Passive managers are increasingly gaining market share relative to active managers, and now own significant portions of the broad equity markets. For example, almost 40 per cent of US equity assets under management are held in passive vehicles, more than twice the level from about 10 years ago.

But passive management should not be about just tracking a broad market index. Given their scale, passive managers are in a unique position to effect change, not only within a company but also across the wider market, on a number of important governance and sustainability issues.

In contrast to active managers, who have the ability to sell out of a holding to signal their views on the future prospects of a company, passive equity managers are, by nature, long-term shareholders. They are, therefore, just as exposed to risks around corporate governance and environmental and social concerns as active investors, while also being in a strong position to engage with and positively influence companies on these issues.

How to assess passive managers’ stewardship

In 2014, Mercer started formally reviewing and rating the largest passive managers on their active ownership activities, with the introduction of our environmental, social and corporate governance passive (ESGp) ratings.

Our approach focused on understanding the voting and engagement process, the resources required to implement stewardship responsibilities, internal initiatives to promote and enhance ESG integration, and the level of firm-wide commitment and industry collaboration that the managers undertake. With these factors in mind, we assessed the extent to which these managers were exercising their ownership responsibilities.

In 2016, we revisited this research and extended ESGp ratings to a wider range of passive equity managers, who collectively control more than $4.8 trillion in passive equity assets and over $14 trillion in total assets (as at June 2016). The aim was to review each manager’s progress and evaluate how industry practice has evolved in recent years.

What is best practice?

Overall, we have seen a positive trend in the development of best practice on active ownership; however, we believe more can be done. Our results showed a greater distribution of ratings across ESGp1 (highest) and ESGp4 (lowest) in 2016, compared with 2014. Attaining our highest rating is not easy but we have seen some instances of what we would consider best practice.

We see this emerging where passive managers are considered leaders in their stewardship activities, with a consistent approach to voting and engagement at a global level. Policies should be clearly articulated and transparent, with the resources, systems and expertise in place to ensure that these activities are implemented and communicated effectively.

We expect the policies of leading managers to clearly and proactively address environmental and social issues in order to vote effectively and engage with companies, rather than abstaining or just focusing on corporate governance issues.

Best practice further demands that engagement is undertaken in a thoughtful manner and typically done at the company, industry and regulatory levels. It’s not just about exercising a vote at company meetings; a level of engagement that takes place in the background is often essential in whether to vote along with company management, or even to abstain.

Leading managers are also active collaborators with other institutional investors on ESG issues, such as engaging with regulators and policymakers to drive market practice forward. The ‘Aiming for A’ investor coalition engaging with companies and encouraging successful climate change-related shareholder resolutions is a great example of such activity.

Where there’s room for improvement

Asset managers are coming under greater scrutiny, and asset owners have become more vocal in holding their managers accountable for their voting policies and actions. In particular, large passive managers have come under growing criticism for their voting actions, specifically as they relate to a perceived inconsistency between their voting policies and their public positions on various topics, such as climate change.

We believe managers need to be more clear and explicit in communicating how they implement their voting policies and why voting actions may differ from stated policies or positions. Asset owners should be aware of the rationale behind managers’ votes and assess the level of engagement that managers undertake to arrive at their decision.

Most passive managers have thoughtful approaches to engaging with companies on corporate governance matters, but we believe more can be done around engaging on environmental and social issues. Data from managers has shown that engagement on environmental and social issues can range anywhere from about one-10th to one-third of total engagements.

Furthermore, the Interfaith Center on Corporate Responsibility (which focuses on shareholder proposals during the US proxy voting season) has noted that the number of shareholder proposals generally – and climate change-related resolutions in particular – increased from 2014 to 2016. We expect this trend to continue as ESG issues increasingly appear on agendas at annual general meetings (AGMs), and believe asset managers must be clear on how they are engaging with companies to resolve these broad issues.

