Mercer Investments is using its deep insurance and environmental, social and governance (ESG) skills, contacts and processes to evolve its tools for advising clients on investment risk assessment, analysis and reporting – a move that reflects the evolving landscape for risk faced by investors.

Partner and global head of responsible investment at Mercer, Jane Ambachtsheer, said the landscape for risk includes factors such as resource scarcity, climate risk, an ageing population and a growing population, and so reliance on past performance in risk assessment is no longer adequate.

Mercer looks at the importance of complexity economics and how risk reporting is being influenced by the changing nature of risks, and the interconnectedness of risk.

In the World Economic Forum’s 2015 Global Risks report, which highlights the most significant long-term risks by drawing on the perspectives of experts and global decisionmakers, water crises were the greatest risk facing the world.

Other top risks alongside that and interstate conflict in terms of impact are: rapid and massive spread of infectious diseases, weapons of mass destruction and failure of climate change adaptation.

Given this perspective, Mercer is now talking to clients about looking at risk management using seven different risk management tools to measure, manage and report on risk. Many of these focus on climate risk, stewardship and long-term investing to assess and manage total portfolio risk.

  1. ESG ratings. Mercer now has more than 6000 ratings at the strategy level across all products and asset classes.

An example of how this is being used is that Bloomberg, as a plan sponsor, in its defined contribution plan is white-labelling the ESG ratings and providing this information to employees for selecting funds.

  1. Mercer is increasingly looking at the security-level information for its ESG analysis. It will be announcing a security-level partnership soon.
  2. Mercer now assigns ESG passive ratings and believes there is not enough focus on the assets that are managed passively. It is focusing on asset owners challenging passive managers.
  3. In the UK and other countries where there is a stewardship code, Mercer is advising on and helping with assessing whether managers are compliant; it has a ratings system of green, amber and red on the code principles and stewardship overall.
  4. Mercer’s new study, Investing in a time of climate change looks at climate risk in terms of technology, resource availability, impact and policy (TRIP) and provides a quantitative measure for investors’ climate risk in their portfolios. Ultimately the assessment can calculate the basis point impact of climate change on the portfolio.

“Fiduciaries need to be aware of climate risk and where their exposure is, they can then tilt towards those things that do better,” Ambachtsheer says.

  1. Carbon footprinting. This is a risk tool to capture policy risk.
  2. Insurance tool to assess total portfolio risk of real asset climate risks.

“No investor I have come across has a map of the world with all their physical assets on it. The concentrations of risk are ignored,” Ambachtsheer says.

Mercer is collaborating internally with Marsh and Guy Carpenter to do a real assets environmental risk assessment using insurance tools.

“We will be using insurance tools to run risk analysis at the total portfolio level and property, infrastructure, timber and agriculture,” Ambachtsheer says.

Mercer is also doing a lot of work on long-term investing, and asking such questions as whether investors should be giving managers targets beyond relative benchmark performance.

“How do you behave like a long-term investor should be a standing item on the investment committee meeting [agenda],” Ambachtsheer says. “We aim to embed long-term thinking.”

 

 

World Economic Forum 2015 Global Risks report

Top 5 global risks in terms of impact

  1. Water crises
  2. Rapid and massive spread of infectious diseases
  3. Weapons of mass destruction
  4. Interstate conflict with regional consequences
  5. Failure of climate change adaptation

 

Ontario Teachers’ Pension Plan (OTPP), an investor known for its advanced risk-management tools and processes, considers that the common tools available to investors to mitigate carbon risk for investors – portfolio carbon footprints and thematic divestment – provide incomplete risk management. The fund has suggested macro- and microanalysis is necessary to understand a company’s complete picture, which then supports a specific investment thesis, use of non-equity instruments, an engagement strategy or a divestment decision.

In its paper, Climate change: separating the real risks for investors from the noise, OTPP uses an example to demonstrate that the carbon footprints of a portfolio have limited use and do not provide investors with a complete picture or response to climate change.

It says that a portfolio footprint can give a false assurance of managing climate risk and miss[by missing?] the complete picture of physical impact risks in those sectors with supply chain risks.

OTPP believes with the right analysis and interpretation, carbon footprinting can be one element of a risk-management strategy. For instance, in its example only one company in the construction and materials sector is driving the portfolio carbon intensity higher than the benchmark. Thus engagement with that company could be the next step.

