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Investment strategy at Chile’s second largest pension fund, the $45 billion AFP Habitat, is characterised by both a large exposure to emerging markets and a growing global alternatives portfolio.

“We are an emerging market ourselves and feel comfortable assessing the risk return profile of those markets,” explains chief investment officer Alejandro Bezanilla Mena, speaking from the fund’s Santiago headquarters in Chile’s capital.

It’s where protestors recently took to the streets to voice their discontent with the country’s private pension system. Set up under the dictatorship of Augusto Pinochet, Chile requires workers to contribute 10 per cent of their salaries to funds known as Administradoras de Fondos de Pensiones, (AFPs).

It has nurtured a $170 billion pension pool that has encouraged other countries to copy the Chilean model, yet people living longer, saving less, and poor returns from financial markets has fanned today’s demand for reform.

Bezanilla also notes that the Chilean system doesn’t cater for those either without a pension, or who have been unable to regularly contribute during their working life, leaving too many without retirement provision.

“We are in the middle of a reform process that should address a new scenario of expected returns and higher longevity. In the last 35 years we haven’t changed the main parameters of the system, so the level of contributions and the retirement age are the same as they’ve always been,” he says.

As the government tries to settle on a new system, AFP Habitat remains set on its own, adventurous course.

Emerging market equities account for almost 60 per cent of the fund’s total equity allocation, while emerging market bonds account for 45 per cent of the international fixed income allocation.

Japanese equities ‘disappointing’

“At the beginning of the year we started to rotate from developed markets into emerging markets, on the back of less perceived risk and very low valuations. It proved to be good timing,” says Bezanilla, detailing that investments in international fixed income include credit, mainly US and European high yield, hard currency emerging market corporate bonds and local currency emerging market government bonds.

He says he has been “disappointed” with Japanese equities where he hoped changes in corporate governance and the renewed focus on profitability in Japanese companies would pay off.

Asset allocation at the fund depends on its two million contributors’ own risk appetite. Since 2002, AFP Habitat, like the other five AFP funds, was required to run five different funds with different levels of exposure to equities and risk, ranging from the conservative to the very risky.

“This multi-fund system was created to allow contributors to choose amongst any of the funds while taking into account their age and risk preferences,” says Bezanilla who joined the fund as a domestic equity portfolio manager in 2005.

Contributors can invest in two funds at any given time. The most aggressive fund, Fund A, can have up to 80 per cent in equities and has seen real term returns since inception of 6.4 per cent, while the most conservative fund, Fund E, has an equity allocation capped at 5 per cent and has posted returns since inception of 4.1 per cent in real terms.

“Our asset allocation depends primarily on the decisions our contributors make regarding their risk appetite. Currently, they are very active and opt towards changing from aggressive funds to conservative funds back and forth often,” he says.

AFP Habitat has posted an 8.4 per cent return in real terms since inception 35 years ago.

Stiff competition

Stiff competition for returns within Chile’s borders has encouraged a diversified, global strategy.

“The Chilean pension system manages about $170 billion, which represents more than half of Chile’s GDP. This means we don’t have any other option but to diversify our investments outside of Chile,” he says.

A growing global alternatives allocation is one consequence. The fund used to have local investments in private equity, infrastructure and real estate, but the allocations were too small to make much of a difference to the portfolio, mainly because of the lack of local managers with the experience and track record, he says. After the financial crisis, global

alternative managers seeking new opportunities began to appear in Chile.

“It allowed us to enter an asset class that was interesting and diversifying for our portfolio. Since then, the alternative portfolios have been growing slowly but steadily,” he says.

The fund favours passive management in US equities and “some passive” in Japanese and European equities, but actively manages its emerging markets and high yielding debt allocations.

“The decision to invest in active management is based on quantitative analysis to assess the ability of the manager to generate alpha consistently, and on the conviction that, in certain markets, it is easier to produce that alpha due to information asymmetries and indices that are too concentrated in a few companies,” he says.

“We only invest passive when we can prove that there is no alpha generation or when we need more liquidity for our decisions.”

The fund tends to use its own in-house team to invest in local assets, but favours external managers in international markets.

