The 8th annual International Forum of Sovereign Wealth Funds kicked off in New Zealand today. This is an excerpt of the welcome speech by the chief executive of New Zealand Super, and the event host, Adrian Orr.

 

At the last meeting in Milan, I set out the roadmap for the way ahead – the navigation chart set out in the new strategic plan. The checklist was to:

  • Promote the Santiago Principles through case studies and improved levels of self-reporting;
  • Have more frequent opportunities to share knowledge, both face-to-face and through on-line platforms;
  • Encourage collaborative research with academic institutions;
  • Engage governments and international institutions where we can make a meaningful contribution.

We have made progress on all of these. Case studies are being launched at this meeting. Self-assessments on implementation of the Santiago Principles are more robust.

Knowledge exchange has ramped up this year, with excellent workshops hosted in Azerbaijan in March and another set of workshops held before the start of this meeting. These workshops are substantial and will become the core benefit that IFSWF can deliver to its members.

In research, we have established partnerships with the Bocconi University’s Sovereign Investment Lab, Milan, the Fletcher School at Tufts University, Boston, and the London School of Economics. A joint workshop with Bocconi was held in Milan in June.

We have established relations with the Commonwealth Secretariat and the Hedge Funds Standards Board in the past few months, as well as the relationships we already in place with the International Monetary Fund, World Bank and the OECD.

If this organisation is able to fulfil its potential, just think of what we will be able to achieve:

  • Collaboration on investment opportunities;
  • Increased investment in infrastructure and emerging markets;
  • Deeper knowledge about the characteristics of long-term investment opportunities; and
  • Better understanding of good investment practice – including environmental, social and governance practices.

The single, most fundamental commitment that IFSWF membership entails is commitment to transparency, accountability and good governance, as expressed through the Santiago Principles.

As I said last year, we told the world that the Santiago Principles are a benchmark against which we can be measured. We cannot be surprised if the world measures us against them.

Transparency isn’t easy. Accountability isn’t easy. People ask questions. People criticise what you do, even when you’re trying to do the right thing. Good governance isn’t easy. It’s time-consuming, inconvenient. It requires a lot of thought about what you should be doing and how.

None of it is easy, but it is right. It is the right thing to do because the result will be better understanding of our activities and stronger support for them through both good times and bad. The results will also include more efficient access to opportunities, better performance by each member fund and a stronger financial system overall.

The theme of this year’s Annual Meeting is Investing in a Climate of Uncertainty: The Sovereign Wealth Fund Response

The global economy is in unchartered territory, with negative interest rates becoming a reality and the traditional central bank target and levers being sorely tested.

These uncertainties create some strong head winds: low growth, low yields, and an eroding capital base.

There will be an inevitable shift towards a less carbon-intense economy.

The financial sector is now caught in this tide. Our investment strategies must necessarily address this, either actively – looking at opportunities in carbon-friendly energy – or reactively, in terms of dealing with the consequences, such as failed investments and stranded assets. Relative prices throughout the economic value chain will change.

There are very practical questions around this issue for long-term investors. How do you accurately measure the carbon exposure in a portfolio? Does divestment really work as a strategy? Is it better to engage as a business owner? And what investment opportunities will be the winners in a rapidly changing energy sector?

We will discuss the investment implications of climate policy over the next couple of days.

I remind you all that the spirit of this meeting is to share ideas and knowledge, to encourage the free and open exchange of ideas, and to respect all views.

 

The International Forum of Sovereign Wealth Funds is a voluntary organisation of sovereign wealth funds. It is committed to working together and strengthening its activities through dialogue, research and self assessment.

IFSWF was formed in 2009 by a group of state-owned international investors from around the world. The forum’s aim is to maintain an open and stable investment climate by setting and following a set of principles and practices, known as the Santiago Principles, which address issues around institutional governance and risk management.

There are three issues investors should be addressing in the current investment environment according to Greg Jensen, co-chief investment officer of Bridgewater Associates told delegates at the Fiduciary Investors Symposium at Yale School of Management in October.

Firstly low returns on assets have been postponed by the quantitative easing.

