No one can pretend the last few years have been boring. The period I’ve overseen since starting at the National Employment Savings Trust (NEST) has covered some of the most unusual events many investment professionals have seen in their careers.

From major shake-ups in politics, historically low interest rates, turbulent commodities markets and big shifts in long-term trends like climate change, we’ve coped with plenty over the last eight years. This is why it’s so important for us at NEST, as long-term investors, to have a strategic view of where we’re trying to go and not get blown off course by short-term events.

Having steadily diversified our portfolio as funds under management have grown, we’re doing all we can to mitigate the kind of turbulence we’ve seen over the last few years.

We’re invested in a wide range of asset classes, from equities to debt to property. We’ve just seeded a new climate-aware equities fund and are about to add high-yield bonds to our universe. It’s a pretty good range but it can’t stop there.

Our assets are going to continue growing exponentially over the next few years. We’re projected to be one of the biggest pension funds in the UK, if not internationally, by 2030. Our challenge is where to put the money. We need a large asset allocation toolbox to give us a choice of where to invest at any one time.

That’s why I’m going to be spending much time this year looking into alternative or private-market investments.

I want to know how we can access, within a defined contribution (DC) framework, things like infrastructure, private debt, private equity, renewable energy and timber.

We’ve got three main reasons for this. Firstly, we need the additional diversification. Secondly, we want the extra returns the illiquidity premium should provide. And thirdly, lower volatility assets like these sit well with our long-term strategic aims.

When we reach scale, our peers will be large, defined benefit or superannuation schemes, which are already far more diversified than most UK DC pension schemes.

It’s where we’re heading, and as we get larger, the constraints that often come with DC will be less of an issue. But we still need to work with the asset-management industry to access these alternative classes in ways that are cost effective.

Extra return, lower volatility

We know, for example, that we can get an extra return for money that’s tied up for a long time. And because we’ve got a lot of money coming in, we can take advantage of that. If you’re a 25-year-old and you’re in NEST, you don’t mind tying up your money for 10, 20, 30 years.

Most private market funds at the moment have a limited life, so after 10 or 15 years, the fund shuts and investors get paid out. We need longer time horizons than that and we need to be able to add an ongoing flow of money as our assets grow.

That means we’ll need customised funds that are focused on our specific requirements and can start small but essentially be an evergreen portfolio. These are long-term opportunities that make sense for long-term investors, like us.

Illiquid private-market assets also often have lower volatility, at least reported volatility, than more publicly traded securities.

Our long-term strategic aim is to increase members’ money as much as possible without exposing it to unnecessary volatility. We want to avoid volatility drag and, as best we can, manage sequencing risk. But, in particular, we want our members to feel confident in saving, and our research shows that excessive volatility is likely to discourage them.

Our members are relatively risk averse. They would probably be scared off by big falls in their pots. That’s particularly true for our younger members but the bottom line is, no one likes losing money.

Having a highly skilled and experienced in-house team is critical to allowing NEST to make these types of strategic investments in line with our members’ interests.

One of the first decisions we had to make when setting up NEST was what to outsource and what to do ourselves.

Academic evidence shows that the majority of the variation in returns comes from asset allocation, so it was important to us to keep that in-house, where we understand our members’ needs and expectations best. That’s ultimately why we’re here – to find the right solutions, so our members see steady returns, regardless of what’s happening around the world.

 Mark Fawcett is chief investment officer at NEST.

Over the past 10, 20 and 43 years, the South Dakota Investment Council (SDIC), which manages the benefits of more than 84,000 of the US state’s public-sector employees, has ranked in the top 1 per cent of public pension funds in terms of investment performance.

Strategy at the $10.5 billion fund is based on strict adherence to long-term strategies during underperforming periods and nurturing an expert internal team, state investment officer Matt Clark explains, in an interview from the fund’s Sioux Falls, South Dakota, headquarters.

“We are old-fashioned. We remember that first finance class at university and present value maths,” says Clark, who joined South Dakota in 2000 and made state investment officer in 2005. All investment begins with an assessment of an asset’s long-term fair value.