However, it recently began to invest directly in international government bonds to better hedge and manage liquidity, and is also beginning to invest directly in Latin-American equities and bonds for the first time.

“This was a natural step, since we already invest directly in Chilean companies, many of which are already competing within the same markets as Latin-American companies, and that we have therefore already studied to have a better understanding of the competitive environment.

“We believe we can produce alpha with our knowledge of the markets and savings from the external managers’ fees.”

External managers’ costs are down 40 per cent in comparable terms since 2002, accomplished by “several rounds of negotiations with our counterparts,” he concludes.

Sustainability is defined as the capacity to endure. Sustainability is not just the consideration of environmental or social and governance considerations.

It is not a negative screen. It is so much more than climate change, so much more than corporate engagement. Sustainability is the system and the ability to continue.

Princeton University professor and sociologist, Robert Gutman, said: “Every profession bears the responsibility to understand the circumstances that enable its existence.”

This should be a call to action for the finance industry, which has rested on its laurels; it’s rested on its low barriers to entry, high fees and complex language that has created enduring principal/agent problems that restrict transparency and accountability.

All participants in the finance industry should take heed. Simply, if you want to endure then you should consider your role, the industry and its purpose, through a sustainability lens.

After nearly 10 years of reporting on sustainability, the finance industry is finally waking up.

conexust1f.flywheelstaging.com is an investment publication. It covers broad issues relating to institutional investment including investment strategy and implementation, macro-economic conditions and asset class specific solutions.

We have been writing about sustainability since the publication’s inception in 2008, because we see environmental, social and governance issues as a central theme for the world in which we live, both now and, importantly, in the future – and that’s true if you’re a pension fund member, a pension fund executive, a provider of service to that industry, or a company in which the industry invests.

This is not about tree-hugging, but a sensible and robust investment strategy and a logical, thematic, holistic world view. The finance industry is inward looking, it’s time to look out.

In this regard, I consider my job will be done when there is no ESG alpha but it is priced into markets and embedded in the process of managers and asset owners.

We are very proud to be partnering with the PRI on a special publication to celebrate the PRI’s 10th anniversary and look at the achievements of the past 10 years, and challenge the industry to move forward.

The magazine looks at big picture issues such as the purpose of finance – which is not to make money, but to serve the real economy – the achievements of the PRI, and the role institutional investors can play in financing solutions to global challenges such as climate change, social injustice, poverty and inequality.

In this issue we also highlight through case studies the asset owners that are leading the way in ESG integration – and how they hold managers to account on ESG will be a key development in the next 10 years.

We celebrate asset owners, and believe that building strong buy-side organisations is the key to much-needed change in the finance industry, change that will allow investors to focus investments on the long term, and better align decisions with the needs of their members and stakeholders.

In order to do this, asset owners need to take stock of their internal organisations, pay attention to governance and decision making, hire good internal teams, invest directly, reduce the number of external providers, integrate ESG into investments and be conscious of costs. All are issues of sustainability.

An e-mag of this special print edition will be made available on conexust1f.flywheelstaging.com following the PRI in Person conference next week.

Listed equities and alternatives remain the strongest performers at the SEK303 billion ($36.1 billion) Third Swedish National Pension Fund, AP3, one of the five AP Funds that manage the capital buffer of Sweden’s state income pension system.

“We have gradually increased our exposure to alternatives. This allocation has done as good as listed equity,” says chief investment officer, Mårten Lindeborg, who joined AP3 in 2009 as head of strategic allocation, from previous roles in portfolio management and tactical asset allocation.

The fund’s biggest risk exposure comes via some 50 per cent equity allocation, mainly tilted towards market cap indices. Yet Lindeborg ensures diversification through strategies that include following alternative indices and pursuing thematic investments like, for example, stocks with high direct yields and pharmaceutical and biotechnology companies.

A new focus will seek more precision when it comes to harvesting risk premiums such as quality and small cap companies in the European portfolio, which has been close to 7 per cent of total fund assets.

“The illiquidity premium you are paid in small caps is similar to alternatives. It’s risky and potentially expensive, so you have to consider valuations and where we are in the credit cycle,” he says.