“But they are in there and they are coming, and coming relatively soon. Are you prepared, have you thought through the implications of that?”

Secondly there is a wide range of potential outcomes.

“Two huge pressures have collided and created low volatility in markets and a calm. These huge pressures are this secular deleveraging debt problem that’s deflationary in pushing down assets and inflation. And second the massive liquidity push by the central banks through quantitative easing, too huge forces, leading to low volatility, but that won’t continue, one way or the other, significant volatility will return. And the nature of that volatility could be pretty bad for your portfolios, so recognising this wide range of outcomes, the possibility we move down something like a Japan path, what would that be like? Or potentially that money shifts out of the massively produced, cash, low real yields assets, into alternatives and central banks have an inflation that’s not tied to growth. Are you prepared for the wide range of possibilities?”

And thirdly, with interest rates at zero, the only free market mechanism largely left is currency.

“So look at this picture of where currencies lie in your portfolio, and whether they are well managed. We expect a secular environment of currency volatility. The lesson of Brexit is a good one in terms of what the future can be like in terms of currency volatility, those that managed their currency well going into Brexit had very different outcome,” he told delegates.

Jensen says given this environment, and the fact all assets have been really overbought relative to their fundamental returns, there are three choices for investors in how they get the best out of their portfolios.

“Investors can accept lower returns. Accept your portfolio will get 3-3.5 per cent and deal with the consequences of that,” he said.

Secondly investors can take more risk, a scenario he says Bridgewater is “nervous about”.

“We see people moving into assets they will think will get their return targets even though those assets are flooded with liquidity and are dangerous. They are moving up the risk curve and into more growth and equity sensitive assets. This makes us nervous given the environment, and the fact we are at something like peak liquidity.”

And thirdly, the most preferred option is to take risk more efficiently. Jensen recommended that investors do a strategic review of how they’re taking risk, and think through whether it is as efficient as possible given the secular environment and range of potential outcomes.

“People have extremely biased beta, they are invested in assets that will do well if growth is better than expectations and inflation is low but not negative,” he says.

“All assets have cash in them, and cash is zero for all assets. Historically assets that gave you 8 per cent had an excess return on cash of 2-3 per cent. Now we have zero on cash and those assets that used to give 8 per cent now give 2-3 per cent. The excess return relative to cash now is at best normal, so 2-3 per cent, but probably worse than normal. So beta is difficult,” he says.

“For us in terms of taking risk more efficiently, the most important part of that is to balance your beta to deal with the wide range of outcomes, to deal with the outcome that US and Europe might look like Japan, which has had negative equity returns since the 1990s and bonds going to zero. Or there is an environment where inflation is priced very low, and money leaves cash as a store of wealth, creates an inflation with re-growth. Both of those environments would be devastating for most portfolios in this room.”

Jensen also acknowledged that alpha is very difficult to find, but if you can find true alpha managers which don’t get returns from beta it can be very additive in a low beta world.

“There will be people who understand markets better than it is priced in. And thinking through alpha that will do well in the case that beta does poorly. What ways can you improve that outcome with alpha managers? And find managers that are uncorrelated to beta or even better structurally negatively because they are taking advantages of opportunities that will do well if beta does poorly.”

At the end of 2015 ATP, Denmark’s statutory DKK 806 billion ($120.2 billion) pension fund, announced plans to switch to a new risk-based investment approach. One year on, and new chief investment officer, Kasper Ahrndt Lorenzen, one of the architects of the strategy in his previous role as head of portfolio construction, explains how the factor approach offers real diversification and flexibility.

“Factor investing allows us to look at all assets through the same lens and compare all types of investments; it is easier to make decisions based on a comparable characteristics. It feels good to now be implementing so much of what we previously worked on,” he enthuses, speaking from the fund’s Hillerød headquarters.

ATP divides its assets into two portfolios: a hedging portfolio composed of long-dated fixed income instruments, which insulates the fund’s liabilities against interest rate risk, and a return-seeking investment portfolio based on the risk parity approach put into action at the beginning of 2016.

