In the past five years, Mass PRIM has moved from using five fund of funds to 25 direct relationships in its hedge fund portfolio, and in the process has removed any “over-diversification” and dramatically reduced fees.

Eric Nierenberg, senior investment officer, hedge funds and low volatility strategies at the Massachusetts Pension Reserves Investment Management, oversees the fund’s 9 per cent target for hedge funds, and 4 per cent portfolio completion strategies.

Although Nierenberg’s team is small – it comprises two people, including him – he outlines how determining risk diversification is a priority, and how moving from a fund of funds setup to managing direct relationship helps PRIM achieve its objectives.

“The way that we see that is to try and figure out how to help diversify the risk that’s within the overall pension fund while still achieving the attractive risk-adjusted rate of return, but most importantly, having low to zero correlation with equities, since that’s the predominant risk.

“A lot of the things we’ve done over the last couple of years in terms of restricting the hedge fund portfolio, has really been designed to try and reach those objectives,” he says.

The simple recalibration from fund of funds to direct relationships not only took the number of funds down by 90 per cent, but resulted in a savings of $40 million dollars per year,” Nierenberg says.

Change to fees and strategies

A focus on costs is a part of Mass PRIM’s approach and something Nierenberg feels strongly about. The $40 million savings on removing the fund of funds approach has grown into much larger savings.

“We really think it’s our duty to try and be as prudent on fees as we possibly can. Now, that doesn’t mean that there are investments that we won’t do because there are high fees; it simply means that if an investment is a high-fee investment it has a higher hurdle to clear in order to determine whether or not it’s something that we feel like would be prudent to do. That $40 million was just basically the first stage of the savings in the hedge fund program –as we restructured further, that number has more than doubled.”

When Mass PRIM started implementing change, it changed not only the number of managers but also the style of managers and types of strategies.

“In that first stage, in 2011, they took the low hanging fruit which was to cut off the fund of funds layer, but the overall profile of the hedge funds that they had really didn’t change that much. So if you looked at the 24 managers that were put into the portfolios in 2011 they were mega-cap hedge funds, $30 billion to $40 billion in size.

“When I joined in 2012 and we really started decomposing the portfolio, there was a tremendous amount of overlap in the positions that these funds had, so there was very high correlation among the funds, and even more worryingly, the fundamental correlation of these funds to equity markets was very high.

“We realised we really needed to make some continued changes to the portfolio, and it was at that point that we decided that if we’re going to do this, we’re going to have to focus on strategies that have that lower correlation; we need to find managers who can operate on those smaller niches that maybe the larger managers aren’t able to access.”

Great change in composition

Although the number of direct relationships with hedge funds remains the same, it’s markedly different to when the fund first established its own relationships.

“We still have about two dozen hedge fund relationships, but the composition has changed pretty dramatically. And really, the genesis of that was around two years ago we decided to make all of our new hedge fund investments in managed account format,” Nierenberg says.

“I come from a long-only equity background When I came over to the hedge fund side I was shocked at how antiquated it was that everyone’s invested in a commingled fund. And a lot of the reasons that were given to me about why it’s necessary to be invested in a commingled fund didn’t make sense to me. So the managed account format has been crucial in achieving a lot of those different objectives.

“First of all, it’s having direct control of the assets. That’s something that the board of trustees felt very pleased to have, that you can’t be gated out of an account that you fundamentally own.”

Nierenberg says that there were limits on how much Mass PRIM could be in a commingled fund. Once the board set a limit of 20 to 25 per cent of any commingled fund, given the size of the allocations made, it pushed up the minimum entry point to funds of US$1 billion and above. This had the effect of wiping out a massive part of the potential manager pool, but once the fund moved into managed accounts, it specifically targeted those managers operating in the smaller space.

“We think that’s been really beneficial because these managers have differentiated strategies which we think have higher alpha potential; and it’s not just us, there’s a number of different academics both on the mutual fund side, where it’s very well known, but also on the hedge fund side where it’s maybe not as well known, that smaller funds do tend to outperform larger ones.

“The other piece is fee reduction. With commingled funds, a lot of managers are able to give some discounts for sizeable allocations, but frankly, they’re somewhat limited. With managed accounts, really it’s a whole different ball game, especially if you’re tweaking the mandate so it looks somewhat different to the commingled fund. We’ve been able to get fee reductions on the order of 40-50 per cent, so if there’s a rack rate of 2 and 20, you’re talking in the range of 1 in 10 or 1.25 in 12.That’s really meaningful cost savings. That $40 million in cost savings in the fund-of-fund layer being removed, it’s now up over $100 million a year because of the savings from management fees.”

