Success in investment management should be measured by holistic returns; it’s not enough to think about investments as just a bet on markets, said Saker Nusseibeh, chief executive of Hermes, who reminded delegates at the Fiduciary Investors Symposium that the financial world has become completely isolated from the real world.

“We collectively have a responsibility; we control the world economy,” Nusseibeh said. “The financial system sits in a bubble separate to the rest of the world. Why do we invest? Do we invest purely to accumulate wealth? Investing in the economy is a stupid way to invest if the only motivation is to make money for your clients. You should go to Las Vegas and hire a top-rated poker manager. They have better hit rates than any top-rated funds manager, even high-alpha managers.

“Skilled fund managers are rare. So now we are betting on factors in the economy, like a bet on the uptick of the European economy. That’s not the language of investment.

We have to think about what we are trying to achieve with this money. There is a disconnect between the amount of money we have invested and the world we live in.”

He made the case for measuring success by holistic returns.

“There are two reasons you invest in companies,” Nusseibeh said. “The first is to participate in economic growth, the second is [the need to engage about wanting] the businesses to be sustainable. And for that to happen, they have to be long term, more than just the next year or three years.

“We can prove that bad governance leads to bad returns. We have absorbed the idea that finance is a science, which is wrong, and built models, which is wrong. But part of what we are doing is betting on the economy. The other part is to encourage the economy we are building to be sustainable, environmentally friendly and friendly for the people who work in it. We have a duty of care to use the money to benefit the people whose money it is. Good [environmental, social and governance practice], good stewardship, is actually good business.”

 

Traditional asset managers are in a serious crisis of relevance, William Blair portfolio manager Ken McAtamney said during a panel discussion on digital disruption at the Fiduciary Investors Symposium at INSEAD, in France.

“Managers who are stock pickers are at risk of being disrupted,” McAtamney warned. “The move from active to passive has picked up pace, and as an industry we may have been guilty of under-delivering on performance net of fees. There is more on that but we can also focus on improving those things if we are more forward thinking on how we employ technologies in our industry.”

In his presentation, he said the asset-management industry spends about 8-9 per cent of revenue and about 14-15 per cent of total operating costs on IT. This in an industry that generates 40 per cent net operating margins.

The breakdown of IT spending shows the majority is on the back office and operations (50-70 per cent), investment process (10-30 per cent), and client engagement (10-30 per cent).

“IT spending has been focused more on reducing risks and costs than on enhancing alpha,” McAtamney said. “We think there is no replacement for judgement and decision-making, but, at the same time, we need to begrudgingly adopt technology in the front of the house. We’ve invested a lot in the back office, in trading and settlement, because we have to – that’s more defensive spending. Now can we move to using IT to [enhance] fundamental investing and decision-making?

“The focus is on how to process information and how we can come to investment conclusions more efficiently or quickly. That’s where the value add is.”

Ultimately, technology can add more science to the art of investing, but not replace art completely, the panel stated.

Speaking alongside McAtamney was Accenture head of digital strategy Bruno Berthon, who said no matter what’s happening in your market, there’s a lot of ‘digital inside’ that needs to happen.

“It seems the investment industry is investing that 70 per cent into non-discretionary [costs], to keep things running and respond to regulation,” Berthon said. “The big challenge is to find space for discretionary investing, to be innovative. I think the industry needs to be more efficient in the non-discretionary space to make way for that. What is new today will be legacy tomorrow. There is such speed at which technology is changing, you have to be present in the now.”

Keep internal technology in sync

Panellist David Long, senior vice-president and co-chief investment officer at the Healthcare of Ontario Pension Plan (HOOPP), said the biggest lesson the fund has learned in building its internal technology has been to manage the value chain of analytics, execution and workflow in sync.

“We want to make sure idea generation and the ability to execute and manage the workflow from transactions can operate at the same speed,” Long said. “What we want to do with technology is not treat each new investment challenge as a new problem and have to build everything from scratch again.

“We have a 600-person organisation and about half work on investment-related stuff, so we are trying to build platforms everyone can use and synchronise our activity across the organisation. In practice, this is difficult, because there are a lot of different users with different demands and priorities.”

HOOPP has built a number of internal platforms, including an exchange-trading app called octopus, and a repo collateral app called Flash.

Deputy dean of INSEAD Peter Zemsky, a professor of digital transformation who is also responsible for INSEAD’s digital transformation, called digital strategy a big issue for executives.

“Why now? Why is digital shooting up the CEO agenda? It’s absurdly cheap, but also the infrastructure is in place, such as the cloud, and companies that have packaged up data, storage and communication so you can scale it up. A start-up doesn’t need an IT department,” he said.

