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. 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.

  1. 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.

  1. 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.

  1. 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.

  1. 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.
  1. 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.

  1. 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.

  1. 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:

  • Underpin a sense of partnership between investors and fund managers

Promote strong performance and risk management, and

Minimise costs related to intensive monitoring and changing managers.

David Scobie is a principal in Mercer’s Investments business, based in Auckland.

Pensionskassernes Administration A/S, PKA, the multi-employer DKK235 billion ($35.6 billion) Danish pension fund for the country’s healthcare professionals, nurses and social workers, returned a 5.7 per cent return in the first half of this year, boosted by strong performances from private equity and alternatives.

“We are quite satisfied,” says Peter Damgaard Jensen, chief executive officer, speaking from the fund’s Hellerup headquarters outside Copenhagen.

“Particularly because of market volatility and Brexit.”

The fund has posted an 8 per cent average annual return over the past five years from a portfolio primarily invested in bonds, shares, real assets and absolute return.

The fund is split 50:50 between external and internal management, with investment ideas and themes typically developed in-house with external mangers brought in to execute them.

PKA has grown its alternatives portfolio to account for 25 per cent of assets under management, in one of the biggest allocations among the fund’s Danish and European peers.

“There are still some allocations in the pipeline to real estate and infrastructure, but in private equity we are where we want to be,” he says.

All the alternatives allocation – bar real estate – is run through PKA AIP, an offshoot responsible for investing and monitoring PKA’s alternative investments in private funds, co-investments and direct infrastructure based out of Copenhagen.

Current alternative strategies include diversifying the portfolio away from its concentrated exposure to offshore wind, as well as diversifying infrastructure investments into North America and different European markets from its current northern European bias.

Damgaard Jensen also likes solar, arguing: “Solar costs have fallen so much it is now possible to invest without subsidies and this is less risky.” He’s also got an eye on the UK energy market following a decision by the new, post Brexit government to pause planned nuclear investment.

“If the UK doesn’t invest in nuclear there will be a huge energy deficit. This could be a significant opportunity. It will be interesting to see what they do.”

Deep local knowledge

The bulk of the real estate portfolio is invested in Denmark, which Damgaard Jensen prefers to forays into foreign markets because of PKA’s deep local knowledge and the ability and cost advantages of investing direct.

Going forward he plans to develop the portfolio to invest in “whole areas” within cities alongside other investors, rather than confine investment to individual buildings.

“The Danish economy is promising; we are seeing more investors coming in to Copenhagen from the outside,” he says.

Only 2 per cent of the real estate portfolio is invested overseas and all investments here are with funds.

Cutting costs through direct investment in private equity is more challenging however. Only 30 per cent of the private equity portfolio lies in co-investments, which does reduce the cost “considerably” but still leaves private equity “expensive.” The fund has made eight private equity co-investments in the past two years..

The fund also plans to increase its allocation to corporate debt. Its current allocation stands at a tiny 1 per cent of the portfolio, but as banks shed debt to comply with new BASEL regulations, Damgaard Jensen believes this will grow.

So far all PKA’s investment in the asset has been alongside banks because of PKA’s reliance on their expertise in the asset class.

“We are building up our competence here but at the moment the banks still have all the experience in this area.”

Membership ‘very active’ on coal

Low carbon investment is becoming increasingly important across the portfolio with PKA’s most recent green infrastructure investment coming via a 50 per cent stake in a new UK biomass plant, expected to be completed by 2020.

The fund aims to have 10 per cent of the real estate allocation in sustainable properties by 2020. In another initiative launched after the Paris agreement on climate change last year, the fund is divesting from all its holdings in “coal-reliant” companies like mines and utilities, spurred on by its membership, which Damgaard Jensen describes as “very active” on the subject of coal.

The fund has also asked companies that generate between 25 and 50 per cent of their revenues from coal to provide plans on how they will reduce their exposure to the fossil fuel.

