We believe the standard tools of economics, and the risk methods derived from them, are not going to steer us through market dislocations and crises.

At the University of California Office of the Chief Investment Officer, we are developing a new approach to risk management that may be better suited to dealing with market dislocations. We call this Risk Management 3.0. It extends risk management beyond the standard Risk 1.0 methods – like value-at-risk – which use historical relationships that assume the future will look like the past as their guide. It also looks beyond Risk 2.0 stress testing, which allows for non-historical stresses, but isn’t able to take the cascades and contagion of crises into account.

Based on our recent experience, economics does not fare too well in times of crisis. Despite having an army of economists and all the financial and economic data you could hope for, on March 28, 2007, then-Federal Reserve chair Ben Bernanke stated to the Joint Economic Committee of Congress that:

“The impact on the broader economy and financial markets of the problems in the subprime market seems likely to be contained.”

Less than three months later, this containment ruptured, taking a course that blew through one financial market after another. In 2008, Bernanke testified that there might be failures within the ranks of the smaller banks, but:

“I don’t anticipate any serious problems of that sort among the large internationally active banks that make up a very substantial part of our banking system.”

That September, Washington Mutual became the largest financial institution in US history to fail.

Risk Management 3.0 aims to be a better predictor of crises than Bernanke was. It is based on agent-based models that draw from complexity science, and take a bottom-up approach of looking at the interactions of the entities that make up the financial system, to uncover what emerges for the system overall.

Agent-based models at work: traffic flows and congestion

To see agent-based models at work, consider one area where they have become a standard tool: traffic. Traffic has readily identified agents: the drivers and their cars. When we are driving, we are operating in our own micro-environment, seeing a small set of the other cars on the roadway. The drivers react in different ways. Some go back and forth from one lane to the other. Some go slowly in the left lane, annoying all of us. Some speeding in the right lane. One minute, we might be part of a co-ordinated, smoothly flowing stream of traffic; another, we’re unaccountably contributing to a ripple effect of congestion.

All of this can be expressed in an agent-based model:

There are agents (cars, people) that employ various heuristics and can act with some degree of independence or autonomy.

At the start of each time period, each agent observes its environment and acts according to its heuristic. The agent’s environment is only a local view of the overall system.

The agents’ actions change the environment.

In the next period, each agent sees its new environment, altered based on the actions of the previous period, and takes action again. Thus there is an interaction between the agents and the environment, and between one agent and another.

These are the threads of agent-based models in a simplistic example. It ultimately boils down to the dynamics of interactions driven by the various agents and their environment, and the heuristics applied to that environment.

Models for financial crises

To understand how agent-based models can deal with the risks of market dislocations and crises, consider an analogy with an area where agent-based models have found application – dealing with the stampede of people escaping a fire. If you are a fire marshal, the critical question is whether people can get out in the case of fire, and this depends on three things: the number of people in the space, how many people can exit per minute based on the number and size of egress, and the time available to exit based on the flammability of the space. We are not looking at people walking through the exit in an orderly way. There is the potential for panic and stampedes. So we need to model this based on how people behave in a crisis – a job for agent-based models.

Using this as an analogy for the financial system, the spark creating the fire is a market shock. Market concentration measures the number of people in the market, liquidity determines the rate at which people can exit and leverage or, more generally, the potential for forced selling, determines the flammability of the market, and thus the number of minutes available to exit. Things get particularly complicated when we are dealing with financial markets. The exits shrink as investors push through them to liquidate. Flammability increases if the exits become smaller, because in financial markets the drop in liquidity fuels cascades.

So for Risk 3.0, and the use of the agent-based model that underlies it, we start with concentration, leverage and liquidity, and then see how that informs actions in the face of a market stress.

This time – every time – it’s different

A crisis is not simply a fat tail event or a bad draw from the urn. It is a draw from a new urn. Agent-based models allow us to recognise some essential aspects of the world, ones that are particularly apparent during crises. The real world is a rich and complex place. There are many different players and institutions interacting in sometimes surprising ways, changing the market environment, and these changing them in turn.