Manager selection

Although PRIM has had an identifiable bias to US-based managers, with a handful in the UK, Nierenberg says it is time for change.

“One of the weaknesses in our portfolio currently is not having enough managers from other part of the world.

“Finding good managers is without a doubt the bottleneck in this process. I wish I had deployed even more of our legacy commingled fund capital into more managed accounts with more new managers.

“It’s just that it’s a tough process. Alternative beta is a huge part of our diligence process. We’ve developed an internal framework that really can take a manager’s returns and decompose them into alternative beta loadings, and we’re looking for those managers that have true alpha exposure. We have a risk premia portfolio that sits in our portfolio completion strategies. That portfolio is about $700 million in size and will probably grow in the coming months, and I definitely think alternative beta and risk premias are an important part of the portfolio, but focusing on the active hedge fund piece, we need to find those funds that are willing to accept the fact that the fee structure of the industry is changing, and we’re not going to be willing or able to pay 2 in 20 or anywhere close to that going forward. Willing to accept the idea of a managed account, and really, have some unique skill that doesn’t just get captured by some kind of alternative beta. What they get in return is really a very patient, very knowledgeable organisation that’s willing to stand by them, especially if there are periods of performance that aren’t so great.”

One of the biggest thing Nierenberg advocates is to bring in a specialist if an investor plans to move to managed accounts.

“There’s a lot of different organisations out there that can help an institution set up a managed account program, and that’s one thing I’ll stress, if you’re thinking about doing it yourself – don’t. Make sure that you utilise someone else. This was advice what was given to me by Dan McDonald at Ontario Teachers; they had a managed account for probably 10 years, and he said they started off trying to do all this internally – onboarding of managers, the prime brokerage agreements, the swap agreements. He said there was so much brain damage from that process that, in hindsight, they should have just paid the few basis points or whatever it was to an outside provider who has a real skill in doing this to help them. We took that advice to heart and it was a lifesaver, because there was no way we could have done this without them.”

The next step in the hedge fund program evolution, Nierenberg says, is for Mass PRIM to fund emerging managers.

 

Investment strategy at the German pension fund Ärzte-versorgung Westfalen-Lippe, ÄVWL, the €12.3 billion ($13.7 billion) fund for doctors and their dependants, is shaped around long-term, anti-cyclical investments concentrated in real estate, infrastructure and asset-backed lending to corporates.

Based in Germany’s northern city of Münster, only 10 per cent of the fund is in listed equity. It is not only the stable cash flows associated with these assets that the fund favours; they also provide shelter from market events – none more so than its own struggling Eurozone.

More than 20 per cent of the fund’s assets are invested in real estate in an allocation that has led returns over the years.

“Real estate has always represented a cornerstone of the ÄVWL’s total investment strategy,” explains Markus Altenhoff, director of capital investments.

“Our approach within real estate is to diversify across the whole risk-return-spectrum and to cover the entire value chain. A fundamental principle of the strategy is to also identify real estate opportunities in new regions, trends, and niche segments in which we can – sometimes anti-cyclically – play a pioneering role.”

Important recent investments include the fund’s stake in a three-building office complex in Washington, D.C. of which 89 per cent of the space is leased to AA-rated federal agencies, Altenhoff explains.

“This is about an A-class asset that offers credit cash flows with incremental yield opportunities; ideal characteristics of a long-term wealth preservation tool. The rent roll will also offer a significant yield premium over the U.S. Government credit.” ÄVWL’s in-house real estate team stuck by their anti-cyclical ethos when they divested from some of the fund’s trophy London real estate holdings in response to overheating in that market; a strategy that has also fortified the portfolio from any Brexit tail-wind.

Now, growing competition for real estate assets and tougher market conditions has made value added a key theme.

“Here we identify under-valued and fairly valued markets with a substantial appreciation potential over the investment period. A stable basis of at least 70 per cent in core and core plus investments guarantees steady and sustainable cash flows,” Altenhoff says.

ÄVWL is also busy building its allocation to infrastructure with the unlisted allocation now “a significant part of the portfolio” accounting for around 15 per cent of total assets and including asset-based investment and project financing, often as part of a consortium, and a growing commitment to renewable energy.