The factor strategy is only applied to the return-seeking part of ATP’s overall assets which consist of its bonus reserves worth approximately DKK100bn ($14 billion). The bulk of the pension fund’s assets are held in the hedging portfolio, designed to meet the fund’s pension guarantees.

At the end of last year the fund swapped its allocation to the conventional risk classes it invested in over the preceding decade, to focus instead on four specific risk factors.

The return-seeking portfolio is now split between an ‘equity factor’ (49 per cent of assets) ‘interest rate factor’ (22 per cent) ‘inflation factor’ (12 per cent) and ‘other factors’ (18 per cent and comprising alternative liquid factors – alternative risk premiums – and alternative illiquid factors.)

Given the number of different factors to choose from, choosing the right ones was challenging. ATP’s answer was to keep it simple.

“We built on academic insight on what constitutes high level risk sectors; equity and interest rates were always going to be the two big factors. Rather than squeeze in 10 different risks we went for four distinct risk dimensions which capture real diversification at the top level.”

Now assets are chosen according to the extent to which they “load to the right factors” and meet the return hurdle based on the fund’s understanding of risk.

The clear sight of the risk factors at play behind investments has led the fund to reject some deals through the year.

“If the investment doesn’t meet the hurdle it’s easier to say ‘no’. We walk away from investments all the time because they don’t meet our required hurdle rate,” he says.

Lorenzen also believes the approach has been most helpful in scrutinising the underlying risk in alternative, illiquid assets where there is less data available compared to bonds or listed equities.

Real estate, and often infrastructure too, can contain all four risk factors with a single asset holding inherent interest rate and inflation risk on rental income, equity risk and illiquidity risk.

The approach allows the fund to compare the expected return on a real estate investment with the return on other assets with the same underlying risks.

“It makes it easier to compare the compensation for locking up capital long-term,” he says.

Beneath the four main factors lie sub factors within each allocation.

“We have our four main factors at the top and then sub factors below that add onto them as you drill down. It is like an iceberg.”

For example, within the equity factor lie a host of factors, including regional beta and credit spreads that are benchmarked against various indices.

“As we drill further down, indices give us our reference benchmark.”

It’s much cheaper than active management, although slightly more complex.

“The complexity is justified but it is hard work, and the work is ongoing. It takes up human and IT resources.”

A key element in the process has been the adjustment of ATP’s risk modelling and return reporting to the new investing principles. ATP has around 60 people in its internal investment team, and the new approach has engendered a cultural shift at the fund.

“We are no longer divided by asset class. Our teams still work within their own asset classes but they produce the factor loadings for the whole fund. It is a common framework that is both motivating and uniting.”

His advice for other funds: “What works for one institution may not work for another. What may be justified complexity for one, may not be for another.”

He is also aware that the approach doesn’t wholly solve diversification and performance issues.

“The fact that several risk factors have performed well is nice, but it is also disturbing.”

His solution is to regularly review the current factors.

This is an ongoing learning process, where one can always refine and deepen the level of understanding. We will still have to think about whether we’ve got it right and make sure for the next quarter, over the next year and into the future, that we have the right set of factor exposures.”

The Minnesota State Board of Investment, the state agency responsible for managing Minnesota’s $82.3 billion retirement assets, plans to increase both its allocation to public equity and passive management within the equity portfolio.

Public equity exposure will increase from 60 per cent of assets under management to almost 65 per cent, explains Mansco Perry III, executive director and chief investment officer at the SBI. Around 30 per cent of the current equity allocation is passively managed; going forward, this will increase to around 65 per cent, he explains.

“We’ve been prettily heavily weighted to active management in public equities. We are going through a process to significantly increase our passive exposure. Active management has not met our expectations. It is very resource-, time- and energy-intensive; it’s expensive, and we haven’t been rewarded for it. In fact it’s not just us, others are going in the same direction too.”

Current asset allocation at the fund is divided between domestic equity (45 per cent) international equity (15 per cent) bonds (18 per cent) and alternatives (20 per cent) with 2 per cent of the fund in cash.

“We are strategic investors so we follow our asset allocation pretty religiously, always rebalancing back to it,” says Perry in an interview from the fund’s St Paul’s headquarters.