The standard Risk 1.0 and 2.0 models will work some of the time, like when people are all pretty much the same, doing the same sorts of things as always. But they generally aren’t all the same, and don’t all act the same. Especially during periods of crisis. That is when we need to move to Risk Management 3.0.

 

This essay is derived from, The End of Theory: Financial Crisis, the Failure of Economics, and the Sweep of Human Interaction, by Richard Bookstaber, Princeton University Press, 2017.

 

Jagdeep Singh Bachher is chief investment officer, and Richard Bookstaber (pictured) is chief risk officer, of the Office of the Regents at the University of California, which manages a portfolio of $100 billion.

The $12.5 billion School Employees Retirement System of Ohio (SERS) plans to trim its allocation to hedge funds through the course of the year, building on a strategy begun during its last asset liability study three years ago.

“We have had a number of discussions with the board, our staff and consultants and it looks like the current asset allocation is reasonable,” says chief investment officer Farouki Majeed, speaking from the fund’s headquarters in Columbus – Ohio’s capital city. “We do have concerns that the hedge fund allocation of 10 per cent is high, and we might trim this down. But I am not in the camp of eliminating hedge funds altogether.”

In 2013, SERS decided to reduce its hedge fund allocation from 15 per cent of assets to 10 per cent. That money went from hedge funds into real assets and that is the plan this time as well.

Gruelling 2016 for hedge funds, healthcare

The decision follows a gruelling 2016 for SERS’s hedge fund allocation, which was hit particularly hard when Visium Asset Management, the fund’s equity long/short manager specialising in healthcare, folded mid-year.

“It was a disappointing year on account of hedge fund manager underperformance and healthcare was a volatile play,” Majeed says. “Once we realised the problems with Visium, we began to withdraw money; we were never fully exposed right through.”

A UK-based, relative value quant manager for the portfolio also had negative returns, further weighing it down. Yet Majeed still says hedge funds are a vital part of the investment puzzle because of the diversity the allocation brings to the fund.

“The hedge fund and fixed-income portfolios are risk diversifiers because their contribution to total fund risk is lower than their asset allocation; this is the role these allocations play in the portfolio,” Majeed explains, adding that the hedge fund portfolio is bouncing back.

“At the end of December, our five-year net return for hedge funds was higher than its benchmark and well ahead of fixed income. Multi-asset strategies have brought a five-year return of 4.74 per cent, net of fees.”

SERS uses 20 hedge fund managers, reduced from 48 after a policy to allocate more money to fewer managers. This has helped reduce fees, as has negotiating longer lock-ups with high-conviction managers.

The process of reviewing the asset allocation has prompted Majeed and his team to examine introducing target allocations to sub-asset classes, namely high-yield debt, emerging market debt and master limited partnerships (MLPs) in the US – the mid-stream infrastructure asset. However, the review left the CIO unconvinced that separate allocations are necessary.

“Developing niche asset classes makes the policy portfolio more complicated,” Majeed explains. “The optimisation process becomes prone to more errors. There are more inputs, and the more inputs you have, the more likely you are to have errors. I believe less is more.”

He says the fund is now more likely to gain additional exposure to these assets via fixed income in actively managed, opportunistic allocations.

“If you have a target allocation for a fixed amount, you are forced to allocate it, otherwise you have a discrepancy relative to the policy portfolio. I prefer to access these assets on an opportunistic basis.”

Real assets within this opportunistic allocation include high-yielding infrastructure, such as aircraft leasing and oil terminals, and mid-stream MLPs.

“Valuations in MLPs were down 50 per cent in 2015. It was a good time to buy,” Majeed says. Credit strategies in private debt have also proved a rich seam, with SERS investing in funds lending directly to small- and mid-market companies.

“We look at the managers who have had very little or no credit losses,” he explains. “Terms include upfront fees and strict covenants; the loans are highly secured and shorter-term, so not beyond five years. Most are repaid before that anyway.”