The paper also says that carbon footprints do not show the opportunities from[associated with?] climate change, such as measuring the reduction in emissions from technologies like carbon capture and storage. But importantly, carbon intensity doesn’t provide useful information about the context of the investment or corporate strategy.

The paper also says that divestment should be the outcome of a well-informed and thoughtful investment process, rather than a wholesale approach to a single sector.

“At OTPP, we are particularly sensitive to investment losses given our maturity; therefore, risk is managed from the top down and bottom up and matched carefully to liabilities. This risk consciousness flows down to individual investment decisions,” the paper says.

“Investors need a toolbox of solutions to help manage physical and regulatory risk across their portfolios, both in the short and longer term.”

Meanwhile the Environment Agency Pension Fund has released a policy to address the impacts of climate change, which aligns the portfolio and processes with keeping the global average temperature increase to below 2 degrees Celsius relative to pre-industrial levels.

The fund has set targets for 2020: to invest 15 per cent of the portfolio in low-carbon, energy-efficient and other climate mitigation opportunities and decarbonise the equity portfolio, reducing exposure to future emissions by 90 per cent for coal and 50 per cent for oil and gas compared to the underlying benchmark.

 

The UN-backed Principles for Responsible Investment (PRI) is considering a seventh principle that will focus on broad financial system systemic risks.

The six principles were written before the global financial crisis and are focused on environmental, social and governance (ESG) integration. Now, a decade after their creation, consideration of systemic risks is on the agenda and part of a consultation with signatories regarding a 10-year blueprint for making responsible investment mainstream.

Managing director of PRI, Fiona Reynolds, says this will include policy and behavioural issues affecting the financial system.

She said this would include the role of asset owners in addressing policy issues, the role of stock exchanges, and the impact of high-frequency trading, short-term payment incentives and short-term mandates.

The PRI will conduct a consultation with signatories regarding the development of a seventh principle in the middle of next year.

The six principles were developed 10 years ago and are focused on implementation and the effect of ESG on portfolio holdings. But the PRI’s mission is focused on an economically efficient and sustainable global financial system, so the evolution of the principles to include systemic risks is a natural step.

“We believe that an economically efficient, sustainable global financial system is a necessity for long-term value creation. Such a system will reward long-term, responsible investment and benefit the environment and society as a whole,” the PRI mission says.

PRI has engaged an independent Dutch consulting firm to measure the PRI’s impact over the past 10 years and will launch this document at its tenth birthday celebrations in New York next April.

Separately it will produce a blueprint outlining the areas of focus for PRI in the next decade in making responsible investment mainstream. This will include interviews with signatories about systemic risks.

“We are recognising that as universal owners, asset owners are in the whole market so they have to care,” Reynolds says. “We’re calling this PRI 2.0 internally, and focusing on what we need to do to get to the next level.”

Speaking at conexust1f.flywheelstaging.com’s Fiduciary Investors Symposium at Chicago Booth School of Business in October, Martin Skancke, chair of the PRI Advisory Council, called on investors to step up to the conversation about the systemic risks such as carbon risk and long-term stability of markets.

“The asset owner perspective is missing. Asset owners are not necessarily in the market daily, they are removed from the market, but are paying the costs of an inefficient market,” he said.

“You should be asking ‘What does a good trading place look like for me? Who should be allowed to trade? How should information regarding trades be made available and to whom?’ These are really important questions and asset owners are absent from the conversation.”

Skancke said some of the perceived conflicts between ESG and fiduciary duty come from a misconception.

“For me it’s about the stability and usefulness of the financial system itself,” he said.

“It is seen as responsible investment limiting the investment universe. All investors exclude assets for various reasons; for example, you don’t believe in the business model, don’t like the market, the investment doesn’t meet cashflow requirements. It’s just another constraint.

“For me it’s about widening your information set, not limiting the investment universe. How do you organise the information set and take a broader view of the risks you’re taking?”

ESG as a fiduciary duty is about raising the standard of corporate behaviour generally, he said.