The International Corporate Governance Network’s February 2017 article “Governance questions posed by the changing US political landscape” reviews a range of governance challenges posed by the shifts in US politics, reinforcing the importance of a consistent voice from long-term investors.

In conclusion, as asset managers prepare to ask their investee companies challenging questions during the next round of AGMs, so too should asset owners be preparing to ask their managers how they implement their voting and engagement policies and communicate these to investors. The approaches to active stewardship can vary significantly across passive managers, and investors should have a clear understanding of what their managers are doing.

Mercer believes ESG risks and opportunities can have a material impact on the long-term risk and return outcomes; and taking a sustainable investment view is more likely to create and preserve long-term investment capital. Furthermore, we believe active ownership – through voting and engagement – helps the realisation of long-term shareholder value, and provides diversified investors an opportunity to enhance the value of companies and markets they hold for the long term. This is the active side of passive management, and it must not be ignored.

Sarika Goel is a research specialist, responsible investment at Mercer.

In the next few months, the UK regulatory body, the Financial Conduct Authority, will publish a sweeping final report on the country’s £7 trillion asset-management industry, calling for more competition and reduced investor costs. An interim report, Asset Management Market Study, released at the end of last year flagged weak price competition and found asset managers were making profits from underperforming funds. It was a forewarning of a damning final verdict on the sector, £3 trillion of which is managed on behalf of UK pension funds and other institutional investors.

The FCA’s sights are set on active management in particularly.

The regulator argues that actively managed funds have high costs that are not always justified by high returns. It states that the majority of active funds do not beat their benchmark, and in a study of two funds – one active and one passive, both earning the same return before charges – estimates that over a period of 20 years, the passive fund could yield a return 44 per cent more than an actively managed equivalent, because of costs.

Since 2005, passive funds have experienced nearly five-fold growth. They now represent about 23 per cent of the assets under management in the UK. Yet the FCA estimates that the annual average fee for actively managed equity funds is 0.90 per cent of AUM, in contrast to the average passive fee of 0.15 per cent. Transaction costs are normally higher for active funds, too.

“Our analysis shows mainstream actively managed fund charges have stayed broadly the same for the last 10 years,” the watchdog states. “Few asset-management firms told us they lower charges to attract investment; most believe this would not win them new business.”

Pricing not competitive

The FCA has also flagged “considerable price clustering for active equity funds”, something it believes is consistent with firms’ reluctance to undercut one another by offering lower charges. As fund size increases, prices don’t fall, suggesting the economies of scale are captured by the fund manager, rather than being passed on to investors in these funds.

Actively managed investments don’t necessarily outperform their benchmark after costs either. The FCA states that investors choose funds with higher charges in the expectation of achieving higher future returns. However, there isn’t any clear relationship between price and performance; the most expensive funds do not appear to perform better than other funds, before or after costs.

Absolute return funds are also in the regulator’s sights. The FCA has two concerns with these funds, which aim to deliver a positive return whatever the market conditions. First, it states that many absolute return funds do not report their performance against the relevant returns target. It has also criticised these funds for charging performance fees when returns are lower than the performance objective. “The manager is rewarded despite not achieving what the investor considers to be target performance,” the FCA asserts.

More transparency

The FCA wants greater transparency and standardisation of costs and charges for institutional investors. This could include the introduction of an all-in fee approach to quoting charges, so fund investors can easily see costs. Investors pay a management fee along with other costs of running a fund, yet not all of these charges are made clear. For example, only one in five investors knew they footed the bill for trading costs, the FCA states.

The regulator also has found that investors are not always given information on transaction costs in advance, meaning they cannot take the full cost into account when they make the initial investment decision.

“We have concerns about how asset managers communicate their objectives and outcomes to investors,” the FCA states.

Fee transparency is certainly an issue on the radar of the UK’s pension industry.