SERS assets are split between a 22.5 per cent allocation to domestic stocks, a 22.5 per cent allocation to international stocks, 19 per cent to global bonds, 15 per cent to global real assets, 10 per cent to global private equity, 10 per cent to multi-asset strategies and 1 per cent to short-term securities.

“We are comfortable with this exposure to growth for now,” Majeed says.

REITs in favour

The allocation to real assets comprises property, infrastructure and real-estate investment trusts, in a portfolio that has netted a return of 11.58 per cent over the last three years. The portfolio used to have a heavy allocation to value-added real assets, in a risk-oriented approach with high levels of leverage. Now, 80 per cent of the portfolio is in core assets and the leverage is about 30 per cent on a total portfolio basis. Majeed particularly likes the allocation to income-producing REITs, which account for less than 5 per cent of the allocation to real assets but could, in theory, climb up to 10 per cent.

“REITs have equity-like volatility but offer good returns over a very long period of time,” Majeed says. “Over the long term, they have performed better than private real estate. It is helpful having a liquid component in the real-estate allocation.”

He also notes that accessing real-estate opportunities is becoming more difficult.

“In 2013, it was still a good time to deploy assets, when the allocation was increased from 10 per cent to 15 per cent. Managers could take and deploy money quickly and were also buying assets 25 per cent lower than the high values pre-financial crisis. Right now, the markets are much more richly priced. We will be very selective now.”

Majeed attributes much of the fund’s success to governance. The investment team provides the board with monthly reports, as well as quarterly and annual reviews that include analysis of all asset classes and managers. In return, the board has delegated all investment decisions to the investment staff.

“The delegation the board gives us to invest is crucial to our success, and our governance is a source of alpha,” Majeed concludes. “Not taking every investment decision to the board [allows us to] be opportunistic and nimble.”

The giant Japanese Government Pension Investment Fund (GPIF) is pushing its external managers to fulfil stewardship responsibilities and improve their own governance, as part of its conscientiousness as a “super-long-term investor”.

About 24 per cent of the fund is in domestic equities and it exercises its voting rights via external asset managers. Therefore, it fulfils stewardship responsibilities by promoting constructive engagement between its external asset managers and investee companies. In 2016, all of the fund’s external asset managers exercised their voting rights.

Targeting short-termism

The ¥144 trillion ($1.26 trillion) GPIF has clear expectations of its external managers around stewardship, including improving their own effective governance, exercising voting rights and integrating environmental, social and governance (ESG) principles.

This year, in addition to those tasks, GPIF is also asking external managers to establish a remuneration system for directors and employees of asset managers to prevent short-termism, and to look at passive management in the context of stewardship.

The fund is also calling for applications for more fund managers in passive Japanese equities.

About 80 per cent of the fund’s domestic equities are already in passive management.

In the qualitative assessments of GPIF’s external passive managers, the weighting to “activities of stewardship responsibilities” has been raised to 30 per cent, from 10 per cent. However, engaging fully with companies is difficult territory and some of the fund’s passive managers have indicated that the current fee structure does not provide enough compensation for the stewardship responsibilities they are asked to fulfil.

Of the fund’s 19 external domestic equities managers, 16 have signed the United Nations’ Principles for Responsible Investment, and seven have introduced independent outside directors.

In a formal summary report of its stewardship activities in 2016, GPIF indicated it would move away from one-way annual monitoring and toward constructive communication. It will also expand its stewardship activities to asset managers handling international equities. About 23 per cent of the fund is in foreign equities.

In the 2016 stewardship report, the fund states that: “It is essential for GPIF as a ‘universal owner’ (an investor with a very large fund size and a widely diversified portfolio) and a ‘super-long-term investor’…to minimise externalities of corporate activities (environmental and social issues, etc.) and to promote steady and sustainable growth of the overall capital market.

