For a fund that prides itself on approaching new investments “methodically and without haste” Norges Bank Real Estate Management, the unlisted real estate arm of Norway’s NOK 7167 billion ($871 billion) Government Pension Fund Global (GPFG), has built up a sizeable portfolio in a short amount of time.

The ministry of finance only gave the green light for the fund to invest in real estate in 2010.

Three years later it had broadened that mandate to allow investment in property outside Europe, and it made an inaugural investment in the US in the first quarter of 2013.

Now the fund is busy looking for opportunities in Asia since setting up shop in Tokyo in October last year.

At the end of 2015, unlisted real estate accounted for some $21.9 billion under management – 2.4 per cent of the total fund – as GPFG fast becomes one of the world’s best known landlords.

“Our strategy is to invest in a limited number of major cities with various common characteristics. We look for cities expected to see continued population, employment and economic growth and we believe cities that attract intellectual and financial capital will also have the greatest potential for economic growth and increased trade.

There should also be constraints on the development of new real estate, whether regulatory, such as height restrictions or annual construction limits, or topographical limits such as coastlines or mountains, as this will favour long-term growth in rents,” said fund spokeswoman Line Aaltvedt in an interview from GPFG’s Oslo headquarters.

About 62 per cent of the real estate allocation is in office property, with investment spanning locations on New York’s Times Square to Paris’s Champs-Elysees. The fund has a stake in Berlin’s emerging technology sector; Munich’s fast-growing business services, media and manufacturing sites and London’s Oxford Street – in a deal closed two weeks after Brexit.

“In Europe, we are concentrating on large real estate markets such as London, Paris, Berlin and Munich. Our investments in the US span four major cities: New York, Boston, Washington, DC and San Francisco,” she says.

Despite the office bias, diversity is an essential pillar. The portfolio is spread across 13 countries with the greatest exposure in the US (48.9 per cent) followed by the UK (26.3 per cent) and France (11 per cent.)

Diversified assets include logistics facilities near ports and transport hubs, tapping into global supply chains. Logistics account for 24.4 per cent of the real estate portfolio split between the US and Europe. European investments totalled 240 logistics properties across 11 countries at the end of last year, compared to 390 properties in the US.

“Our aim is to build a global, but concentrated portfolio, in a limited number of cities around the world,” she says.

“We try to avoid making too many major investments in any one year, as this reduces the risk of investing excessively in a period when the market subsequently turns out to have been overpriced.”

Scouting for opportunities

In all, the fund has some 3,100 tenants in different industries in Europe and the US. Net rental income amounted to $841 million in 2015.

With only 2.4 per cent of fund assets invested in property to date, but a mandate to increase that to 5 per cent, GPFG is scouting for more opportunities.

It means pushing into a market at a time many critics believe prices are poised to fall. Competition for assets has increased, as global investors seek real estate’s stable, inflation-adjusted cash flows while interest rates are so low. Yet Aaltvedt counters the fund will only increase its allocation when the right opportunities arise.

“We currently have a mandate to invest up to 5 per cent of the fund in real estate, but there is no deadline for reaching this percentage,” she says.

The allocation will grow with a corresponding decrease in bond holdings. According to the mandate from the ministry of finance, the fund should be invested 60 per cent in equities, 35 per cent in fixed income and up to 5 per cent in real estate.

The portfolio, which has returned 6.9 per cent since inception, depends on high values, strong rental income and low vacancy levels.

Investments in offices and retail in the UK and the US, and investments in European logistics, have performed best since inception. In contrast, investments in offices and retail in Germany and France have performed less well.

At the end of 2015, 93.5 per cent of the portfolio was let, and 1 per cent of the portfolio was under development. The ministry of finance mandate requires the fund target a net return on the real estate portfolio that matches, or exceeds, returns on MSCI’s Investment Property Databank (IPD) Global Property Benchmark, excluding Norway.