The US passive allocation will track the Russell 3000 index and the international allocation will track the MSCI ACWI ex US. The passive allocation will increase in domestic US first, followed by international. He still believes active management pays in small cap US and emerging markets.

“We haven’t given up on active management in every area, but over time we will have significantly less active exposure to US large cap.”

It will mean a smaller roster of public equity managers in the next couple of years at the fund that outsources all asset management.

“We are also going to review managers relative to our expectations, not just their expectations of value-add relative to the benchmark. Managers say they can add between 200-300 basis points gross over the market cycle. We haven’t experienced that very much. If I can get between 50-75 net, why would I spend so much time and effort on active management?”

The increased equity focus will also be characterised by greater diversification outside US stocks. Public equity currently has a 75/25 bias in favour of the US, explains Perry. Now that will change to favour the US two-thirds to one third international.

“We will still have a large home country bias but less so than historically.”

He is also planning more geographical diversity in the alternative allocation.

“We are increasing our European exposure and building a toehold in Asia. Our liabilities are in dollars but we are trying to be more globally diversified.”

Minnesota’s State Retirement System comprises numerous pension funds, trust funds and cash accounts commingled in pooled investments.

The lion’s share of the portfolio lies in the so-called combined funds, representing the assets of both active and retired public employees who participate in the defined benefit plans of 10 state-wide retirement systems. The combined funds, which have a market value of $60.1 billion, returned 4.4 per cent last year.

The fund is 85.7 per cent funded, putting it in the top quartile compared to other US public pension plans.

“We’ve been pretty fortunate. We were able to benefit from the tail winds of the 1980s as interest rates declined and equity markets had a strong, sustainable bull market. Going forward we face low returns and low interest rates. The tailwind has turned into a headwind,” says Perry, who has spent much of his professional life at the fund.

Aside from a five-year stint running the investment portfolio of Maryland State Retirement Agency and St Paul’s Macalester College, he has been at the SBI in various senior roles since 1990.

Balanced alongside plans to increase the allocation to public equity, the fund is equally committed to being a “long-term private market investor”.

Up to 20 per cent of the value of the combined fund is targeted to alternatives, although the allocation is underweight with only 13 per cent currently invested.

“Over the last five years we have received back more money from managers than what we’ve invested,” says Perry. “It’s a good thing; we’ve got our money back. But we could invest more.”

Statutory rules guide Minnesota’s investments in alternatives: each investment must involve at least four other investors and participation in an investment may not exceed 20 per cent of the total investment. The allocation is divided between real estate, yield-orientated strategies and private equity, and provided a 7.6 per cent return last year versus a 13.6 per cent return annualized over the past 10 years. Minnesota has no allocation to hedge funds.

“We’ve stayed away from hedge funds; it’s not an area we’re really excited about.”

Going forward, Perry aims to increase the allocation to real estate, which was reduced four years ago. “We are looking at adding a bit more back here. There is fierce competition in private markets. Certain groups of managers see our size as a plus but we can’t access small managers so easily”.

The main components of the real estate portfolio consist of investments in closed end, commingled funds.

Private equity disappointed last year, primarily because of the allocation’s exposure to oil and gas markets. “We have a large amount of private equity in resource investments,” says Perry.

Last year’s poor performance came despite it being one of Minnesota’s strongest performers in a portfolio that aims to bring an inflation hedge and diversification. Going forward he is also determined to build up the fund’s ESG investment.

“We are in the process of determining how ESG factors should be viewed. We have begun the process. It includes education and looking at what other funds are doing.”

 

The $7.6 billion Employees Retirement System of Rhode Island, (ERSRI), is cutting its allocation to hedge funds. In a “back to basics” strategy, the fund will slash its hedge fund allocation by $500 million over the next two years, reducing the allocation to 6.5 per cent of assets under management, down from 15 per cent. It will reallocate funds to more “traditional” strategies for growth and stability, consisting mainly of low fee index funds. The fund’s hedge fund exposure is currently about $1.1 billion.

“Most hedge funds aim to produce positive returns that have low correlation to the movements of the global equity markets,” says general treasurer Seth Magaziner, a native Rhode Islander whose role heading up the state’s treasury department includes overseeing investment strategy at the pension fund.