However, it is noteworthy that the fund does not see infrastructure as an asset class in its own right. Rather its sees infrastructure investment across the portfolio in loans and mortgages, fixed income and alternatives; projects with system relevance, or those involving a certain type of regulation, explains Lutz Horstick, head of securities and loans.

“When we speak about ‘long-term’ investments, we mean ones that have a time horizon of at least 10 to 20 years. If we believe in the long-term profitability of an asset, we intentionally accept a certain degree of volatility and price fluctuations. We are ready to enter investments with more complex structures in order to profit from extra yields in terms of illiquidity premiums. This often includes arranging consortia,” he says.

Seizing opportunity

One consequence of the fund’s increased exposure to infrastructure has been a jump in US dollar exposure.

“We have sought access in particular to the US dollar credit markets, important because infrastructure and asset-based investments are to a large extent US dollar denominated. We have moved away from full currency hedging and used the US dollar as an asset class in its own right. In addition, we also keep a high share of hard currency emerging market debt. As a consequence, the US dollar exposure at the end of August 2016 was about 12 per cent of assets under management.”

It has given rise to the other reason the fund is immune to structural weakness in the Eurozone post Brexit: “ÄVWL is a net gainer of the Brexit decision so far and has profited from the US dollar appreciation which has, to a large extent, overcompensated the depreciation of a relatively moderate sterling exposure,” Horstick says.

Along with financing infrastructure, asset based lending with an anti-cyclical bent includes the fund financing ships and aircraft, seizing opportunity in two niche segments where traditional bank backers have fled the market.

“In the asset-based space we saw a widening of the spreads as a consequence of banks leaving the sector, especially in the aviation and shipping sector. ÄVWL invested a three-digit-million-Euro-amount in this sector during the last three years.”

ÄVWL manages about 60 per cent of its assets internally.

“We aim to have internal know-how for all relevant asset classes. External managers help us in asset classes where it is not worth building in depth in-house expertise and we also use external managers in areas where we have no direct access to the market or where we are regionally not present, like the US and emerging markets. We use consultants only in special niches or if we are entering a new area or asset class and do not have the necessary experience.”

The fund uses dedicated managers in private equity because it doesn’t have the resources for direct investments.

“At this point in time we are focusing on manager selection in private equity as this is the main driver for the performance within this asset class.”

Active management also lies at the heart of strategy.

“We strongly believe that active management adds value. To us it is very important to select the best strategy which fits our requirements. We see this as an essential driver for the performance of our fund,” Horstick says.

On September 22, 2016 CECP, ‘The CEO Force for Good,’ will launch its Strategic Investor Initiative (SII). The purpose of the SII is to shift the conversation between companies and their investors from one about quarterly earnings to one about long-term value creation. The SII is funded by grants from the Ford Foundation and the Heron Foundation, in addition to robust support from CECP staff, CECP’s 217 member corporations (more than half in the S&P 500), and the Newman’s Own Foundation.

Based on the initial feedback received from the five-month listening tour, the SII’s initial focus areas will include:

  • CEO long-term plans that include stakeholders beyond shareholders

In order to move stakeholders, as building blocks to long term value, into the ‘CEO quarterly call’ discussion, chief executive officers  must first articulate how multi-stakeholder governance drives long-term value creation. In the afternoon following CECP’s 2017 Board of Boards, a three hour, closed-door networking discussion and Forbes-named top three “power player” event for CEOs, the SII will convene its first Strategic Investor Conference. This will be a ‘many-to-many’ engagement opportunity between CEOs presenting their long term value plans and a group of long term investment analysts. These conversations will be made public and archived and will provide insight and information needed by long-term investors.

  • Investor segmentation

Chief executive officers routinely segment customers, vendors, and other markets in order to allocate scarce resources to those segments which most efficiently contribute to long term value. However, segmenting investors is rarely done. If CEOs can promote and encourage a greater proportion of their investor base to be longer-term holders, and a smaller proportion to be shorter-term holders, it follows that the long term investor-CEO dialogue should have greater resonance. By leveraging well-established segmentation schemes such as Wharton Professor Brian Bushee’s Institutional Investor Classification system, the SII will arm CEOs with new measures of the holding term behavior not only of their own company’s investors.