 

The six principles are:

Principle 1: we will incorporate ESG issues into investment analysis and decision-making processes

Principle 2: We will be active owners and incorporate ESG issues into our ownership policies and practices

Principle 3: We will seek appropriate disclosure on ESG issues by the entities in which we invest

Principle 4: We will promote acceptance and implementation of the Principles within the investment industry

Principle 5: We will work together to enhance our effectiveness in implementing the Principles

Principle 6: We will each report on our activities and progress towards implementing the Principles

 

 

 

Valuations have increased, lowering the prospect of above-average returns. This holds true for risky assets in particular, but sovereign bonds will also be expensive in the scenario of subdued but expanding growth we expect in 2016. Read more »

The investment industry should be constantly looking at the impact of technology on the status quo. Just because indexes have been defined as cap-weighted portfolios, doesn’t mean that can’t change. In fact, the evolution in portfolio management necessitates a change in thinking with regard to the definition of indexes, in particular so risk management can be decoupled from alpha generation. In a new paper that argues for a new definition of what constitutes an index, Andrew Lo, professor of finance at MIT Sloan School of Management pushes the boundaries by not only suggesting change, but by demonstrating a new functional definition for indexes and the benefits, and pitfalls, of doing so.

Technological advances in telecommunications, securities exchanges and algorithmic trading have facilitated a host of new investment products that resemble theme-based passive indexes but which depart from traditional market-cap-weighted portfolios.

Lo proposes broadening the definition of an index using a functional perspective. He says that any portfolio strategy that satisfies three properties should be considered an index:

(1) It is completely transparent

(2) It is investable

(3) It is systematic, or it is entirely rules-based and contains no judgment or unique investment skill.

He says that portfolios satisfying these properties that are not market-cap-weighted are given a new name: “dynamic indexes”.

“This functional definition widens the universe of possibilities and, most importantly, decouples risk management from alpha generation. Passive strategies can and should be actively risk managed, and I provide a simple example of how this can be achieved,” he says in the paper.

“Dynamic indexes also create new challenges of which the most significant is backtest bias, and I conclude with a proposal for managing this risk.”

Lo’s paper looks at a brief history of indexes and index funds, defines an index and looks at the separation of alpha, beta and sigma.

He says that indexes have evolved over time and today, indexes serve many purposes. In addition to their original function of information compression, indexes act as indicators of time-varying risk versus reward, and as a benchmark for performance evaluation, attribution and enhancements. And since the advent of the Capital Asset Pricing Model, indexes have been used to construct passive investment vehicles and as building blocks for portfolio management.

But, as Lo and many others have pointed out, the advent of “smart beta” need not be smart at all.

He says that the lack of risk management – or the fact “smart beta” is often accompanied by “dumb sigma” – is perhaps the greatest weakness of traditional passive investing.

“A new framework is needed for thinking about indexes, indexation, and the distinction between active and passive investing that reflects the new reality of technology-leveraged investing.

“The starting point for this new framework is to generalize the definition of a financial index by focusing on its basic function. If an index is to be used as a benchmark against which managers are judged, it must have three key characteristics: it is transparent, investable, and systematic.”

 

To access the full paper click here

What is an index?

With its 10th birthday looming, the Future Fund is entering its next incarnation complete with a new investment team structure. AMANDA WHITE spoke to Raphael Arndt, Stephen Gilmore and David Neal.

When David Neal, the inaugural chief investment officer of the Future Fund, became its managing director on August 4 last year, his previous role was split in two. Long-time head of timberland and infrastructure Raphael Arndt became the chief investment officer responsible for leading the investment team in developing the research, due diligence and selection and monitoring processes for assets and investment managers. Stephen Gilmore, previously the Future Fund’s head of investment strategy, became the chief investment strategy and risk officer. In doing so he took on additional responsibility for managing and monitoring total portfolio risk settings and continuing to focus on portfolio design, and understanding the macroeconomic and market environment. Both report to Neal.

The new investment team structure is indicative of the Future Fund 2.0. It reflects the need for more resources and communication due to the increased complexity and competitiveness of the investment environment, as well as the increased complexity of the fund’s investment portfolio – particularly compared to 2006, when the fund was created.

Something is clearly working. For the year to the end of June 2015, the fund returned 15.4 per cent – 9.4 per cent above its benchmark – and the fund’s best one-year performance. Since its inception in May 2006 it has returned 8 per cent, against a target return of 7.1 per cent (CPI plus 4.5 per cent).

At A$117 billion ($82 billion), it is Australia’s largest investor. It is not set apart by size alone, as it has one of the most flexible and adaptive portfolio construction processes among its global peers. One of the fund’s investment strategy beliefs is that “portfolios are most efficiently managed as a whole, rather than as a collection of individual sub-portfolios”.