Equities managers step up efforts

The report also showed that all the fund’s domestic equities managers have set up or reinforced departments or committees dedicated to overseeing stewardship activities and stepped up their efforts to include continuous organisation-wide stewardship activities, not merely voting rights. They also all responded positively about ESG integration, although only a few of them have used ESG meaningfully in actual engagement.

Since 2001, the fund has returned 2.7 per cent annualised. It has been focusing on stewardship and ESG activities since May 2014, when it announced acceptance of Japan’s Stewardship Code.

More recently, it established a stewardship and ESG division comprising seven members – including two full-time staff members. And in November, it convened the Global Asset Owners’ Forum, to exchange ideas with global pension funds on ESG issues.

 

There is a relationship between the type of trustee on the board and the riskiness of a pension fund’s investments, according to research that supports the idea that governance and board composition matter.

In particular, there is a relationship between the riskiness of a US public pension fund’s assets and the proportion of trustees on the board who are political appointees and worker representatives elected by member schemes.

Under the rules of the Government Accounting Standards Board, US public pension funds are allowed to discount their liabilities by the expected return on their assets. This is a perverse incentive to invest in more risky assets, according to work by Rob Bauer, academic director of the International Centre for Pension Management, along with Martijn Cremers and Aleksander Andonov.

Their paper, “Pension fund asset allocation and liability discount rates”, compares public and private pension funds in the US, Canada and Europe, and finds that US public pension funds do act on their regulatory incentives.

Bauer, who is a professor of finance at Maastricht University, says the regulatory link between the liability discount rate and the expected return gives US public plans an incentive to increase their allocation to risky assets.

In particular, these funds have an incentive to increase the allocation to risky assets when expected returns decline, and Bauer contends that board composition, and especially stakeholder representation, will be a driver of the funds’ response to these incentives.

The research also shows that funds with a higher representation of state and participant-elected trustees respond more to the regulators’ incentives (and perform worse).

“Our empirical results show that funds with a higher percentage of board members from these categories take more risk, use higher discount rates and perform poorly,” Bauer says.

So the research has shown not only that US public pension funds have become the biggest risk-taking pension funds around the globe, but also that the increased risk-taking by US public funds has a negative correlation with their performance.

US public pension funds, on average, underperform their strategic benchmarks by about 55 basis points per year, the research shows.

This means the regulatory framework matters and, moreover, the pension fund board composition matters in a profound way, too.

Bauer is also the executive director of the International Centre for Pension Management, which runs a board effectiveness program (BEP) that he programs as academic director of BEP, which is a joint initiative between Rotman and ICPM. The week-long course is held twice a year, and the next event (April 3-7) will mark its 10th iteration.

Board composition and dynamics are discussed during the program, which instils best practice in key areas such as organisational mission, fiduciary duties, investment styles, the role of the board versus management, risk management, and human resources management, including compensation.

In essence, it focuses on the higher level responsibilities of board members to provide oversight of what is essentially a complex financial institution.

Over the years, more than 250 trustees from 64 organisations and 12 countries have attended the BEP. Participants consistently say meeting other trustees with different experiences and backgrounds and from different types of funds and countries is invaluable.

“What the 250-odd alumni like is we discuss real strategic issues relevant to the board of a pension fund,” Bauer explains. “It’s not about, for example, investments; it’s about not interfering with management but having the right tools to deal with management.”

 

More information about the board effectiveness program can be found here.

For many institutional investors, the short-term impact of the United Kingdom’s decision to leave the European Union was positive.

The £20.9 billion ($25.5 billion) medical charity Wellcome Trust reduced its sterling exposure to a record low ahead of the vote, in a strategy that helped the fund return 19 per cent in 2016.

The €12.3 billion ($13 billion) German pension fund Ärzteversorgung Westfalen-Lippe (ÄVWL) Brexit-proofed its portfolio with a large US dollar exposure. Dollar holdings accounted for about 12 per cent of its assets last summer, offsetting weakness from a moderate sterling exposure and making the fund a net gainer from the Brexit decision.