  • Stakeholder mapping and disclosure

To our knowledge, no organisation has attempted to map industry-specific significant stakeholders across all industries. CECP has a multi-decade history of robust measurement and assessment in the corporate responsibility domain that can be leveraged in mapping these stakeholders. This mapping will help companies determine their ‘significant audiences’ so that their board can issue an annual Statement of Significant Audiences and Materiality (The Statement). One of the objectives of the SII is to encourage widespread adoption of ‘The Statement’ which will support a longer-term oriented quarterly call, long-term multi-stakeholder plans, and a higher promotion of long-term shareholders.

  • Cultural KPIs

In the SII listening tour, institutional investors expressed great interest in new metrics that can quantify qualitative factors such as corporate culture, so that these predominantly social factors can eventually make their way into valuation models, and as a potential antidote to greenwashing. Incorporating qualitative environmental, social and governance (ESG) factors into analysts’ models is a key focus of High Meadows Institute’s Future of Capital Markets effort. Using new ESG big data technologies such as TruValue Labs, the SII will bring to investors quantitative evidence of how corporations are working with their most significant stakeholders to create long term value.

According to Mark Tulay, director of the SII: “SII envisions a new platform for leading CEOs to develop, convey, and deliver their long-term plan to long-term investors – including specific commitments on financially material ESG factors and articulating their non-shareholder stakeholders. SII hopes to spark the movement of trillions of dollars of capital to companies demonstrating performance excellence over the long-term and will help build trust in capitalism as an engine of global prosperity,” and thus help evolve the role of the sustainable corporation in a sustainable society.

Robert G. Eccles is chairman of Arabesque Partners and Tim Youmans is research director for the Strategic Investor Initiative at CECP. They are research collaborators and global experts on materiality and integrated reporting. To learn more about CECP’s Strategic Investor Initiative, please contact Tim at tyoumans@cecp.co

One year into his chief investment officer role at Baltimore-based Maryland State Retirement and Pension System, Andrew Palmer is steering the $45 billion portfolio in new directions.

He’s overseen a doubling in the fund’s exposure to emerging markets and a move to a long duration benchmark in the fixed income portfolio.

“Fixed income gained from switching from an intermediate benchmark to a long duration benchmark with average maturities of 25 years. The Barclays Aggregate index wasn’t doing much for us. We broke it apart and took what attributes we wanted.”

Now he promises to apply a similar “thought process” across the entire portfolio.

One area Palmer is particularly focused on is the absolute return portfolio, accounting for around 10 per cent of fund assets, which returned 0.7 per cent in fiscal 2015 compared to a benchmark of 2.7 per cent.

“We still want part of our portfolio to have a low correlation to stocks and the absolute return allocation is dedicated to that for us. However, the allocation hasn’t provided strong returns or diversification recently,” he says.

He believes Maryland’s hedge fund allocation performs more like the stock market in down markets than up markets, and may not be diversified enough.

“I want to make sure we have the right mix of managers. We have multiple managers and many of them are doing the same thing. We are seeing different returns but they are correlated; we want uncorrelated returns.”

The portfolio consists of four global macro funds, one risk parity strategy, two fund-of-funds, five relative value multi-strategy funds, and one insurance fund.

“The insurance fund is the one that gives the best uncorrelated returns,” he observes.

Poised to reduce manager numbers

Other areas of the manager roster are also poised for change. The fund currently uses around 350 external managers in a strategy that is entirely outsourced: Maryland only employs 15 investment professionals of its own, most of who are involved in sourcing and monitoring external managers.

The fund has committed around 6 per cent of assets to an emerging manager program that includes 100 managers favoured for their independent, original and diversifying strategies. Now Palmer plans to reduce the number of managers, although the size of the portfolio will stay the same.

“We work through consultants, but consultants tend to stick with tried and tested managers. We like these aggressive, bright minds but we are working to reduce the number of managers here – not because they are doing poorly but because we have so many that together they perform like an index.”

Emerging managers are particularly focused on the fund’s active allocations around stock and bond picking, as well as quants. He would also like to build internal expertise.

“Where we can have confidence, and build the skills set, we will start to do more ourselves.” The first area is likely to be around tactical asset allocation, including in-house beta allocations and using exchange traded funds or futures to change the asset mix. He also believes Maryland is well positioned to manage currency risk and fixed income allocations itself.

“I worked in fixed income for 30 years. I think this would be a natural place to start building success.”

One hundred managers sit on the private equity side, monitored by an internal staff of four.

“Our staff are managing the relationships and deciding whether to subscribe to the next fund; in private equity we are in partnerships and have no control of the investment.”

Although he says external management in private markets drives fees higher, he attributes the fund’s strongest returns in private equity and private real estate to “good managers” – as well as improving valuations.