“While some of our hedge funds have delivered on this mandate; too many have not. In recent years, too many hedge funds have shown low correlation to the market when the market has been strong, but high correlation in times of market decline. At the end of the day, absolute return strategies need to generate positive returns and provide legitimate protection from market risk in order to justify their fee structure.” With this in mind, the fund will only keep the hedge fund allocations which show adequate non-correlation to the market to protect the fund from volatility, and a strong enough performance to justify fees.

New strategy

Cutting management fees is a key motivation behind the latest strategy at the fund which serves 60,000 active and retired public sector workers in America’s smallest state, and where none of the active allocations are managed in-house. Rhode Island frequently monitors its returns net of fees and compares the figure to peers, as well as the fund’s index fund performance, the fund’s benchmark, and a hypothetical 60/40 stock to bond ratio fund, explains Evan England, a spokesman for treasurer Magaziner. The overall hedge-fund portfolio has posted a return of 4.85 per cent after fees since its launch in 2011, but many of the individual funds within the allocation haven’t met expectations. More than half the gains of the hedge fund allocation have been swallowed by the high fees.

Reducing the hedge fund allocation is part of wider changes to Rhode Island’s asset allocation following a comprehensive review of the fund’s target allocation. The process included modelling potential portfolios against potential market conditions. The new allocation portions 55 per cent of the fund’s assets to growth. Along with low-fee index funds, the growth bucket will include a 15 per cent allocation to private equity – more than double the previous allocation of 7 per cent.

About 39 per cent of the fund will be in stabilising assets divided between volatility, crisis and inflation protection strategies and include allocations to fixed income, real estate and momentum, among others. Six per cent of the fund will be in income strategies. The new strategy comes on the heels of lagging returns. As of June 2016 the fund posted a one-year loss of 0.3 per cent, a five-year return of 5.8 per cent, and a 10-year return of 4.8 per cent versus a 7.5 per cent assumed rate of return.

Magaziner was only sworn in as general treasurer in January 2015, joining from environmental, social and governance (ESG)-focused asset manager Trillium Asset Management. As well as being quick to push on manager fees, he is also championing greater transparency. His “transparent treasury” policy now asks the fund’s 100-odd managers to publish their fees, but also their performance and expenses on a regular basis.

“If you are managing public funds, the public has a right to know how you are performing and what you are charging for that performance. Not a single one of our managers left us when we initiated this policy, and we have seen no evidence that it has limited our options when we have been searching for new managers to invest with.

“Since we announced this policy, other public pension funds, including large public plans in New York and California, have followed suit. I believe that the type of transparency we have championed will soon be the norm,” Magaziner adds.

Say-on-pay

It’s the kind of collaboration he would like to see in other areas too.

“Rhode Island is a small state with a relatively small pension fund. While we work to be thought leaders on issues facing pension funds globally, it often makes sense for us to team up with our larger peers to attempt to drive change.” One area he believes collaboration will begin to bring real change is corporate governance in investee companies.

Rhode Island is already a vocal shareholder, most recently voting against management-backed pay proposals at US giants Facebook and eBay in “say-on-pay” proposals where companies ask shareholders what they think on executive pay packages.

“When the companies we invest in award excessive pay packages to executives, it comes at the expense of the pension fund and the public employees we serve,” he said.

“Our say-on-pay effort reflects our position that executive compensation should be transparent and based on performance.”

So far this year the fund has voted “no” on executive compensation plans at 75 companies. It sends a letter to all companies that received “no” votes to inform them of the fund’s opposition and offering to open dialogue on how best to progress on “the important issue.”

 

Anyone browsing the popular investment press recently would be forgiven for thinking that diversity has become the latest buzzword in the investment industry and that by demonstrating diversity, organisations may increase the probability of generating superior investment returns.

Copious volumes of research are regularly published supporting the assertion that financial benefits accrue to companies that value diversity in its many forms. McKinsey & Company has published analysis suggesting that ethnically diverse companies in the top quartile for diversity are 35 per cent more likely to outperform, and gender diverse companies are 15 per cent more likely to outperform.

