Cultivating organisational purpose, identity and culture, and leadership throughout asset-owner organisations that embeds and champions sustainability is the next frontier for responsible investment, says Rob Lake.

Some asset owners have been working on responsible investment (RI) in one form or another for over 10 years – since before we started calling it “responsible investment” in fact.

In the early days we talked about “corporate governance”, “social, environmental and ethical issues”, and “socially responsible investment”.

As the terminology has stabilised, the tools and techniques for hard-wiring into investment practice the relevance of sustainability and corporate governance issues to asset owners’ long-term objectives have developed and – for some funds at least – matured.

 

Engineering

We now understand pretty well the “engineering” that’s needed – investment beliefs and strategy; incorporation of environmental, social and governance factors into investment manager selection; and monitoring through clauses in mandates and clear communication, etc.

A useful new paper How Asset Owners Can Drive Responsible Investment from the Principles for Responsible Investment (PRI) sets this machinery out very clearly.

At the same time, it highlights the fact that many of PRI’s 306 asset-owner signatories have little of this machinery in place.

PRI argues that these asset owners “should”, for example, gather their own evidence on how integrating environmental, social and governance (ESG) factors contributes to investment performance; or ensure that their approach to responsible investment is consistent with their wider investment and organisational objectives.

In principle this is good advice – and perhaps asset owners “should” indeed follow it.

But to understand how easy this might be in practice, it is useful to explore some of the characteristics shared by the funds with the most mature RI programs that determine why they have reached this point (as distinct from the how of the tools and techniques they have developed).

For convenience, we can cluster these factors under four interconnected headings: legal obligations; governance; purpose, identity and culture; and leadership.

 

Legal obligations

In some countries, asset owners – and pension funds in particular – are under a legal obligation to take account of sustainability issues.

These obligations take different forms – but there is a duty of this kind in (for example) France, the Netherlands, New Zealand, South Africa and Sweden.

Clearly a legal obligation will drive behaviour.

This behaviour may be minimalist and compliance-oriented, or creative and innovative – depending on various other circumstances, including those discussed below.

Asset owners that already have a strong commitment to RI may support the introduction of legislation that reflects what they are already doing.

But it would be foolish to expect turkeys to vote for Christmas (i.e. asset owners that do not currently focus strongly on ESG are unlikely to welcome regulation that requires them to do so).

 

Governance

Some jurisdictions prescribe a formal role for beneficiary representatives in pension-fund governance.

Examples here are Australia, the Netherlands, France, the UK and some US states.

Fund boards may also include government representatives – e.g. state government appointees in the US. An elected public official may even be the sole trustee – as in some US states.

While all board members are subject to fiduciary duty (or equivalent), employee or government representatives are likely to be particularly alive to members’ and society’s values, and concerns beyond just financial returns and retirement incomes.

This sensitivity may well be reflected in the fund’s policies and investments. Moreover, additional cognitive diversity around the board or investment committee table may also help the fund to better understand the long-term financial relevance of ESG issues, thereby enhancing returns.

 

Purpose, identity and culture

Every organisation created by human beings has its own distinct sense of purpose, and its own identity and culture.

Pension funds and other asset owners are no exception.

Purpose, identity and culture are shaped by forces that include history, the expectations of the fund’s most important external stakeholders (its members), and the views and values of the organisation’s board and employees.

Some funds have a particularly strong identity rooted in the constituency they serve – local or national government employees, health sector workers or environmental protection officials, for example.

Past reputation shocks – e.g. campaigns challenging particular investments – may make a fund more attentive to responsible investment.

The internal culture within which investment professionals work is influenced by these wider factors.

This may give rise to innovative investment behaviours – for example, a greater willingness to seek out investment opportunities that meet financial return requirements while also demonstrating alignment with the fund’s identity and its members’ values.

 

Leadership

Leadership is an elusive quality, yet we recognise it when we see it.

In asset-owner organisations (like others) it is found both at the top and elsewhere.

There are chief executive officers and chief investment officers of asset owners in all parts of the world who stand out for their leadership in sustainability and responsible investment.

They blend investment acuity, management and organisational skills, and an authenticity that reflects personal commitment and values.

They are willing to do more than is strictly necessary, to be publicly visible in support of RI and to encourage their peers to follow their example.

It would be invidious to name examples; but I suspect we can all think of some.

Leadership is found too among responsible investment specialists and portfolio managers who work hard within their organisations to find new ways to integrate sustainability into investment decisions; to pursue engagement that genuinely challenges the status quo and drives forward corporate responses to tough sustainability challenges; and to press for public policy change that supports sustainability and responsible investment.

These leaders are often motivated as much by their personal values as by the pursuit of financial value (even if they seldom say so openly).

 

Reflection

We need to continue to work on the “hard stuff” – the “engineering” of responsible investment, in the form of investment beliefs, policies, procedures, internal structures and reporting.

This hard stuff can be hard; many asset owners still have a long way to go.

But if the hard stuff is hard, the soft stuff is harder.

Cultivating organisational purpose, identity and culture, as well as leadership throughout asset-owner organisations that embeds and champions sustainability, is the next frontier for responsible investment – indeed for the investment industry as a whole.