Zemsky argued that investors need to look at picking the players to take advantage of the digital revolution.

McAtamney added that managers are constantly analysing who the future winners are, but he said “we also feel like we are being disrupted as value adders”.

There is a European risk premium that investors can access, executive director of the Fonds de Réserve pour les Retraites, Olivier Rousseau, told delegates at the opening of the Fiduciary Investors Symposium, at INSEAD in France.

In a session during which he explored whether there was a European risk premium, whether one could be justified and how big it could be, Rousseau said there was a 5-10 per cent premium in the eurozone and a 10-15 per cent premium for the French market.

“The European risk premium is very much there and is connected with the political landscape we have been through over the past few years, [which has] taken a more dramatic turn recently,” Rousseau said. “What has happened elsewhere is of great significance for the eurozone. Markets don’t like the eurozone very much; the euro is weak and equity markets have been underperforming.

“There are not bad policies but we have inflicted a lot of problems on our markets with Basel III and Solvency II. And you have first-class companies in Europe.

“Profits have not been doing well in the eurozone, which is why markets have not been doing well.

Conditions for a recovery in the sharemarket are there, but we have the geopolitical risk overhanging.”

Also speaking at the Fiduciary Investors Symposium, Philippe Tibi, professor of finance at École Polytechnique, said venture capital could help transform the European market the way it has transformed US capitalism. The US enjoys 60 per cent of venture-capital flows, he said, followed by China, which already receives 20 per cent of flows. Europe represents 10-12 per cent of the funds allocated to venture capital.

“Why is it such a small allocation, given the size of the economy? It’s not because of lack of talent or size. The problem for Europe is more about institutions and agents,” Tibi said.

In Europe, wealthy individuals tend to invest outside of the continent, he explained, and institutions are restricted by legislation. He called France one of the few hubs of Europe.

“We have a vast pool of talent; there are 60,000 French people in Silicon Valley. We have 13 Noble Prize winners and are strong in science and mathematics,” Tibi said.

Swiss asset manager Compenswiss was established in 1948 to manage the assets of three Swiss Federal Social Security Funds: Old Age and Survivors’ Insurance (AHV), Disability Insurance (IV) and the Income Compensation Scheme (EO). Almost 60 years on, Compenswiss is continuing the development of a sophisticated strategy, investing assets of CHF34.8 billion ($34.8 billion) in a way that provides returns but is also low risk and has a high level of liquidity.

“By law, we must be fairly liquid and ensure our treasury has enough cash to deploy during the year. Building up a portfolio within these confines that delivers both returns and liquidity is a fine balance. We sometimes liken it to squaring a circle,” says Frank Juliano, head of asset management, speaking from Compenswiss’s Geneva headquarters. After deductions for hedging, the fund posted a return of 3.93 per cent in 2016, in spite of nearly a quarter of the return-seeking portfolio lying in negative-yielding bond investments.

The three schemes are managed on a pooled basis to keep costs low. Yet each scheme’s different asset and liability projections are met via an innovative structure that moves assets between a market (or return-seeking) portfolio, and a basis portfolio in cash and money markets.

Two portfolios are better than one

“The scheme’s assets are invested in a combination of the market and basis portfolios, according to their own risk/return profiles. We realised that the different schemes were facing different futures and that each had a different risk tolerance and cash needs.”

The vast majority (93 per cent) of the funds’ assets are in the market portfolio, half of which Juliano’s internal team manages. The interplay between the return-seeking and basis portfolios becomes particularly important during spikes in market volatility. The asset liability management (ALM) unit has developed a volatility tracking process, which means that a sharp market move triggers a decrease in risk according to the needs of each portfolio.

“When markets are volatile, we sell part of the market portfolio and invest in cash, bringing the risk portfolio back into a defined band.” The last time the volatility tracking was triggered was the summer of 2015.

Assets in the market portfolio are split between a 21 per cent allocation to Swiss bonds and loans, a 44 per cent allocation to foreign bonds – including high yield, credit and senior loans – a 24 per cent equity allocation, an 8 per cent real-estate allocation, and a 1 per cent allocation to commodities. The remainder of the market portfolio is in cash.

The allocations within the market portfolio have changed over time in a dynamic process that Juliano says is essential because of the confines of the local investment universe.

“Switzerland is a small country, with a strong currency and negative interest rates. We have to diversify the portfolio to find returns.”

Last year, the fund added an allocation to European high-yield and local currency emerging-market debt; it already had an allocation to hard currency emerging market debt.

