A large percentage of the outperformance of private equity can be replicated by using sector exchange traded funds, according to new research.

The research empirically unbundles the sources of private equity return, differentiating between alpha, due to manager skill and illiquidity, and the return that comes from “asset class alpha”.

This “asset class alpha” – referred to as “liquid private equity” – can be captured by using sector ETFs, and has portfolio construction uses for investors wanting to capture outperformance of private equity without the liquidity constraints.

In a paper, ‘The components of private equity performance: implications for portfolio choice’ published in The Journal of Alternative Investments, the authors show that the sector weights of private equity funds predict the subsequent performance pf public equity sectors within large and small-cap universes.

One of the authors, Will Kinlaw, head of State Street Associates and a senior managing director of State Street Global Exchange, says a significant portion of the excess return of private equity over public markets can be captured by sector bets.

“Whether this is alpha or beta is a tricky philosophical question. From a public markets point of view this is alpha,” Kinlaw says.

“This is not a substitute for private equity. Private equity managers have clearly shown they can deliver company selection and capture an illiquidity premium.”

However the research, which is the first of its kind to look at the role of sector bets in private equity returns, shows that private equity exposures are predictive of public equity performance.

The research uses the State Street Private Equity Index, updated quarterly based on the cashflows of institutional investors (LPs), to evaluate the performance of actively managed private equity funds.

The research “conjectures” that the private equity managers collectively produce an asset class alpha because they anticipate the relative performance of economic sectors.

The authors point out that many private equity funds, such as venture capital funds, focus on emerging segments of the economy in which innovation is likely to be concentrated. Other funds, such as buyout funds, focus on underperforming segments of the economy.

“It may, therefore, be the case that private equity managers anticipate outperformance, whereas public investors respond to outperformance.”

Kinlaw says there has been a lot of research on the impact of size, value, leverage, and the liquidity premium with regard to private equity performance, but little on the role of sectors.

“So we set out to understand the role of sector bets, and used a regression technique to look for just the statistically significant exposures to sectors,” he says.

This “asset class alpha” can then be captured by using sector ETFs.

“We also looked at the shelf life of this information. Private equity managers are locked up for a period of time so there is decent information for two to three years in those bets.”

The authors – which include Kinlaw’s long-time collaborator, Mark Kritzman, chief executive of Windham Capital Management and a senior lecturer at MIT’s Sloan School of Management, and Jason Mao, vice president of State Street Associates – show that the decomposition of private equity excess return into an asset class alpha and an illiquidity premium affects the optimal composition of a portfolio.

“Private equity is less appealing than liquid private equity because liquid private equity delivers asset class alpha without subjecting the investor to illiquidity. Public equity becomes less attractive than liquid private equity because it does not offer an asset class alpha. Finally, private equity becomes less attractive than all liquid asset classes because it is seen to offer a smaller premium to compensate for its illiquidity.”

Today marks the relaunch of our publication with a new look and added features. I’m sure you’ll agree our amazing team of graphic and web designers have done a stellar job. While we have a new look, you can be assured we are not only maintaining, but honing, 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.

Our editorial will continue to showcase best practice, highlighting good news stories through case studies and in-depth interviews with chief investment officers and heads of pension funds, sovereign wealth funds and endowments.

In addition to original stories and editorials, our relaunch includes more voices in our publication and next year you will hear from some of the leading thinkers in our industry including academics, chief investment officers and consultants.

The new look conexust1f.flywheelstaging.com also marks a closer unity with our event series, the Fiduciary Investors Symposium.

This event, held twice a year, brings together global investors to examine the management of fiduciary assets looking at asset allocation, risk management, beta management and alpha generation.

It has become recognised as an event that challenges the influence and responsibility of fiduciary capital and explores the evolution in fiduciary investment management.

As institutional investors grow in asset size and power, bring more investments in house and demand more of their service providers, it is essential that they are equipped with contemporary thinking and technology. The event, and the subsequent stories we write from the excellent presentations, aim to arm investors with tools to do their jobs better.

The event series is hosted at leading educational institutions – including in the past Harvard, Oxford and Chicago Booth – and draws on some of the world’s leading investment thinkers.