Maryland has some 35 per cent of assets in a public equity allocation, balanced between dollar and non-dollar stocks that use a currency overlay program to hedge risk.

“It’s expensive to hedge currencies back all the time and our currency exposure is also an important source of diversification, however the overlay protects the portfolio against any sustained currency trends.”

The dynamic strategy adjusts according to currency market conditions, with managers tending to use low hedge ratios when the dollar is weak, and high hedge ratios when the dollar is strong. Maryland doesn’t hedge emerging market currencies.

“We like these currencies long-term; they are growth drivers across the globe.”

 

Blockchain technology

Going forward, Palmer believes emerging markets will offer better value than they have and he is also looking at new asset classes that have appeared since the banking crisis like mortgages, and commercial real estate mortgages.

“We can start to invest in areas where traditional owners can no longer invest as much,” he says.

He also believes it won’t be long until blockchain technology, the shared database technology that allows consumers and suppliers to connect directly removing the need for middlemen, will broaden the potential investment universe to include more easily accessible opportunities in assets like leveraged loans, securitised loans and asset-backed loans.

“These assets don’t tend to trade as well as others and block chain technology could make it easier,” he says. They would also offer the kind of diversification he views as paramount.

“We like the fact that returns vary across the portfolio; the balance gives us a smoother ride. When everything moves in the same direction at once it may put pressure on the system in falling markets,” he says.

 

David Blood, who co-founded Generation Investment Management with former vice president of the US, Al Gore, has outlined five priorities to focus the sustainable investment effort on over the next five years.

“We need to step up our efforts in the next three to five years no matter who gets into power in the US,” he says.

“We don’t have nearly enough capital in the transition to [a] low carbon economy. It’s not just renewable energy, everything will change.”

Speaking at the PRI in Person conference in Singapore last week, Blood said that the framework around sustainable investing rests on two things:

  1. The macro environment and the drivers of change – such as the environment, climate change, poverty, health, and demographics – are becoming more intense, and interlinked and so more relevant to business and investors
  2. From a business point of view, the issues of reputation, brand and resource management are becoming more relevant.

Generation, which was formed 12 years ago, is anchored in the philosophy that sustainability is best practice and makes the group better investors.

“Categorically we believe that the integration of sustainability makes us better investors,” Blood says.

“The more we prove the business case, the more it says it’s a fiduciary duty to do so, it will become mainstream.”

“Over the past 12 years the macro backdrop is increasingly important, and the integration of sustainability into investment practices and philosophy is best practice. Dumping a lot of oil into the Gulf of Mexico is bad for your stock price; reputation clearly matters,” he says.

“Companies that minimise the use of resources and maximise the resources they have will do better.”

In his keynote speech at the PRI conference Blood listed priorities for the next five years in order to progress sustainability integration.

  1. Win the battle, or debate, on fiduciary duty.

“Many investors say that fiduciary duty precludes them from looking at sustainability or ESG [environmental, social and governance], that is wrong,” he says.

Change the debate from why integrate, to how you integrate sustainability into investment practices. This includes looking at reporting, fiduciary duty, increasing the number of firms actively integrating sustainability, and looking across asset classes, not just equities.

  1. Recruit the other 50 per cent of managers to integrate sustainability, not just the people attending, or signed up to, the PRI.

“We’re good at convening those that agree,” he says. “Asset owners are key to bringing the other investment managers along the journey.”

  1. The transition to a low carbon economy is a big deal, and it has to happen now.

“If we are still talking about this in 10 years then we’ve missed it. Must make it critical, we need consistency of data.”

  1. The industry needs to recognise that finance and capitalism is not working for everyone. There is significant inequality and people are upset about it.

“Most people in the world have no idea we are integrating sustainability in finance. The finance industry is close to losing its licence to operate.”

“Most people outside of finance don’t differentiate between hedge funds, asset managers, asset owners, pension funds – they are all lumped in one bucket,” he says.

“We need to put the ‘social’ in the front of our agendas, impact investing as an extension and encourage companies to think about social issues. We have done a pretty good job on the ‘environmental’ and ‘governance’ but not great on the social.”

“It concerns me that of the top 25 asset managers in the world, about 50 per cent are here, but those that are not here are mostly American,” he told the PRI in Person audience.

“In the US, sustainable and responsible investing is seen as a political agenda and not really investing. We need to make the business case for it to win the argument,” he says.