Investors should be contrarian in their private equity allocations because there is a negative relationship between capital flows and returns, according to Steve Kaplan, the Neubauer Family Distinguished Service Professor of Entrepreneurship and Finance at Chicago Booth School of Business.

Kaplan, who is one of the world’s leading academics on private equity, was speaking as part of a panel at the Fiduciary Investors Symposium.

“There is a negative relationship between the amount of capital committed and subsequent performance,” he said.

“When a lot of funds are coming to market in a particular asset class, as they are about to do in venture, and you want to be in those funds because they are good funds, lower your allocation,” he said.

“So stay in the funds … but don’t do a pro rata. I would lower it down because venture, just like private equity, is very cyclical; when a lot of money goes in, returns are bad. And I would do the opposite in years when people are not raising so much money, which are good years to invest. I would be a little bit more aggressive, so I would be – within maintaining my relationships – I’d be as contrarian as I could possibly be.”

The session was moderated by John Skjervem, chief investment officer of Oregon State Treasury and a former student of Kaplan, who now oversees around 20 per cent in private equity which dates back to 1981.

Skjervem asked Kaplan what the appropriate premium for private equity is in order for institutional investors to allocate.

“The answer is religious,” Kaplan said, “it depends. For investors with a long horizon, say 20 years, any premium is ok. 1 per cent would be fine. But if there are liquidity needs then its higher, 3–4 per cent. The real question is, is it beating the public markets, and if it’s not then it’s not worth it.”

In addition to his advice for investors in private equity to be contrarian, he said in order to make an allocation investors need to be satisfied that there is a premium.

Increasingly this will need to be about skill of the private equity managers and not just an illiquidity premium.

“It’s got to be about skill. As private markets get more competitive that is more so. It is not just about being illiquid and having a premium for that,” he said.

In terms of private equity performance, Kaplan’s research shows extreme outperformance for vintages before 2006.

“There has been an unbelievable run from 1991 to 2005, every private equity (buyout) vintage was better than the S&P over the life of the vintage. They returned 1.4 times or 40 per cent over the S&P over the life of the fund, that’s 7 per cent per annum better than public markets,” he said.

But while up until 2006 private equity has “unbelievably” outperformed public markets, after 2006 performance is “about the same as public markets”.


 

 

The ambitions and provisions of the Paris Agreement are clear, as is its future impact on returns. Investors responding to growing and changing risks can contribute to stabilising both the climate and capital markets in the coming decades. And as Jane Ambachtsheer writes, the ball is now in the court of the world’s fiduciaries – strong governance is a prerequisite for the effective management of climate risk.

The 21st UN Climate Change Conference of the Parties (COP21) concluded with a landmark agreement.

For the first time, countries committed to lower their greenhouse gas emissions sufficiently to keep a global temperature rise well below 2°C this century, relative to pre-industrial levels.

This outcome raises the level of near-term climate transition risk for investors – based on the strength of climate change policy that is now needed.

This is balanced by the opportunity for investment in low-carbon technologies and infrastructure, which is likely to grow significantly.

These developments present some immediate challenges for investors – most notably the need to add “What is our approach to climate change?” to their 2016 to-do list.

But they also offer the best hope of a stable and secure climate, which is a necessary condition for stable and secure capital markets over the coming decades.

It is for this reason that many investors adopted the role of “climate cops” and sought to directly influence the outcome of the negotiations.

Making climate risk assessment easy

What is critical to mainstreaming climate risk assessment is to create straightforward tools that allow investors to easily assess financial risk.

In June 2015, Mercer published its second ground-breaking study on climate change and investment, entitled Investing in a Time of Climate Change.

Undertaken in collaboration with 16 investors representing $1.5 trillion in assets, this study established a formal framework for considering the impact of different climate change scenarios on investment risk and return across asset classes and sectors.

The report drew some important conclusions – that climate change will have an impact on returns regardless of which scenario unfolds and that investors can take specific actions to make their investment portfolios more resilient. The outcome of COP21 means that Mercer’s “transformation” scenario, which sees warming limited to 2°C this century, is now more likely than it was just a few months ago.