Other changes underway in equities include plans to halve AP3’s carbon footprint in listed equities and credits by 2018, compared to 2014 levels; the fund will also triple its holdings of green bonds from $0.5 billion to $1.7 billion by the end of 2018.

“The fund is Co2 positive, as in we are absorbing carbon via our timberland holdings, but we still want to improve the footprint of our listed equity and credit portfolio. Part of the strategy is of course to understand which sectors have the most negative impact on Co2 emissions, but also consider the prospect of the sector in respect to future return and risk.”

As 2018 approaches, the challenge is finding clear business cases for jettisoning the assets that produce most carbon-like energy and utility groups. Lindeborg says it was easy to see the business case for divesting from coal before the fund shed all its shares in coal mining companies from April to June 2015.

“Coal was expensive, dragging on the whole portfolio, and only accounted for a small part of the fund.” In contrast, applying a similar strategy to AP3’s other carbon holdings would not necessarily make sense.

“We know that our energy and basic materials holdings contribute most to our carbon emissions. We could sell them, but we need a clear business case for selling them and basic resources are one of the best performing sectors in Europe. The second best is oil and gas. It’s very easy to have zero carbon emissions but it will cost you at some point if you exclude carbon producing sectors”.

He believes the answer to the problem will come as companies themselves increasingly change, something AP3 actively encourages through stewardship and engagement.

“Companies are not deaf. Companies will become more sustainable and that will help us,” he says.

Pragmatic approach to costs

It’s a pragmatic, business-focused attitude that Lindeborg also applies to costs. He’s grown weary of the constant pressure on costs, believing that sometimes costs are worth it.

“The cost side is attacked because it is more transparent than returns. We are a government entity and we are aware of our costs. It is easy for our constituents to compare our costs to other funds and we are always trying to improve on our costs and keep them low. But you have to consider if low costs are always the best thing for pension funds. The best thing is good returns.”

In 2015 costs of AP3 were 0.12 per cent of assets under management, which is very low for a modern pension fund investing in listed and unlisted securities.

Alternative investments, including private equity, timberland, Swedish real estate and infrastructure, now comprise around 18 per cent of the total portfolio in a growing inflation-hedging allocation born from the restricted returns in fixed income.

“The allocation to different asset classes also depends on how they perform against each other. If listed assets do well, then we have to buy more alternative assets to keep up the share of the allocation,” he explains.

Private equity returns have averaged 14.5 per cent annually over the past three years and ideally Lindeborg would be overseeing a much larger allocation.

Yet strategy is limited by government restrictions which cap private equity investment at 5 per cent of the portfolio.

The fund is also required to hold at least 30 per cent of assets in liquid fixed income. In reality, AP3 has to keep well below the 5 per cent ceiling to allow for headroom, given that some allocations to other asset classes are often embedded within private equity funds.

“Take credit market opportunities – we often have to consider them as private equity because they are wrapped in a private equity fund,” he says.

“We have to work with this limitation from the Swedish Parliament. We should be able to make decisions ourselves and consider the costs. We would have more than a 5 per cent allocation if we were able to.”

All private equity investment is via funds. AP3 currently uses between 30-40 private equity managers that together manage around 100 funds of different vintages.

“If we want to invest directly we would need more in-house skill,” he says.

Currently 69 per cent of the fund is managed internally, with an asset management staff of around 30.

He describes the AP funds as siblings in a relationship that combines healthy independence with co-operation.

Co-operation comes in infrastructure and real estate – together with AP1, AP2 and AP4, AP3 owns and manages Vasakronan, Sweden’s largest commercial real estate company – as well as through the development of sustainable polices via the ethical council, a collaborative venture between AP funds 1-4.

“We all have the same mandate but different strategies; there is no one view that fits all of the funds.”

Last year Sweden’s government cancelled reforms to reduce the number of buffer funds to three, following fierce resistance from both the funds and others opposed to the decision.

Brexit’s long term uncertainty

Lindeborg flags ongoing market uncertainties. AP3 has profited from the dollar strengthening against the krona in a currency exposure that is beneficial, given many of Sweden’s corporations are exporters.

“Our currency exposure has contributed to our total return based on the fact that the dollar has gone up against the krona. It’s nice, but it won’t go on for ever.”

