Impressive statistics from Canada’s OPTrust, manager of C$18.4 billion ($13.9 billion) in assets for 87,000 former and current public-service employees in Ontario, make enviable reading for pension funds weighed down by deficits and low returns. In 2015, the fund returned 8 per cent and remained fully funded. Over its 21 years of operation, its investment portfolio has realised an average annual return of 8.4 per cent and, on average, 73 cents of every pension dollar paid to beneficiaries in the mature plan is generated by investment returns.

“Our investment strategy is based around the interests of our members, first and foremost,” explains Hugh O’Reilly, president and chief executive of the fund. “We are investing … to protect the funded status of the plan; we are not beating a benchmark. We take risks to generate returns but we will not jeopardise our funded status or our level of contributions. We see ourselves as a pension fund and not an asset manager.”

Prioritising members has led to a member-driven investing (MDI) strategy that O’Reilly contrasts with better-known liability driven investment (LDI), in which strategy is shaped around the cash flows needed to fund future liabilities.

“Some pension funds have adopted LDI, while others seek to maximise their returns,” O’Reilly says. “There is no right answer. We are driven by our members, by demographics and by what makes sense to us. If one looks at the Canadian model, therein lies a recipe for success founded in a few factors. Our plans are governed independent of the government and unions. We have internal investment teams, which allows us, generally speaking, to run the pension plan at a low cost, and our contributions are strong.”

Putting members first lay at the heart of last year’s successful navigation of volatility and low returns.

“Last year, we assessed the funded position and, seeing that we had a surplus, we set about steps, from an investment perspective, to preserve that surplus.” O’Reilly’s strategies included protecting the fund against Canada’s depreciating dollar, hedging the public-equity exposure and ensuring a strong alternatives portfolio, all mixed with a resolute belief in his team’s ability – although he does acknowledge some good fortune.

“We have skilled investors and it’s important to recognise those skills,” he says, but adds that “markets have a way of humbling you.”

Looking ahead, he sees continued uncertainty, which he plans to counter with strong alternative allocations.

“While US markets have reacted positively to the incoming administration, we are somewhat concerned [that they] may be overly optimistic,” he says. His strategy is to continue to hold robust allocations to real estate, private equity and infrastructure, which together account for a third of the fund’s assets. All are internally managed.

Infrastructure involves strategic partnerships and accounts for 12 per cent of assets under management. Through 2017, O’Reilly will look particularly at mid-market opportunities around the $100 million-$150 million mark.

“The market is expensive for larger assets like toll roads; we have changed our focus to smaller projects.” In 2015, he committed to four new infrastructure investments in North America, Europe and Australia, totalling $636 million; the portfolio generated a net return of 7.0 per cent in that year.

For private equity, O’Reilly has a sanguine approach, at a time when opportunities to invest are competitive and expensive.

“There is no pressure on us to put money out the door,” he says. “Only where we see opportunities that make sense to us do we pursue them.” Private equity represented 9.2 per cent of net assets at year-end 2015, up from 7.3 per cent at year-end 2014. The private-equity portfolio generated a net return of 14.4 per cent for 2015.

The public-equity allocation is managed externally but O’Reilly and his team are in the process of bringing the bond and foreign exchange allocations in-house. It’s a strategy designed to bring the fund closer to the market.

He explains: “We want to better understand where the trends are going in fixed income and foreign exchange, and bringing management in-house is the best way to achieve this. If you use external managers, you can’t react to secular trends. We also believe that this will save on fees and transaction costs.”

He is also steadily building the hedge fund allocation from 2.5 per cent of assets in 2015. The allocation now favours style premia and momentum strategies, although O’Reilly stresses a dynamic approach here – changing the allocation according to the needs of the total portfolio.

“Hedge funds are a way to harvest returns without owning the underlying asset,” he says. “We work to make sure the fee exposure is reasonable and look actively to make sure the strategies make sense for us.”

Responsible investment is integrated across every asset class in the fund. O’Reilly points to the latest suggestions from the Financial Stability Board’s Task Force on Climate Related Financial Disclosures. The task force is calling for companies to publish their potential losses from climate change. He says this is the latest step in an evolving movement. It’s an observation that leads him to ponder the growth of environmental, social and governance strategies.

“It is no longer about screening securities [over whether] they are good or bad,” he argues. “It is about engagement and due diligence and monitoring, and this is an exciting and important change. It’s here to stay.”