 

Rob Lake, heads up Rob Lake Advisors, was formerly director of responsible investment at the UN-supported Principles for Responsible Investment, and previously built and led the sustainability and governance team at APG, in the Netherlands.

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John Skjervem has only been chief investment officer at Oregon State Treasury for three-and-a-half years, but he has already overseen important and material changes to the $90 billion portfolio that includes the $70 billion Oregon Public Employees Retirement Fund.

In a process he describes as an “odyssey”, Skjervem secured legislative support to overhaul Oregon’s antiquated internal management infrastructure with crucial investment in technology and personnel.

“From the outside, we probably don’t look much different, but from the inside, we have transformed and greatly improved several key elements of our operating environment. Before these upgrades, we were like a modern-day call centre using rotary-dial phones,” he says.

Changes include increasing Oregon’s internal headcount from 14 to 25 and introducing BlackRock’s Alladin state-of-the-art risk and order management system.

Within the portfolio, strategy has been just as thoughtful.

In what he describes as “a logical extension” rather than “a change” Skjervem has introduced more discipline and discussion of the role of each asset class in the portfolio in an overarching strategy to lower equity risk that lay across the fund.

“We had equity risk embedded in each piece of the asset allocation pie. Fixed income had large credit, high-yield and bank-loan exposures that we have reduced given their elevated correlation to equity beta. Real estate had lots of pro-cyclical equity beta in the form of leveraged, opportunistic strategies. Essentially, we were trying to play lead guitar with every part of the portfolio. Now we’ve added more bass and drums for better balance.”

Going forward, Skjervem’s priority is expanding Oregon’s allocation to alternatives that will include infrastructure, minerals and mining, and timber in a bid to build resilience into the portfolio.

“We’re expanding the non-private equity, non-real estate allocation to alternatives from 5 per cent to 12.5 per cent of the total fund. But we’re still in the early innings with only 4 per cent of that allocation invested or committed. This effort, with its underlying objective of finding return streams that are less than perfectly correlated to capital markets, is our top investment initiative,” he says.

Skjervem has trimmed Oregon’s private equity allocation to 17.5 per cent of the asset allocation from 22 per cent.

Private equity generates the best returns at the fund and, to continue the music metaphor, is Skjervem’s “lead guitar.”

But he is mindful of the modern-day challenges within private equity, an asset class Oregon first invested in back in 1981 with early bets on Kohlberg Kravis Roberts when the New York firm was establishing its dominance in leveraged buyouts.

“In private markets, Oregon has historically held a competitive advantage due to commitment size and reputation, but now good GPs enjoy all the market power as most LPs have raised their PE allocations, creating heightened demand for and often well-oversubscribed commitments to the top funds.”

That said, as long as he can access the best managers, he remains convinced that private markets offer Oregon the best returns.

“We have been investing in private markets since 1981, so we have experience and know the risks. Still, success in private markets requires good diligence, disciplined underwriting and persistent vintage-year diversification. Empirically speaking, skill can be sufficiently rewarded after fees and transaction costs in private markets provided one has consistent access to good managers. In contrast, skill is seldom rewarded net of fees and transaction costs in public markets.”

In another development, Oregon’s long-only public equity portfolio is moving away from more costly active management in favour of more internally and externally managed systematic or “smart beta” strategies that tilt to size, value and other risk-factor exposures.

“These strategies now account for 8 per cent of the fund’s public equity allocation and are expected to garner more of the fund’s AUM in the future,” he says.

Externally managed mandates in this area include strategies run by Dimensional Fund Advisors and AQR Capital Management.

But despite Oregon’s fortified internal capabilities, insourcing will not become a major theme at the fund.

“Following these upgrades, we may increase the AUM we manage internally, but will remain focused on plain vanilla index and systematic strategies. Conversely, we are not interested in pursuing skills-based strategies internally. We see our peers doing this, but we don’t think we have any competitive advantages trying to run skill-based strategies from little ol’ Tigard, Oregon,” he says.

It amounts to a strategy that sets the fund up for the tough economic climate that is battering public pension funds.

Oregon recorded a 2.1 per cent total return in 2015 against its 7.5 per cent assumed earnings rate.

“As well as we did last year in relative terms, we still missed our assumed rate by over 500 basis points,” says Skjervem.

“That shortfall has an immediate and adverse impact on both our funding ratio and state employer contribution rates.”

He says low nominal returns are outside his control.

“We are returns takers, not returns makers. People in policy positions like Barak Obama, Paul Ryan and Janet Yellen are the nominal returns makers.”

For higher nominal returns he wants policy changes in order to generate higher levels of economic growth.

“This prolonged environment of low interest rates and tepid growth is a punishing environment for public pension funds,” he says.

 

In this Research Note we show that low-risk credits had superior risk-adjusted excess returns over the past 20 years. By selecting low-risk bonds from low-risk issuers, investors would have earned credit-like returns at substantially lower risk. Read more about the low-risk anomaly in credit markets using various dimensions of risk. Read the research paper »