He also believes that Brexit poses long-term uncertainty despite the short-term benefits with which it was initially weathered.

“The short term impact of Brexit was positive for the fund but the longer-term implications are uncertain, like the kind of agreement the UK will have with the EU, and the results of coming elections in Italy, Germany, and France.”

He also notes that the European central bank has limited policy options, what he calls “zero ammunition,” with rates so low. It means more decisions will be taken by politicians through fiscal policies, he says.

The inclusion of China A-shares in the wider MSCI indexes, an inevitable outcome, will have a profound effect on investors’ portfolios. The steps China needs to make to satisfy investors, and the implications of inclusion, will be discussed at the Fiduciary Investors Symposium at Yale School of Management in October.

MSCI announced in June it would delay the inclusion of China A-shares in its emerging markets index. Around $1.5 trillion is benchmarked to this index.

The current proposal, which has not yet been approved, is for a partial or 5 per cent inclusion. This would see the number of constituents increasing from 155 (overseas listed Chinese companies) to 609.

A potential full inclusion of China would mean an abolishment of the quota system, full liberalisation of capital mobility restrictions and alignment of international accessibility standards. If these requirements were met, a full inclusion would mean China would make up nearly 40 per cent of the emerging markets index. This could have a huge impact on investors’ portfolios.

In announcing the delay, Remy Briand, MSCI’s global head of research, said that international institutional investors had indicated they wanted to see further improvements in the accessibility of the China A-shares market before its inclusion. This included investors’ ability to move funds in and out of China and a desire to see whether new stock suspension rules were enforced.

MSCI has said it would review China-A shares again next year, but did not rule out a potential inclusion before then if changes were made.

Briand will be part of a discussion on the impact on investors’ portfolios of the inclusion of China in the emerging market index at the Fiduciary Investors Symposium at Yale School of Management from October 23-25.

Also joining the discussion will be Professor of Finance at Yale, Zhiwu Chen, who is an expert on finance theory, securities valuation, emerging markets, and China’s economy and capital markets.

For the past 15 years Chen has focused on investigating market development and institution-building issues in the context of China’s transition process and other emerging markets.

He asks: What institutions are necessary for markets to develop? Why is finance important for society? How does financial development affect social structure and individual freedom?

The panel will also hear from Stephen Kotkin, Professor in History and International Affairs at Princeton University, who specialises in geopolitical risk and will explore the history of China and its influence in the world.

David Tien, senior portfolio manager within global tactical asset allocation at the Canada Pension Plan Investment Board will explore the impact on broader equity markets of China’s declining growth, and the impact on investors when China’s share of the broader market indexes increase.

For the full program and to register for the Fiduciary Investors Symposium at Yale School of Management from October 23-25 visit www.fiduciaryinvestors.com

Finland’s newest pension fund, Elo Mutual Pension Insurance Company, (Elo), emerged in 2014 when Pension Fennia and the LocalTapiola Pension Company merged.

One of the rationales behind the merger was to create an economy of scale that combined each fund’s investment skills in one strong, in-house team with expertise across the asset classes.

Two years on, and with some 80 per cent of assets now managed in-house, the EUR 21 billion ($23.8 billion) fund is one of the most popular pension providers in the country, with one in three companies, and more than 40 per cent of Finland’s self-employed, holding pensions with Elo.

Elo returned 5 per cent last year from a portfolio that although diversified, still has around a third of investments in Finnish assets.

In an interview from the fund’s Espoo headquarters, Finland’s second largest city, chief investment officer, Hanna Hiidenpalo, who joined Elo from Tapiola Mutual Insurance Company where she was chief investment officer for more than 10 years, says 2016 promises similarly stable returns.

“We’ve been positively surprised by good performances in our emerging market investments, both in equity and fixed income. Some other parts of the fixed income portfolio have also performed very well, like high yield. On the other hand, this market environment seems to be difficult for hedge fund managers,” she says, attributing this to new capital flowing into hedge funds and the narrowing risk premiums.