GPFG invests mostly alongside partners in order to benefit from local knowledge and expertise, explains Aaltvedt. The fund had 10 investment partners at the end of the year.

“Investing with partners gives us better access to new investment opportunities and better information on which to base investment decisions,” she says.

“We have started making investments alone. We have wholly-owned assets in several of the European cities, and although we will continue to invest with partners, we also expect to do more transactions without partners.”

“At of the end of last month we had 135 employees working for us. When the fund began investing in 2010, the real estate department had just three employees,” she concludes.

 

Photo credit: Times Square:CoStar

The $1.3 trillion Government Pension Investment Fund of Japan has a 100-year timeframe but that doesn’t mean all of its assets are long term.

“We are happy for active managers to trade on a short-term cycle, and passive managers to focus on sustainability over the long term of the company,” executive managing director and chief investment officer, Hiromichi Mizuno says.

“You can’t force all investors to have the same horizon. If as a whole it works, I am happy. I agree the sum of investors as a whole have a long term perspective, but you can’t dictate that all investors behave the same way.”

The GPIF is managed externally and around 20 per cent of the portfolio is managed by active managers and 80 per cent passive.

“The direction we are trying to make clear is that active and passive managers can have different roles and different time horizons,” Mizuno says.

“We are encouraging passive managers to engage with companies with a long time horizon in mind. On the other hand, if active managers say they think three months is the best timeframe to produce alpha then I won’t discourage it. The mismatch might be difficult to manage but we are trying to make the rules as clear as possible.”

This month the GPIF established a new division in its public market investment department, called “stewardship and ESG”.

Its investment principles outline that the fund will continue to maximise medium- to long-term equity investment returns for the benefit of pension beneficiaries by fulfilling stewardship responsibilities. And it believes that it is appropriate and essential for GPIF as a pension fund to increase long-term investment returns for pension beneficiaries by fostering sustainable growth and worth of companies in which it invests.

The fund accepted Japan’s Stewardship Code in May 2014 and became a signatory of PRI (principles for responsible investment) in September 2015.

Mizuno’s comments were made as part of a panel discussion at the PRI in Person conference in Singapore last month. Mizuno is a member of PRI asset owner advisory committee.

Commenting on climate risk and fiduciary duty, he said that “I don’t see a point in beneficiaries getting a full pension but they can’t step outside”.

The fund is looking at how to interpret this into daily investment activities, including looking at a proposal for environmental, social and governance (ESG) indices.

“Climate change is a long-term issue but we need to take it into our daily investment practice, ESG indices/positive screen companies is one way to do that.”

Bold proposition

To overcome the problems associated with short term reporting, Mizuno made a bold proposition to the audience.

“I propose that every asset owner only reports 50-year rolling performance number,” he said.

The session, which was chaired by the chair of PRI, Martin Skancke, also heard about the challenges of reporting long-term numbers.

Paul Smith, chief executive of the CFA Institute, says keeping focused on the long term is hard.

“With a 100-year time horizon you’re not around to reap the benefit, so behaviourally it is difficult, but also hard from a metric point of view. Also difficult where there’s a trust issue in the industry, hard to conduct long term investing in that environment,” he says.

Scancke says the Norwegian Sovereign Wealth Fund’s working definition of long-term is the capacity to hold an asset and not be forced to sell it; the ability to be contrarian and can sell or buy and rebalance when others aren’t.

Smith says the problem the industry is trying to resolve is that ESG issues, especially the environment, require a long-term focus.

“As the joke runs, the long-term is a series of short-term events, not as simple as saying the long-term is good and the short-term is bad, but about needs; finance industry structure needs to change to fit those needs,” he says.

“If we believe those challenges exist, then how do we enable that to happen?”

Chief finance and chief risk officer of APG, Angelien Kemna, says that APG and PPGM have collaborated on metrics to measure sustainability impact and keep returns focused first.