The study also introduced the concept of “future maker” investors – those that make a concerted effort to influence the climate scenario which comes to pass.

 

What’s in the Paris Agreement?

The Paris Agreement is a bold commitment to drastically reduce carbon emissions and transition to a low-carbon economy.

The approach taken at COP21 was very different from previous attempts. First, rather than using the meeting to negotiate specific emissions reduction targets, countries were invited to submit their pledges in advance.

More than 180 countries did this, via Intended Nationally Determined Contributions (INDCs) reflecting their own circumstances.

Second, there was unprecedented engagement by non-state actors – investors, businesses and civil society – committed to achieving a strong outcome.

Their efforts have a reinforcing effect: the level of ambition reflected in the Paris Agreement sends strong policy signals which businesses and investors cannot ignore.

It was known well before Paris that the INDC pledges were – in aggregate – insufficient to limit warming to 2°C this century.

Thus, the Paris Agreement sets out the overall level of ambition and a framework to facilitate monitoring of each emission reduction pledge as well as the tightening of pledges over time.

 

Key features of the Paris Agreement

  • Temperature goal – An aim to limit overall global warming to less than 2°C, and possibly even down to 1.5°C. Given that we have already reached 1°C of warming, this will require a significant ramp up of national pledges by 2030.
  • Coming into force in April 2016 – Once at least 55 countries accounting for 55 per cent of global emissions have formally signed it.
  • Net zero emissions goal – It was agreed that we would reach net zero emissions in the second half of the century (by balancing carbon released with an equivalent amount sequestered or offset), with emissions peaking as soon as possible.
  • Five-year review cycle – Pledges will need to ratchet up over time, with countries resubmitting every five years. Submissions can only be strengthened (i.e. no backtracking on prior pledges) and long-term targets are encouraged.
  • Climate financing – To provide financial support to poor countries on the cost of the transition, the agreement has a climate finance goal of $100 billion per year by 2020. This amount is a floor, so it is anticipated that it will increase over time.
  • Legal status – Emission reduction plans are not legally binding, but the reporting mechanisms (yet to be determined) and the five-year review process is. There will be a strong role for non-state actors in policing the agreement.

 

We expect investor focus on climate to continue to grow

Hundreds of investor representatives participated in the numerous events taking place in Paris. During the two weeks in which COP21 took place, the assets committed to the Portfolio Decarbonization Coalition increased from $100 billion to $600 billion.

Also, Mark Carney (governor of the Bank of England and chair of the Financial Stability Board) announced that Michael Bloomberg will chair the Financial Stability Board’s new climate disclosure taskforce, which will make recommendations to the G20.

This will bolster the push for corporate reporting on emissions that the Carbon Disclosure Project has been driving for more than a decade.

Since COP21, we have also seen the launch of the Paris Pledge – where more than 800 non-state actors, including Mercer Investments, “affirm our strong commitment to a safe and stable climate in which temperature rise is limited to under 2 degrees Celsius”. Expect more signatures to follow.

 

The investor 2016 “to-do list”

Going forward, fiduciaries are expected to look to stress-test their investment portfolios under different climate change scenarios over a 10 to 35 year time horizon to ensure they’re prudently managing this growing and changing risk.

In addition, we can expect that investors will increasingly work to:

  • Educate their boards and committees about climate science and climate-related risk factors, and establishing climate-related investment beliefs
  • Integrate climate considerations with other important ESG factors
  • Allocate to sustainability-themed and low-carbon private and public market investment strategies across asset classes
  • Engage companies and regulators on the effective implementation of the Paris Agreement
  • Map location-specific environmental risks for aggregate real asset portfolios (real estate, infrastructure, natural resources)
  • Report activity and progress to beneficiaries and other stakeholders.

While the ambition of the Paris Agreement is important, it is the implementation of the commitments that will ultimately determine the climate pathway we follow.

For “future maker” investors, this means they will need to continue their role as climate cops. For “climate aware future takers”, it means that ongoing monitoring of climate-related developments will be essential.