Assets are split between a 43 per cent allocation to fixed income, including credit and cash and direct lending to corporates, a 31 per cent allocation to equities which includes private equity, 13 per cent to real estate – of which 10 per cent is in direct investments – and a 13 per cent allocation to hedge funds.

High Finnish exposure

Although the fund’s high exposure to the Finnish economy comes mostly from its direct real estate holdings, Finnish companies account for about one fifth of Elo’s equity portfolio.

It amounts to a significant exposure to the current challenges in Finland’s economy, the eurozone’s worst performing economy in the third quarter of 2015, but Hiidenpalo believes the affect is muted.

“Elo’s direct real estate portfolio is mainly invested in Finland and this domestic exposure accounts for most of the whole portfolio’s Finnish exposure. On the equity side we have Finnish companies in the portfolio, but almost all of them operate in the global markets. I don’t count these as a domestic exposure if a company’s turnover is generated mostly outside Finland,” she says.

Over the course of 2015 the fund increased its equity exposure to the US and emerging markets, while cutting its allocation to European equity.

It also increased the proportion of index investments and exchange traded funds (ETFs) which Hiidenpalo likes, and plans to increase further, because of the low costs, efficiency, entire market exposure and diversification the strategy brings.

Along with the allocation to Finnish equity, the portfolio is portioned to European stocks (37.4 per cent) the US (20 per cent) and emerging markets (17.8 per cent) with “other markets” accounting for the final 6.8 per cent.

From the beginning of 2017, Finnish pension insurance companies will be able to increase equity investments by about 5 per cent, due to changes in Finland’s solvency framework: Hiidenpalo won’t be drawn on whether that means a bigger equity allocation next year.

“Any possible increase will be related to the market view and return expectations on equities,” she says.

In-house models and big data

Building in-house management is an ongoing theme at the fund, where Hiidenpalo seeks to develop in-house models and use big data to enhance the cost effectiveness and transparency of the portfolio.

“In-house management will increase in the future. In-house costs are only a fraction of the total costs and so it makes sense to increase in-house capabilities and our own resources,” she says.

As well as moving more management in-house to cut costs, she is embedding a culture around the awareness of costs, particularly those related to investment processes that includes monitoring third party fees on funds and keeping a close eye on any “unnecessary trading.”

Almost all fixed income investments are managed in-house as well as forex, European equity and part of credit portfolio, as well as well as direct real estate. Indirect real estate and private equity is outsourced.

The portfolio is also becoming increasingly carbon aware.

Last year the fund measured its carbon footprint in direct equity investments, corporate bond investments and real estate.

It found the carbon intensity of its direct equity portfolio was already 15 per cent lower than the MSCI World Index. Strategy includes robust engagement with companies on their carbon profile, Hiidenpalo says.

Investors tend to focus predominantly on investment capabilities and operational strength when assessing whether to engage or retain a fund manager. These are important factors, but an often overlooked factor is alignment; or the extent to which fund managers, acting in their own interest, can also act in the best interests of their investors.

Attention to fund manager alignment is part and parcel of good governance.

As an investor, you want to know to what extent the two of you are ‘in the same boat’ – whether your partner is shoulder-to-shoulder with you or is paddling broadly in the same direction but from a separate vessel. The difference becomes most evident when the waters aren’t smooth.

Mercer identifies three key parties:

The funds management firm (including the owners)
The portfolio managers and investment staff
The investors (including advisers).

Biologists might call this scenario ‘obligate disjunctive symbiosis’, where two or more species live separately but depend on each other for survival.

Each party does not necessarily benefit equally, although that is surely a worthy goal for a successful long-term relationship.

To quote Charlie Munger of Berkshire Hathaway: “Show me the incentives and I’ll show you the outcome.”

Incentives drive human behaviour and we underestimate them at our peril.

It’s not that the majority of fund managers don’t fundamentally want to deliver good outcomes for their clients. Rather, Munger’s quote highlights the importance of creating an environment in which mutually beneficial outcomes are most likely to happen.

Steps to improve alignment

1. Co-invest for success

Assume you have a large amount of money to invest. Would you want your portfolio manager to have a significant amount of their own money similarly invested? Why would they not invest in the same product?

A significant co-investment supports the notion that the manager is going to actively manage the risks in addition to pursuing as much upside as possible.

