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.

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.