Modern investment practices require building straightforward frameworks to quantify and manage the world’s increasing number of long-term and complex risks.

Significant innovation across the industry has made this possible. The ball is now in the court of the world’s fiduciaries – strong governance is a prerequisite for the effective management of climate risk.

 

 

Jane Ambachtsheer is partner and global head of responsible investment at Mercer, she lives in Paris and attended COP21.

Norges Bank’s latest paper in its Asset Manager Perspective series examines the feature of “last look” in foreign exchange markets. The paper, which focuses on the impact of financial innovations on long-term investors, outlines the metrics that Norges Bank has put in place to monitor liquidity providers.

 

“Last look” is a unique feature of foreign exchange markets that gives liquidity providers the option to reject orders received from liquidity takers in response to the provider’s quote.

Norges Bank believes that while it provides a legitimate need for liquidity providers, and can help improve available liquidity to investors, there is also room for improvement.

For one, there are intrinsic conflicts related to the asymmetry in optionality that last look introduces, as well as the potential for misuse of private information.

The paper says that last look is one approach to handling the potential of aggressive latency arbitrage in a fragmented market. It preserves quote depth at tight spreads, but introduces execution uncertainty, in contrast to the equity market which preserves execution uncertainty but reduces quote depth.

Norges Bank Investment Management advocates for greater transparency in the application of last look.

“Monitoring of liquidity providers’ behaviour will continue to be a critical element in maintaining fair implementation of Last Look,” it says.

Norges has developed a set of metrics to monitor liquidity providers’ behaviour, and believes other investors should do the same. This looks at rejection thresholds, the maximum evaluation periods permitted and the symmetry of the thresholds. It also looks at quoting and rejection behaviour of counterparties, and the price action in a currency pair following the rejection of an order through last look, and the quoting behaviour of the counterparty that rejected the order.

The paper concludes that there are three areas that Norges believes would benefit from greater transparency. They are:

The evaluation period should be limited to price comparisons only. “We believe more prescriptive codes of conduct for liquidity providers are needed in this regard.”

Over the counter dealers as liquidity providers need to be more transparent about their implementation of last look thresholds.

The reasons for the order rejection need to be more transparent.

 

The paper can be accessed here

In 2015 we have delivered more than 300 investor profiles, analytical and research-driven pieces on the global institutional investment universe. The most popular investment stories have been about ESG integration, in particular CalPERS’ story on holding managers to account on ESG – a game changer for the industry – was well received. But asset owners have also liked stories on how to improve their internal structures, decision making and team cultures. Below is a recap of the 10 most popular stories for 2015.

CalPERS gives its managers ESG ultimatum

In what promises to be a transformational moment for ESG integration and investment manager accountability, CalPERS will require all of its managers to identify and articulate ESG in their investment processes. CalPERS staff led by Anne Simpson, senior portfolio manager and director of global governance, presented the ESG manager expectations, and draft sustainable investment guidelines, to the investment committee this week. The $307 billion fund will factor into its decisions about hiring and monitoring external investment managers the degree to which managers assess ESG factors and integrate them into their process.

AustralianSuper’s insourcing jouney

By 2018 AustralianSuper will be managing about A$50 billion ($38 billion) of assets in-house. Chief investment officer of the A$84 billion($64 billion)  fund explains the logic behind the move.

Why consultants can’t pick winners

A research paper that concludes that the funds recommended to institutional investors by investment consultant do not add value, has won the Commonfund Prize, awarded for original research relevant to endowment and foundation asset management. The paper, by academics at Saïd Business School, Oxford University and University of Connecticut School of Business, found that there is “no evidence that these recommendations add value, suggesting that the search for winners, encouraged and guided by investment consultants, is fruitless.”

Why Andrew Ang joined Blackrock

Andrew Ang believes factor investing is a more efficient way to organise a portfolio as it allows liquid and illiquid strategies to be managed across the portfolio. It also has the added benefit of honing managers on value creation. He’s been working with a handful of investors while Professor of Finance at Columbia University on implementing factor investing, and the motivation to join Blackrock was the opportunity to springboard the practical implementation of these beliefs and transform the way assets are managed.