 

 

The $188.8 billion California State Teachers Retirement System, CalSTRS, will decide next April whether or not to divest from non-US thermal coal. The giant US fund only has a small exposure to emerging market coal, but the decision, which would follow on from the fund divesting from US thermal coal, and investing in a low carbon index strategy earlier this year, isn’t straightforward.

“We are conducting a deep dive into our non-US thermal coal holdings, but you have to consider the human issues as well as the climate issues in emerging market coal. In countries like India, there are so many people without electricity that without coal they will burn wood and dung, which is often worse than coal. There are two sides to the argument,” observes chief investment officer, Christopher Ailman, speaking from the fund’s Sacramento headquarters.

The decision to jettison US coal assets was easier, consistent with both the fund’s fiduciary duty and the changing regulatory landscape in the US.

Divestment in the US was limited to CalSTRS passively-held equity index portfolio and fixed income securities; active managers had mostly chosen not to own US coal in recent years.

CalSTRS further pushed its low carbon strategy this year when it committed up to $2.5 billion to low-carbon strategies in US, non-US developed and emerging equity markets.

The passively managed portfolio will be invested in an index designed to have significantly lower exposure to carbon emissions than the broad market, and a nearly complete reduction in exposure to fossil fuel reserves.

The MSCI ACWI low-carbon target passive index portfolio will be internally managed with implementation phased in, beginning with US equity, followed by developed markets and then, eventually, emerging markets.

Hedge funds for risk mitigation

The fund, which invests assets for nearly 896,000 active and retired school employees, is also in the process of introducing more risk mitigation into the portfolio through hedge fund strategies.

A new allocation to ‘risk mitigating strategies’ (RMS), will specifically target “less correlation to global growth,” smoothing volatility as the fund matures.

“We are a mature fund and we pay out more in benefits than what we receive in contributions. It means we care a great deal about the downside. We can’t ignore the low interest rate environment we’re in today, so we have to recognise that fixed income does not serve our purpose,” says Ailman.

The allocation will comprise four different strategies because “there is not one security you can buy to mitigate risk; you need to buy a basket.”

The components include long treasury bonds; trend following strategies; global macro and systemic risk premia.

In all, between 50 to 55 per cent of the allocation will be allocated to hedge funds. The whole strategy will account for 9 per cent of fund assets and the money will come out of fixed income and the global equity allocations, he says.

The bid to reduce risk comes as CalSTRS continues to be battered by volatility in a portfolio characterised by a 56.6 per cent allocation to global equity, as of the end of August 2016. The fund returned 1.4 per cent last year, due particularly to a poor performance in stocks.

The best performances came from real estate and fixed income which returned 11.1 per cent and 5.7 per cent respectively. Private equity, which currently accounts for 8.3 per cent of assets under management, also disappointed, returning 2.9 per cent, 1.7 per cent below CalSTRS custom internal benchmark.

“We think long-term, and the economy ebbs and flows. The US has been so strong for the last five years, it is not surprising there has been a pause,” says Ailman.

He also points to the funds three-year and five-year net returns at 7.8 per cent and 7.7 per cent respectively; CalSTRS has a target average return of 7.5 per cent over time.

Fee crackdown

Enduring investment themes include continuing to strengthen the fund’s internal teams, although Ailman says allocations to emerging markets, some private equity, and real estate will remain with managers.

Around 60 per cent of assets are currently internally managed. He is also keeping a keen eye on fees. CalSTRS says its fees come in at 30.8 basis points, meaning for every $100 it invests, it costs around 31 cents.

“The value-add has to exceed the fees you pay. Outperformance is inconsistent, hard to find and not easily repeatable. I’ve been in this business for 30 years and I thought fees would have come down by now, but Wall Street has just gotten cleverer at introducing new products that have a higher fee. Investors are focused on the net result and are willing to pay the fees if they are achieving a superior return net of fees. The problem is they pay first and wait; it’s not fun.”

Ailman plays down the outcome of the US presidential election on the pension fund, stressing again CalSTRS’s long-term outlook. Although he does ponder on one of the longest election processes in the world.