What this means in practice is a multi-faceted approach to portfolio construction. Strategic themes and a “view of the world” are fed into scenario analysis. Sector risk and opportunity analysis is conducted, including top-down and bottom-up analysis; and the manager review committee and asset review committee also feed ideas to the investment committee. The investment committee – which includes the sector heads, the chief investment officer, chief investment strategy and risk officer, and the managing director – is responsible for the investment decisions. This team approach makes the fund unique.

Ideas are debated by the investment committee, and staff are rewarded for supporting ideas that are not their own. Whether or not an investment is “good for the portfolio” is always front-of-mind.

In this way, Arndt says, nothing much has changed with the new team structure. The decision-making process is the same as it has always been.

“The portfolio was built under the ‘one portfolio’ approach. So irrespective of who you are and what you do, no one person controls the decisions.”

It is as if they share thoughts and philosophies, and to add emphasis to the point, Gilmore finishes Arndt’s sentence.

“It is very collaborative along the way; you always want team buy-in. It can be a challenge when people come from different work backgrounds and bring their experiences. We all have biases. A person with a top-down background will look at things differently to the way we do things. A while ago we asked people, ‘What portfolio would you have if you could choose?’ Everyone had more of what they did in it.”

But the Future Fund isn’t big on individuals. No individual is mentioned in its culture, value statements or behaviour. The ‘one portfolio’ approach is central; and regardless of job function, remuneration for all employees is partly based on the entire portfolio performance.

For the investment team, this is more significant, with remuneration based on contribution to the total portfolio. This can be demonstrated in a number of ways, Arndt says.

“For example, if you said your sector is overpriced, or if you lent staff to a project or were challenging views, that is regarded well,” he says.

So the new investment team structure hasn’t changed decision-making. But what has changed since the fund was created, according to Arndt, is “the external world”.

During the financial crisis the most important decisions were beta, or asset-allocation decisions. The fund had money it had to invest, having received $60 billion from the government.

“We had a lot of cash, and our conversations were debates about whether to buy this or that risk, and then have the sector heads implement and choose managers,” he says. “Looking back to then it seemed easy. The world has evolved and assets are expensive; there is more competition for assets.”

Now that the portfolio is fully invested, holding cash is a choice. The investment programs are also more complicated and more nuanced in assets such as private debt.

According to Gilmore, the increased complexity and competition for assets means it is more important to have one portfolio.

“The portfolio is fully invested, so anything new needs a sale. The new structure makes that easier. For example, I’ll look at the portfolio risk level then go to Arndt to implement. The new structure just reflects the fact the jobs are more complicated.”

Gilmore says the fund is continually adapting its risk-assessment tools.

“At the beginning it was a focus on CVAR or tail losses; now we look at market exposure, liquidity, and refined metrics and factor exposures,” he says. “At the beginning it was easier, and a good environment for risk assessments. As time has gone by it is less clear, and growth is muted. The dispersion of scenarios has grown, there is more uncertainty and at the same time returns are lower.”

This environment of competition and complexity means investors are left with the choice to take more risk, or accept lower returns; the Future Fund is okay with this choice. One of its investment beliefs is that reward for risk varies through time. Being flexible allows for ideas to be implemented quickly and negative environments to have less impact on the portfolio, or to be turned into opportunistic investments.

Gilmore and his team are responsible for the macro economic view, and Arndt then looks at the portfolio in total and how to best implement that view. The main constraints for the fund are the volatility in the Australian dollar, some illiquid investments, and the risk tolerance.

At the moment, the Future Fund has nearly 20 per cent of its portfolio in cash. But the cash level is misleading as a mark of the portfolio risk, Gilmore says. Instead he describes the risk level as mildly below neutral.

In fact, the fund sees better value investments further up the risk curve.

Last year was a very active year for the portfolio, with a slow turnover up the risk level. The cash holding is used to adjust for total portfolio risk.

“At the higher risk end there is a better payoff and plenty of good things to buy,” Arndt says. “We had a big year last year with more than 50 transactions, and a net sale of $14.5 billion of assets. It was a very active year,” Arndt says. “Most assets are expensive. But we think higher risk assets are more attractive on a risk-adjusted basis.”

Arndt is excited about the “innovation cycle”. In particular, he talks about the energy space – fuel cells and solar – as areas of interest.

“There are lots of good ideas out there trying to disrupt the business model. We are always thinking about how we can be disrupted.”

Maintaining flexibility

A principle enshrined very early in the development of the investment program was the value of maintaining flexibility in order to capture opportunities presented by evolving market conditions.

