The $2 trillion Australian superannuation industry continues to evolve, with the move to collective defined contribution the latest product innovation for pension funds. While the industry is largely defined contribution, it hasn’t been good at providing retirement income products. Now, a number of Australian funds that have had both defined benefit and defined contribution plan members, including UniSuper and Telstra Super, are looking to their Dutch and British contemporaries and introducing collective defined contribution. David Rowley reports.

Telstra Super is to explore the potential to create a collective defined contribution scheme as a way of avoiding sequencing risk for its members.

Chris Davies, chief executive of Telstra Super, says the A$17.5 billion fund has the scale to tailor its own pooled investment vehicle that would smooth investment outcomes.

He believes the fund may not have to rely on an external product provider to create the Comprehensive Income Product for Retirement as recommended in the Financial System Inquiry.

“We have got a dedicated product manager and our own in-house administration, so we can design systems,” said Davies. “Funds with scale can do that, or like other funds we may leverage off a third-party arrangement, whether it is Mercer Lifetime Plus or another.”

The only other Australian superannuation fund that has announced its intention to create a collective DC scheme is UniSuper – a project that its chair Chris Cuffe publicly mooted six years ago and for which a decision is expected this year.

Davies said that similar to UniSuper, Telstra Super had members who were used to the idea of pooled investment risk through Telstra’s defined benefit fund – which was closed to new members 15 years ago, but still has 5,400 active members.

“If you got the core competency around defined benefit and you have a core of members who have been through defined benefit then you have the culture, you have the ingredients to do something like a collective defined contribution arrangement.”

Davies is watching what other funds achieve in the space and the moves being made by the UK government to set up a legal and tax framework conducive to allowing collective defined contribution before proceeding.

He is also hoping that the Coalition Government’s long promised liberalisation of tax and legal restrictions on post-retirement product development will ease the way for CDC.

Davies says Telstra Super is committed to offering a sophisticated level of advice, communication and products for its members. To this effect, its submission to the Financial System Inquiry argued against the proposal for a narrow band of approved funds for accumulation on the grounds, that this would lead to a no-frills, low fee approach unlikely to offer the range of engagement and tailored outcomes that Telstra Super is trying to achieve for its members.

The two largest institutional investors in the Netherlands, PGGM and APG, have responded to the European Commission’s investment plan, urging the commission to call on institutional investors to collaborate on the investment proposal. However they also warn that institutional investors are not just a “subsidising entity” and the Juncker Plan is best executed as a partnership.

In a paper entitled “We need to talk”, director of group strategy and policy at APG, Tjerk Kroes, and chief investment management of PGGM, Eloy Lindeijer, are dubious about the relationship between government and investors in the past, saying that whenever governments see the need for large investments they tend to look at large institutional investors to supply the funds.

While this is only natural, they say: “…institutional investors have not been created to fill the gaps in government budgets they are here for a reason of their own.”

“In the case of APG and PGGM, our mandate is to invest pension savings in the best interest of our clients’ pension plans. Consequently APG and PGGM can participate in the Juncker Plan, ie invest in Europe, if and only if the actual risk-return profiles of the investment projects are at least as attractive as the best alternatives.”

The funds’ both currently invest around 50 per cent of their assets in Europe.

“In other words,” the authors say, “we do not feel entitled to take on the role of a subsidising entity, liberally supplying funds that have been entrusted to us by our clients’ participants.”

However they say that there may be scope for cooperation between the Commission and institutional investors, in particular on getting the “framework right”.

“Institutional investors have extensive market knowledge, concerning for instance securitisation and infrastructure investments. They also have extensive market experience, for instance where investment project selection is concerned, or investment structuring or project monitoring. We feel that not only the general regulatory framework, but also the actual set up of the Juncker Plan could benefit from market insights. In short, the actual execution of the Juncker Plan should ideally be organised as a partnership between the public and private sector.”

Commenting on the endorsement of the Juncker Plan and the European Commission’s green paper on the capital markets union, the investors say the measure of success for the capital markets union will be the extent to which it can raise actual investment in the real economy.

Eduard van Geldren, chief investment officer of APG, echoed these comments, calling for the European Commission to seek deeper private sector investment in its plans.

Broadly, he says, APG welcomes the ambition of broad and far-reaching policy objectives.

The European Commission’s investment plan emphasises environmentally-sustainable projects, expansion of renewable energy and resource efficiency.

This is aligned with APG which is actively seeking to invest in solutions for sustainable development issues and the fund has made a commitment to double renewable investments from 2014 to 2017.

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

 

Ang says that his ambition is to see factor investing implemented across the industry more generally and oversee how funds managers can organise themselves and the management of assets to meet investor needs.