Does pay for performance work?

Governance experts say that paying competitive salaries for internal staff will have benefits across the entire fund. For some, including those working in public sector pension funds or profit-to-member funds, that is unpalatable. But a comparison of salaries and total investment costs, between two large, different and high profile funds – Ontario Teachers and CalPERS – has got me thinking about what value for members looks like.

What is the minimum AUM for internal management?

Large funds outperform small funds mostly mainly due to the cost savings of internal management. So when does internal management make economic sense for a fund? It’s at a much lower AUM than you might think.

CEM Benchmarking analysed a universe of 186 pension funds globally. That universe is split into four groupings: 77 funds with an average of £1 billion, 56 with an average of £10 billion, 30 with an average of £20 billion and 23 with an average of £50 billion.

Stanford dumps coal: why divestment doesn’t work?

The decision by the Stanford University endowment to divest from coal stocks might produce some positive PR, but from an investment perspective it’s only making them worse off, says Andrew Ang, professor of finance at Columbia University, who says the move prompts the bigger question of what the purpose of a university endowment actually is.

Investors from the moon: Fama

A highlight of the Fiduciary Investors Symposium at Chicago Booth School of Business was an intimate Q&A session with the “Father of Modern Finance” and Nobel Laureate, Eugene F. Fama.

Fama, who is the Robert R. McCormick Distinguished Service Professor of Finance at the Chicago Booth School of Business, believes that because markets are efficient, investors should not pay to try and beat the market. He’s surprised that the industry has not adopted passive management more than it has, despite 50 years of data evidence.

2015 could be watershed year for ESG issues

2015 is poised to be the turning point as a number of key issues relating to environmental, social and governance (ESG) issues take centre stage says Fiona Reynolds, managing director of the Principles for Responsible Investment.

Do pension funds add value?

Asset owners, on average, add 15 basis points of value above their asset class benchmarks after fees, according to an extensive study by CEM Benchmarking.

The survey, which measured 6,666 data points from a global set of defined benefit plans, and some sovereign wealth funds and buffer funds, from 1992-2013.

Gross of investment fees, funds deliver 58 basis points of value added.

The study highlights why costs continue to remain a key concern for funds, with the author of the report, Alex Beath, finding that 75 per cent of that value added by funds is eaten by investment fees.The net amount of value add on average is 15 basis points.

 

Thanks for another great year. In 2016 you can be assured we will not only maintain, but hone, our fierce passion and dedication to advancing institutional investment best practice and will continue to tackle the issues we believe the industry needs to overcome to operate efficiently and serve its various constituents fairly and justly – particularly the workers whose money they manage.

We aim to courageously challenge the industry on fees and value, investment transparency and complexity; governance, agency problems, decision making and organisational change; and importantly, ethics, integrity and systemic risks.

 

In an entertaining and informative session at the Fiduciary Investors Symposium at Chicago Booth School of Business, the John P. Birkelund ’52 Professor in History and International Affairs at Princeton University, Stephen Kotkin, said geopolitical risk is largely priced in to markets.

“Geopolitical risk is about incompetence of decision makers, which is mostly an unknown and unpriceable. This remans the key variable,” he says.

“With game theory you try to guess what the others will do. We can’t predict China and can’t predict US actions. It’s unknowable.”

“We know nothing about Chinese decision making, the inner circle is very narrow and there are no spies,” he says.

“It is hard to imagine investors could change anything.”

Guiding investors through the geographical, military and political histories of Russia and China, Kotkin pointed out that China “has no California”, or west coast, which prohibits its activities.

Two presenters at the recent Fiduciary Investors Symposium in Chicago, Roger Urwin of Towers Watson and Jaap van Dam of PGGM, report on a productive workshop session in which delegates brainstormed ideas for the ideal investment model for the future. The session led them to conclude that the industry has creative hands and smart heads.

