Trading is necessary to follow an active strategy, but excessive trading is linked to human behavior. In his new paper just published on SSRN Pim van Vliet looked into why investors trade and how much trading is needed for an effective low-volatility strategy. For potential low-volatility investors the question arises: is turnover a good or a bad thing? Read more about this new white paper.
Mercer’s extensive climate change report, launched today, gives investors a practical framework for monitoring and managing climate risk, shifting the discussion from philosophical agreement to practical investment implementation.
In Investing in a time of climate change Mercer outlines extensive dynamic investment modelling that analyses changes in the return expectations of assets between 2015 and 2050 driven by four climate change scenarios and four climate risk factors.
It looks at asset classes viewed through four risk factors that indicate the future implications of climate change: technology, resource availability, impact and policy.
Helga Birgden the recently appointed global business leader of Mercer’s responsible investment business, says the report gives investors a concrete, practical outcome for dealing with climate risk.
“It is critical as far as we are concerned, to have the tools and practical support to help asset owners,” she says.
Naturally, the report concludes that climate change will have an effect on investment returns so climate risks should be viewed as a new return variable. But the granular analysis of this year’s report shows the impact will be most meaningful at the industry level, giving investors clearer strategies on how to deal with the portfolio implications.
In particular average annual returns from the coal sub-sector could fall by anywhere between 18 and 74 per cent over the next 35 years, with the next 10 years seeing the biggest impact with average annual returns eroding between 26 and 138 per cent.
Conversely the renewables sub-sector could see average annual returns increase by between 6 and 54 per cent, or between 4 and 97 per cent over the next 10 years.
The impact on asset class levels depends on the climate scenario that unfolds. A 2 degree scenario would benefit emerging market equities, infrastructure, real estate, timber and agriculture. But a 4 degree scenario presents a different outcome for the same asset classes.
The report advises positioning investor portfolios to access the positive return assets, and minimising risk exposures to those where there will be negative impacts.
Mercer adopted a collaborative approach in developing the report, including input from 16 asset owners and asset managers, including CalSTRS, AP1, Cbus, New Zealand Super, and New York State Common Retirement Fund.
“As a long-term, intergenerational investor, we need to understand the investment risks and opportunities associated with climate change. This study will help us calibrate our investment strategies accordingly,” Adrian Orr, chief executive of New Zealand Super said in the report.
Mercer’s Birgden says the report discovered that investors need to look under the hood.
“The report found that the issue of climate change as a systemic risk is most prevalent at the asset sector level,” she says. “The report provides investors with a story to focus on. Climate is so large and complex it requires a clear focus on what to do.”
The report, which is a follow up to the 2011 study and the follow up paper, Through the Looking Glass, is a more granular analysis of the climate risks looking at sectors and subsectors and the potential asset allocation implications. It also looks in more depth at the physical impact of catastrophic events.
“This requires a change of behaviour as investors need a line of sight,” Birgden says. “It will mean governance change much closer engagement with managers, as well as a framework for the mainstream monitoring of these issues.”
“This is a story about sustainable growth and how asset owners can identify their footprint, reduce coal exposure, and invest in a transition to low carbon.”
The report was sponsored by the IFC World Bank Group and the UK Government.
The Norwegian Parliament’s finance committee recommendations to direct the Government Pension Fund Global to divest from companies that generate more than 30 per cent of their output or revenue from coal-related activities, is the evolution of a climate-related investment strategy that dates back to 2010. Amanda White explores the raft of tools the fund uses to execute its strategy to combat climate risk, including divestment, a tool it actively uses for other criteria as well.
Companies that generate more than 30 per cent of their output or revenue from coal-related activities is the latest criteria for investment exclusion by the 6.9 trillion Kroner ($894 billion) Government Pension Fund Global.
The fund has divested from 114 companies in the past three years, including 14 companies in the coal-mining sector in 2014.