“Our members say fee information and reporting from private equity and hedge funds are particularly opaque and difficult to access,” says Luke Hildyard, policy lead, stewardship and corporate governance, at the UK’s Pensions and Lifetime Savings Association. “We believe the [Institutional Limited Partners Association] Reporting Template could be a good basis for the FCA to build upon,” he says, referring to ILPA’s first standard fee reporting template for the private-equity industry.

Consolidation for pension funds

Trustees of pension schemes, and other committees that oversee institutional investments, can face a range of challenges in their dealings with asset managers. These include low and variable levels of investment experience on the committees and resource constraints.

That situation is behind another recommendation expected to be in the final report. The regulator will extol the benefits of greater pooling of pension scheme assets amongst the UK’s thousands of small defined contribution schemes. It believes there is “a relationship” between some of the challenges facing oversight committees and their size; smaller schemes have fewer resources and are less knowledgeable. Pension schemes with more funds also have a better bargaining position; smaller schemes are less able to secure discounts from asset managers.

“The influence these small schemes have over asset managers is pretty minimal,” Hildyard says. “Consolidation is something we have supported for a long time.”

Finally, the FCA also has its sights set on consultants.

The regulator states: “There are a wide range of investors in the institutional market. This includes many small pension schemes [that] rely heavily on the advice of consultants. We have found concerns about the way the investment consultant market operates.”

The impact that length of investment horizon has on pension funds’ allocations to illiquid assets was the subject of a new study by Dutch researchers. The authors, Dirk Broeders, Kristy Jansen and Bas Werker, looked at the asset allocation of 220 Dutch defined benefit pension funds from 2012-16.

They took liability duration as a proxy for investment horizon and found that up to a period of 17.5 years, a longer liability duration positively affects the illiquid asset allocation; after that, the positive correlation starts to decline.

The researchers attribute this to the liquidity and capital constraints to which pension funds are exposed.

The liquidity constraints on a pension fund consist of two components: short-run pension payments and collateral requirements on interest rate and currency derivatives.

As for capital constraints, defined benefit pension funds need to have sufficient capital to manage factors such as interest-rate risk, market risk, currency risk and longevity risk.

A pension fund’s liability duration shows the weighted average time to maturity of its pension payments. Having fewer short-term liabilities, as a fund would with a longer liability duration, creates opportunities to invest in illiquid assets.

However, a longer liability duration is also associated with a quadratic increase in interest-rate risk, which limits the opportunity to invest in illiquid assets, due to a higher capital requirement.

A pension fund can hedge risk exposures to reduce the capital requirement but hedging strategies using derivatives involve collateral requirements, which impose a liquidity constraint.

The authors also found other pension fund characteristics that affect investment policy. For example, size positively affects the allocation to illiquid assets. Also, corporate pension funds tend to invest less in illiquid assets than industry-wide and professional-group pension funds do.

To access the full paper click here

 

Investment management is a people business. That statement seems quite obvious, but the point is a critical one.

Investment management, whether fundamentally or quantitatively based, derives its value from the intellectual capital of the principals.

Technology, assets under management and process are used as differentiators for investment groups, but none of that matters if you do not have the right people and the culture to support their development.

In the end, the most important job of a chief investment officer is talent management. While many aspire to be the smartest person in the room, and some succeed, it is not enough. A sustainable investment program is never about one individual. It is about a team working to its potential, under the guidance and support of a policy-focused and supportive board.

Success within the investment management industry is, therefore, dependent upon execution by skilled professionals.

However, talented individuals do not always reach their potential, resulting in suboptimal execution. This means talent management is the critical element in creating excellence. This is best facilitated by establishing an environment that fosters learning, collaboration and competition as a team. Culture makes this possible.

The wrong culture will destroy a team or organisation. The right culture will create sustainability of process and allow for individuals and the organisation to thrive and grow. The organisation is as strong as its individual members, who must be able to grow with a clear vision, mission and delineation of roles.