Already a few  investors, such as the Canadian Pension Plan Investment Board, the Singapore GIC, Norway’s sovereign wealth fund, and Japan’s GPIF, take a total portfolio view using factor investing. But Ang says there are missing tools in the industry to enable this to be more widespread, and part of his job will be to develop those platforms.

“It is obvious the benefits of organising a top down approach and treating liquid and illiquid investments in the same framework: more intelligent diversification and you can rebalance the factor exposures. It is more efficient to organise a portfolio that way and it is theoretically correct,” he says.

But re-orienting a portfolio along factor lines takes time, requires consultation and technology tools.

“The pulpit I have for factor evangelism at Blackrock is far wider than my reach as an academic,” he says, commenting on Blackrock’s scale, talent access and ability to innovate.

“It’s a huge opportunity to help transform how assets are managed,” he says.

Basically he sees smart beta and factor investing as versions of the same thing, with the main difference in the delivery.

“There are some differences in sophistication, whether you use leverage, shorting, and how you put it together in portfolio construction via weighting or security selection,” he says. “Smart beta is often a delivery vehicle, usually long-only, concentrating on different weighting schemes, factor investing is far broader.”

Choosing which factors, or vehicles, investors use is a very specific investor question, Ang says.

“Academia has discovered hundreds of factors. Pick only a few, understand they will have losses at some point, and implement them in a way appropriate for your fund where you can stay the course. Play to your comparative advantages on your ability to trade, whether you are best at making low versus high frequency decisions, and how skilful you are in dynamically constructing portfolios.”

In addition to being an ambassador for factor investing and a conduit for the industry at large Ang will be involved internally at Blackrock in the development of factor funds, re-organising the manager along factor lines and the development of a technology platform to help investors allocate to different factors.

While as managing director and head of the factor-based strategies group, Ang will report day-to-day to the global head of multi-asset strategies, Ken Kroner, he sees his role as much larger than just developing smart beta products for Blackrock.

“I will lead the design of accessible, scalable and cheap factor funds across asset classes and geographies and develop technology to help investors allocate optimally to those factors, and hopefully, eventually, see the whole portfolio through factors.”

It’s the technology that Ang is particularly passionate about, viewing it as a missing tool which will allow investors to facilitate factor implementation. While he sees Blackrock has having a competitive advantage in the development of such a platform, because of its risk analysis tools, he says there is a missing link in the ability to use forward-looking tools.

“Investors have good tools to see the factor risks in the portfolio they currently hold. They also want a tool that looks at what factors they ought to have, a forward-looking tool and I want to help them meet that gap,” he says.

In an age where driver-less cars are being invented he says finance is often behind when it comes to technology.

“You can go online and interact with websites and see the immediate results of our choices. But there is no tool today where you can allocate towards different factors and see the consequence of those decisions on the whole range of liquid and illiquid assets in an interactive, geographically-driven package,” he says.

He says investors don’t think of illiquid investments as bundles of factors but they are and should be considered in the overall portfolio as such. Private equity is not an asset class, he says, it is a bundle of stocks and bonds.

Factor investing is a better way to construct a portfolio, he says, all the way from the top-down portfolio to the benchmarks you give your active managers.

“This is transformative, that is one of the reasons I joined Blackrock. We can touch thousands of investors,” he says.

Ultimately, he says if investors outsource investment management they want to have funds managers spend most of the time on activities that add value. Factor investing hones the activity of a manager to decisions of compensated risk that consistently deliver higher returns, he says.

“In the long run primary benefit of factor investing is higher risk adjusted returns.”

Ang, who is the Ann F. Kaplan Professor of Business, at Columbia Business School, has been at Columbia for 15 years and was chair of the finance and economics division. As a professor he has had extensive experience consulting and advising large institutional investors, most regularly with the Norwegian sovereign wealth fund, but he’s had limited commercial experience working full-time for a commercial institution.

“I’m very proud of the work I’ve done at Columbia and the research I’ve done,” he says.

Ang’s approach to harvesting factor risk premiums is outlined in his recent book, Asset Management: A Systematic Approach to Factor Investing.

 

 

Andrew Ang will speak on factor investing at the Fiduciary Investors Symposium, Chicago Booth School of Business from October 18-20.

It is called the “CalPERS’ Effect” but it could easily be called the asset owner effect, or the institutional investor effect, or the power of engagement effect.

Wilshire, which is a consultant to the $300 billion Californian fund CalPERS, has provided an update on its study measuring the effect of engagement on a targeted list of companies called the Focus List.

The study puts a tangible measurement on the power of improving stock returns by institutional investor engagement.

“The evidence is… clear that many corporate assets are poorly managed and that resources spent on identifying and rectifying those cases can create substantial opportunity and premium returns for active shareholders,” the report says.