“Friends in Canada have pointed out that they held their country’s election, and reorganised their government, in less time than what we took to just run the primaries.”

Looking back over her 10-year career at France’s €36.3 billion ($41 billion) Fonds de Réserve pour les Retraites (FRR), chief investment officer Salwa Boussoukaya-Nasr observes that despite steady innovation, all change at the public fund has come against a backdrop of enduring continuity.

Boussoukaya-Nasr was appointed chief investment officer in 2012 at the fund which was created in 2001 to build reserves for the country’s public pension system. The reforms under her watch include introducing strategic hedging options, investment in a wider selection of asset classes, and most recently de-carbonising the passive equity portfolio.

“Since I joined we have gone through many changes but we still have the same goals, and much of the same team,” she says.

FRR is split between performance and hedging assets – 48.9 per cent versus 51.1 per cent respectively – and returned 3.08 per cent net of charges last year.

The largest allocation in the performance bucket is to developed market equities, with the rest in emerging market debt and equity and high yield euro and dollar bonds. In the year ahead she believes small cap European stocks, high yield and emerging debt and equity will be the star performers.

“Emerging markets were disappointing, but they are now doing well,” she says.

Hedging assets include French treasury bonds as well as euro and dollar-denominated investment grade corporate bonds. Eurozone and US corporate bonds together account for more than 45.6 per cent of the hedging component.

FRR is required by law to use external managers across the portfolio and active management strategies also dominate.

At the end of last year around 53 per cent of total net assets and 59 per cent of equity investments were actively managed.

Boussoukaya-Nasr believes these active mandates have helped shield the fund from enduring structural weakness in the Eurozone and Brexit fallout.

Here, additional hedging through option strategies ahead of the UK referendum, also dampened the impact of post-Brexit volatility.

Now she believes active strategies will position the portfolio for new trends, particularly slower UK growth and a “normalisation” of US and Eurozone valuations as Eurozone earnings improve.

FRR increased its exposure to the Eurozone with allocations to the region’s investments rising from 41 per cent in 2012 to 49 per cent in 2015. She also favours active management in US investment grade credit.

“Credit is a good place to find active returns above the benchmark.”

Growing Eurozone optimism

At the heart of FRR’s building Eurozone optimism lies a sizeable stake in the French economy.

Investment includes listed shares in French small- and mid-cap companies, debt and private equity and French real estate, with particular focus on long-term illiquid unlisted assets, after the French government granted the fund permission to invest beyond 2024.

Although the strategy is actively encouraged by the government, Boussoukaya-Nasr believes it is mutually beneficial both for the fund and the wider French economy.

“France is an obvious place for us to focus. We have a micro economic impact where we help companies develop and create jobs. It’s important because companies lack capital to the extent that many promising companies go abroad to the US for financing or go to public markets too early because they can’t find the capital. It’s challenging but interesting and we have the money and time to invest. We are also investing where there are less actors, so there is more opportunity and we can find attractive premiums.”

More than two thirds of the passive equity allocation in Europe, North America and Asia Pacific, excluding Japan, is now in low carbon strategies using MSCI Low Carbon Leaders indices that FRR worked with MSCI, AP4 and Amundi to help develop.

“We think that in the long-term, stranded assets will penalise equity valuations,” she says.

The indices exclude 20 per cent of the highest emitting companies, with a maximum 30 per cent – by weight – exclusion of companies by sector. They also exclude the largest owners of fossil fuel reserves with the objective of cutting both the carbon footprint and fossil fuel reserves of companies in the index by 50 per cent, compared to the relevant parent index. The most challenging aspect of the strategy so far has been minimising the tracking error compared to the performance of the standard indices in Asia.

“We have had a higher tracking error in Asia that has made it difficult to achieve the objectives of the low carbon leader in Asia so far – it has been very volatile but we began less than a year ago,” she says.