The key elements for the development of an optimal investment management culture within a multi-asset class fiduciary pool are the following: functional governance structure; a supportive learning environment; adequate technical and research resources; aligned and reasonable incentive structures; and a long-term investment horizon.

You will notice from the above list that the focus is foundational. If you establish the proper structures to support individuals and teams, success will follow, leading to a self-renewing pattern of achievement. I will expand my thoughts on the key attributes necessary for success in the following paragraphs, with the hope of providing practical insights into optimal team structuring and management.

Functional governance

Success is not possible without functional governance. I use the term “functional” with intent. Many organisations have bloated and complicated governance structures, which often results in mission drift and poor performance.

A multi-asset class fiduciary pool’s core objective is to make money to support the mission of the organisation.

Governance should be set up to help, not hinder, that objective. Boards should set policy that supports successful asset management and allow the investment staff to invest the money.

Clear delineations of roles and responsibilities for all parties and autonomy for the investment team are essential. Checks and balances and accountability are important, but trust must underpin the entire governance structure. This ‘trust effect’ is the most critical piece of the optimal investment management culture.

Supportive and resources

The landscape is always changing, and having personnel with intellectual curiosity is critical to establishing a culture of success.

My organisation’s first foray into active equity management was in microcaps. This was a result of staff feeling empowered to conduct research independently and then having a structure that provided support, resources and, eventually, funds to execute.

If people know they are expected to learn and develop and leadership is committed to that objective, success and innovation will happen. In this case, it has led to the creation of two additional equity strategies and a fixed-income strategy.

Our internal asset management now covers more than 30 per cent of AUM and that’s increasing. Millions of dollars in fee savings and alpha have been generated for the fund. Most importantly, the team’s job satisfaction has increased and new research continues.

Staff members know they are encouraged and expected to learn and develop continually, resulting in positive structural changes to the portfolio. Retention rates are high because the work environment is positive and intellectually challenging.

Remuneration

Now to compensation.

Above I mention that a key element of success is talent aligned with appropriate compensation structures. Investment management as an industry pays its talent well and competition for that talent is fierce.

Unfortunately, the history of many pension funds was inadequate compensation for internal investment professionals and paying more than necessary for consultants and external investment management. Even though the cost-benefit analysis supports building out internal teams.

My view is that if you hire talented investment professionals internally and have established the right culture and governance structure, then additional layers of oversight prove costly and often counterproductive. Compensate your talent appropriately, allow them to operate in a challenging yet supportive environment, hold them accountable, and they will stay and produce successful outcomes.

Attracting and retaining top talent within the pension industry does not require aggressive compensation.

The asset owner side of the business is stable, mission focused, intellectually challenging, and does not generally require sales activities. It is a lifestyle assignment and, with appropriate compensation, retention is high.

With respect to alignment, incentive compensation is important. Investment professionals are competitive. The ability to earn a bonus brings the team together and focuses action on achieving the goal of higher returns.

Therefore, I remain a firm believer that incentive compensation should be linked to long-term successful outcomes and collective, rather than individual, success. Being reasonable is the key. Incentive compensation needs to be meaningful but not excessive.

A long horizon
Fiduciary pools are often perpetual in their mission.

That means embedded within their structures should be the ability to take a truly long-term approach. Maintaining this long-term view and linking it to governance, policy and incentives can be a powerful competitive advantage.

The markets are often painfully slow to reward long-term investments, so ongoing effective communication of strategy and execution between the investment professionals and the board is critical to maintain trust.

The board needs to support taking a long-term, valuation-based approach and compensation should incentivise the investment team to strive for consistent success over a business cycle, not a quarter.

Jeb Burns is chief investment officer at the Municipal Employees’ Retirement System of Michigan.

Stringent regulatory constraints dictate investment strategy at French public service pension scheme Régime de Retraite additionnelle de la Fonction publique, a €26.2 billion ($28.0 billion) mandatory fund for French civil servants and members of the judiciary, established in 2005.