Real estate grows in importance

Other recent allocations include foreign real estate, accessed via core real-estate funds in Europe and Asia. In the real-estate allocation, Juliano is also contemplating investments into value-add and opportunistic, and diversifying the portfolio across geographies and time spans. Such flexibility means real estate has become an important portfolio for delivering Compenswiss’s need for both returns and liquidity.

“We can invest only a limited portion into less liquid assets and, at this stage, can’t do the long time horizons of private equity and infrastructure. Increasingly, real estate has become a priority.”

Most allocations at the fund were managed externally until 2009. Today, half the portfolio is managed externally and half by Juliano’s internal team, in a decision-making process shaped by the extent to which internal management of an allocation can reduce costs, the ability to hire the right staff, and the operational risk of Compenswiss running the allocation itself.

“The availability of skills is an important consideration around internal and external management,” Juliano explains. “In Geneva, we have some good equity managers, but it is hard to find credit and high-yield managers. Also, the further you are from the market, the more difficult internal management is. For example, we have very limited access to the primary US credit market here.”

Currency risk becomes priority

As the fund diversified its asset base and invested outside Switzerland, managing currency risk at a portfolio level became another priority. Compenswiss’s Treasury Department runs a currency overlay program that covers roughly three-quarters of the fund’s currency exposure, through a dynamic and systematic process. It is not a full hedging program because of cost constraints, Juliano explains.

“We still keep some risk because hedging is costly. The Swiss base rate is -0.75 per cent. To hedge any currency involves paying the interest rate differential, so there is that trade-off between the currency risk and the cost of hedging.” In a recent example of the strategy at work, the investment committee took the view that hedging the fund’s Euro/Swiss currency risk ahead of the United Kingdom’s vote to leave the European Union last June was worth it.

“We increased our hedging ratio on the euro/Swiss exchange rate. Our fear was that should Brexit happen, the euro would fall and the Swiss franc would become a safe haven currency,” Juliano says.

Eleven elected members sit on the Compenswiss board, mostly drawn from representatives of the funds’ employers and employees. The investment committee prepares scenarios and proposals, which the board then scrutinises before approval.

“The board approves the risk budget, the asset allocation, the fluctuation bands of each asset class and the managers, and we then manage and execute investments according to their guidelines. It is a very transparent process and the universe is well defined,” Juliano says.

 

Institutional investors all over the world are grappling with the fact investment markets will not deliver what they once did, so their ability to reach their return targets is compromised. Rather than take on more investment risk, they are looking to reduce those targets. So what changes will that mean?

The chair of the $A127 billion ($97.6 billion) Future Fund and former Australian federal treasurer, Peter Costello, told a media briefing in January that the fund’s target investment return of 4.5 per cent to 5 per cent above inflation was likely to be unsustainable without taking on excessive investment risk. Costello said that even though the fund’s actual returns since inception have averaged 7.7 per cent a year, and it has met its return targets over the past decade, those goals should be adjusted for the next 10 years.

He did not suggest an appropriate revised target, nor did he suggest changes to the fund’s long-term asset allocation ranges were necessary. As of December 31, 2016, the Future Fund held more than 19 per cent of its assets in cash, reflecting what Costello described as “elevated risks [from] geopolitical factors”.

Lowering return targets often has a disproportionate effect on a fund’s liabilities, because investment earnings typically make up the lion’s share of funds’ revenue. A National Association of State Retirement Administrators (NASRA) issue brief, Public Pension Plan Investment Return Assumptions, states that about 63 per cent of public pension fund assets have been accumulated through investment earnings, with about 25 per cent from employer contributions and 12 per cent from employee contributions.

In February, the NOK7.7 trillion ($913.46 billion) Norway Government Pension Fund Global (GPFG) announced it was reducing its target real rate of return to 3 per cent. At the same time, the fund announced it was increasing its strategic benchmark allocation to equities from 62.5 per cent to 70 per cent. Full details and the reasoning behind both moves will be presented to the Norwegian Parliament at the end of this month.

In a statement, the Norwegian Ministry of Finance and the Office of the Prime Minister said the estimate for the expected real return on the GPFG has been 4 per cent since the introduction in 2001 of the so-called fiscal rule, or handlingsregelen. This law states that spending of revenues from the fund over time will be equal to the fund’s real rate of return.

“Returns are likely to be lower going forward, as assessed by two separate public commissions (the Thøgersen and Mork commissions) and Norges Bank. We must adapt to this fact. We, therefore, propose to adjust the return estimate downwards to 3 per cent,” the statement read.

It also explained the fund’s increased exposure to equities, stating that the expected return on equities “exceeds that of bonds, thus supporting the aim of increasing the fund’s purchasing power”.