Among the 10 different pension and insurance schemes within the $16 billion Kentucky Retirement Systems portfolio lies one of America’s most distressed pension plans.

At only 17 per cent funded, the Kentucky Employees Retirement System (KERS) Non-Hazardous Plan is the biggest headache for chief investment officer David Peden. Speaking from the fund’s headquarters in Louisville, Kentucky – the US state best known for its horse racing and fried chicken – Kentucky-native Peden is under more pressure than the average pension fund CIO.

“Our investment decisions are under the microscope because of the funded status of the KERS plan,” he explains. “It’s a challenging place to be because even good investment returns will really have little impact on the health of the KERS system.”

And the investment returns Peden is dealing with are poor.

Rock-bottom bond yields and lacklustre equity gains have taken their toll on the portfolio, which reported a loss of 0.52 per cent in 2015. The worst performers were non-US and emerging market public equity (the allocation to emerging markets was axed through 2016) and hedge funds, in a result that falls short of the portfolio’s actuarially required rate of return of 7.5 per cent. Two of the 10 plans require a lower rate of return of 6.75 per cent.

Yet together with a new five-strong investment team, Peden is determined to turn Kentucky Retirement Systems’ fortunes around. He’s midway through altering the portfolio along fresh guidelines to cut costs and complexity and reduce risk.

“This is a complicated problem and we are putting as much intellectual firepower on this topic as we can,” he says, although he does acknowledge the challenge of recruiting dynamic teams in Kentucky. “We are not fully staffed; it’s a difficult place to recruit because Kentucky has only a small investment community.”

A first step has involved cutting the allocation to hedge funds by $800 million. Kentucky first invested in hedge funds five years ago and Peden stresses that this year’s lacklustre results are less of an issue in ditching the allocation than the desire to cut costs.

“Half of the hedge fund allocation will definitely be sold; the other half is under review. It is hard for hedge funds to sit within the context of a less complex and less expensive philosophy. It doesn’t mean they are wrong. In a [time of low inter-bank lending rates], while many may still be doing their job, it is difficult to justify the fee.”

Peden and his team will jettison the allocations that are duplicated in the main portfolio and don’t provide “enough bang for their buck”, such as equity beta, and credit beta in fixed income.

Global macro and trend followers, fixed income arbitrage and convertible arbitrage will remain for now. Peden is also exploring using managed accounts, rather than limited partnership structures, to improve transparency.

“I can’t say where we will invest the money from the hedge fund allocation yet; I don’t know the answer. I will in the next month or so.”

KERS Non-Hazardous has just over half its portfolio in equity, comprising a passive core with active management. The fund has increased its allocation to equity in recent months to try to achieve the 7.5 per cent long-term return goal; 2015’s best-performing allocations were US equity, private equity and real estate. Nevertheless, gradually reducing the equity allocation in line with a more risk-averse strategy is another of Peden’s priorities going forward.

“Over the last three years, the non-US equity allocation, and the dollar impact of that, have been a big drag on the portfolio. It is time to have the conversation about what is the proper allocation between US and non-US equity.”

The current allocation of the pension assets is 25.6 per cent to US equities, 25.2 per cent to broad market international equities, 10 per cent to private equity, 10 per cent to absolute return strategies, 8 per cent to real return strategies, 7.2 per cent to credit fixed income, 6.8 per cent to global fixed income, 5 per cent to real estate, and 2.2 per cent to cash or short-term securities.

The fund has relationships with 105 managers and about half of those are in private equity.

“We are looking to have fewer, more meaningful manager relationships,” Peden says.

As of June 2016, KERS Non-Hazardous had $3 billion of commitments across 42 private equity managers (66 partnerships) gaining exposure across the spectrum of strategies, including buyout, venture and growth, and credit-oriented strategies.

Peden is hopeful that the first signs of a rotation are under way as a consequence of the US election result. The selloff in bonds and rally in US equities led by sectors closely tied to economic growth, like banks, plus surging treasury yields, could be the beginning of a new era.

“[For] three years prior to the US election, it has been a very difficult period to have a diversified portfolio,” he says. “Value is doing better [since] the US election. To me, it seems that the psychology of the market has tipped, post-election; it is saying we are coming out of recession. The traditional stock-picking market is coming back.”

If he’s right, it could be just the change Kentucky needs.

