that, he said, would be something happening in fixed income markets.

“The market is accepting a risk in rates over time; if there was a shock then it would create a challenge.”

Farley said the expectation is that there will continue to be mid-single digit returns across many asset classes, with fixed income in the low single digits.

“That’s very hard to work with to get towards outcomes we all want.”

In conclusion, he said, the Trump administration is evolving, and how it reacts and who’s in power and whom they rely upon is still coming out.

“The backdrop is improving but challenged,” he said. “It does favour equities but with a more modest return.”

Farley is based in Boston and oversees a team of more than 75 investment professionals managing more than US$180 billion in multi asset-class portfolios, including tactical asset allocation, liability driven investments and customised portfolios.

Norges Bank Investment Management has developed a proprietary database allowing it to assess non-financial risks across the 9000 portfolio companies in which it invests. The database gives its risk team and portfolio managers the ability to make more in-depth decisions around the sustainability of a company’s business.

Speaking at the Fiduciary Investors Symposium at INSEAD, Patrick du Plessis, global head of risk monitoring at Norway’s NOK7.93 trillion ($940 billion) NBIM, explained the large investor’s approach to environmental, social and governance (ESG) risk and integration.

“Most investors are familiar with traditional investment risks and use these as the starting point for analysis, but we think to get a holistic picture of a company’s risk profile you need to take into account other risks, those that are below the surface and harder to identify,” du Plessis said. “We believe that what gets measured gets managed, and non-traditional financial data has been slower to become available.”

To counter this, the fund built its own database, which incorporates non-financial data alongside financial information.

“We don’t just look at financial data for opportunities; we think you need to look at ESG considerations as well, and that works for risk mitigation and investment opportunities,” du Plessis explained. “We need to consider all externalities and understand what they mean, because we are running a global fund.”

The database includes non-financial information on issues such as carbon, climate change, waste, water, child labour, corruption, and health and safety, at the country, sector and company level. The NBIM risk team incorporates the data into relevant systems, analyses and processes to facilitate a more comprehensive assessment of risk exposure. The data relies on company-reported ESG information, which is supplemented by other service providers, such as Trucost, MSCI and CDP.

This all allows for a deep dive on certain ESG themes. For example, all countries could be assessed on greenhouse gas risks. Risks can be viewed across countries and sectors, so a matrix could assess a risk threshold between countries and sectors, du Plessis said.

“The intention is to create a one-stop shop,” he said. “In one place we have traditional valuation metrics, benchmark-relative positions and a standalone ESG tab that looks at company ratings, fossil fuel compositions and inherent country and sector risk. The risk team and portfolio managers can use the tool and find much of what they need. The intention is to create a good dialogue between the risk team and portfolio managers.”

NBIM can look at specific ESG risk related to a certain theme, such as conventional electricity in the US. The database will spit out those companies with an inherent risk related to that theme that could affect the sustainability of business models. The risk team can then focus on 60 or 70 companies specific to that threat.

“This is not a discussion about ethics, it’s about the sustainability of business,” du Plessis said. “We are not just looking at income statements but other things below the surface of the iceberg. This is the quantifying and formalisation of ESG in the business analysis process.”

Risk and portfolio managers get a more holistic company profile, including traditional and non-traditional factors, on which to assess companies.

NBIM has three pillars to its responsible investing approach:

  1. Standard setting: It collaborates on global standards and expectations. Because of the sheer size of the portfolio (9000 companies) the fund can’t engage with all of them. Standard setting, and expectations documents, create an opportunity to affect them all.
  2. Active ownership: NBIM engages on specific ownership issues with the most material holdings.
  3. Risk: the entire portfolio of 9000 companies is examined on a risk basis. The database is a key tool for this.

Separate from this ESG risk analysis, NBIM is mandated by the Norwegian Ministry of Finance to implement certain exclusions, including coal, on ethical grounds.