The next event will be at King’s College, Cambridge University from April 10–12, 2016 and will enable institutional investors to engage with industry thought leaders in academia and practice in a collegiate environment that promotes shared discussion. Managing assets as a fiduciary comes with a complex range of responsibilities and commitments. This conference examines the holistic approach to fiduciary investing and how fiduciary management has evolved, including the wider responsibilities of long-term investors in stabilising financial markets, social welfare and environmental management.

Thank you for your support and we hope you enjoy the new publication.

Chief executive of AP4, Mats Andersson – who is one of the co-founders of the Portfolio De-carbonisation Coalition (PDC) – has announced that the PDC has far exceeded its decarbonisation target and reached the $600 billion mark. He gave a speech at the United Nations Framework Convention on Climate Change’s (UNFCCC) event Journée de l’Action – COP21 alongside actor Sean Penn, former US vice president Al Gore and United Nations secretary-general Ban Ki-moon.

 

His speech in full can be read here:

Ladies and Gentlemen,

I am here today to share with you a fascinating story about a huge movement related to climate change: Institutional investors are finally, and in a very serious way, entering the game of action.

They are increasingly tackling climate change-related risks. And on a large scale.

The truth is that this major shift has taken place only recently. I would say over the past 18 months.

Four important developments have contributed to this movement.

First: Investors are increasingly incorporating climate risks into their standard risk management approach.

We know that, short term, markets are not taking carbon-related risks into account. But as Governor Carney recently noted, there are at least three families of risks: physical, liability and transition risks. Polluting companies and companies holding fossil-fuel assets are particularly exposed to these risks. The risk on fossil fuel assets stems from the very simple fact that current reserves far exceed the carbon budget for the planet.

Motivated by their fiduciary responsibilities, profit maximisation and risk minimisation, institutional investors are now understanding, analysing and reducing their exposure to climate risks.

And this trend is spreading. 120 investors with $10 trillion of assets under management have already signed the Montreal Pledge and are committed to publishing their carbon footprint.

Second force: Financial innovation.

There are now some new solutions available. Low carbon indexes. They aim to break the so-called “tragedy of the horizon”. That is, how can we manage a risk that has an unknown time horizon and most likely exceed what is regarded to be a standard investment horizon?

Low carbon indexes aim to reduce carbon risk in the long run without impacting market returns in the short term. They are simple, low cost, straightforward and transparent. It accelerated the transition towards a low carbon economy.

Now we also have green bonds. They are promoted by leading banks. Green bonds accelerate the funding of projects dedicated to a low carbon economy. And as Christine Lagarde recently said, green bonds will “reallocate investments to sectors that support environmentally sustainable growth”.

Third force in place: The sharing of best practices.

The Portfolio Decarbonisation Coalition (PDC) was founded by UNEP-FI, CDP, AP4 and Amundi, and launched during the 2014 Climate Summit in New York City under the umbrella of the United Nations.

PDC has two goals:

First, to bring together the doers, that is the actors who are taking concrete action to deal with climate change.

Second, to send a signal to other asset owners that portfolio decarbonisation is feasible.

The bar was set very high; a target of $100 billion portfolio decarbonisation. And by the end of the COP21, this figure will reach more than $600 billion. With these achievements, the PDC sent four strong messages.

First, to the investor community: to tackle risks associated with climate change is feasible and scalable.
Second, there is a diversity of pathways to action.

Third, the signal from the investor community to society: we are getting serious about acting on climate change.

Four, we are moving from billions to trillions.

Let me finish by the last major force at work for the wake-up call among investors.

In China, Brazil, England, Sweden, and France, policy makers are exploring various measures to accelerate the mobilisation of assets owners.

France is leading the pack with a new law that asks asset owners to report on their assessment of their exposure to climate change-related risks.

All in all, this means that whether you manage money in Rio de Janeiro, Amsterdam, Abu Dhabi, Kuala Lumpur, Beijing or Sydney, you cannot bury your head in the sand anymore.

It is now part of the new norm for long-term investors to come up with an answer on how to tackle climate change.

And remember, we are only at the beginning of this journey.

A journey through which financial systems can be aligned with sustainable development goals, including the fight against climate change.

Since Christmas is coming up soon I have two wishes to make on behalf of my kids’ and grandkids:

First, deliver a meaningful agreement.