Investors are scouring the world searching for ways to eke out a few more basis points in returns in an environment characterised by low prospective performance. Generally, they are having to push out along the risk spectrum to do this, so success is far from guaranteed.

For many investors, a more promising path to improving returns lies right at their doorstep. It’s not an easy route to travel but it is one they have a high degree of control over. This journey involves strengthening the governance arrangements they employ.

Let’s start with a definition. The Chartered Institute of Public Finance and Accountancy states that governance comprises the arrangements put in place to ensure that the investor’s mission is both defined and achieved.

There is now general acknowledgement that effective governance plays an important role in the success of organisations. But does improving the quality of an organisation’s governance improve the chances of it meeting its mission? In a recent paper, The Investment Case for Better Asset Owner Governance, Willis Towers Watson set out to determine how much better governance is worth to institutional funds.

The short answer is that it’s hard to be definitive about the answer. Measurement is difficult. If we had an objective score for governance recorded over many years, then we might, in conjunction with empirical data, be able to answer the question definitively. But we don’t.

Building on studies first initiated in 1994, Canadian pension governance expert Keith Ambachtsheer has argued that an improvement from poor to good governance is worth 100­-200 basis points a year. Moving from good to great may be worth another 100 basis points or more.

CEM Benchmarking has developed a database of net value add (a like for like measure) of contributing pension funds with more than 20 years of continuous history. Over the last decade, the difference between a first decile and 10th decile fund is about 140 basis points a year.

None of this work is conclusive about the value of better governance but it gives a broad estimate to which an investor might apply both their belief in the strength of the evidence and arguments supporting such value and the gap between their current and target governance state.

Because the link between governance and performance is not conclusive, the degree to which better governance leads to better performance is best expressed as a matter of belief. Many leading funds have an explicit belief about the importance of good governance. For example:

CalPERS CalPERS will be best positioned for success if it has strong governance
NZ Super Fund Clear governance and decision-making structures that promote decisiveness, efficiency and accountability are effective and add value to the fund
Railpen We value effective governance, leadership and strong culture as essential for a world-class investor

How strongly an organisation holds a belief about the value of governance will be a matter of some introspection. In addition, organisations will have their own inherent view of the quality of their governance. The danger with self-assessment in this area is the human tendency to be over-confident in one’s own abilities. Few funds will be willing to admit they have below-average governance, even though half must, by definition.

A common feature of better-governed funds is that they have organised themselves to counter inherent human tendencies that can contribute to value destruction through behavioural biases affecting how they invest, such as over-confidence and representativeness. Various studies looking at average investor performance in sharemarkets point to a drag of 100 basis points or more from behavioural biases.

Successful investors start by being clear about their mission, their organisational strengths and their beliefs about what drives investment markets and returns. They have a highly competent board and executive; the latter builds clear frameworks to guide their investment decision-making and applies them under clearly delegated authorities. They make decisions in real time, able to respond to opportunities as they arise. Finally, they never assume they have investing fully worked out; they are always learning. In short, they tend to score well across 12 factors highlighted in the landmark work on best-practice governance undertaken by Oxford University’s Gordon Clark and Willis Towers Watson’s Roger Urwin. These 12 factors can be attributed to the four broad areas where we believe asset owners can either create or destroy value.

figure-2

 

 

 

 

 

 

 

A governance rating framework, developed at Willis Towers Watson, allows us to rank organisations’ governance from C (very weak) to AAA (global best practice) across these factors. Using this framework, we can help funds make a realistic assessment of how much governance improvement is within their grasp.

figure-one

 

 

 

 

 

 

 

 

 

The attractive aspect of focusing on better governance is that it is a relatively inexpensive exercise – at least in dollar terms. An assumed $25 billion fund aiming for a lift from moderate to strong governance might expect to spend no more than 1-2 basis points up front to re-engineer itself to a stronger governance platform. This initial investment triggers the potential for a multi-year delivery of superior returns. Discounting reasonable expectations about what the future payoff might be demonstrates attractive returns on the initial investment.

If the investment case for better governance is so strong, why doesn’t everyone do it? It’s surely not a cost issue. As we have seen, financial costs to transform governance are relatively small in the context of other decisions funds routinely make.

The reasons are diverse. Some funds are constrained by legislatively enshrined poor institutional structures or are burdened by competing multiple objectives. Some lack the awareness to recognise that there are better governance models available and some that are aware simply might not know where to start. While the financial cost is relatively low (especially when viewed against other investing costs), the psychic costs of change can be high. Boards and their staff have to commit to a transformation program that will shake up the ways things have been done.