“At the same time, equities carry higher risks,” it stated. “The proposal to increase the equity share is based on a comprehensive assessment of the recommendations received.

“All in all, the government considers an equity share of 70 per cent to carry acceptable risk. The downward revision of the return estimate underpins the long investment horizon of the fund, a prerequisite for holding a high share of equities.”

 

CalSTRS review recommends lower target

US public-sector pension funds grappling with the likelihood of lower investment returns over the next five to 10 years are preparing stakeholders, including fund members, governments – and ultimately, taxpayers – for the possibility of higher contributions to meet pension funding liabilities.

In February, the California State Teachers’ Retirement System (CalSTRS) revealed that it had a less than 50 per cent chance of reaching its 7.5 per cent return target, based on its current strategic asset allocation, capital market assumptions and inflation predicted at 2.75 per cent.

The prospect of the fund missing its target rate of return is included in a paper presented to the board that recommended a reduction in the target rate to 7.25 per cent, to be phased in over two years starting on July 1, 2017.

The recommendation followed CalSTRS’ regular four-year study of actuarial and demographic assumptions used to monitor the system’s funded status – including the returns and contribution rates necessary to ensure the system is fully funded.

The previous study was completed in 2012. The one planned for 2016 was delayed by 12 months to take into account additional data, including updated member mortality information, and stated that while the fund’s strategic asset allocation remains appropriate, it cannot reach the higher target with that allocation nor without taking on greater risk.

Long-term, short-term projections diverge

US-based NASRA’s brief, updated in February this year, states the lower-for-longer investment environment since the global financial crisis (GFC) has affected return assumptions, but funds have more recently faced another issue.

“One challenging facet of setting the investment return assumption that has emerged more recently is a divergence between expected returns over the near term, that is, the next five to 10 years, and over the longer term, that is, 20 to 30 years,” the brief states. “A growing number of investment return projections are concluding that near-term returns will be materially lower than both historical norms and projected returns over longer timeframes.

“Because many near-term projections calculated recently are well below the long-term assumption most plans are using, some plans face the difficult choice of either maintaining a return assumption that is higher than near-term expectations or lowering their return assumption to reflect near-term expectations.”

Targets dropping at public funds

NASRA analysed 127 public pension funds and found that at least 65 of them have reduced target rates of return since 2012. Each of the 65 reduced its targets after applying expected future returns to existing strategic asset allocations, NASRA’s report stated.

“The median return investment assumption was 8 per cent in 2011 and is now [in February, 2017] 7.5 per cent,” the report stated. “The number of plans with an investment return assumption below 7.5 per cent has been steadily increasing since 2009. In that year, only six of these plans had an assumption below 7.5 per cent. Today, 34 of these plans have an assumed investment return of 7.25 per cent or less. Of these 34 plans, 17 have adopted an assumption of 7 per cent or less.”

Just before Christmas last year, the $306 billion California Public Employees Retirement System (CalPERS) board of administration announced a reduction in the discount rate used to calculate future pension liabilities, from 7.5 per cent to 7 per cent, to be phased in over three years starting in 2018-19. It’s not the first time in recent years CalPERS has reduced its discount rate, having cut it from 7.75 per cent to 7.5 per cent in 2012.

The board said it would review the fund’s asset allocation during its next regular asset-liability management cycle, a process that ends in February 2018.

Divestment has long been a controversial topic and practice in the investment industry.

For decades, institutional investors around the world – many encouraged by stakeholders – have chosen to divest from specific asset classes, sectors or companies on ethical or financial grounds.

The fossil-fuel divestment campaign is very much alive today; 155 foundations have signed the Divest Invest pledge and the value of assets represented by institutions and individuals committing to some sort of divestment from fossil-fuel companies has reached $5 trillion.

Beyond the adverse moral implications of investing in products that are precipitating climate change, divestment campaigners argue that fossil-fuel investments expose institutional investors to the risk of stranded assets, implying that when industry or government acts to effect a swift transition to a low-carbon economy, many fossil-fuel reserves will be rendered unburnable and thus sharply devalued.

Although this argument has merit, there are reasons for investors to take a more nuanced approach to managing climate-change risks in their portfolios. Investment professionals often push back against divestment pressure, given a number of theoretical and practical issues with taking such a blunt action in a fiduciary context.

Most notably, practitioners typically argue that divestment limits the investable universe, which, according to Modern Portfolio Theory (MPT), inherently reduces long-term risk-adjusted return potential. In addition, investors may prefer to stay invested in fossil-fuel companies in order to engage with management and influence change.