How the fund continues to maintain that flexibility but have more processes, technology and staff in a more complex and integrated world is a constant conflict. For example, the fund now has more overlays and is more active in currency hedging and exposures.

“We are responding to market conditions. What we do now is more complex. Both Steve and I lead highly skilled teams, and we guide and oversee them. We talk together about the process, and implementation of ideas,” Arndt says. “The systems and approaches weren’t formed in the early stages. We are enhancing those to reflect a more complex world.

“We want to develop better processes and systems but guard against process-driven investments. We don’t want to get stuck on mandate definitions or risk budgets for the team.”

Gilmore says when the portfolio is fully invested, like it is now, and new opportunities arise, they need to be compared to each other, and the quant framework needs to support qualitative decisions.

“For example, in unlisted assets we need to look at listed or unlisted proxies, and the expected outperformance,” he says.

Instead, the team will remain small and nimble enough to always be able to focus on the question of “Does it make sense to the portfolio?”

The investment team now numbers around 50 to 55 and Arndt expects it to grow in response to the more complex environment. Ideas are screened early by the sector teams and strategy and risk team, and those ideas then go to the investment committee to debate. The team, under Arndt’s watchful eye, is very wary of becoming too complex, and is guarded on the point of being so complex that the portfolio is not fully understood. Keeping a sense of simplicity is guiding their decisions.

Working with managers

The Future Fund is already known for its relationships with fund managers, and it remains an area of focus for the next iteration of the way the internal team works.

“We want to enhance the way we work with managers,” Arndt says. “We use managers because we think prioritising our time for asset allocation is a better use of time than managing assets.”

The fund does not manage money directly [it can’t by law] but it is increasingly investing alongside its partners. “As the world is more competitive, capital providers need to get better and more nimble at reliably bringing capital to the best opportunities. We are now doing quite a lot of co-investments.” For example the fund now has around a dozen private equity co-investments, as well as co-investments in the debt portfolio.

“We have done a lot of regression analysis on our hedge fund managers to see their positions and exposures, and whether it is beta or skill. We have terminated managers where we don’t think they have been adding value; others have great conviction,” Arndt says. “The best managers like being challenged on ideas.”

The fund has an internal team of around 50 but employs 100 managers that employ tens of thousands of people, and the investment team considers those employees and their ideas to be an extension of the fund.

New systems

Neal says that focusing close attention on managers has added greatly to the fund, much of which is hard to quantify.

“The edge in the mandate is not selecting managers, but getting the best out of managers, the broader intellectual property out of them,” he says.

The benefit of such close relationships shows up in other ways, such as the ability to have flexible and evolving mandates with managers the team trusts. The credit exposures and some private market exposures are examples of this.

“Most of our private markets’ portfolio is unusual and is made of ideas in response to the market. Look at things in our portfolio that are really different; they’re not mandates we’ve tried to structure, like the joint venture with Dexus on industrial property,” Neal says.

He also sees this almost free and inventive approach to investments as intellectually stimulating to his staff. “For senior people this is important; we don’t box them in.”

What Neal is now interested in developing is knowledge management systems, to help process that. “How do we measure the additional knowledge we get and where does it pop up?” he says.

Neal says 10 years ago the focus was on the investment challenge, and building the business was a simultaneous activity. There was no opportunity to grow slowly.

“We were given $60 billion to manage and get on with it, it needed to be up and running, so we were trying to do both at the same time. We woke up one day and saw the systems and support structures creaking as we’d been so focused on investments.”

The risks that the Future Fund focuses on are investment, organisational and structural. The new investment structure allows Neal to spend time and resources on the latter two.

The fund has developed a data management platform – designed to be nimble and flexible – with analytics and external integration. At times, Neal says, it is a challenge to get the investment team to tap into that. “They need to think what they want and how it is delivered, and that takes time to think about. But the investment team is focused on, and motivated by, investment opportunities.”

So Neal has now hired someone with finance programing skills to take on that responsibility.

Knowledge management is another example of the new processes Neal is working on. “We need to do it, because the investment world is getting harder and more competitive and the less competitive investments are often smaller and more complex. Whichever way you look at it, it is more labour intensive.”

Asset allocation as at June 30, 2015

Australian equities                  6.8 %

Global equities

Developed markets                  17.6

Emerging markets                   9.4

Private equity                           10.8

Property                                     6.0

Infrastructure & timberland   7.5

Debt securities                          9.8

Alternative assets                    12.7

Cash                                           19.5