In our view, the case for continually improving how funds are managed holds through any environment. However, at a time when investors are faced with historically low expected returns, the case seems overwhelming. By combining how strongly they believe in the proposition that improved governance adds value with an objective assessment of where they currently sit in terms of best practice, funds can develop a strong business case to strengthen their governance.

In his book, Finance and the Good Society, Nobel Prize winner Professor Robert Shiller says at its broadest level, finance is the science of goal architecture – of the structuring of the economic arrangements necessary to achieve a set of goals and of the stewardship of the assets needed for that achievement.

“The goals served by finance originate within us. They reflect our interests in careers, hopes for our families, ambitions for our businesses, aspirations for our culture, and ideals for our society; finance in and of itself does not tell us what the goals should be. Finance does not embody a goal. Finance is not about “making money” per se. It is a “functional” science in that it exists to support other goals – those of the society. The better aligned a society’s financial institutions are with its goals and ideals, the stronger and more successful the society will be. If its mechanisms fail, finance has the power to subvert such goals, as it did in the subprime mortgage market of the past decade. But if it is functioning properly it has a unique potential to promote great levels of prosperity,” he says.

Put more simply, finance is good for society. The problem is finance has been waylaid, it has become about making money, and has lost its purpose.

This is an age of financial capitalism, and that will not change, and Shiller argues finance should be embraced. But it should be expanded, corrected and realigned.

In their new book What they do with your money: How the financial system fails us and how to fix it, Stephen Davis, Jon Lukomnik and David Pitt-Watson lists four main roles for the finance industry: providing safe custody for assets, a payments system, intermediation between savers and borrowers, and risk reduction (insurance).

Lukomnik, who is the executive director of the Investor Responsibility Center Institute, says the book postulates the purpose of the financial sector, which he says, like Shiller, is not to make money.

“The purpose is a service business, to serve the real economy,” he says, and its success should be judged on that.

Intermediation the same price for 130 years

However in recent times finance has been failing the real economy. One simple point of failure is the fact the price of intermediation hasn’t changed, and in the past 130 years has hovered between 1.3 and 2.3 per cent.

Thomas Philippon from New York University measures the cost of financial intermediation and shows that the cost has been trending upwards since 1970 and is significantly higher than in the past.

“In other words, the finance industry of 1900 was just as able as the finance industry of 2010 to produce loans, bonds and stocks, and it was certainly doing it more cheaply,” he says in his paper, Finance versus Wal-Mart: Why are financial services so expensive?

One reason is that the total compensation of financial intermediaries (profits, wages, salary and bonuses) as a fraction of GDP is at an all-time high, around 9 per cent of GDP in the US.

Another reason is that while some layers of intermediation may have contracted, others have been added, and money saved in one area has been offset by new charges in other areas.

What is clear is the end user is no better off.

“Despite its fast computers and credit derivatives, the current financial system does not seem better at transferring funds from savers to borrowers than the financial system of 1910,” he says.

Overcoming short termism

So while the finance industry has increased output it has become inefficient in its production, and much of that is due to more trading, Philippon says.

“Trading activities are many times larger than at any time in previous history,” he says.

Lukomnik says it is a failing that the industry is paid by activity or assets and not outcome.

“We’ve moved to a trade-oriented investment management industry,” he says. “The steps between agents is improving, but the A to B of touching the real economy is not becoming efficient.”

“There are 79,669 mutual funds or trusts in the world, this decreases the economies of scale and adds to the costs of investments.”

Lukomnik and his co-authors say in an ideal world, banks should hold more capital to ensure the safety of deposits; stock exchanges should be prevented from giving high-frequency traders faster access to market prices; and executives should be paid bonuses linked to the long-term growth of the business rather than the share price.

But above all, they argue, the interests of the underlying clients of the finance industry – the depositors, the workers and the pensioners – should come first.

So what needs to be done to expand, correct and realign finance? And what role do institutional investors play?

Overcoming short- termism has been touted as one of the cornerstones to recalibrating large institutions and their beneficiaries.

Focusing Capital on the Long Term (FCLT), which was started in 2013 by Mark Wiseman of CPPIB and Dominic Barton from McKinsey & Company, is focused on developing practical structures, and approaches for longer-term behaviours in the investment and business worlds.