“We engage with companies on policy and how they can change to have less reliance on coal,” says Damgaard Jensen, adding that looking at low carbon indexes within the equity portfolio is “on the to-do list.”

Equities remain the biggest single risk at the fund, responsible for 50 per cent of PKA’s entire risk.

In 2012 it restructured the equities portfolio to invest in risk premia strategies, building exposure to factors like value and momentum, as well as systematic risk exposures typically found in hedge fund strategies, via a robust absolute return portfolio that Damgaard Jensen believes is a crucial defensive play.

“During any market crash, it is the absolute return portfolio that performs much better than the equity portfolio. History shows there will be another equity crash.”

Ongoing efforts to tamper equity risk – and costs – include increasing passive strategies, he concludes.

The shift from defined benefit to defined contribution means a shift in risk pooling to individual risk bearing by individual participants. This means that adequacy on an individual level becomes the objective of retirement savings, but the question of how funds can provide retirement security for all plan participants is a more difficult one.

Michael Drew, Professor of Finance at Griffith University in Australia, says there needs to be a shift from the plan sponsor’s business imperatives to a real fiduciary focus.

In the paper Governance: The Sine Qua Non of Retirement Security, Drew and his co-author Adam Walk, question whether when plan sponsors say they are taking a fiduciary focus, they are prioritising values of the profession or doing what is best for investment clients, over the economics of the business or doing what is best for investment managers.

“Plans are concerned that the economics of the business are being prioritised over the interests of plan participants,” the authors say.

In defined contribution funds there is a real tension between a fiduciary focus and business imperatives, and that needs to be recalibrated. Drew questions whether those that say they have a fiduciary focus actually put it into practice.

“Do we really, hand on heart, live like that and put that into action? Simple questions like what does this mean for our 58 year old members, and not our peers,” Drew says.

In Australia, possibly the most established defined contribution market in the world, this tension is heightened because there is no requirement to ensure a certain level of retirement income for plan members.

Regulation in Australia is focused on inputs to wealth, such as the level of contributions and the investment risk, not on the outputs from wealth such as the replacement ratio or level of retirement income.

“In terms of defined contribution plan governance, there needs to be a shift from returns being the solution to being one of the inputs, not the outcome,” Drew says. “Delivering retirement income should be the headline objective of a defined contribution plan.”

Following the ‘north star’

In this context, that retirement income is the destination, and everything cascades from that “north star”, he says.

By following this north star, governance and investment decisions will be recalibrated.

“We wonder out loud if governance is below the line, for example focused on investments and returns,” Drew says. “If you reframe your beliefs as part of achieving an outcome, it leaves you with different beliefs. This is especially in the post-retirement phase where you can’t keep applying the idea that time is continuous.”

The authors say that defined contribution plan fiduciaries and the investment teams must take a more sophisticated approach to performance evaluation, consistent with the investment objectives set by plan fiduciaries.

“A replacement ratio of 70 per cent of final salary is an infinitely more useful objective for a plan participant than a return target of CPI+3 per cent per annum over rolling 10-year periods after fees and taxes.

“Once fiduciaries have set appropriate objectives, the entire governance framework and the investment complex should be directed toward this achievement. With the target properly set, the means needed to achieve it become clearer, as do the ongoing monitoring requirements.”

In a defined contribution context, Drew and Walk advocate the following investment beliefs as (nearly) universal:

  • Retirement income is the true measure

Investors are heterogeneous

Timeframes are finite

Market returns (or beta) matter most

Dynamism is important.

“Whatever their progress, we would recommend to defined contribution plans, one overriding principle: coherence. For example, a plan that claims it is “outcomes focused” and yet only reports time-weighted returns to participants is subtly undermining its message or just using its “outcomes focus” as a slick marketing line. Claiming to be “best practice” will not suffice in the absence of both institutional commitment and tangible action – which is often costly – to evidence such a claim.”