The interaction between governance, culture and performance is increasingly a topic around asset owner board tables. But little has been written about the relationship between culture and the financial crisis, and how to change culture in financial services organisations. Andrew Lo, professor of finance at MIT, has come up with a proposal to change culture by drawing on traditional risk management protocols used at major financial institutions.

 

Roger Urwin, head of content at Towers Watson has been integral to advancing the conversation on culture at asset owner organisations, advocating that an organisation’s culture lies at the heart of its ability to improve governance. And governance has a direct relationship with performance.

“Culture is the fuel to how organisations are powered: culture is hugely important,” he told delegates at the Fiduciary Investors Symposium at Oxford University in April.

He argues that culture is specific to individual organisations, ruling out any single best practice, although he says culture together with leadership are the two conduits to good governance.

Organisations need to nurture and encourage culture even once it is established, he warns. “Left to its own devices culture declines overtime. It regresses and people don’t understand this.”

He suggests organisations actively manage culture so that it is vibrant and established enough to withstand buffeting from the immediacy of business.

He also believes that incentives are the prerequisites for governance change within an organisation.

“Incentives have a profound impact on how institutions function. People respond to incentives, yet incentives in the investment industry are strange at times, acting perversely. There is work to do be done here.”

Like Urwin, Andrew Lo, professor of finance at MIT, is interested in the culture of financial services firms, its contribution to the financial crisis and specifically how it can be measured and managed.

He believes culture has received scant attention in the context of financial risk management and proposes that culture can be changed and managed via “behavioural risk management”.

Culture can be a choice, not a fixed constraint, he says, and that through the emerging discipline of behavioural risk management can be measured and managed.

In an article prepared for the Federal Reserve Bank of New York’s Financial Advisory Roundtable last year, Lo wrote a paper, revised last month, presenting a specific framework for analysing culture in the context of financial practices and institutions.

He applies his framework to five specific situations – Long Term Capital Management, AIG Financial Products, Lehman Brothers and Repo 105, Societe Generale’s rouge trader, and the SEC and the Madoff Ponzi scheme.

Through these case studies he outlines how corporate culture is clearly a relevant factor in “financial failure, error and malfeasance”, citing examples such as Lehman Brothers, which spent more time concealing the flaws in its balance sheet than it spent remedying them. And AIG which felt so secure in its practice of risk management that it allowed billions of dollars of toxic assets to appear on its balance sheet.

In this article, Lo looks at the advice of psychologist Philip Zimbardo who offers 10 key behaviours that will help minimise the effectiveness of destructive culture in spreading its values, including willingness to admit mistakes, refusal to respect unjust authority, the ability to consider the future rather than the immediate present, the individual values of honesty, responsibility and the independence of thought.

“Human behaviour is clearly a factor in virtually every type of corporate malfeasance, hence it is only prudent to take steps to manage those behaviours most likely to harm the business franchise. One this semantic leap has been made, it is remarkable how quickly more practical implications follow. By drawing on traditional risk management protocols used at all major financial institutions, we can develop a parallel process for managing behavioural risk,” Lo says in his paper.

He says the alignment of corporate values and mission with behaviour can be facilitated in a number of ways once behaviours, objectives and value systems are specified.

While economic incentives are the standard approach favoured by the private sector, there are other tools available to the behavioural risk manager, including changes in corporate governance, the use of social networks and peer review and public recognition or embarrassment.

“A more extreme measure to change risk-taking culture of an organisation is to make all employees who are compensated above some threshold, eg $1 million, jointly and severally liable for all lawsuits against the firm. Such a measure would greatly increase the scrutiny that such highly compensated individuals would place on their firm’s activities, reducing the chance of misbehaviour.”

Robert Eccles has been trying to change the nature of corporate reporting for more than 20 years. He has been an advocate for supplementing financials with information on non-financial factors that are leading indicators of financial results – such as product development, customer satisfaction and the development of intangible assets.

The premise is those companies that do so, perform better.

Eccles is the Professor of Management Practice at Harvard Business School, the founding chairman of the Sustainability Accounting Standards Board and is a member of the steering committee of the International Integrated Reporting Council.

Now, he is also chairman of Arabesque Partners, the first funds management firm to combine a unique quantitative approach and the values of the United Nations Global Compact, the PRI and the Accounting and Auditing Organisation for Islamic Financial Institutions, together with balance sheet and business activity screening.