Its stated goal is to break the short-termism cycle that rotates from a perceived need by investors for short-term performance, to a perceived need for continuous positive quarterly earnings guidance by corporate boards and senior management. The result is a systemic underinvestment in the kind of longer-term value creation that retirement savers need to generate adequate income streams after they have finished working.

FCLT.org says that “fundamentally rewiring the ways we invest, govern, manage and lead to better focus on the long-term outcome will require taking concrete, pragmatic steps.”

In its long-term portfolio guide it says that “long term investing is a frame of mind rather than a holding period, and a culture rather than a directive.”

Importantly it is also not driven by rankings or benchmarks, but focuses on long term expectations and outcomes.

It outlines five core action areas for institutional investors:

  • Investment beliefs – Clearly articulate investment beliefs, with a focus on portfolio consequences, to provide a foundation for a sustained long-term investment strategy
  • Risk appetite statement ­– Develop a comprehensive statement of key risks, risk appetite, and risk measures, appropriate to the organisation and oriented to the long term
  • Benchmarking process – Select and construct benchmarks focused on long-term value creation; distinguish between assessing the strategy itself and evaluating the asset managers’ execution of it.
  • Evaluations and incentives – Evaluate internal and external asset managers with an emphasis on process, behaviours and consistency with long-term expectations. Formulate incentive compensation with a greater weight on long-term performance
  • Investment mandates – Use investment-strategy mandates not simply as a legal contract but as a mutual mechanism to align the asset managers’ behaviours with the objectives of the asset owner.

In other practical steps, the paper says that investors wanting to focus on the long term should align stakeholders and minimise agency costs; focus on intrinsic value of assets and long term real value creation, invest rather than speculate; develop and execute robust, sustainable investment processes and positively influence the management of investee companies.

Similarly the PRI’s mission calls for it to promote a sustainable global financial system that supports long-term value creation and benefits the environment and society as a whole.

This mission was borne from a belief that the financial system must contribute to sustainable economic development if it is to effectively serve society.

But Martin Skancke, chair of the PRI board, says: “The reality, however, is that the financial system does not function as effectively as it should. It does not exhibit the characteristics that market participants would typically associate with being sustainable, such as being fair; resilient; transparent; efficient; inclusive; well-governed and aligned with society’s needs.

It is susceptible to risks and sustainability challenges that can manifest themselves in various ways.

“We believe that because the operation of the financial system influences the performance of institutional investors, investors should consider the operation of the financial system as a whole, including its purpose, its design, its effectiveness and its resilience to risks and sustainability challenges.

“We are already supporting signatories to respond to financial system risks, including: integrating externalities such as climate change; providing guidance to asset owners on how to embed environmental, social and governance (ESG) considerations into mandates; improving corporate sustainability disclosure via the Sustainable Stock Exchanges initiative; and re-stating the case for action on ESG issues as part of investors’ fiduciary duty.”

This year the PRI conducted a consultation process with signatories to identify the key areas for the PRI to influence, the underlying causes of risk and sustainability challenges in the system; and the drivers that may shape these over the next decade.

According to the PRI, the issues affecting a sustainable financial system fall into four main areas of risk and opportunity:

The relationship between investors and companies

The relationship between managers, owners beneficiaries and advisers in the investment chain

The operation of the markets

Asset owner power

Many commentators agree that an effective way to really enact change is to focus on building strong buy-side organisations.

Stephen Davis, associate director of the Harvard Law School Programs on Corporate Governance and Institutional Investors, says in the past two decades there has been considerable effort reforming the governance of corporates, and great improvements have been made in management and on corporate boards.

“But we have made those companies more accountable to large institutional investors, and little time has been spent on the governance of those investors,” Davis says.

“We need to shift the focus to the issues of accountability and transparency of institutional investors, then the agents will be more aligned with the grassroots – us, the people. If asset owners are more aligned to the beneficiary then there will be a knock on to asset managers.”

Building strong buy-side organisations is something Keith Ambachtsheer has been advocating for many years.

This means asset owners need to take stock of their internal organisations, pay attention to governance and decision making, hire good internal teams, invest directly, reduce the number of external providers and be conscious of costs.

“It is costing the Norwegian Sovereign Wealth Fund around 1 per cent a year not to have an arm’s length organisation with internal management, like the Canadian Pension Plan Investment Board,” he says.