Nine months on and a ‘soft Brexit’ – which would give the UK continued access to the single market based on the free movement of goods, capital, services and people throughout the bloc – is unlikely. Instead, the UK is set to leave not only the single market but possibly the customs union as well.

The customs union sets a common external tariff for countries within the bloc, and leaving it would free the UK to sign trade deals with the rest of the world. The timeline is fraught with unknowns, none more important than the fact an eventual tariff deal would need to be ratified by parliaments in all 27 member states. A protracted split could encourage other members, particularly those with elections this year, to leave. With a hard Brexit in the offing, what are the long-term investor challenges and opportunities?

Selective optimism in real estate

The UK’s real-estate market is looking vulnerable, particularly London’s financial sector. The big question is whether UK-based institutions will hang onto the ability to sell their services throughout the EU, via existing ‘passporting’ rights, once Britain leaves the bloc. If they can’t, many could relocate to Europe, dragging down real-estate values in their wake.

“The area we see as most vulnerable is tenants in the financial sector. It is unclear how the new trade regulations might affect their business,” says Dale MacMaster, chief investment officer of Canada’s Alberta Investment Management Corporation, (AIMCo), the C$90.2 billion ($69.4 billion) pension fund with a $12.4 billion real-estate portfolio, of which 11.8 per cent is in the UK.

Nevertheless, AIMCo still views UK real estate “in a positive light” and MacMaster notes steady demand for office space from tech and media tenants, as well as leasing demand from industrial groups.

“We will pursue opportunities in areas such as modestly priced housing projects and logistics warehousing projects for firms supplying the UK market,” MacMaster says. “Moreover, the depreciation in sterling against the Canadian dollar is a chance to add assets.”

Other investors share his selective optimism.

PFA Asset Management chief investment officer equities and alternatives, Henrik Nøhr Poulsen says, “We believe the UK is still likely to be the most attractive real-estate market in Europe in 10 years. However, the long-term attractiveness of UK real estate will depend on how attractive a country the UK is for business in the future. We don’t know if the level of demand is going to be 90 per cent of what it is today or 120 per cent.”

PFA Asset Management is the investment arm of Denmark’s DKK550 billion ($78.2 billion) PFA Pension, where strategy is focused on building an alternatives allocation from 2 per cent to 10 per cent of assets under management over the next five years.

Others funds have a more negative outlook on UK real estate, and have been quick to shape their allocations to benefit from demand for office space in rival European financial capitals, such as Frankfurt and Paris.

Lutz Horstick, head of securities and loans at ÄVWL, says: “There is opportunity in Frankfurt’s office market from banks relocating from London to European cities. A lot of money from the Far East and Middle East headed exclusively to London but this is starting to change. We have been very sceptical of the London property market for a while.”

Ilmarinen, Finland’s third-largest pension fund, has an 11 per cent allocation to real estate and has also cooled on the UK market. Despite plans to boost investment in Europe, the fund has put investment in UK real estate on hold since Brexit.

“There are so many open questions about Brexit for investors,” Ilmarinen chief investment officer Mikko Mursula says. “We don’t know the time schedule, or what will happen in the end.”

Canada’s appetite for UK infrastructure

Canadian pension funds have poured into UK infrastructure, buying stakes in the High Speed 1 railway line that connects London to the Channel Tunnel, critical energy infrastructure and landmark London property, ports and airports – including London City Airport, in a deal closed a few months before Brexit.

Appetite at AIMCo, which has more than a quarter of its $5.2 billion infrastructure portfolio in the UK, will cool going forward. But MacMaster, who likes UK infrastructure for its links to inflation, especially as sterling weakens, doesn’t attribute this directly to Brexit, but more to the fact that the portfolio is already weighted towards the UK.

“The ongoing focus is now on Euro-denominated investments, regardless of Brexit,” he says. “One investment area we are interested in exploring longer term is new infrastructure opportunities potentially put forward to help the UK compete more effectively post-Brexit.”