De-carbonisation

Boussoukaya-Nasr has also begun to de-carbonise the smart beta allocations which she admits is a “challenge without changing the characteristics of smart beta.”

“We gave our managers a maximum tracking error target that they have applied to their in-house processes. From what we have seen so far it’s encouraging.”

Smart beta strategies at the fund focus on value, small cap and low volatility factors in the Eurozone and North America, and represent 24 per cent of FRR’s allocation to developed-country equity and 42 per cent of its total passive equity mandates. There is a fixed weight between the different smart beta strategies.

“Some of the strategies behave better than others, but all have cycles,” she says.

In contrast, de-carbonising the bond portfolio is still a way off.

“Working to reduce CO2 and divesting from the worse emitters in equities makes sense because the valuation of those companies will fall. But in bonds the link is less obvious because as long as a company doesn’t default – even if there is a higher financing cost and the spread increases – there is still a return from investing in a company with high carbon emissions.”

She also questions the “ownership” ethos of a bond investor.

“If you have equity in a company, you are an owner of a part of that company and responsible for emissions, but bond holders are not owners. As an equity owner the emission belongs to you; as a bond holder you’re responsible for financing emitting activities.”

The fund is also working to combine active strategies with its de-carbonisation ambitions, considering reducing exposure to coal by divesting from companies that use mostly coal as a primary source of their energy.

The United Kingdom’s Northern Powerhouse, one of the funds to emerge in a pooling process that is combining 89 local government pension schemes (LGPS), into some eight so-called wealth funds, will prioritise infrastructure investment and low costs.

The £17.6 billion ($22.8 billion) Greater Manchester Pension Fund, GMPF, pooling with West Yorkshire Pension Fund and Merseyside Pension Fund are together shaping an investment strategy that will include a 10 per cent allocation to infrastructure within three to five years, says councillor Kieran Quinn, chair of the GMPF.

The Northern Powerhouse, named after the previous UK government’s policy to boost growth in the region and with combined assets of $45 billion as also pledged to become “the lowest cost pool in the LGPS on a like-for-like basis.”

Most of the savings will come from building direct investments in illiquid assets like private equity and infrastructure, says Manchester-born Quinn, a former postal worker elected to the board of the pension fund in 1997. Existing private equity allocations in fund of funds will move to a single fund with a focus on co-investments. Similarly, hedge fund allocations in fund of funds will move to single strategy funds

The GMPF currently has a target allocation to private equity of 5 per cent and a target allocation to infrastructure of 4 per cent. Asset allocation at the fund is split between a 61.5 per cent allocation to public equity, 23.5 per cent to bonds and cash, 10 per cent to property and 5 per cent to alternatives.

The Northern Powerhouse will also reduce the proportion of indirect property and infrastructure relative to direct property and infrastructure, says Quinn.

To date the fund’s direct local infrastructure holdings are characterised by investments anchored in the community and include house building on brownfield sites, office developments and a stake in Manchester city airport. Additional cost savings will come from moving equity and bond allocations in-house as the internal team is strengthened.

“The GMPF sees the potential from further internal resourcing,” says Quinn. Here managing assets in-house will benefit from West Yorkshire’s strong internal team which manages around $11.6 billion of listed assets.

It starts from an advantageous position of already having many of the economies of scale that other merged funds are seeking, says Quinn.

“We have been very efficient regarding our fees and issues around costs. There is more to do, but this is less fertile ground to plough. Some of the smaller funds will make more significant savings.”

 

Counterproductive to compete

He wants infrastructure investment to include co-investment with the UK’s other local authority pooled funds. Co-investment will help win the bigger deals where competition has squeezed UK pension funds out of the market, he says.

It’s a strategy the GMPF has already embarked on through collaboration with the London Pension Fund Authority, LPFA, in two direct infrastructure investments in renewables in the last year. The joint venture, which he hopes will double in size to $1.3 billion worth of investment, is currently exploring opportunities in a rail franchise scheme.