“The Norway model produces 15 basis points of excess return per year but Ontario Teachers Pension Plan produces excess return of 2 per cent per year.

“Applying the Drucker principles to pension organisations – you’re effective or not, and this comes down to vision clarity,” he says.

“Removing the number of agents is key. There are too many agents and we need more clarity so the agents truly represent the principals.”

And, he says, the most direct way to deal with that is to produce strong buy-side organisations.

Harvard’s Davis says that beneficiaries should know who’s in charge of their money, who the governing body is and how to reach them.

“And if the governing body is not performing they should be able to get rid of them,” he says. “There should be more transparency so beneficiaries know how their money is used. You can look up how a manager is investing in what companies, and the last transaction, but you can’t find out exactly what you’re paying in fees or how on a regular basis your money is voted. Beneficiaries should know how their voice is expressed on certain issues, for example CEO pay, or climate change risk.”

“Mostly as an ordinary beneficiary you don’t know how your money is managed. We need to refocus and look at where the beneficiaries’ interests lie.”

“If we can get the governance of the fund sorted out they can make choices to, for example, invest directly. Are decisions made in best long term interest of the beneficiaries? We can’t have confidence in that if the governance is not there.”

PRI transformative

Davis, who was involved with the PRI since the beginning, says it has been transformative in influencing the capital markets, but it is still feeling its way.

“That’s right that it is still feeling its way, there’s a new adventure.”

“It’s all about stepping back, and looking at how do you make institutional investors, these large bureaucracies, into long term owners?”

Geoff Warren, research director at the Centre for International Finance and Regulation agrees that addressing agency issues associated with multi-layered investment organisations is central to organising an investment firm to be focused on the long term.

The aim is to ensure alignment,” he says. “All involved should remain focused on long-term outcomes; and success should be appraised in these terms. It is critical that the organisation is designed to foster this alignment, which in turn is reinforced in the processes by which outcomes are evaluated and rewarded.”

In his paper, Designing an investment organisation for long-term investing, he highlights the need to avoid making judgments based on the flow of short-term results, and how an element of trust is required to give fund managers the encouragement and confidence to be long-term investors.

Another key theme, he says, is the requirement for an investment approach that focuses on the long term. The investment philosophy, process and information used should all look beyond near-term market prospects, and address what will maximise long-term outcomes.

In sum, long-term investing is about perspective and horizon: the sights should be squarely directed towards the long run.

 

Two in-depth studies of the investment practices of sovereign wealth funds (SWFs) have revealed the delicate nature of balancing long-term and short-term objectives, and a leaning towards more illiquid assets.

Conducted by one of the International Forum of Sovereign Wealth Funds’ research partners, State Street, both papers used existing academic literature, interviews with academic experts and IFSWF members to collect their findings.

Asset allocation for the short and long term, a survey of 10 SWFs focusing on asset allocation – both current allocations and the evolution of allocations – showed that they tend to allocate to more traditional investment categories, and are more heavily weighted to fixed income than equity.

The funds’ investments were primarily focused in foreign markets (about three quarters of assets) and were predominantly focused on the developed world, rather than emerging markets.

However 50 per cent of respondents said they had increased their allocation to emerging markets over the past three to five years. Other asset classes to benefit from increased allocations by SWFs in the recent past include infrastructure, real estate, and hedge funds.

In the future, around 20 per cent of respondents said they would increase allocations to equities, infrastructure, real estate, non-listed, and emerging markets.

Actively managed investments were favoured over passive by only a small margin of respondents (54 to 46 per cent), and listed outweighed non-listed by three to one.

The paper explored how SWFs, as long-term investors, evaluate asset classes and asset managers, and how diversification and risk can be measured as a long horizon investor.

Will Kinlaw, senior vice president at State Street and one of the papers’ co-authors, said one of the concepts explored in the asset allocation paper was how diversification plays out over different time horizons.

“For example in emerging markets, if you are using monthly data, the correlation between emerging markets and the US is very high. But if you use three-year time periods then it’s a much lower correlation, near zero,” he says.

“This means you can’t just rely on simple metrics, especially in alternatives. There is a blend of qualitative and quantitative analysis that needs to go into it. It’s important in examining diversification and correlations to look over different intervals. What drives risk over different periods varies; for example over a long-term period it’s driven by earnings, over shorter time it’s discount rates.”

In terms of the SWF’s opinions of the most relevant competencies required in expanding to new assets classes, an overarching theme, apart from the obvious need for analytical aptitude and commercial acumen, was the importance of being able to build and maintain relationships.

Whether it was with regard to building internal capacity through cooperation with outside resources, through establishing relationships with consultants/advisors, or through establishing communication channels with external managers, the key competency mentioned revolved around relationship building. This has important implications for identifying external investment resources, for hiring investment talent, and for establishing and maintaining a collaborative culture within investment teams.

The asset allocation survey also looked at the challenges faced by SWFs in investing in private markets, which included lack of transparency, illiquidity, lack of appropriate benchmarks, fees and insufficient in-house resources.

The respondents thought the keys to success in private market investing were:

Investment and operational due diligence process.

Institutional relationships and manager alignment.

In-house resources and human resources policies.

Governance structure and stakeholder communication.

Speed of decision making.

Sophistication of risk management systems.

Size of assets under management.

 

Overcoming challenges in private markets

A separate study that looked at how SWFs are addressing the challenges of private market investing, Comparison of members’ experiences investing in public versus private markets, found that the primary driver for investing in private markets, by the SWFs interviewed, was the potential for a return premium.

Some SWFs stated that they were well suited to bear illiquidity risk due to their long time horizon. But, even where private market investments have performed well, internal debates continue as to whether the premium compensates fully for the illiquidity and other risks associated with private markets investing.

“Illiquidity is the biggest risk of investing in private markets even if these investors have long horizons, because illiquidity is the opportunity cost; it’s what you give up for that premium, you can’t just assume illiquidity premiums are priced in,” Kinlaw says.

In addition to a return premium, the SWFs said private markets offered access to specific exposures, and introduced some beneficial diversification.

The main risks that SWFs needed to manage and mitigate included a concern that investments were too concentrated; a concern about leverage risk; the risk of capital loss; a greater degree of reputational, tax and regulatory risk; currency risk; illiquidity risk; the risk of hiring a bad manager; and key person risk and turnover.

Each of the SWFs spoke at length about the capabilities and governance structures that they had developed in order to launch a private markets program. The importance of people was a major theme, and each of the SWFs said that their commitment to developing a qualified and talented team was a key ingredient to their success.

“The interviews revealed that to be successful the funds have to have good talent, they really focus on it but also struggle with it because many SWFs are in remote locations. The human element is more essential in private investments than public investments,” Kinlaw says.

“Access is also linked to having the right people in house. Private markets are a long-term investment, so it’s tricky to have staff turnover; you want someone around for the long haul.”

Funds also spoke about the need for enhanced governance and decision-making frameworks to balance the complexity of private markets, and the need for due diligence, with the pressure to move decisively when opportunities arise.

The SWFs employed a range of practices to hire, develop and retain strong teams, including developing local staff by co-operating closely with private equity firms, leveraging external consultants to supplement or complement in-house staff, identifying staff with relationships, avoiding silos in the organisational structure, building strong middle and back office teams, building teams with a diverse set of skills, and retaining staff by instilling them with a sense of purpose.

Following the hour-long interviews, the paper produced a list of advice to sovereign wealth funds wanting to invest in private markets:

  • Establish a strategy based on expertise you can build in-house.
  • Start slow. “This was a really emphatic point,” Kinlaw says.
  • Private markets are local markets and require local knowledge. One big advantage is to partner with other SWFs. When the survey asked SWFs if they have co-operated with other SWFs or large investors, 100 per cent said they had.
  • Thorough due diligence.
  • Establish strong governance and decision making, avoid silos and group think.
  • Emphasise qualitative over quantitative factors with managers.
  • Cultivate a long-term horizon and a long-term culture. This includes performance measurement and the way people are compensated.
  • Create ways to build a team and have them be committed.
  • Learn from your success and failures. “Really take the time at the end of the investment to look at the reasons for going into it versus what happened, and institutionalise that learning,” Kinlaw says.

“The investment landscape has evolved significantly in recent years, and SWFs have contended with an ever-expanding array of investment opportunities in both public and private markets,” Roberto Marsella of CDP Equity (a company of the Cassa Depositi and Prestiti group of Italy) and lead of the investment practice committee of IFSWF, says. “In response, many are re-evaluating the methods they employ to construct portfolios and measure and manage portfolio risk. The low interest rate environment creates new challenges and requires reassessment of investment methodologies and professional skills.”