Interest in understanding and measuring the benefits of diversity in a tangible way is growing quickly. According to a study published by the UK-based Criterion Institute, in 2015 only a quarter of investors placed importance on gender diversity, whereas in 2016, a total of 51 per cent of investors agreed.

The speed of change in this attitude is both surprising and welcome. Diversity has long been an important part of our manager research process, based on a belief that more diverse teams with shared values make better decisions.

Mercer’s approach to researching and rating investment managers and their strategies is underpinned by our assessment of four key factors, the most important of which is idea generation. In assessing this, we consider how effective a manager is in generating value-adding investment ideas, which is central to the ability to generate superior returns for investors.

This is an intentionally broad perspective which ranges across the entire spectrum of opportunities, including those in particular asset classes, countries, sectors or specific strategies.

In all cases though, a common thread we observe in assessing the quality of a firm’s investment outcomes is the need to assess the quality of the organisation and team that is implementing the investment process.

Cognitive diversity

Of course a group of people who look different from one another are diverse in terms of identity. However, of greater importance for an investment process is cognitive diversity. Our research process is focused on identifying and avoiding the phenomenon of “groupthink”, which we regard as the natural enemy of good decision-making.

Groupthink is a phenomenon that occurs when the desire for group consensus overrides an individual’s underlying preference to present alternatives, critique a position, or express an unpopular opinion. In this situation, the desire for group cohesion effectively overrides good decision-making and creative problem solving.

Diversity as a characteristic of a team is only beneficial to the extent that it helps drive imaginative and creative solutions and reduces the likelihood of groupthink.

There are circumstances other than a perceived lack of diversity of a team that can foster a culture of groupthink. For this reason we are wary when we observe a team with a dominant group leader or a low level of challenge within the group, regardless of any surface-level diversity.

The operating environment for a team can also discourage positive decision-making.

For example, a team that is subjected to pressure from poor performance or from funds outflow or other business pressures may be more vulnerable to groupthink.

Mercer’s onsite meetings with management teams are central to our investigation of the existence of constructive challenge in decision-making. In meetings we investigate the way a team reaches its decisions and also how it manages the mistakes it has made.

In discussing an organisation’s resourcing, it is as insightful to explore a leader’s attitude to diversity. We are focused on uncovering the illusion of unanimity, where in reality team members are hesitant or reluctant to disagree.

The freedom to disagree with consensus views must be valued by the team and a discussion of how a team works through dissenting views is useful.

Having established a good track record, any team is at risk of becoming complacent, believing in its own wisdom at the expense of other ideas. To counter this effect, many successful teams adopt an approach that invites a devil’s advocate to question the logic of a widely-held belief.

Self-perpetuating cycle of homogeneity

The exploration of staff turnover and the reasons behind recent departures can be informative in understanding team dynamics and the value a team places on diversity. The need to fill vacancies can also shine a light on a manager’s attitude to diversity.

Often we are told that a team which does not appear to be diverse is so because individuals with different backgrounds or experience do not apply to fill positions in a team. This creates a self-perpetuating cycle of homogeneity which is unlikely to be beneficial to investors in the longer term.

An understanding of alignment and remuneration is also important in appraising the team’s approach to decision-making.

A team that is remunerated as a whole rather than as individuals contributing independently may react to challenge or debate differently and this can impact the way the team accepts and manages dissent.

Returning to the increasing publicity of the importance of diversity in organisations, it is very apparent that the most visible dimension of diversity being discussed in the investment market and in the media is that of gender diversity.

Studies highlighting and exploring the dramatic deficit of women in senior roles in the investment industry, and in portfolio management in particular, are raising many pertinent questions about the roadblocks to improving gender diversity and how these may be dismantled.

Many of these questions are the same ones we ask managers during our review process. However, the recent sharpening of the focus on gender diversity is only one aspect of the diversity narrative that we explore in our interactions with teams of investment managers.

We believe that successful investment teams can come in many shapes and sizes. But we firmly believe that, other things being equal, a diverse team with shared values is more likely to outperform their less-diverse peers.

Clare Armstrong is a principal at Mercer.