“I’d never seen an ESG quant fund before. These guys are really cool,” he says. “As a professor I’ve been saying all that – and now I can practice what I preach.”

Eccles was taken by Arabesque, and its chief executive Omar Selim, and thought the combination of a “hard core quants” with ESG guys was a nice sound bite.

“The connotations of ESG is they’re nice people, they have good values, they care about others. The quant implies they’re really smart. Arabesque – it’s nice and smart. It’s an incredibly sophisticated quant model where financial and non-financial information is given proper weights.”

Corporate reporting that includes non-financial information is a no-brainer for Eccles, who alongside Harvard colleague George Serafeim has been leading the charge on corporate sustainability and the value implications on performance.

The pair have studied the relationship between investors and companies that engage in sustainable, or integrated reporting, and in a recent paper Serafeim says that firms that report more information about the different forms of capital or follow more closely the guiding principles as described in the Integrated Reporting Framework exhibit a more long-term oriented investor base.

Eccles says that if investors take one thing from the integrated reporting movement it’s about materiality, a subject he goes into detail in his new book: The Integrated Reporting Movement: Meaning, Momentum, Motives and Materiality.

“A fact is either material and so it should be reported, or it is not material, in which case it does not need to be reported,” he says. “It is management’s and the board’s responsibility to ascertain what information it’s reasonable investors would want to know. In the end materiality is determined by the company itself and is entity specific.

“When the board of a company is very clear in its communication of what is material and what is not, and which audiences it feels are significant, investors gain relevant guidance on how the board judges importance and its ability to exercise this judgement. Investors are looking for this guidance.”

In this context he says, if all a company thinks about is the short term, then ESG is not important.

The international integrated reporting framework, on the other hand, seeks to improve the quality of information available to providers of financial capital to enable a more efficient and productive allocation of that capital.

Its focus on value creation, and the ‘capitals’ used by the business to create value over time, contributes towards a more financially stable global economy.

Christian Strenger, Professor and Academic Director at the Center for Corporate Governance, at the HHL Leipzig Graduate School of Management, who is a board member of the International Integrated Reporting Council, says while the annual report remains the most important information source for investors, the reports in their present form do not provide a sufficiently true and fair picture of the company.

He says this is due to the intensive weight that factors like ESG, brand values, customer and employee loyalty, market position (concept of capitals) that increasingly impact the long-term viability of the business models: for example, ‘intangible assets’ account for more than 80 per cent of the S&P500s market value.

“Integrated reporting is a chance for companies to tell their story – it’s the interface between a company and the market. Companies can explain how they are creating value and investors can have access to what the companies think is important. Let’s take a step back and forget labels, whether it is Impact Investing, SRI, or ESG and agree on the material issues,” Eccles says.

“The investment world is now recognising that superior returns can be earned by investing in companies that are performing well on material sustainability factors,” Eccles says.

“This is at the core of Arabesque’s investment strategy. Here is an asset manager that combines advanced ESG analysis with a quantitative investment approach to drive better performance. The results are highly impressive.

“We need companies to do integrated reporting, and investors need to screen and reward companies for good performance, which is what Arabeseque does,” he says.

“I’m 64, I’ve been opining on this for a long time, this opportunity came along and it’s a great opportunity to put this into practice.”

Established in 2013 after a management buy-out from Barclays, Arabesque fuses traditional investment techniques with an analysis of environmental, social and governance issues.

Chief executive, Omar Selim, says Eccles’ arrival underlines the firm’s focus on research and sustainability as key drivers to generate value for investors, shareholders and the capital markets more broadly.

“ESG information as a critical factor in the investment process is fast becoming a mega-trend across financial markets. With Bob´s background as a mathematician, an expert on sustainability and reporting and an academic from Harvard and MIT, he unites the three key building blocks of Arabesque’s partnership.”

 

For more reading:

Integrated reporting and investor clientele

The impact of corporate sustainability on organisational processes and performance

Corporate and integrated reporting – a functional perspective

 

 

Investors and academics agree that political developments in Greece are important because they may shape how financial markets will respond to future political situations in the Eurozone. But according to Olivier Rousseau, the executive director of the FFR, the French pension reserve fund, there is more hype outside of the Eurozone on the implications of a Grexit than from within it and analysts are undervaluing profit prospects of European companies. Amanda White reports on the views of a number of investors including FFR, PGGM and APG, on the impact of the European crisis on their portfolios.

 

Investors, and academics, are calm about the implications of the potential financial Greek tragedy on long-term returns.