Many institutional investors engage with companies on issues ranging from to basic governance structures and decision making to complex environmental impacts and supply chain problems.

Norges Bank Investment Management for example, which manages the assets of the 6.9 trillion Kroner ($894 billion) Norwegian Government Pension Fund Global, held 2,641 meetings with companies in 2014, and raised environmental, social and governance issues at 623 of those.

The giant Dutch pension fund manager PGGM engaged in dialogue with 510 companies last year, and says it got results from those with 21 related to the environment, 32 related to social factors, and 80 related to corporate governance.

But there are few studies that tangibly measure the impact of engagement in the same way that the Wilshire study demonstrates. The study looks directly at the financial performance of the stocks on the focus list and the impact, on the stock returns, of the CalPERS’ engagement.

Wilshire the fund’s consultant published a report on the CalPERS Effect for some years but a recent update shows that CalPERS’ good governance campaign has added value to the share prices of targeted companies.

It measures the impact of engagement on 188 companies over the time period of 1999 to 2013, by examining stock returns before and after the “initiative” event. The number of companies on the list in any one year ranges from four to 11.

The report acknowledges it is difficult to isolate the contribution of CalPERS engagement as the stock returns can be influenced by many factors. It deals with this by extending the measurement period to five years in the belief that any other announcement pertaining to the company will have less effect over a longer time period.

Wilshire compares the daily return of each engaged company to the Russell 1000 and to the appropriate sector index of the Russell 1000, and compounds the return differences through time.

The study does not account for rebalancing and assumes that there is an equal dollar investment in each company over time. However despite this, Wilshire believes the results of this study demonstrate CalPERS’ approach to improving portfolio returns by engaging management of poorly performing companies to rethink governance and strategy continues to work.

For the three years prior to the initiative date, the engaged companies have produced returns that averaged 38.91 per cent below the Russell 1000 index, and 36.13 per cent below the appropriate Russell 1000 sector index.

For the first five years after the initiative date, targeted companies collectively produced stock returns of 12.27 per cent above the Russell 1000 index and 8.90 per cent above the appropriate sector index on a cumulative basis.

Wilshire says the analysis shows the steady erosion in shareholder value by companies prior to being placed on CalPERS’ focus List. It also demonstrates the end of that erosion subsequent to CalPERS initial contact.

Within one year the 188 companies on the focus list outperformed by 1.61 per cent and by the fifth year the cumulative excess return was 12.27 per cent. That’s a big turn around.

Wilshire says that CalPERS’ approach to improving portfolio returns by engaging the management of poorly performing companies to rethink governance and strategy continues to work.

In a tribute to the strategy, Wilshire says: “most investment resources in the industry continue to be focused on identifying small misvaluations in publicly traded stocks. This is, perhaps, unfortunate since investors are not earning a satisfactory return on the manager fees and brokerage costs they pay, given the evidence showing that the public stock markets are fairly efficiently priced.

“However the evidence is equally clear, that many corporate assets are poorly managed and that resources spent on identifying and rectifying those cases can create substantial opportunity and premium returns for active shareholders.

“CalPERS has been active corporate governance investor for many years and the continued success of the engagement process is proof that good corporate governance can improve shareholder returns.”

Factor-investing has not yet won the right to be the endurable and dominating asset allocation method, according to new research, which shows that industry or sector-based allocation still has its merits. In particular the study shows that industry-based investing offers defensive opportunities as it delivers better risk-return trade-offs for long-only portfolios during recessions and bear periods.

In the paper, Factor-based versus industry-based asset allocation: The contest, Marie Briere and Ariane Szafarz, explore the two methods looking at performance including costs and robustness.

Conceding that “applied to equities, factor investing is probably the most serious contender to the classical sector-based approach to asset allocation”, the conduct “a contest” between the two styles that addresses two questions:

1) Are the excess returns of factor investing offset by higher risks, and if so, are factor-specific risks eliminable by means of factor diversification?

2) How does factor investing perform during crisis times?

In the study, the results show that factor investing is the best strategy when short sales are permitted. Most academic studies, the authors say, draw conclusions on portfolio management with unrestricted short selling, which is a considerable limitation, since benchmark restrictions and implementation costs make long-short factor investing difficult to implement in practice.

In addition transaction costs are neglected which they say presumably, plays in favour of factor investing compared to the more passive style of sector investing.

They also point out that transactions are especially numerous for rebalancing the two momentum factors, quoting a study by Robert Novy-Marx and Mihail Velikov that estimates that the momentum factor turns over around 25 per cent per year, which implies a monthly trading cost of almost 50 bps.