Second, put a fair price on carbon.

To conclude, the financial sector is ready and is already taking action.

And remember billions mobilised today will be trillions tomorrow.

Thank you.

 

 

More than half of the world’s largest sovereign wealth funds, and around a third of the largest US state pension funds, have a disclosed code of ethics for their staff.

According to the Public Fund Investment Policies 2015 annual review produced by the Ohio State University Moritz College of Law, a code of ethics helps to ensure that investments are made in accordance with the fund’s investment policies and regulations.

Singapore’s Government Investment Corporation, for example, states “we expect the highest standards of honesty from everyone in GIC, both in our work and in our personal lives. This includes abiding by the laws of the countries we invest in, and observing our code of ethics in letter and in spirit.”

While most funds disclose only the existence of an internal code of ethics, a few funds disclose the entire code of ethics. The report highlights Mubadala’s report as “exemplary”, with its code of ethics covering a wide variety of ethical issues including “preventing improper payments in cash or kind”, “preventing money laundering”, and “protecting intellectual property and confidential information”.

But the ethical aspirations of a company are only as good as the behaviours of its employees.

The Mubadala code of conduct requires a personal commitment by each employee to make the company’s aspirations of being an ethical and compliant company a reality.

“Our Code of Conduct clearly states our aspiration to remain an ethical and compliant company. However, words are not enough. It requires the personal commitment of each of us to make it a reality. By working for or with the Mubadala Group, you are agreeing to uphold this commitment. Each one of us is required to acknowledge annually that we have read, understand and will comply with the requirements contained in our Code of Conduct. Those who fail to follow our Code put themselves, their colleagues and the entire Mubadala Group at risk. This annual acknowledgment will be made in writing or electronically. New employees will be provided a copy of the Code of Conduct and will complete their acknowledgment during the orientation training.”

The Korea Investment Corporation also has a very strict adherence to a code of ethics and periodically

It has adopted ethics and transparency as basic principles of its operation promotes ethical awareness and transparent management. All employees are required to sign a pledge to comply with the code of ethics and code of conduct upon joining KIC. In addition assessment of employees’ compliance with the code of ethics are conducted at regular intervals, and counselling on related issues is provided on an on-going basis.

Further an ethics training is offered periodically to employees to provide them with guidelines for sound decision-making and ethical judgment, and an ethics hotline has been set up which can be used to report inappropriate or unethical conduct by employees

Separately the CFA Institute has developed a code of ethics for pension fund trustees which outlines 10 fundamental ethical principles.

The practice of benchmarking the salaries of senior executives of institutional funds with reference to external financial services firms, instead of the shared objectives of the fund, is a major barrier to their success, according to Professor Gordon Clark of Oxford University and director of Smith School of Enterprise and the Environment.

Clark sees the problem arising from the norms of benchmarking at the financial services companies that institutional funds are recruiting much of their staff.

“There is a group of people who think they should be paid according to industry norms and conventions in terms of rate of pay and bonuses that might come with, for example, working with Goldman Sachs,” he said, citing the pressures of compensating investment teams.

He said a shared objective for the fund agreed upon by the chief executive and the board could be used to reconcile individual competing claims to a share of disposable income and also in managing claims for power and prestige within the fund.

“You need to get people thinking beyond their immediate professional real interests and think of the overarching objective of the institution itself. That is a challenge we all face and it is a measure of successful financial institutions,” he said. “What you are trying to do is form an organic whole, rather than simply think of it as a see-through organisation where nothing much happens other than the individual tasks and functions.”

Clark said the board is part of the problem, particularly where membership was handed out as a political perk or where board members might not take the role as seriously as they ought to, all of which would hinder the achievement of a shared objective.

He said this could lead to boards that are conflicted over what the goals are.

Clark recognised that articulating a clear and easy to follow objective was challenging. He gave the example of a national pension fund that had three objectives; to properly manage the assets globally, to never lose any money and to be cost effective all the while paying benefits sustainably over the long term.

“How do you square the circle for these competing claims? Some organisations never manage to do this,” he said.