Active management in equities

Investing in UK stocks post Brexit could introduce a new phase where funds embrace active management and stock picking over passive, cheaper investment vehicles.

Chief investment officer Salwa Boussoukaya-Nasr, at France’s €36.3 billion ($38.4 billion) Fonds de Réserve pour les Retraites (FRR), thinks this strategy has already paid off. Nearly 60 per cent of equity investments are actively managed at FRR, in a strategy that has helped shield the fund from enduring structural weakness in the euro zone and the Brexit fallout.

Going forward, Boussoukaya-Nasr says, active strategies will position the portfolio for new trends, particularly slower UK growth and a normalisation of valuations as euro zone earnings improve. FRR increased its exposure to the euro zone from 2012 to 2015, with its allocations to the region’s investments rising from 41 per cent to 49 per cent during that time.

ÄVWL’s Horstick says: “The fall in sterling offers a window of opportunity for investors to build exposure in UK equities.” UK companies with a global customer base and dollar earnings, say, tech companies, won’t be affected by any domestic downturn and look cheap.

AIMCo’s MacMaster says companies that could feel the fallout are those dependent on strong UK demand.

“At the moment, AIMCo tends to underweight sectors where, on average, companies derive a larger portion of their revenues from the UK,” he explains. Sectors dependent on an immigrant workforce, like farming and hotel services, and companies focused on trade with the EU also face a more uncertain future.

Uncertainty is the abiding theme of Brexit.

“The most obvious impact of Brexit is uncertainty,” says Ian Scott, head of investment strategy at the UK’s Pension Protection Fund, the £23.4 billion ($28.4 billion) lifeboat fund where post Brexit strategy included scaling back of risk in the growth portfolio.

An LDI strategy cushioned the PPF from the shock of Brexit, in contrast to many other UK funds which have been hit by gilt yields falling, pushing up their liabilities. “Because we are fully hedged the impact of Brexit on our balance sheet is mirrored by the impact on our liabilities. Brexit does mean, however, we are managing the risk on our growth portfolio differently.”

The $188.8 billion California State Teachers Retirement System (CalSTRS) will navigate Brexit uncertainty via tilts. The fund has been developing an asset allocation away from its home-country bias and towards a more global asset mix since 2015.

“CalSTRS will continue to move toward our long-term allocation policy and may take short-term tilts allowed in the allocation policy, given our market outlook,” fund spokesman Ricardo Duran says. “We continue monitoring the impact of Brexit on the European market for these tilts, and the implementation of our long-term asset allocation policy.”

For now, few funds are factoring in much lower EU growth, or further exits from the bloc; moreover, the UK’s loss is Europe’s gain. Most are unlikely to increase investment in the UK, and those that do will be highly selective and opportunistic.

“In general,” MacMaster concludes, “AIMCo believes that where there is uncertainty, there is always opportunity.”

Finally there is a robust measure of whether or not corporations that focus on the long term achieve better results. According to the McKinsey Global Institute, the answer is a resounding yes.

McKinsey has released a discussion paper, Measuring the Economic Impact of Short-termism, which analyses whether short-termism genuinely detracts from corporate performance and economic growth.

Using a data set covering 615 large- and mid-cap publicly listed US companies from 2001 to 2015, McKinsey has created a five-factor corporate horizon index.

The data looks at patterns of investment, growth, earnings quality and earnings management. It separates companies with a long-term focus from others and compares their performance.

Among the findings:

  • From 2001-14, the revenue of long-term firms cumulatively grew 47 per cent more, on average, than the revenue of other firms, with less volatility.
  • Long-term firms invested more than other firms from 2001 to 2014.
  • Long-term companies exhibited stronger financial performance over time
  • From 2001-15, long-term firms added nearly 12,000 more jobs, on average, than other firms.

The research shows that firms with a long-term focus exhibit stronger fundamentals, deliver stronger superior financial performance, continue to invest in difficult times and add more to economic output and growth.

 

To view the discussion paper, click here.