Specialist in geopolitical risk, Stephen Kotkin, who is Professor of History at Princeton University says the Greece/Euro crisis has been so long in the making, unfolding right in front of everyone, that “one would think institutional investors would have taken prudent measures by now. We shall soon learn if that is the case.”

Indeed it seems Kotkin is right. Institutional investors have been keeping a close eye on the situation and have been allocating accordingly.

PGGM, for example, set up a special financial crisis team which monitors this crisis closely and issues daily reports to its pension fund clients. Its biggest client, PFZW, has very little direct exposure in Greece – about €50 million, or 0.03 per cent of its assets – and Greek sovereign bonds were sold years ago.

Similarly the €428 billion Dutch investor APG has a very limited exposure to Greece – also about 2 to 3 basis points of the total portfolio. APG’s position is that the fate of these investments depended too much on a binary outcome. It prefers to position the portfolio for capital preservation and as a long term investor it doesn’t like to speculate, so Greek bank holdings were sold some time ago.

An APG spokesperson said: “Our investments currently move with the sentiment in the market, among others as a result of the Greek unrest, although volatility is less than expected by many beforehand. We do not expect this unrest to impact the long term prospects of our investment portfolio.”

Similarly the French sovereign wealth fund, the FFR, has 40 per cent of its equities allocation in the euro zone, and its exposure to Greece is very small.

The FFR doesn’t take many tactical bets – choosing to act only when there is a very strong view on an asset class – but took a tactical position a few months ago and reduced the allocation to the Eurozone through selling futures.

Executive director, Olivier Rousseau, says the fund bought back in a few days ago, and is now sitting at slightly above its normal Eurozone asset allocation.

“We think most of the Greek worries have been priced in,” he says.

But Rousseau says there is an Anglo-Saxon view of Europe that is not accurate for those within the Eurozone, and in his opinion as a consequence analysts are undervaluing European equities, which presents an opportunity for investors.

“Eurozone companies derive very substantial shares of their profits from elsewhere, for example large French companies have 50 per cent of their profits from outside the Eurozone,” he says. “The euro crisis is massively overplayed and the implications for long term investors is not as much as some paint it to be. Outside of the Eurozone there is more hype of the implications of a Grexit than from within it. A Grexit would first and foremost be a tragedy for the Greek people and a very worrying geopolitical situation.”

Rousseau who has held several senior jobs in the French Treasury as well as positions at BNP Paribas, and was previously the alternate director for France on the board of the European Bank for Reconstruction and Development, says there is a bias against the Eurozone and within Europe there is a significantly different view.

“I perceive that among many Anglo Saxon analysts the Euro is a monstruosity of the European continent. A capital sin that has to be punished by the gods of the financial order,” he says.

“But there is so much willingness from within the Euro zone to keep it.”

Rousseau says the recovery seems to be on track and that profits reported by companies will surprise on the upside.

“Analysts are behind the curve on the profit forecast at the moment we think,” he says.

 

Contagion

Perhaps the less than expected volatility within European equities, at least compared with China, is a reflection of Rousseau’s view that the market has priced in the Greek worries.

Toby Nangle, head of asset allocation at Columbia Threadneedle Investments agrees that markets have not moved as much as perhaps expected by some.

“We are surprised that the moves have been so modest and continue to believe that market participants are optimistic in their assessment as to the possibility of a favourable resolution of Greece’s travails,” he says.

Princeton’s Kotkin also says that the direct economic consequences given the scale of Greece and of the global economy should be relatively small, even in a worst case scenario.

“But of course, this will be all about psychology, and therefore one cannot say whether the impact will be contained or colossal,” Kotkin says. “Whatever happens in Greece, the bigger worry could be China’s rickety financial system.”

Nevertheless there is concern that there may be some contagion in Europe, not the least of which is due to the behavioural finance aspects of politics and sentiment, with Columbia Threadneedle’s Nangle acknowledging it is a challenge to understand the prospective channels for contagion.

“Financial market contagion typically spreads when assets that are understood to be risk-free turn out not to be so. For example, when currency pegs previously understood as invulnerable break, when AAA-rated securities are revealed as worthless, when risk-free government debt becomes risky, when systemically-important banks with involvement across the financial system fail,” he says.