Funds that had succeeded in these challenges he identified as having a chief executive who was able to clearly articulate the mission or the shared objective of the fund and as having a board that was clear as to what their fiduciary responsibilities were and where shared goals united them.

He cited the large public sector Canadian funds, as examples of funds that had succeeded in these aims.

“The Canadian funds that they talk with great enthusiasm about their shared ethos, common goals and objectives and how the sustainability of long-term pension income guides their policy right through the organisation,” he said. “There is a lot to be learnt from talking to these funds about how they basically got better in dealing with these issues, in a systematic manner right through the organisation.”

Clark also described how a poor organisational structure and a poorly articulated shared objective could impact on the way in which funds invested for the future in skills, expertise and technology.

He gave the example of the need for some funds to update their information technology to ensure better analysis of portfolio risk and to understand their members’ liabilities.

“When board members realise that their information system is archaic and it is going to take $50 million to fix over a five-year period of time, there is an audible in-take of breath from the board. They are going to make a decision that binds their hands over a five-year period with no guarantee of success.”

Often, he said, it was easier for boards to opt for a “two-to three-year fix” costing $20 million.

“If there is that sense of short-term or long-term, boards think of their own careers and their own prospects,” he said. A board, he said, should rather be thinking of it as sustaining the mission off the organisation, rather than as an immediate cost.

 

 

 

Ahead of the COP21 in Paris, the second largest Dutch fund with €161 billion ($160 billion), Pensioenfonds Zorg en Welzijn (PFZW), has announced it will halve the CO2 footprint of its investments by 2020.

After an in-depth study with its fund manager, PGGM, the fund has decided its capital should be focused on companies that anticipate a sustainable future, and the first and most obvious starting point for implementing the change is liquid equities.

As a result of this approach, coal companies will be largely eliminated from the PFZW portfolio by 2020 and investments in fossil fuels will be reduced by 30 per cent.

With this first step, AUM for CO2 reduction within market cap equities is about $31 billion. “We are intolerant of high CO2 emissions,” principal director of strategy at PGGM, Jaap van Dam, says.

For PGGM this asset class is managed close to the benchmark in an index-plus strategy and will focus on energy, utilities and materials sectors which have the biggest CO2 emitters.

“We have done intensive analysis, and the expected tracking error for the ESG customised benchmark is about 0.3 per cent annualised versus the former broad FTSE global benchmark.

The changes will mean the portfolio will stay sector neutral and there is not much change from a risk or factor exposure perspective,” van Dam says.

“We expect return to be equal to the generic FTSE benchmark. Deviations from benchmark in terms of tracking error are relatively small and we do not expect systematic under- or outperformance as we control for sector risks [and] country risks and have not observed noticeable factor tilts such as quality, value, min volatility, momentum, size.”

The number of holdings scaled down will be between 200 and 250, but importantly, engagement remains a core part of the approach.

“We chose not to optimise the strategy but to have a clear rule-based approach. Optimisation is anonymous. We want to be able to have a conversation with the companies affected.

“Collectively, as investors and consumers, we are part of the world in which carbon plays a large part, so we will do it gradually. Painting your front door green doesn’t change the real world,” he says.

“We want to inspire other investors to go down this route. On our own we can’t change the world.”

While the first instance will see a focus on equities, in the next few years the agenda will expand to credit investments, and real estate is also being investigated.

The gradual move allows companies a chance to move too, says van Dam, with the aim to inspire other investors about the ease of putting their money where their mouth is.

“This says to companies that we believe the world should be more CO2 efficient and we are engaging with you, and you can move this way too.”

It can also be seen as “cheap insurance against a high CO2 price”, says van Dam, with the portfolio moving from CO2-intensive emitters to CO2-efficient companies by 2020.

The important starting point for this decision was the White Sheet of Paper project which determined very clear beliefs about being a sustainable pension plan.

Van Dam acknowledges there was significant potential tension between two of the fund’s objectives – namely, financial ambition and sustainability.

“We had an intense conversation with the investment committee of PFZW, and together developed the path towards this solution which satisfies both the financial and the sustainability objectives. The portfolio or benchmark can move from CO2 intensive to CO2 reduction within the same sectors,” van Dam says. “These are relatively small changes in the makeup of the portfolio. This was a key for PFZW to sign up for this strategy.”