Conferences can be dry affairs but this workshop session produced some full-on participation and demonstrated how fast-changing our investment environment is.

The delegates worked at tables in teams and responded to a case study with ideas for the ideal investment model for the future in the form of the investment strategy and the governance budget to get the strategy implemented. The key question was how the delegates would design a new pension fund or sovereign wealth fund with a size of roughly $50 billion or more.

We also surveyed a number of key investment beliefs in the asset owner area in a “clickers-fest” which yielded some very interesting conclusions about governance arrangements in particular.

The results of the beliefs survey proved to be helpful to the interpretation of the chosen investment model and the understanding of their evolved governance. The key results on the frameworks used are in table 1 below. The “reference portfolio” framework is increasingly used by large asset owners. It is essentially a benchmark decided by the asset owner board for the strategy of the fund captured in a low-cost and low-complexity portfolio. This is not radical thinking but has proved effective in improving the accountability of the investment executive functions. The reference portfolio frames the investment executive’s mandate through guidance from their boards on what amounts of risks are seen as consistent with the mission. The “strategic portfolio” is a benchmark decided by the executive team which aims to add value over and above the reference portfolio.

Table 1
The “reference portfolio” concept and framework % The “strategic portfolio” concept and framework % The ideal decision-making flexibility is a risk budget of: %
I like it 65.3 I like it 64.7 1% pa tracking error 8.2
I can live with it 30.6 I can live with it 21.6 2% pa tracking error 40.8
I don’t like it 4.1 I don’t like it 13.7 3% pa tracking error 51.0

 

FIS delegates showed support for both concepts, with a large majority of delegates seeing their merit. But a significant minority see benchmarks, particularly the strategic portfolio, as necessary but sub-optimal tools in effective governance. This reflects the sense that the best investment management follows a predominantly absolute return unconstrained style. The mantra mentioned was: “Bad benchmarks produce bad portfolios”.

FIS delegates also supported the reference portfolio being less of an anchor, with preference for higher tracking errors and less “benchmark hugging”.

Another area of consideration was the resourcing needs of large funds and how that resourcing is organised. The data from these questions are in tables 2 and 3 below.

Table 2
The desirability of internal resourcing in CIO/strategic skills/board liaison is: % The desirability of internal resourcing in the area of portfolio management is: % What cost structure is preferable for a fund of this size? %
Very important 76.0 Very important 55.1 5 bps of internal plus 70 bps of external 15.4
Important 24.0 Important 26.5 7.5 bps of internal plus 60 bps of external 36.5
Unimportant 0.0 Unimportant 18.4 10 bps of internal plus 50 bps of external 48.1

 

The underlying assumption is that large funds can now acquire significant internal resource and relevant expertise, but the key question is where that resource is most critical. The delegates’ preference favoured the high-level capability in strategy, rather than for portfolio management, where funds can continue to search out the best external firms. The underlying premise is that alignment of internal teams matters more at the CIO and board level than at the portfolio manager level.

The delegates had clear preferences for a larger internal capability that enabled the board to concentrate on its high-level role. A fund of the size envisaged ($50 billion) would more commonly operate at an overall expense of much less than 5 basis points per annum or $25 million, but delegates saw the merits in a stronger internal function with a significantly larger operating budget.

Governance principles suggest the splitting of roles between board and executive has a high impact on effectiveness. Boards’ abilities with the determination of the highest principles – mission and goals, values and beliefs – mark out the best funds. But with the strategic competency assured in the fund’s executive team, the arrangement settles naturally into a combination of the CIO deciding on strategy with the board assuming the oversight of that decision.

Table 3
In the board role, where is their greatest potential to add value? % What role/influence should the board assume in strategic allocation? %
Establishing mission and fundamentals 56.9 Primary decision maker 0.0
Operating governance including CEO+CIO selection 31.4 Decision ownership shared with executive 25.0
Investment strategy decisions 5.9 Decision oversight of executive recommendation 75.0
Oversight of executive investment decisions 5.9

 

The delegates’ second task was to set both governance budget and strategy in response to a case study.

The case study fund background was set up to be similar to the proposed “British Wealth Funds” drawn from the 89 local government funds and was profiled as:

  • $50 billion in assets and with positive cash flow and a long time horizon
  • Public sector defined benefit liabilities with funded status of around 90%
  • Current investment goal is CPI+3.5% per annum after costs
  • By reference to their size and capabilities, the fund has an “average” executive team and board
  • The asset allocation is also relatively average:
  • equities 50%
  • government bonds 25%
  • credit 15%
  • real estate 6%
  • private equity 3%
  • infrastructure 1%
  • The fund is looking to evolve its investment model, having regard to both its governance arrangements and the direction of its investment strategy.

 

The first task for delegates was to set the high-level parameters. The workshop results are in table 4. The fund’s stated goal was to achieve CPI + 3.5% per annum. The 50–50 equity-bond reference portfolio left 1.5% of added return needed; the 70–30 portfolio left 0.5% per annum needed. Delegates preferred the explicit reference portfolio specification and the higher risk portfolio arguing that the longer-term orientation would support the higher drawdowns that would occur.

Table 4
Reference portfolio choice % New investment strategy choice %
Reference portfolio = 50% equities, 50% bonds; CPI + 2% target and vol of 7.5% 22.2 Alternatives allocation 5–10% (mostly RE); active management exposure low; active risk vs RP of c.1%, active return c.0.5% 0.0
Reference portfolio = 70% equities, 30% bonds; CPI + 3% target and vol of 10% 77.8 Alternatives allocation 10–20% (RE + PE + infra + abs rtn); active management exposure medium; active risk vs RP of c.2%, active return c.1.0% 44.4
Reference portfolio not specified; all focus on strategic portfolio; no targets 0.0 Alternatives allocation 20–30% (RE + PE + Infra + Abs Rtn); active management exposure high; active risk vs RP of c.3%, active return c.1.5% 55.6

 

The choice came down to the preference between more bulk beta in the return (that all funds can achieve) or more skill-based value added to the return (that only some funds will achieve). The most popular combination added the 70–30 reference portfolio to the 2% active risk portfolio. The next most popular choice combined a 50–50 reference portfolio with the higher active risk. The differences come down to investment beliefs of course, and here the critical differentiation lies in funds that have the greatest confidence in their comparative advantage to generate skill-based returns.

When it came to how to evolve the investment model, delegates were asked to build a combined proposition around both governance and investment strategy. Results are shown in table 5.

Table 5
Governance budget choice % Strategy choice %
Build executive capabilities in insourced portfolio management in public markets 2 Develop active management line-up including engaged partner model (managers with widened/aligned role) 31
Build executive capabilities in strategy skills 6 Build smart beta research and allocation 7
Build executive capabilities in private markets 16 Build private market strategy using external firm mandates 15
Strengthen board capabilities and effectiveness 6 Build internal private market strategy – co-investing/direct 6
Strengthen risk management capabilities and culture 27 Develop ESG and sustainability policies and strategies 0
Build executive team culture and employee value proposition 16 Develop absolute return strategies 6
Evolve mission and beliefs clarity in the fund by significant “socialisation” and collaborative process in the board and exec 27 Develop long horizon investing commitment, through better long-term mindset, process and mandates/KPIs 35

 

The difficulties of board and executive team alignment figured heavily in discussions on governance, as did the deepening of the risk domain.

When it came to strategy, a fund’s focus on long-horizon investing had the result of making the individual allocation of time to ESG much lower. Funds appear to prefer to see ESG as a particular part of sustainable investing. Delegates’ commitment to active management, with a desire to allocate more time and design to these relationships, was also considerable. That said, the biggest resource allocation to active management is in private markets where active approaches are necessary.

The starting assumption for the session was that investment strategy is a complex, governance-challenged existing in a battle-for-return and war-for-talent world. The case study discussions supported this view, and the FIS delegates demonstrated a wish to think ahead so as to meet these challenges and to work together to produce better solutions.