Similarly, investors have been grappling with how best to profit from investments in ‘climate solutions’, defined generally as technologies that reduce greenhouse-gas emissions or improve the resilience of assets against physical climate impacts.

Investors harbour many different views on how to position such investments within a portfolio (that is, as a hedge against deterioration in fossil fuel-intensive assets, as a pure source of alpha generation within a thematic portfolio, or as some combination of the two).

Questions also persist about the size and diversity of the opportunity set and the ability for investors to access this theme across asset classes. Past attempts to capitalise on climate solutions have also been hampered by over-exuberance (for example, early-stage clean tech underperformance in the mid-to-late 2000s) and regulatory risk (as in Spain).

Answering these questions can prove challenging for investors operating within existing dominant risk-modelling and management frameworks.

Back-testing in a time of climate change

To understand the impact of fossil-fuel divestment, or investment in climate solutions, on portfolio risk/return, practitioners naturally turn first to the historical record, though the question remains as to what extent past data can be relied on to make long-term predictions regarding the future effects of climate change, which is a phenomenon that has not yet fully manifested and has no proxy in history.

It is also unclear to what extent markets are pricing climate change into valuations and what potential large changes in policy, technology and weather patterns may unfold over the coming years and decades.

Moreover, most asset allocation modelling tools in use today are based on MPT and heavily influence most strategic decisions.

This speaks to the power of quantitative modelling techniques and their ability to reduce complex systems into more readily interpretable numbers. However, we believe that the full complexity of economies and markets cannot be measured or captured entirely in mathematical models and that these models benefit from qualitative supplementation.

To this end, we have attempted to marry a complex risk with an existing quantitative risk-assessment framework, to make it more approachable. Our technique for climate-change risk assessment was initially described in our Investing in a Time of Climate Change report.

This research informed the development of four scenarios aligned with temperature rises 2-4 degrees above pre-industrial average. It also identified four risk factors: technology, resource availability, physical impacts and policy (TRIP). The scenarios developed reflect plausible outcomes and represent a broad global consensus on how certain futures might unfold. The multiple risk factors acknowledge that climate change is not one risk; rather, it is a diverse basket of risks that manifest economically in different ways.

The low-carbon transition premium

In a recent paper, to test whether the investment decisions the Divest Invest pledge contemplates might result in a low-carbon transition premium, we developed several asset classes that were fossil-fuel free and sustainable, with associated TRIP factors.

Sustainable investments are typically positioned to avoid areas most exposed to risks climate change poses, while being positively aligned with the shift to a low-carbon economy. In developing the sustainable asset classes, we assumed such investments had greater positive sensitivity to the technology and policy risk factors, relative to standard asset classes.

Using these new asset classes, we built a sample Divest Invest foundation portfolio, ran it through our climate change model and compared it with a more traditionally managed ‘base’ foundation portfolio, one that maintains exposure to fossil fuels and does not tilt towards climate solutions.

We found that the Divest Invest portfolio outperformed the base portfolio under our +2 degrees transformation scenario.

This result is attributable to the Divest Invest portfolio’s lack of exposure to fossil fuels and its tilt towards sustainable assets, suggesting that if an investor envisages a favourable policy and technology environment leading to a +2 degrees outcome, then both reduction in exposure to carbon-intensive assets and positive allocations to sustainable investments should be considered to improve results.

This being said, the future of climate-change mitigation action (including global or regional policy and continued technological advancement) is uncertain, and other climate-change outcomes are possible.

For instance, while our transformation scenario is broadly consistent with the baseline goal of the Paris Agreement, the ability to meet this goal will be influenced by global ambition (for example, the Paris Agreement also includes a reference to a more desirable +1.5 degrees outcome) and political realities (the country emission commitments submitted going into Paris are not yet sufficient to meet a +2 degrees goal). Other scenarios thus warrant further consideration if investment decision-makers deem them more probable or more important – from a risk-management perspective – over the relevant time horizon.

Investors can use a climate scenario analysis to better determine if they wish to be climate-aware future takers or future makers. Future takers will manage climate-change risks and pursue related opportunities, irrespective of which scenario comes to pass.

Future makers will determine which scenario is best for long-term investment outcomes and make a concerted effort to influence its occurrence. As an increasing number of investors look to position themselves either as future takers or future makers, continued market innovation to meet related demand for investment solutions that positively align portfolios with a shift to a low-carbon economy will be critical.

Progress is being made in scaling certain market segments (for example, the growth in green bond issuance), and an increasing number of funds are being developed to suit a broad range of investors, though much more remains to be done. We look forward to working with a range of investors to help them understand their climate risks and develop appropriate risk management.

Alex Bernhardt, is principal and US responsible investment leader at Mercer