It’s more the exception than the norm to see disclosure details on co-investment, but it does happen.

To quote an actual factsheet of an equity manager: “The portfolio manager has $100,000 invested in the fund, and staff have $1.5 million invested in the fund, as at quarter-end.”

We can then make a judgement call as to how meaningful such amounts are to the staff concerned.

2. Share a mutual timeframe

As an investor, do you have a long-term investment mentality and have you discussed it with your fund manager? A lot tends to get assumed.

If a portfolio manager detects that his/her client base is likely to have a strong reaction to short-term outcomes, they may be discouraged from making value-adding longer-term strategic decisions that might entail some short-term volatility.

Good investments often require patience and a side benefit is lower trading costs from lower portfolio turnover.

3. Defer a portion of rewards

If your portfolio manager performs well and gets a bonus – preferably reflecting a multi-year outcome – then great. But what should happen to that bonus? Would you rather it was released straight away as cash, or half of it was invested in the investment product for a minimum of say three years?

Most of us would take some comfort if the manager had that sum locked away for a while. Then there is a greater disincentive to take risks in the portfolio which may pay off in the short term but ‘come home to roost’ later on.

4. Support board independence

As an investor, would you want the board of the fund’s management entity to have independent directors or consist entirely of internal executives?

Some board independence helps balance the interests of the three parties referred to earlier – shareholders, staff, and investors. While their presence is no guarantee that investor interests will be at the fore, they offer an increased chance of broad representation at the board table.

5. Think strategically about fees

When it comes to fees it is useful to establish some principles:

Fund managers are entitled to rewards that reflect the true value of their skills
As an investor you want to reward skill, though the real question is how much is too much?
When it comes to performance-based fees the devil is often in the detail. Thought needs to be applied to issues such as the correct benchmark, high-water marks being in place and a cap on the total fee. A well-designed structure should mean that the manager is rewarded for performance that meets the long-term objectives of the end-investor.

6. Discourage personal trading

There’s plenty of merit in your portfolio manager co-investing in a product, but would you want them to be able to trade in the same asset class separately on a personal account?

In part this represents a compliance issue (prohibiting or making transparent certain trade activity), but even if personal trades are cleared through internal compliance teams, the scope for conflict of interest is hard to eliminate.

And, as a fund management firm, why open up the risk in the context that, as a general statement, portfolio managers are fairly well compensated for their day job.

7. Consider the ownership structure

Where investment staff have an ownership stake in the firm, does that promote alignment?

On the positive side, ownership by key individuals can help with staff retention, amplify incentives for the business to succeed, and help foster a longer-term mind-set.

On the other hand, it ties individuals more directly to the interests of the business, being the total revenue picture, rather than the outperformance of a certain product (over which they have much greater control).

This is particularly relevant if the product you are invested in does not represent a large part of the overall business, since the success of the firm may not be closely tied to how well that product does.

And there is an issue of what to do if a staff member is a shareholder but the strength of their contribution diminishes. Arrangements can be difficult to unwind, even though parting company may be the best outcome for the business and for clients.

Hence we can regard the self-ownership model as positive in many respects for alignment purposes, but not entirely without issue.

8. Implementation issues

Some challenges present themselves when trying to execute material change to alignment structures. Many investors are not big enough, relative to the size of a manager’s total client base, to have meaningful influence.

Existing fee structures may be so ingrained that there is little chance of affecting change. In some cases, managers have been so successful that they do not feel obliged to be flexible on arrangements – ‘there is plenty of demand so if you want to invest with us, these are the terms’.

The reality is that negotiation is mostly evident when (a) the investor is large and/or prestigious and (b) the manager or strategy is in its relatively early stages. In some cases, smaller or boutique-type firms are well-placed to apply flexibility given relatively smoother pathways to implementing internal policy changes.

Notwithstanding some implementation challenges, we believe fund managers should always be open to ways to improve mechanisms for stronger investor alignment. Where this is not the case, this should act as a red flag to potential investors.

While it is not realistic to expect every funds manager to tick every alignment box, investor interests need to be at the forefront of the manager selection process. Well-structured alignment arrangements should: