Days of intense negotiations at the long-awaited COP21 meeting in Paris have seen a definitive agreement emerge on climate change. Delegates from almost 200 countries voted to endorse the first universal, legally binding effort to tackle global warming. Fiona Reynolds, managing director of PRI, was there.

The deal commits countries to try to keep global temperature rises “well below” 2 degrees Centigrade, the level that is necessary in order to mitigate the most devastating effects of climate change. It also requires developed nations to continue providing funding for poorer countries as they struggle to create new low emission intensity growth paths.

While we hail the new climate agreement as a breakthrough that many people have been working towards, we need to remember that it’s a beginning and not an end in itself.

But the deal must be seen as a foundation for action; that is, a signal to global financial markets, triggering a transition from investment in coal, oil and gas as primary energy sources to zero-carbon energy sources like wind, solar and nuclear.

The agreement requires countries to reconvene every five years starting in 2020 to publicly report on their progress in cutting emissions compared with their original plans. The investor voice must support this process.

The PRI welcomed the general recognition by all stakeholders of the pivotal role of private finance in achieving INDCs (country-level plans) and emissions reduction goals. This acknowledgment will give additional encouragement to institutional investors, both asset owners and managers.

One factor that made this year’s COP21 different was investors finding their voice earlier in 2015 and seizing the initiative on climate issues. The Global Investor Statement on Climate Change was signed by over 400 investors representing $24 trillion AUM. A coalition of 25 institutional investors with over £45 billion ($67 billion) AUM called on nine publicly listed companies to review their membership of lobbying groups that seek to undermine EU climate policy.

BHP Billiton, BP, EDF, Glencore, Johnson Matthey, Proctor and Gamble, Rio Tinto, Statoil and Total are companies whose professed climate policies are undermined in the eyes of some investors by their membership of lobby groups with a track record of obstruction on climate-change policy. The post-Paris spotlight is now firmly on those boards to publicly resolve this fundamental contradiction.

While the agreement places commitments on governments and sets further timetables, investors are not passively waiting for 2020. They are already taking action to measure their carbon exposure through the PRI Montreal Carbon Pledge, signed by over 120 investors, as well as taking steps to decarbonise their portfolios.

Investors are also making commitments to low-carbon, climate-resilient and green investment opportunities.

Leading PRI signatories are actively engaging with companies on business planning around the transition to a low-carbon economy, future investment opportunities and full transparency around political and climate lobbying activities.

Many of our signatories, including Allianz, AXA, Caisse des Depots, CalPERS, Old Mutual and HESTA pension fund, have already taken a stance on climate finance and carbon risk issues. The PRI is working across its membership base to deepen investor awareness and understanding of climate issues and to formulate responses to key climate finance questions. To that end, the PRI, together with other organisations, has launched a new Green Infrastructure Coalition to mobilise capital to meet the growing need for climate-resilient infrastructure development that supports INDCs and global targets. The Paris Climate Agreement now gives investors further impetus to act.

Clearly, the finance community has emerged as a formidable partner in the climate-change dialogue. In addition to highlighting the threats from climate changes, investors also have a chance to take the new commercial opportunities that climate change presents, from clean energy initiatives to new infrastructure and advanced technologies to help mitigate pollution, build resiliency and limit human impact on the environment – all the while creating new markets, jobs and export opportunities. Investors that think long term will benefit from these new initiatives.

Finally, PRI congratulates the various parties, and in particular the French Government, the UN and the UNFCCC led by Executive Secretary Christiana Figueres, on their leadership and commitment to a successful COP21 outcome. Well done.

It is now up to asset owners and managers, the universal investors, to work with governments and other stakeholders and ensure that the agreement becomes a reality in the coming years and that the next agreement is even stronger.

AP2, the SEK300 billion Swedish buffer fund, is attracted to the diversification benefits and long-term nature of timber investments. In a bid to expand its relationship with the asset class it is looking at ways for its capital to be permanently invested rather than act as seed capital.

Anders Stromblad, head of external managers at AP2, says the fund was attracted to timber investments, motivated by the growth characteristics and diversification effects it has on the total portfolio.

“We wanted diverse alpha,” he says. “The risk return profile of timber is attractive with low correlation with other assets. It has the long-term return expectations of equity but with more diversification and less leverage.”

Stromblad’s view is that timber is a good fit for long-term investors like AP2, which has assets of around SEK300 billion ($35 billion), is a patient investor, with a long investment horizon.

“We can live with a significant portion of the portfolio being illiquid and take advantage of that, so we are happy to take that illiquidity risk,” he says.

In addition the long-term nature of the way the fund invests means the portfolio can be built slowly, and it takes a long time to build a portfolio of timber investments.

“When we are looking at the natural part of real assets – which is 5 per cent of the total AP2 portfolio – we are not rushing, we are happy to take time.”

As an asset class, AP2 believes forests offer both diversification and a stable, long-term return.

AP2 has invested in forest since 2010, and has around 0.3 percent of total capital invested in forest assets. The fund’s timberland holdings are in seven countries – with the US (52 per cent) and Australia (40 per cent) dominating. It is roughly split three ways between hardwood/eucalyptus, other hardwood and conifers.

It employs three managers – New Forests, Molpus and Global Timber Resources, which is a company that AP2 jointly owns with TIAA-CREF and other institutional investors including the Greater Manchester Pension Fund.

David Brand, chief executive of New Forests, says forestry and timberland is unique compared to other commodities, partly because it is so diverse.

“It is made up of pulp and paper, the bio markets, construction and building timber, and feature-grade timber like teak and mahogany. They are all different markets with different drivers. This means you can get exposure through the business cycle. Forest assets have an interesting set of market dynamics which is beneficial,” Brand says.

The underlying structure of the asset class is changing, and while it has grown up with supply coming from natural forests, now it is about two thirds natural forest and one third intensive timber plantations.

“In 10, 30 or 40 years from now all incremental supply will be from plantations, with intensified production and pest controls and technology-driven increases in productivity,” he says.

In short, he says forestry is benefiting from the 21st Century’s focus on the bio economy century, and demand is moving from developed to emerging markets.

Stromblad says that AP2 was attracted to the demand and supply dynamics, as well as the growth potential from bio-energy.

AP2 is one of Sweden’s five buffer funds, and sustainability is integral to the asset management process. The fund adopts an active approach to ethical and environmental issues – and recently the five buffer funds coordinated the way carbon footprints are reported.

Within its forestry portfolio, it makes it a condition that fund managers certify forest real estate in compliance with one of the international sustainability certification systems, Forest Stewardship Council (FSC) or the Programme for Endorsement of Forest Certification (PEFC). If the forest assets cannot be certified – as in the case of biomass plantations not covered by FSC or PEFC certification – they will be managed in compliance with the certification principles implemented by these organisations.

AP2 also spends a lot of time with managers to get under their skin.

“We want to get to the plans of our managers, and see what they have done, independent of asset class. With real assets we want to meet with people in the field as well before we invest,” Stromblad says.

“It is also important to us, and you can see in our statements, that we are sustainability driven. In this case we love managers to run forests that are environmentally certified, and work with them on that.”

New Forests has incorporated sustainability issues since its formation, and has a declared ambition to achieve a leading position in sustainability. It has also produced figures stating the number of tons of carbon dioxide stored in the forests it manages.

AP2 has a positive outlook towards its timber investments, and is looking to expand the relationship and the way it invests.

“We want to look at ways we can be permanent capital rather than funding capital for these investments. Instead of selling off be permanent long-term owners to these assets rather than flip between managers,” he says.

Brand says the manager is working with investors on how to extend initial trust terms.

“There is growing recognition that when assets are acquired and restructured then you have permanent cash yield, so why sell. We are getting to the point they are steady/perpetual assets,” he says.

 

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.

He talks candidly alongside Top1000funds.com editor Amanda White and John Skjervem, chief investment officer of Oregon State Treasury, about active management, academic progress, the three-factor model, and efficient markets.

“I don’t have to like you, we don’t have to be friends,” says Chris Ailman, chief investment officer of CalSTRS, about the external fund managers that the $188 billion investor fund hires.

CalSTRS, like many large funds, is on the path to insource more and more investment management functions.

“We have the ability to manage money internally at one tenth of the cost and with more control, so we are constantly looking at it. We’ve looked at our global peers with more than $200 billion, and they have 58 per cent of assets internally.”

Ailman’s comments were part of a panel discussion at the Fiduciary Investors Symposium that looked at the progression, and maturation, of an investor’s relationship with its investment managers.

Ailman says he prefers a bit of tension in the relationship with external service providers, as “my staff find it easier to pull the trigger”.

The panel – which included Tim Corbett, chief investment officer of $120 billion MassMutual; Tom Osborne, executive director of IFM Investors; and was chaired by Brian Clarke, also executive director at IFM Investors – discussed fees, culture and transparency between limited partners and general partners.

The investors on the panel, Ailman and Corbett, both agreed that “you get what you pay for”, and while they are willing to pay for alpha, they will not pay for beta.

“I’ll pay for alpha – not 50 per cent of the alpha, but I’ll pay as much as 20 per cent of alpha. But I don’t want to pay for beta, especially when we can replicate it in-house,” Ailman says.

Performance fee structures were favoured but also found to be challenging, as they seem to favour the upside and not fully account for the downside.

Performance fees can also be an indicator that there is a cultural misalignment, with the investors very wary of managers that were interested in assets under management.

It was unanimously agreed that large investors need to look under the hood of a manager they will appoint, to understand what’s driving the motivation and relationship.

“You can’t get the culture of a firm from the marketing person. I say to my staff, ‘You need to go to the manager’s office and hang out with them over many years’. It is hard to measure the culture; most of us are analysts and culture is behavioural,” Ailman says.

“Picking a manager is similar to picking an investment. If all you see is the chief executive and the marketing people making a presentation then you are not getting the full picture. I have a bad habit of dropping in on a manager unannounced and saying I want to sit out on the floor and work. Eventually people start relaxing and being themselves, and it is very eye opening.”

Ailman is a supporter of increased transparency, and the work by the Institutional Limited Partners Association, among others.

“Every time there’s been increased transparency it’s been a better deal for LPs; we have reputation risk too,” he says. “We will push for it in real estate and infrastructure as well as private equity. It’s our capital to begin with.”

Ailman is an advocate for better alignment that will benefit all investors, not just large investors who are doing their own deals.

Osborne believes the best relationships between managers and investors are where the investor expectations are clearly set out; the investor is fully briefed on the strategy, culture and incentives of the manager; and the manager is appropriately resourced to deliver consistent with expected outcomes.

However, too often the investor is under-resourced and relies on the manager.

“It comes down to alignment, transparency and culture. The investor has to have confidence in the people at the manager,” he said.

 

EDHEC-Risk Institute suggests that investors should be wary when implementing factor tilts to ensure diversification still reigns, and that factor index design does not lead to concentration, which in turn leads to high turnover and investability hurdles. By Felix Goltz, ERI Scientific Beta.

With recent developments in risk factor-based investing, many investment product providers offer strategies that help investors to gain exposure to various identified risk factors, such as value, momentum, and size.

While there is consensus on the factors that are rewarded over the long term, implementation of factor investing, notably in the long-only universe, is not subject to the same consensus.

Concentrated factor indices identify stocks that have a pronounced factor tilt for a given factor, and aim to obtain strong exposure to this factor through stock selection that is often restrictive, resulting in relatively few securities in the portfolio in terms of the nominal number of stocks.

Moreover, the weighting scheme applied to the stock selection is either market-cap weighting or score-based weighting, resulting in a very uneven distribution of weights. Therefore, the effective number of stocks in the portfolio will also be low.

The idea behind this approach is to maximise over the long term the return associated with the strongest exposure possible to the rewarded risk factor.

Smart factor indices implement a relatively mild stock selection, where stocks with above-average exposure for a given factor are retained.

In a second step, these stocks are weighted by a combination of diversification-based methods that aim to create a well-balanced portfolio in terms of weights and risks. The idea behind this approach is to reconcile the exposure to the right factor with avoidance of excessive portfolio concentration. Poor portfolio diversification exposes the investment to risks of excessive volatility over the short and medium term.

Our recent research, presented in a 2015 EDHEC Risk Institute working paper, has compared the results of smart factor indices with several stylised examples of concentrated factor indices. Before turning to the empirical comparison, a number of conceptual considerations are in order.

 

Conceptual issues

Products that aim to capture explicit risk-factor tilts through concentrated portfolios effectively neglect adequate diversification. This is a serious issue because diversification has been described as the only “free lunch” in finance. It allows a given exposure to be captured with the lowest level of risk required.

In contrast, gaining factor exposures exposes investors to risk factors, and therefore, such exposures do not constitute a “free lunch.” They instead constitute compensation for risk in the form of systematic factor exposures. Such capturing of risk premia associated with systematic factors is attractive for investors who can accept the systematic risk exposure in return for commensurate compensation.

However, factor-tilted strategies, when they are very concentrated, may also take on other, non-rewarded, risks. Non-rewarded risks come in the form of idiosyncratic or firm-level risk, as well as potential risk of sector concentration. Financial theory does not provide any reason why such risk should be rewarded. Therefore, a sensible approach to factor investing should not only look to obtain a factor tilt, but also at achieving proper diversification within that factor tilt. To illustrate this point, we focus on the value factor as an example below, but the discussion carries over to other factors too.

In fact, if the objective was to obtain the most pronounced value tilt, the only unleveraged long-only strategy that corresponds to this objective is to hold 100% in a single stock – the one with the largest value tilt, as measured, for example, by its estimated sensitivity to the value factor or its book-to-market ratio.

This thought experiment clearly shows that the objective of maximising the strength of a factor tilt is not reasonable. Moreover, this extreme case of a strong factor tilt indicates what the potential issues with highly concentrated factor indices are.

First, such an extreme strategy will allow the highest possible amount of return to be captured from the value premium, but it will necessarily come with a large amount of idiosyncratic risk, which is not rewarded and therefore should not be expected to lead to an attractive risk-adjusted return.

Second, it is not likely that the same stock will persistently have the highest value exposure within a given investment universe. Therefore, a periodically rebalanced factor index with such an extreme level of concentration is likely to generate 100% one-way turnover at each rebalancing date, as the stock held previously in the strategy is replaced with a new stock that displays the highest current value exposure at the rebalancing date.

While practical implementations of concentrated factor-tilted indices will be less extreme than this example, we can expect problems with high levels of idiosyncratic risk and high levels of turnover whenever index construction focuses too much on concentration and pays too little attention to diversification.

Interestingly, the importance of diversification for a given factor tilt was outlined more than 40 years ago in Benjamin Graham’s famous book on value investing: “In the investor’s list of common stocks there are bound to be some that prove disappointing … But the diversified list itself, based on the above principles of selection […] should perform well enough across the years. At least, long experience tells us so.”

Aiming at a highly concentrated value portfolio would be completely inconsistent not only with financial theory, but also with the principles put forth by the early advocates of value investing.

Cap-weighted portfolios of value stock selections may at first seem to be more neutral implementations than score-weighted portfolios. However, it is well known that cap weighting has a tendency to lead to very high concentration given the heavy tailed nature of the distribution of market cap across stocks in the same universe.

It is well documented in the academic literature that simple cap-weighted value-tilted portfolios have not led to attractive performance. In fact across different studies, empirical results show that a value strategy needs to be well-diversified to deliver a significant premium.

For example, the standard Fama and French value factor includes a broad selection of stocks, and uses a two-tiered weighting approach to obtain better diversification. In particular, the value factor is an equal-weighted combination of sub-portfolios for different market-cap ranges, effectively overweighting smaller size stocks and increasing the effective number of stocks.

The fact that the most widely cited research documenting the relevance of the value factor does not use simple cap-weighted factors, but rather constructs more balanced portfolios, shows the lack of support for industry practices using simple cap-weighted factor indices. For completeness, we may add that the literature does not use any score-weighted approaches either.

Overall, it thus appears that neither of the approaches that propose to construct concentrated factor indices is supported by the academic literature, or for that matter, by common sense.

 

Testing different approaches

 

Turnover and investability

As discussed in our thought experiment in the introduction, it is clear that high levels of concentration potentially lead to severe turnover. Turnover will be high especially when the stock-selection criteria move fast, leading to pronounced changes in eligible stocks for a given factor tilt from one rebalancing date to the next. Of course, intuition suggests that the turnover will depend on the severity of the stock selection screen.

Our research reports the increase in turnover for concentrated portfolios compared to the well-diversified equal-weighted indices created for six different factors (value, size, momentum, low vol, profitability and investment). Narrowing down the stock universe to obtain strong factor tilts severely increases turnover, thus leading to strategies that are more difficult and costly to implement than strategies based on broader selections.

Turnover for the factor-tilted strategies reaches levels close to 50% when selecting only the one-fifth of stocks with the strongest factor score, while turnover is close to 30% for the strategies based on broader indices selecting half the stocks.

The implementation hurdles that are apparent from the analysis of turnover are confirmed when analysing tradability metrics such as the days to trade the necessary positions for the strategy. This measure, which considers the available trading volume in stocks whose rebalancing generates this turnover, confirms the implementation problems of concentrated approaches compared to more diversified approaches.

 

Idiosyncratic risk

Increasing concentration is also expected to lead to an increase in unrewarded, idiosyncratic risk. We assess this issue by regressing returns of the factor strategies onto the standard Carhart factors including the market, size, value and momentum factors. The idiosyncratic risk is then measured as the standard deviation of the residual return relative to the systematic return component which results from the factor exposures.

In order to estimate diversification benefits, we compute the ratio of unexplained return with respect to the Carhart factors (or “Carhart alpha”) to the residual standard deviation.

Our results provide strong evidence that diversification benefits are sizeable when moving from concentrated approaches to better-diversified approaches. A key issue with concentrated approaches is that idiosyncratic volatility increases with higher concentration. Note that financial common sense suggests that idiosyncratic risk should be diversified away! This confirms that many concentrated indices are often exposed to risks which are not only unrelated to the factor tilts that they are intended to capture but also likely to be unrewarded over the long term.

A recent example of how idiosyncratic risk materialised in factor indices is the emissions scandal related to car maker Volkswagen. Clearly, if a company cheats on emissions testing, this is a purely idiosyncratic event from which investors can diversify away by spreading their portfolio weights across multiple firms and industries.

The table below presents the weights and performance attribution to Volkswagen AG and other automobile stocks in various multi-factor indices, for the period surrounding the diesel scandal in 2015.

The SciBeta Extended Europe Multi-Beta Multi-Strategy EW index, a well-diversified multi-factor index only allocated a 0.05 per cent weight to Volkswagen, while the cap-weighted Stoxx 600 index allocated 0.35 per cent to this single stock. It should be noted that the SciBeta Extended Europe Multi-Beta Multi-Strategy EW index follows a methodology which explicitly targets good diversification of specific risk through a diversification-based weighting scheme, in addition to targeting factor exposures to multiple factors.

If we now examine other forms of multi-factor indices that have marketed the performance that can be achieved through strong exposure to factors, and have been less concerned about diversification of specific risk, we note that the exposure to Volkswagen AG risk is considerable.

We observed, for example, that the Lyxor J.P. Morgan Europe Multi-Factor index was very strongly exposed to the risk of the Volkswagen AG stock, as was the MSCI Europe Diversified Multiple-Factor index. As such, these indices respectively contained almost 1.5 and more than 2 times more Volkswagen AG stock than the Stoxx Europe 600, and almost 10 times and 16 times more Volkswagen AG stock than the SciBeta Extended Europe Multi-Beta Multi-Strategy EW index. Since they contain a low effective number of stocks, these indices do not benefit from a deconcentration effect.

 

 

CalPERS has integrated sustainability into its investment strategy and implementation, and uses asset class-specific criteria to assess managers on ESG before selection.

As part of a “manager expectations project” each asset class drafted its sustainability investment guidelines and will request the sustainable investment policies of the manager they are considering, asking asset class-specific questions, which will be factored into whether or not to select the manager.

Outlining a “story of progress” Beth Richtman, portfolio manager, infrastructure and global governance at CalPERS, told the Fiduciary Investors Symposium how clarity from the board was the first step in creating clear processes and structures for assessing and monitoring internal and external managers on sustainable investment integration.

 

“We have clarity from our board, which is important to have when you’re thinking about sustainable investment. We have 1.7 million pensioners, and liabilities going out for the better part of a century, so our board has come to the realisation, to get the returns to service those liabilities, we need a sustainable economy. This has led to a three-pronged approach to sustainability all through the lens of risk and opportunity,” she says.

The three-pronged approach encompasses:

  1. Engagement: For example, CalPERS is currently actively engaging with fossil fuel companies and asking them to consider the resilience of their business model in a “2 degree Celsius” scenario.
  2. Advocacy: Richtman says CalPERS has been very vocal on the path to Paris, pushing for a price on carbon. “If that is achieved, we want our companies to have a plan for that,” she says.
  3. Integration: Like many large investors, integration is the most difficult part of the process. CalPERS has a complicated asset allocation and invests in more than 10,000 companies.

Richtman says that CalPERS’ investment beliefs have helped to guide the implementation, and highlights a number of beliefs that specifically relate to sustainability:

Investment belief 2 – “A long time investment horizon is a responsibility and an advantage.”

“We have long-term liabilities so need to be thinking long term,” she says.

Investment belief 4 – “Long-term valuation creation requires effective management of three forms of capital: financial, physical and human.”

Investment belief 7 – “CalPERS will take risk only where we have a strong belief we will be rewarded for it.”

Investment belief 9 – “Risk to CalPERS is multifaceted and not fully captured through measures such as volatility or tracking error.”

“The sub-belief to that one calls out climate change and resource scarcity as risks we need to consider as they emerge over long periods of time. We are a universal owner and we believe in systemic risks,” she says.

One of the key lessons from the CalPERS integration project is that staff need to have clarity around what they have to do in various asset classes. To this end, the fund put together a cross-asset class team to consider how to integrate sustainability and make it part of the investment process.

“Our fund is complicated; for instance, public asset classes are largely internally managed, and private largely outsourced. It’s about how they are managed – whether passive or active – and the nature of assets differs; for example, with a real estate investment, you can’t pick up and move if the sea level rises. That’s a different perspective than stocks, which you can quickly sell,” she says. “You can’t have a one-size-fits-all approach.”

conexust1f.flywheelstaging.com hosted the Fiduciary Investors Symposium held at the Chicago Booth School of Business at the end of October.