By decree, the scheme’s manager, ERAFP, has to invest at least 50 per cent in bonds; diversifying assets in listed and private equity and infrastructure are capped at 40 per cent. Real-estate investment is limited to only 10 per cent of assets. This leaves the fund with a current strategic asset allocation of 60-62 per cent in bonds, 30-31 per cent in diversified assets (the bulk of which is listed equity) and 9-9.5 per cent real estate – at a time of historic low interest rates.

It is the restrictions governing the fund’s allocation to illiquid assets that chief investment officer Catherine Vialonga finds particularly frustrating.

“As a recently created mandatory pension fund, we are in the very uncommon situation of having predictable and sizeable positive net cash flows for several decades,” Vialonga says in an interview from ERAFP’s Paris headquarters. “Thus, we think we should be able to take advantage of our long-term investment horizon and our particularly low need for liquidity to benefit from the illiquidity premium resulting from investments in real assets. This is why we advocate extending the investment threshold in real estate [beyond] current levels of 10 per cent.”

She is heartened by a gradual diversification of fund assets since 2005, when allocations to sovereign bonds dominated strategy. It suggests a trajectory towards increased diversification and flexibility in years to come.

“Let’s keep in mind that ERAFP is a young scheme and that we have already implemented a policy of gradual diversification,” she says. The fund achieved a 4 per cent annualised internal rate of return, by market valuation, in 2015.

Two years into new investment rules

A landmark change came when new investment rules were introduced two years ago that increased the equity allocation from 25 per cent and introduced allocations to private equity and infrastructure. Other new assets were also added, including short-term credit instruments in order to manage treasury, and allocations to private debt and loan funds. ERAFP is now allowed to invest on its own in any kind of open-ended fund, and is also permitted to use derivatives, although only for currency hedging purposes.

“These changes are important for asset diversification and with regard to matching the duration of our liabilities,” Vialonga explains. “We also want to provide long-term support to the economy via smaller investments.”

The fund recently awarded a 10-year private equity mandate to Access Capital Partners, targeting $213 million in a range of unlisted small and medium-sized (SME) European companies.

ERAFP invests only in developed equity markets, and there is a heavy euro bias, with 70 per cent of the variable asset allocation (comprising public and private equity and infrastructure) invested in euro assets.

Other allocations include a multi-asset portfolio that Amundi manages. It was an important diversifying allocation before the 2015 rule changes and although it accounts for less than 2 per cent of assets under management, Vialonga still likes the allocation for its “decorrelation and a positive performance”.

ERAFP gives Amundi an annual risk budget and generous fixed asset guidelines within the portfolio.

“Within those wide guidelines, Amundi can change the fund’s allocation quite easily,” Vialonga says, adding that political uncertainty in Europe has, in fact, made for a cautious strategy.

“The fund manager is particularly cautious since the beginning of 2016 because of accrued potential volatility risks of Brexit, Grexit, Italian polls and the US presidential elections,” she says.

As of February 2017, equities represent 55 per cent of the portfolio Amundi manages (mainly Asian equities). Bonds represent 42.5 per cent (mainly investment grade). The remainder is equally split between emerging market debt and high yield.

 

Manager selection and SRI

ERAFP’s manager selection has to comply with France’s strict public procurement code.

“When we want to invest in a new asset class, or to renew existing mandates, we launch a public RFP [request for proposals] aimed at selecting one or more asset managers. The different steps and corresponding deadlines of the process, as well as the selection criteria, are pre-determined and closely enshrined in law.”

Every shortlisted candidate is invited to submit an offer, which is assessed according to the quality of their investment process, the track record and experience of the management team, risk management and internal control systems and costs, comprising management and brokerage fees.

Socially responsible investing (SRI) integration is also a deciding factor in manager selection. An SRI charter “persistently and permanently” takes account of the pursuit of the public interest and applies to all “financial management transactions”, whether ERAFP performs them directly or agents perform them on its behalf.