The California Public Employees Retirement System (CalPERS) board meeting was broadcast live from California on Monday, December 19, 2016, presenting an opportunity to watch the body deliberate as to whether it should reverse its tobacco-free investment policy or extend the restrictions to all externally managed funds, which would capture a further US$547 million.

The board decided to maintain and extend the restrictions on tobacco investment. The public health community and politicians lauded this decision, with California state treasurer John Chiang stating, “Today, we not only successfully fought back misguided efforts to lift CalPERS’ 16-year-old ban on direct tobacco investments, but also we ended the system’s inconsistent position of allowing outside partners to quietly make such investment on its behalf.”

A majority of the CalPERS investment committee, consisting of every member of the governing board, supported the motion, with three of the nine directors voting against. The dissenting directors were obviously compelled by the recommendations their staff and external consultants made as they attempted to separate the societal and ethical considerations from the financial (a big ask for the health community).

During the deliberations, Allan Emkin, of the Pension Consulting Alliance, addressed the board. He followed Dr Stanton Glantz, a professor of medicine, director of the University of California, San Francisco Center for Tobacco Control Research and Education, and the author of more than 350 scientific papers.

Emkin said, “There is one agreed principle in the investment community – that diversification manages risk.” He then quickly concluded, “Therefore, divestment reduces opportunity.” The situation seemed clear: diversification is good, divestment is bad, and it’s as simple as that – everyone agrees.

But do they?

This tactic of economists and financiers presenting their positions as universal and uncontestable truths is common. The many assumptions and qualifications that underpin economic theories and investment positions tend to be reduced or omitted completely. This strategy contrasts markedly with the public health and science community, which routinely addresses counter-arguments and explains the rigour behind positions. This variance in approach was evident at the CalPERS meeting, as investment advisers attempted to create a certainty that did not necessarily exist.

There will, of course, always be counter-arguments to any held belief, even if it is considered fact or truth. For example, despite the US Surgeon General declaring in 1964 the link between tobacco and poor health outcomes (based on more than 7000 articles), today British American Tobacco claims the following on its website: “To date, scientists have not been able to identify biological mechanisms that can explain with certainty the statistical findings linking smoking and certain diseases.”

Like almost all issues we face, diversification is not black and white. Emkin claimed that greater diversification reduces risk by definition, with a nod to a classical, Harry Markowitz-style, mean-variance view of the world. This is overly simplistic. In reality, the benefits of diversification may be achieved with relatively few securities. Indeed, diversification for its own sake may contribute nothing in terms of risk mitigation while lowering returns (thus legendary investor Peter Lynch’s neologism ‘diworsification’). Further, Emkin’s presentation offered little discussion of the specific risks of investing in tobacco companies, merely an assertion that their presence in a portfolio would add diversification benefits.

Diversification presents one way to manage risk but not the only way. Analysis of environmental, social and governance factors and investing with a long-term lens, so that prospective risks are not merely acknowledged but truly accounted for, are other ways to reduce risk in an investment portfolio.

There are now plenty of examples of funds that perform well that either enforce exclusions or are considered not diversified. The Responsible Investment Association Australasia went so far as to declare in its 2015 Benchmark Report that “once again … the myth of underperformance of responsible investments is unfounded”.

Those attempting to make a purely financial case against divestment in tobacco tend to oversimplify the situation. They set aside very real risks and considerations in relying on past performance (easier to measure) rather than future expectations (uncertain) and they most often completely ignore the devastating impact of the product.

Divestment is the role the finance community can play in addressing what the World Health Organization calls the “global tobacco epidemic” that will cause the deaths of 6 million people this year. It’s not just about what divestment might achieve in terms of increasing the cost of capital or forcing the industry to fold, it is about joining governments and our health and education sectors as they attempt to de-normalise and stigmatise an industry that has continued to actively encourage new consumers, namely children.

We can debate the certainty of risks and returns, but maintaining that investment in tobacco is in the best interests of ordinary workers is clearly becoming an increasingly difficult position for directors to hold.

We should all hope that a tobacco-free position becomes a certainty.

 

Clare Payne specialises in ethics in banking and finance. She holds the positions of chief operating officer with Tobacco Free Portfolios, initiated – and is now a director of – The Banking and Finance Oath (thebfo.org) and is Fellow for Ethics in Banking and Finance with The Ethics Centre, both in Australia.