“Further work could investigate whether our results are robust to incorporating transaction costs. Factor investing is not only a transaction-intensive style, it also a good performer when short selling is permitted. But short sales imply additional expenses, such as borrowing costs. Accounting for all the costs could actually make passive strategies more competitive,” the authors say.

“The emergence of dedicated indices and funds has made factor investing more accessible to… investors. However, not all identified factors are investable in this way, and the available factor investment vehicles concentrate on long-only portfolios. Therefore, a major challenge for the advocates of factor investing is the practical implementation of the investment rules they recommend.

“Our study suggests that there is no overall winner, but we do find circumstantial evidence of superiority for each style. Factor investing is clearly the best strategy when short sales are permitted. It also outperforms sector-based allocation during expansion and bull periods. In contrast, sector investing offers defensive opportunities for asset managers since it delivers better risk-return trade-offs for long-only portfolios during recessions and bear periods.

“Factor investing keeps its promises, but it still has a long way to go before it can oust sector investing.”

Among academic classifications, and the subsequent implementation of factor investing, “quality” is one of the newer areas of investigation. Robert Novy-Marx, the Lori and Alan S. Zekelman Professor of Finance at the University of Rochester, is leading the charge on the academic justification of quality as a factor, although he has a “jaded scepticism” about the nomenclature.

“It’s a marketing term,” he says. But what he is certain about, however, is that quality exists as a phenomenon, and for value investors their portfolios are enhanced by including quality stocks alongside value stocks.

“Quality is interesting because it has the power of predicting price as well as valuations do, it’s another way of trading value,” he says. “Quality predicts about as well as valuations, and while the strategies are similar to value philosophically they are dissimilar to value in most other ways so they are attractive to value investors.”

Partly because quality as a measure is new, there are a lot of interpretations of how it should be defined, or what it means.

For Novy-Marx “profitability subsumes most of what’s going on in quality.”

“I don’t like quality as a term, it is better to take a profitability tilt directly,” he says.

Novy-Marx has done extensive investigation into the performance of six different quality measures including Benjamin Graham’s quality definition of low levels of debt, long history of paying dividends and earnings growth, Jeremy Grantham’s definition of high returns, stable returns and low leverage, and the defensive measure of low beta, low volatility and low leverage.

He finds that quality strategies are negatively correlated with traditional value and profitability is the only measure that has an outperformance.

“Profitability not explained by value, it has a strong tilt to growth,” he says.

“Highly profitable stocks are growth stocks that outperform, and growth stocks with high returns are even harder to explain.”

“Quality tilts to low beta, large cap and growth and controlling for profitability explains a lot. The real benefit to these strategies comes from getting rid of the big value tilt, you get lower tracking errors and lower drawdowns.”

Novy-Marx believes that profitability, as a measure of quality, is also a more direct way of accessing the risk/return trade-off that some investors have gained from a defensive, or low volatility tilt.

In this way he believes that low volatility portfolios are inefficient and instead advocates that investors access an unprofitable, small growth exclusion directly.

“Low volatility is not a bad way of excluding high volatility and will help the portfolio perform. But it is not best way to do it. Low volatility is not distinct from other factors,” he says.

“This is a high volatility anomaly, not low volatility. We are not talking about the outperformance of low volatility but the terrible performance of high volatility.”

Novy-Marx, who is a consultant to Dimensional Fund Advisors, says the small caps exposure explains more cross sectional volatility than any other factor.

There is a size tilt in low volatility, and a slight value tilt. But interestingly profitability also explains volatility, he says.

“Low profits and being small is the best predictor of high volatility,” he says. “Being more profitable means less volatility – this is a very stable relationship and good predictor.”

Novy-Marx compares a defensive or low volatility portfolio to value and profitability in the same size deciles and discovers there is not one alpha.

“You don’t gain anything from trading an additional defensive (low volatility) portfolio,” he says. “Value and profitability have big alphas, but defensive doesn’t once you control for the size you’re trading in. By avoiding high volatility then you are avoiding small growth stocks, which has been good timing because they dramatically underperformed. But you get clearer and more transactionally efficient transactions by looking at more persistent signals.”

Dimensional introduced profitability factors into portfolios from the beginning of last year, starting with its small cap portfolios and progressing to value and emerging market portfolios.

Novy-Marx is concerned that academics and investors are manipulating data, at their peril.

He says that the idea that multi-signal strategies can be evaluated as one signal is “fiction”.

“All signals must be evaluated separately. If they work well together but not individually it should be a big concern for you.”

“People are over fitting the data. Using the information of individual signals and looking backwards then putting it together completely changes it. The issues around data mining are scary.”

“Data mining is always an issue, but it’s much scarier with multi-signal strategies. This doesn’t mean you shouldn’t combine good strategies but you need to test and believe in each one individually.”