Just under 20 per cent of the equity portfolio tracks a replicated low-carbon index based on the Scientific Beta Efficient Maximum Sharpe Ratio method.

“The aim of the index is to maximise the Sharpe ratio of a Euro SRI carbon-efficient universe,” Vialonga says.

Last year, ERAFP extended the calculation of carbon exposure to its government and corporate bond portfolios as well. This means the fund now measures the carbon output of about 87 per cent of its total assets. In another endeavour to measure carbon, ERAFP now compares the energy mix in its equity portfolio with “a current typical portfolio” and to an energy generation breakdown using the International Energy Agency’s 2°C Scenario (2DS) for 2030-50.

“This measurement is the first step in shaping ERAFP’s zero-carbon strategy. We cannot manage what we do not measure,” Vialonga says. “We will continue to use other tools to measure ERAFP’s climate risks and opportunities.

“One of the most important challenges for climate risk management is the development of robust indicators that provide a comprehensive picture of companies’ direct and indirect emissions. Most available methodologies cover only part of [indirect] emissions. Thus, in some sectors, such as the automotive industry or the financial sector, global emissions tend to be underestimated.”

ERAFP’s board of directors comprises 19 members from various trade unions, the public sector and qualified investment professionals. It is a mix that has particularly championed ERAFP’s integrated and award-winning SRI policy, Vialonga says.

“Since its inception in 2005, the board of directors [has believed] that investment based solely on maximum financial profit fails to account for social, economic and environmental consequences,” she says.

President and chief executive of the Federal Reserve Bank of St. Louis, James ‘Jim’ Bullard, has told a gathering of Melbourne’s business elite that he is more inclined to let the central bank’s massive bond-buying program run off in 2017 than rush to hike interest rates.

He also noted the United States is “a closed market when compared with Australia and other countries” and its financial leaders do not track global events to the extent that more open economies do.

Bullard illustrated his point by arguing the recent US air strike on Syria would have little impact on the US economy nor on the Federal Reserve’s macroeconomic outlook for 2017.

He made the comments during a presentation on his views on current US economic and monetary policy at an event hosted by the Australian Centre for Financial Studies (Monash Business School) in Melbourne on Monday, April 10, 2017.

Bullard sits on the Federal Reserve’s federal open market committee (FOMC), which meets eight times each year to set the direction of US monetary policy.

Key to productivity still out of reach

His presentation played down the likelihood of a hike in global interest rates for investors or people living on fixed incomes. Bullard warned faster productivity was the key to gross domestic product growth and was the only sure way for the US and global economies to expand. But “no one seems to have the answers as to why productivity [is] so low”, and no one seems to have the solution to the problem either.

“There is no shortage of ideas but no good answers,” he said. Until someone comes up with the answers, the US and the global economy are stuck with very low interest rates, he added.

Bullard’s speech also focused on the US’s current low real GDP growth and low real interest rates.

“Real GDP has been growing about 2 per cent, inflation is near the Fed’s 2 per cent target and the unemployment rate has been slowing,” he said. The first-quarter 2017 figures show GDP growth was below 2 per cent and hard data suggested that “things don’t look good”.

“The US policy rate can remain relatively low and still keep employment and inflation targets,” he said.

Although post-Trump fiscal policies for regulation, infrastructure and tax reform could have an impact on growth, Bullard said the Fed would wait and see how these policies developed. He added that if growth or inflation started to pick up, then the Fed could start raising official rates.

Bullard dissented from many of his colleagues on the Fed Reserve Board over its bond-buying program. Instead of going for another rate rise or two this year, he said now might be a good time for the FOMC to consider allowing the balance sheet to normalise by ending reinvestment.

“The Federal Reserve can reduce its $4.5 trillion balance sheet by ending reinvestment in the good times,” he argued. “Just let stuff mature and not replace it. It would not be a major issue for global markets. It would allow for a more natural adjustment.”