“Significant and large direct investment in the UK economy is the holy grail. Pension funds must work collectively.”

It would be counterproductive if the six or so pools competed against each other, as well as against other international pension and wealth funds, for the same trophy infrastructure projects, argues Quinn.

“We are keen to create a significant investment pool, which will enable us to compete with global wealth funds when bidding for airports, shipping ports and new railway connectivity such as HS3 high-speed rail link between Leeds, Manchester and Liverpool.”

Infrastructure investments make up only 1 per cent of the assets of UK pension funds compared to 5 per cent for Canadian pension funds.

Now Quinn is impatient for progress. Like other executive teams at the local authority pools, he is waiting for government approval. Once it comes “we will quickly implement the collective monitoring and benchmarking of legacy illiquid assets, generating improvements in governance and costs savings.”

“Progress is being slowed down because we still need formal responses to our pooling submissions,” he concludes.

The idea that diversification is the only free lunch in investing was popularised by the Nobel prize-winning economist Harry Markowitz in the 1950s and has since become a widely accepted “truth” in the investment world.

However, rather than being thought of as a free lunch (which suggests that any action that helps diversify my portfolio is a no-brainer), diversification should instead be seen as a trade-off between potential upside and possible downside.

To start with a simple example: in a world of just two assets, if an investor knows with certainty that asset A will outperform asset B over the next five years, then diversifying this portfolio (by holding less than 100 per cent of asset A) will simply reduce the investor’s five-year return.

In reality, situations where an investor has certainty in relation to the relative performance of two assets are almost non-existent. However, if one allows for even a modicum of investor skill, then biasing portfolios towards those assets with the greatest expected rewards starts to make sense.

Indeed, Warren Buffett famously said that “diversification is protection against ignorance; it makes little sense if you know what you are doing.”

Put another way, if we allow for the existence of manager skill, then diversification may be detrimental to returns by diluting high conviction positions. To the extent that one believes that manager skill exists and can be identified in advance, this is an argument for seeking managers that are willing to back strongly-held and well-researched views with meaningful positions.

‘Diworstification’

We can also call on another legendary investor to argue against the “diversification is a free lunch” line of thought.

Peter Lynch, one of the most successful equity investors of all time, coined the term “diworstification” to suggest that a business that diversifies too widely risks destroying their original business because management time, energy and resources are diverted from the original purpose of the business.

This argument can easily be extended to institutional investors: an over-diversified portfolio may place such a strain on the governance / oversight capacity of the asset owner that strategic issues are subordinated to discussions around the underlying manager portfolios. This is an argument for ensuring that manager diversification (to the extent that it is justified on fundamental risk / return grounds) is consistent with the governance resources available to the asset owner.

Having argued against excessive diversification on conviction and governance grounds, we should recognise that diversification can be a powerful tool in managing downside risk. To return to the earlier example, if we replace complete certainty with complete uncertainty, we are likely to conclude that a roughly equal mix of the two assets is a reasonable approach. In this situation of complete uncertainty, diversification reduces the impact of one of our underlying holdings experiencing large capital loss.

A trade-off

This allows us to see diversification for what it is: a trade-off between conviction positions that may deliver superior returns and control of the risk that our conviction is misplaced.

Those believing that we live in a world of extreme uncertainty will lean towards diversification, while those believing in a clearer and more understandable world will lean towards conviction. In practice, many investors will find themselves somewhere in the middle of this spectrum, needing to balance conviction with management of downside risk.

Markowitz-inspired finance theory places little weight on the issue of conviction vs uncertainty, assuming a world in which expected returns, volatilities and correlations are all that matter (and that they can be easily estimated). Investors may find a discussion on the issue of conviction and position-sizing a useful input to future decision-making.

Returning to Buffett’s earlier quote, we should perhaps be humble enough to allow diversification to “protect us from our ignorance,” but be bold enough to back our conviction where we have sufficient reason to believe that “we know what we are doing.”