“Greek assets are not widely held across the private sector following the efforts in 2011 by European states to transfer privately-held Greek debt into publicly-held Greek debt. In bailing out private sector bondholders in 2011, the original Greek bail-out largely severed the traditional channels of contagion. Those channels of contagion that persist are political, and sentiment-based. Both are harder to analyse.”

Similarly FFR’s Rousseau, says the issue is not direct exposure to Greece but the consequences that the situation will have on the broad market.

“We are reasonably confident no cataclysm will happen especially for sovereign debt. Contagion is limited so far and should remain so even in the case of a Grexit,” he says.

Rousseau also has confidence in the European Central Bank to put a cap on the widening of spreads should it need to.

“We are very confident the ECB is in control,” he says.

This is also the view of some asset managers including Darren Williams, senior economist for Europe at AllianceBernstein who says the ECB’s tolerance for rising bond yields is likely to be limited. And it has the tools to prevent contagion from spiralling out of control.

But the International Trade Union Confederation, which represents 176 million workers in 162 countries, has called on the creditor institutions  – the International Monetary Fund, the European Central Bank, and European Commission – to unblock support for the Greek banking system, carry out disbursements on previously agreed loans and engage in serious negotiations with the government for reducing Greece’s unsustainable debt burden.

The general secretary of the ITUC , Sharan Burrow, says the institutions must end their demands for further cuts in pensions and public services and continued destruction of labour market institutions in return for payments on loans they already approved. Instead, they should support a pro-growth investment and jobs program in Greece.

“The IMF’s debt sustainability analysis published last Thursday reiterates what many organisations both in Greece and elsewhere have been saying for years, which is that Greece requires substantial debt relief if the economy is to have any chance of making a sustainable recovery.”

New research by EDHEC-Risk Institute questions the usefulness of analysing geographic equities exposures based on the stock’s place of listing, incorporation or headquarters. Head of applied research, Felix Goltz, suggests that in a globalised marketplace, a more meaningful analysis of geographic risk exposures, and performance attribution, comes from looking at geographic segmentation data including total sales disaggregated into sales from different geographies. This type of reporting allows investors to take account of the real geographic risks of their portfolios, whether in constructing strategic or tactical allocations.

In index construction and portfolio construction, stocks are typically assigned to a country or region based on their place of listing, incorporation or headquarters. But in the context of a globalised marketplace in which a company’s operations are usually not restricted to any single country or region, this practice is questionable, and its usefulness in risk reporting and performance attribution is limited.

In addition, now that accounting standards have made firm-level data on business activity across regions widely available, one might ask whether such data can be used for more meaningful geographic exposure reporting of equity portfolios.

To date, research on the use of geographic segmentation data has primarily focused on improving forecasts of a company’s earnings. In our research, supported by CACEIS as part of EDHEC-Risk Institute’s research chair on “New Frontiers in Risk Assessment and Performance Reporting” we analyse the usefulness of a company’s reported geographic segmentation data – or total sales disaggregated into sales from different geographies – in performance reporting and performance attribution.

Firstly, we analyse the application of geographic segmentation data in reporting the geographic exposure (proportion of sales coming from different geographies) of equity portfolios.

We report geographic exposure for five developed market indices (S&P 500, STOXX Europe 600, FTSE Developed Asia Pacific, FTSE 100 and STOXX Europe 50) for four regions (Africa & Middle East, Americas, Asia & Pacific and Europe) and for emerging and developed markets.

Secondly, we analyse the application of geographic segmentation data in performance attribution, where we attribute the yearly performance of the developed market index to the performance of portfolios which have varied levels of exposure to emerging markets or local markets (official market).

Here, we consider only three broad market indices (S&P 500, STOXX Europe 600 & FTSE Developed Asia Pacific) and not narrow indices such as the FTSE 100 and STOXX Europe 50, since sorting stocks based on varied levels of geographic exposure leads to portfolios with few stocks, which can lead to less meaningful results.

We also analyse performance attribution for indices in different market conditions, with performance attribution depending on: the difference in returns of emerging and developed market equity; and the difference in returns of local and foreign market equity.

 

Data and methodology

We report the geographic exposure of the index constituents at the end of June every year over 10 years (2004 to 2013). For the index constituents as of June t, we consider sales for fiscal year t-1 in order to avoid a look-ahead bias.

The source of geographic segmentation data is DataStream (Worldscope), supplemented by Bloomberg, which provides geographic breakdown of sales as reported by companies.

We report the geographic exposure of indices to four regions (Americas, Europe, Middle East & Africa and Asia & Pacific) as well as to developed and emerging markets.

To determine countries that constitute the above mentioned four regions, we rely on the United Nations Statistics Division (UNSD), which groups individual countries (economies) into sub-regions, further aggregated into geographic regions (continents).

UNSD does not have any standard methodology to classify countries into developed and emerging markets, so the classification of countries into developed or emerging is based on ERI Scientific Beta’s methodology. In effect, the countries in the United Nations’ list that are not categorised by ERI Scientific Beta have been grouped into the emerging market category.

 

Mapping reported geographic sales to individual countries

If a company reports sales per country, it is fairly simple to assign it to one of the four regions and to either the developed or emerging category.

However, companies can also report sales from sub-regions (such as North America and South America), regions (for example, the Americas), special economic or political groupings (like the European Union) or a mix of these (for example Brazil and North America).

In such cases, to achieve our objective, which is to report sales of index constituents from the four regions mentioned and from developed and emerging markets, we follow a two-step process.

First, we disaggregate sales for each reported geographic segment into country-level sales. The proportion of sales assigned to a country within a region is the same as the weight of the country’s gross domestic product (GDP) in the total GDP of the geography.

Second, we aggregate country-level sales back to sales from four regions and from developed and emerging markets. In what follows, we summarise the results of the application of segmentation data for reporting the geographic risk exposure and performance attribution of equity portfolios.

 

Application to performance and risk reporting

We examine the exposure of the developed market indices to four regions and to developed and emerging markets. The exposure is examined for the beginning (FY-2003) and end (FY-2012) of our 10-year sample period.

In terms of the regional exposure of developed market indices, all the indices have significant exposure to non-domestic regions in FY-2003. For example, the exposure of the S&P 500 to regions other than the Americas is 19 per cent. The exposure of the STOXX Europe 50 to non-domestic regions (regions other than Europe) is highest at 44 per cent.

Over a period of 10 years, the exposure of these indices to non-domestic regions has increased further. For example, the exposure of the S&P 500 to regions other than the Americas has increased by 8 per cent in a period of 10 years to 27 per cent in FY-2013.

To provide another perspective on the importance of the growing foreign market exposure of developed market indices, we find that for indices such as the S&P 500 and STOXX Europe 600, the sum of market capitalisations of the index constituents (or the cap-weight of the index constituents) weighted by percentage of sales from foreign markets was $2,852 billion (or 29.96 per cent in relative terms) and $2,469 billion (or 41.07 per cent), respectively, in June 2004, which rose to $5,638 billion (38.75 per cent) and $4,683 billion (53.28 per cent), respectively, in June 2013.

We therefore see a clear trend of foreign geographic exposure representing an increasing share of popular regional indices, while the extent to which companies focus clearly on the official region of the index in terms of geographic exposure has correspondingly decreased.

We also look at the emerging and developed market exposure of the five developed market indices. All the developed market indices had noticeable exposure to emerging markets in FY-2003, with the S&P 500 and STOXX Europe 600 having the lowest (6.97 per cent) and highest (10.67 per cent) exposures respectively.

Interestingly, the emerging market exposure of all the developed market indices has almost (or more than) doubled in the 10-year sample period. For example, the emerging market exposure of the STOXX Europe 600 has increased from 10.67 per cent in FY-2003 to 22.69 per cent in FY-2013.

We also find that for popular indices such as the S&P 500, FTSE 100 and STOXX Europe 50, the sum of market capitalisations of the index constituents (or the cap-weight of the index constituents) weighted by percentage of sales from emerging markets was $868 billion (or 9.12 per cent in relative terms), $202 billion (or 11.39 per cent) and $355 billion (12.48 per cent), respectively, in June 2004, which rose to $2,391 billion (16.44 per cent), $542 billion (24.63 per cent) and $1,070 billion (28.11 per cent), respectively, in June 2013.

These figures also highlight the rise in the emerging market exposure of developed market indices.

These figures tell us that the developed market indices have significant and increasing exposure to non-domestic regions and to emerging markets, which underlines the need to report the geographic risk exposure of equity portfolios in terms of geographic segmentation data and not just to rely on simplistic labelling of indices based on stocks’ places of listing or incorporation.

 

Application to performance attribution

We analyse the contribution of stocks with varied emerging and local markets exposure to the performance of developed market indices.

Here we focus on performance attribution conditioned on two different market conditions: performance attribution depending on the spread in returns of emerging and developed market equity and performance attribution depending on the spread in returns of local and emerging market equity.

To emphasise the core idea, we examine performance attribution during a bull market, or when the return on emerging market (or local market) equity is higher than the return on developed market (or foreign market) equity.

In terms of return contributions to developed market indices of stocks with varying emerging market exposure, we note that during bull markets, that is when the emerging market performed better than the developed market, the stocks with high exposure to the emerging market contributed more to the performance of the index compared to the contribution of stocks with low exposure to the emerging market.

For example, during bull markets, the contribution of high-emerging-market-exposure stocks to the performance of the STOXX Europe 600 is 7.83 per cent compared to the contribution of low-emerging-market-exposure stocks (5.47 per cent).

In terms of return contributions to developed market indices of stocks with varying local (official regions) and foreign market exposure, we note that during bull markets, or when local markets performed better than foreign markets, the stocks with high exposure to local markets contributed more to the performance of the index compared to the contribution of stocks with low exposure to local markets.

For example, during bull markets, the contribution of high local market exposure stocks to the performance of FTSE Developed Asia Pacific is 7.53 per cent compared to the contribution of low local market exposure stocks (4.40 per cent).

Overall, these figures suggest that when emerging markets fare better than developed market equity, the stocks with higher exposure to emerging markets contribute more to the performance of indices than stocks with lower exposure to emerging markets.

Likewise, we find that when local markets fare better than foreign market equity, the stocks with higher exposure to local markets contribute more to the performance of indices than stocks with lower exposure to local markets.

As we measure the exposure of stocks in terms of proportion of sales from emerging or local markets, this again underlines the usefulness of using geographic segmentation data in analysing the performance of equity portfolios.

 

Conclusion

In recent research, we analyse the usefulness of geographic segmentation data in reporting the geographic risk exposure and performance attribution of equity portfolios. We find that the indices that are labelled as representing developed market equity have significant and increasing exposure to emerging markets.

More globally, we observe that the economic exposure measured by sales in the domestic region that corresponds to the official definition of the index’s universe has been tending to fall sharply compared to exposure to non-domestic regions.

These economic exposures ultimately have an influence on variations in the performance of the index. As such, we find that the contribution to the performance of developed market indices of stocks with varied geographic exposure (either emerging market or local market exposure) differs noticeably.

These findings highlight the usefulness of geographic segmentation data in risk reporting and performance attribution of equity portfolios.

This reporting will also allow investors to take account of the real geographic risks of their portfolios, whether in constructing strategic or tactical allocations.

It would be a shame if asset allocators compromised their asset allocation policy, which is often based on macro-economic scenarios that use regional dimensions, through poor evaluation of the geographic reality of their portfolio or benchmark.

 

A pension fund that has 10 times more assets under management has on average 7.67 basis points lower annual investment costs according to a working paper from authors at De Nederlansche Bank, that explores the relationship between pension fund size and investment costs.

Written by Dirk Broeders, Arco van Oord and David Rijsbergen the paper finds that these economies of scale are solely driven by management costs.

Using a unique dataset of 225 Dutch occupational pension funds with a total of €928 billion of assets under management, the authors provide a comprehensive analysis of the relation between investment costs and pension fund size.

The dataset is free from self-reporting biases and decomposes investment costs for six asset classes in management costs and performance fees.

The key finding of the paper is that a pension fund that has 10 times more assets under management, has on average 7.67 basis points lower annual investment costs.

Moreover, the effect disappears when asset allocation is not controlled for, indicating that larger pension funds invest relatively more in asset classes with higher investment costs.

Economies of scale do, however, differ per asset class.

“We find significant economies of scale in fixed income, equity and commodity portfolios, but not in real estate investments, private equity and hedge funds,” the authors say. “We also find that large pension funds pay significantly higher performance fees for equity, private equity and hedge fund investments.

“We find that performance fees significantly impact investment costs for equities, private equity and hedge funds. For these asset classes, we find that a tenfold increase in size raises performance fees by 0.74, 41.49 and 33.36 basis points respectively.”

The paper looks at the decomposition of investment costs into management costs and performance fees for six separate asset classes: equity, fixed income, real estate, commodities, private equity and hedge funds.

 

To access the full paper click below

Scale economies in pension fund investments – a dissection of investment costs across asset classes 

Fiona Reynolds, managing director at the Principles for Responsible Investment (PRI) discusses why it’s in everyone’s interests for more investor voices to be heard between now and November before the world’s nations converge at COP21 in Paris.

 

The announcement that the G7 leading industrial nations have agreed to cut greenhouse gases by phasing out the use of fossil fuels by 2100 has been welcomed by climate campaigners and policymakers as an historic move.

In a 17-page communique issued after the summit under the slogan Think Ahead, Act Together, the leaders also agreed to back IPCC recommendations, to reduce global greenhouse gas emissions at the upper end of a range of 40 to 70 per cent by 2050, using 2010 as the baseline.

The G7 also announced that they were committed to raising $100 billion in annual climate financing by 2020 from public and private sources.

While announcement of the goals to cut carbon emissions and be carbon free by 2100 is non-binding, for long term institutional investors it is a signal among many that climate and carbon risks can’t be ignored.

Institutional investors must not let the 85-year window for eliminating fossil fuels blind us to the fact that action is needed now.

As Christiana Figueres, executive secretary of the United Nations Framework Convention on Climate Change, noted at last year’s PRI in Person in Montreal, we cannot let Paris become another Copenhagen.

If we lose this year’s opportunity at COP 21 to get an agreement on climate change, we may never get another one.

We also need to be mindful that the commitment of these seven industrialised nations isn’t the only thing that needs to happen in order to prevent a temperature increase past 2°C and the volatile effects of climate change that the scenarios forecast will come with it.

Combined, the United States, France, Canada, Germany, Japan, and Great Britain emit roughly the same amount of carbon per year as China does, according to data from the World Bank.

That’s why, regardless of the G7’s commitment, efforts to slow then stabilise emissions growth in in China and India — another major emitter — will be essential to transitioning to a low carbon world.

An historic agreement reached last year between China and the US to cooperate on emission reduction was another development in bringing a closer alignment between the world’s two biggest polluters President Obama pledged to cut US greenhouse gas emissions 26-28 per cent below 2005 levels by 2025 while President Xi announced targets to peak carbon dioxide emissions around 2030—with the intention to peak sooner—and to increase China’s non-fossil fuel share of energy to around 20 percent by 2030.

Policymakers are feeling increased pressure to act on climate change.

Financial regulators have begun to think through the potential impact of stranded assets. Finance ministers are being questioned over the extensive cost of fossil fuel subsidies following IMF reports that pre-tax consumer and produce subsidies totalled $541 billion in 2013.

And economic studies continue to point to the transformational opportunities offered by carbon and other environmental taxes that price negative externalities.

Several sovereign wealth funds are becoming increasingly sensitive not just to the financial risks posed by exposure to fossil fuel investments, but also to the potential behind offered by increased exposure to clean energy, clean technology and seeking sustainability innovations up and down supply chains.

Slowly but increasingly central bankers, finance ministers, regulators and some long-term investors are beginning to understand that incorporating measures designed to tackle climate change into their thinking is a core part of their collective responsibility to ensure a stable and robust global financial system.

But more still needs to be done.

Investor voices must be louder in supporting basic reform measures like carbon pricing and in challenging the political and corporate roadblocks still in place.

Governments and policy makers must be both urged and then actively supported in putting in place the new global frameworks and resisting the intense lobby efforts in support of the status quo.

Recently, the PRI, in collaboration with the IIGCC, Asia Investors Group on Climate Change, Investor Group on Climate Change and Investor Network on Climate Risk coordinated correspondence to G7 finance ministers, calling on them to support:

  1. A long-term global emissions reduction goal in the Paris agreement;
  2. The submission of short to medium-term national emissions pledges and country level action plans.

The letter was signed by more than 100 asset owners and investment managers including CalPERS, CalSTRS, Calvert Investments, AustralianSuper, Boston Common Asset Management, Harvard Management Company, the University of California, Robeco, and the Wellcome Trust and LAPF to name a few.

PRI will continue working with international climate groups to put pressure on policymakers to take decisive action on climate in the run-up to COP 21 in Paris.

As set out in our guidance paper The case for investor engagement in policy investors have a key role to play to commit, construct, clarify, collaborate and communicate on key policy issues.

It’s in all our interests for more investor voices to be heard between now and November before the world’s nations converge at COP21 in Paris.

 

 

Martin Skancke, chair of PRI advisory council and chair of the expert group on investments in coal and petroleum companies, appointed by the Norwegian Ministry of Finance will be among the panellists talking about climate change and institutional investors at the Fiduciary Investors Symposium at Chicago Booth School of Business from October 18-20.