About two-thirds of assets are internally managed. Internal research focuses on estimating an asset’s future long-term cash flows, assessing the risk and discounting accordingly to calculate a fair present value.

“We apply this to all our portfolios and at asset-allocation level, adjusting the asset allocation based on relative valuations and targeted level risk,” Clark explains.

Next comes the discipline to wait for opportunities to arrive. Clark says investors have “cyclical and emotional time frames” that tend to fall into three-year periods.

“Over three years, something will change to become cheap, and something else will change to become expensive that you can then sell.”

Long-term fair value requires the patience to wait for opportunities that can take longer to appear.

“If we buy something early and the price keeps falling, it tests our fortitude and we find that we need to have everyone involved. It is scary when you buy something cheap and then it gets a lot cheaper, but you can never guarantee that this won’t happen.”

Contrarian moves in healthcare, real estate

Being contrarian is another strategy pillar. SDIC invests in assets it believes are undervalued from a long-term perspective. Due to the lack of opportunity in the current market, 24 per cent of South Dakota’s assets are in cash. Expensive equity has caused the fund to lower equity risk by placing its current risk target well below its benchmark. Unlike other investors, however, Clark says bonds are also expensive, thus he is “holding lots of cash”.

He explains: “Risk is expensive and bonds are expensive but we are confident that the market will come back to us if it is overvalued; if you wait long enough, it does come back to you.

“We look at what we can buy dirt cheap down the road and what will bring a tremendous return. We will not sit on cash forever. The alternative is to invest in something overvalued, and maybe make a small premium to cash, but overvalued markets are not calm. Markets do wake up at some point and re-price to give you a fair return. We view cash as dry powder waiting for a great opportunity.”

The contrarian theme is also illustrated in the high-yield/distressed debt allocation within SDIC’s fixed-income portfolio. Here, the fund recently pulled back in the belief that high yield is now overvalued.

In July 2015, the portfolio comprised a small allocation to subprime mortgages bought during the financial crisis and an internally managed holding of high-yield corporate junk bonds. Since then, the allocation has been steadily built up with investments that have included a sizeable allocation to energy debt, snapped up as it fell more than energy stocks when values in the sector plummeted.

“Energy had collapsed, and high yield had collapsed, so we increased our position from 1 per cent to 6 per cent and then 9 per cent of assets,” Clark recalls.

Today is a different story. Energy bonds and energy-related investments are no longer undervalued, so the fund is rebalancing the portfolio towards healthcare, investing in an assortment of related companies, including service providers and nursing homes.

“We thought healthcare was overvalued a year ago, when energy debt was so cheap. Many investors were staying away from energy when it was blowing up, and crowded into healthcare. Now energy has surged and there is pressure on healthcare,” he says. However, he cautions, “Healthcare isn’t straightforward. There are fundamental concerns about Obamacare.”

Strategy in real estate follows the same fundamental principles. SDIC’s real estate allocation has fallen to 8.25 per cent of assets under management due to recently sold investments and returned money.

“Real estate is not cheap like it was. In fact, it is more richly valued than anything else,” he says. In the current climate, he favours exposure to opportunistic real estate over core and stresses the importance of relationships with managers who have a track record of keeping their powder dry but are also prepared to invest up to the maximum in a downturn. The fund has key relationships with the Blackstone Group and Starwood Capital Group.

Clark favours arbitrage plays, like buying real estate investment trusts and breaking them up and selling them, or, if REITs are expensive, buying a building and packaging it up to sell as REITs. The fund is also seeking real estate debt opportunities through manager Lone Star in Europe.

“The financial crisis reinvigorated this asset class, but now opportunities in the US have dried up as bad loans in real estate have worked through.” It means distressed investors need to migrate overseas to opportunities in Europe.

“We like the flexibility to invest in any real estate anywhere, [having] patience and being prepared to do arbitrage,” he surmises.

Recruiting and retaining young locals

Clark has applied the long view to recruitment at SDIC as well; it’s a key contributor to the fund’s low costs. He has successfully nurtured, and managed to retain, top investment talent for the fund’s large internal management program, despite Sioux Falls’ location in the rural Midwestern United States, far from the bright lights.

“We never recruit from experienced talent. We don’t employ outsiders. Instead, we get the kids in the door,” he explains.

SDIC recruits through student intern programs, hand-picking the most gifted from South Dakota’s leading universities, with which SDIC has developed strong relationships, aided by Clark’s own status as a graduate of the University of South Dakota. Intensive training follows, and the students committed to staying in South Dakota are pursued most aggressively.

“These are the ones we want, and for them we are the only game in town,” Clark says. It is his job to gauge whether a candidate is “truly interested” in a long-term career in the community, and he gets it right so many times he can count on one hand those he has trained who have left.

Of course, SDIC ensures the incentives to stay are strong. A celebrated investment approach and unique in-house tools are two aspects of that. Leaving all that behind would be a wrench, says Clark, who likens employees’ attachment to the fund’s in-house tools and culture to Linus’s affection for his security blanket in Peanuts. The other strong incentive to stay is financial.

“Our compensation is the best of any public pension fund in the US,” he says, with SDIC offering “up to 200 per cent of base salary in incentives based entirely on performance”.

It is fitting that one of the projects he has been most closely involved in during recent years is re-engineering the fund’s risk and asset allocations into modular components, abandoning a complicated optimisation model. This simplification is allowing the fund to get its “younger people” into the asset allocation process for the first time.

“It is an interesting process,” he says, though he is typically modest about the impact it will have when completed. “I like having lots of pistons in the engine because lots of what we do doesn’t work. If we do lots of things, some things will work.”

Asset owners have rapidly scaled up their response to climate change to protect portfolios, but they have yet to catch up to the asset managers’ progress on a range of key activities, an annual benchmark report reveals.

The Asset Owners Disclosure Project (AODP) Global Climate 500 Index assesses the world’s 500 largest asset owners – representing more than $40 trillion in assets under management – on how well they disclose and manage climate risks that could affect retirement savings and other long-term investments.

This year, for the first time, AODP also surveyed the world’s 50 largest asset managers, which handle $43 trillion on behalf of their clients – representing more than 70 per cent of assets under management worldwide.

Globally, more investors are factoring climate risk into their decision-making. However, the report finds that although asset owners are making “rapid” progress, asset managers are ahead on a range of key activities.

It shows, for example, that 90 per cent of asset managers have incorporated climate change into their policy frameworks, compared with 42 per cent of asset owners. While the asset owners’ percentage is lower, it has doubled since last year.

The proportion of asset owners with staff focused on integrating climate risk into their investment has increased by more than a third, to 18 per cent. Again, asset managers are a long way ahead, as 68 per cent of those surveyed have dedicated staff.

One-fifth of asset managers calculate portfolio carbon emissions, while 13 per cent of asset owners do this – up from 10 per cent last year. Also, 12 per cent of asset managers assess the risk of stranded assets in their portfolio; 6 per cent of asset owners do this – up from 5 per cent last year.

AODP founder and chief executive Julian Poulter says: “Climate change is becoming a central part of risk management around the world, and will transcend short-term political setbacks such as moves by the Trump administration in the US to roll back action on climate change. Once investors adopt prudent risk-management practices, they will not unlearn them.”

Despite the upward trends, 200 asset owners and three asset managers showed no evidence of taking any action to tackle climate risk.

The AODP index assesses asset owners and managers on governance and strategy, portfolio risk management, and metrics and targets. Institutions are graded from AAA (the highest) to A ‘leaders’, down to D-rated institutions taking their first steps on climate risk. Those providing no evidence of action are rated X and classed as ‘laggards’.

In 2017, AODP made some changes to its methodology for constructing the rankings.

“While the underlying questions remain the same as last year,” the report states, “we have calibrated our assessment categories with the [Financial Stability Board] recommendations, to help asset owners and asset managers prepare for potential future reporting requirements. This alignment provides institutional investors with reporting consistency, trend analysis and an effective framework to implement the strategies required to meet – and perhaps more importantly exceed – the FSB’s expected guidelines.”

 

 

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