Climate change is one of three themes that Norges Bank Investment Management (NBIM), which manages the pension fund assets, adopts in its responsible investment outlook (the other two are children’s rights and water management), and the fund has clear expectations of the companies it invests:
“We expect companies to analyse how the challenges of climate change will impact their operations and to develop plans and targets for managing climate risk. We have been assessing selected companies exposed to climate risk since 2010,” it states in its responsible investment report.
Torstein Tvedt Solberg, chair of the Storting’s Standing Committee on Finance and Economic Affairs which made the recommendations which will be voted in Parliament today, says there has been a gradual development of the tool-set to tackle climate risk, and divestment is a stronger tool to continue the climate work.
With regard to divestment, the Council on Ethics makes recommendations to Norges Bank on the exclusion of companies, while Norges Bank makes the implementation decisions. In addition to these ethically motivated exclusions, Norges Bank makes risk-based divestments within the scope of the mandate set by the Ministry.
“The Parliament has played a role in how to broaden the mandates and sectors involved in those guidelines which started with ethical human rights, then weapons including banning nuclear weapons and cluster bombs. In 2009 after a very thorough review of the guidelines, climate entered into the discussion,” Solberg says.
“This long term perspective is why the Labour Party wanted to divest from coal. We have been inspired by ongoing discussion of coal and divestment but it has been on our agenda for a long time,” he says. “This decision is both a target and political vehicle to help reach the 2 per cent target, and a climate risk investment strategy for the fund.”
Risk-based divestments have been a big part of the fund’s strategy, alongside its work on standard setting and ownership strategies including voting, interaction with companies and engagement with boards.
There is an argument that divestment does not have the desired effect of influencing the companies involved because ownership is simply transferred from one owner to another. This seemed to be true in the case of South African divestment, where a 1999 study found the extensive divestment campaign in response to apartheid, had little to no impact on the public market valuations of those companies.
However it could be argued divestment from coal producers is different, if forward looking investment projections on the coal industry are anything to go by.
In Mercer’s new report, Investing in a time of climate change, released today, it estimates that depending on the climate scenario that plays out, average annual returns from the coal sub-sector could fall by anywhere between 18 and 74 per cent over the next 35 years. Mercer estimates the effects will be more pronounced over the next 10 years, eroding between 26 and 138 per cent of average annual returns over that time period.
For NBIM, which invests in about 1.7 per cent of all the world’s listed equities, or about 9,000 companies, it is estimated that the new criteria will effect holdings in about 50-75 companies. And under the new criteria, the divestment will account for about 1 per cent of the fund’s total portfolio.
NBIM spokesperson Marthe Skaar was reluctant to discuss implementation of the divestment of these companies, as the new rules will not take effect before next year.
However she said: “in general we have high focus on implementing trades in a cost efficient way with limited market impact.”
“We do not know the value of the companies that will be affected by this ruling. Minister of Finance Siv Jensen has previously stated that, if there is reached an agreement on ‘a 30 per cent threshold, the number of companies in the funds benchmark index will be around 50-75 companies, with a market value of around 35-40 billion kroner’,” she said.
“Norges Bank Investment Management manages the Government Pension Fund Global on behalf of our formal owner the Ministry of Finance. NBIM operates according to a mandate that is agreed upon by the Parliament,” Skaar says, “and the Parliament has now looked into the question of divestment from coal.”
Active ownership
The fund also actively uses engagement to initiate change, and Labour MP, Solberg believes how the fund works with companies could be where the biggest change comes from.
“We invest in 9,000 different companies, so where to focus on engagement is often asked. Now climate risk a bigger focus in our engagement.”
Commenting on the fund’s first responsible investment report in 2014, Yngve Slyngstad, chief executive of Norges Bank Investment Management, says the fund held 2,641 meetings with companies in 2014, and raised environmental, social and governance issues at 623 – almost a quarter.
Environmental, social and governance issues are integrated into the investment process and based on these assessments, the fund chose to divest from 49 companies in 2014 where it was considered there was high levels of uncertainty about the sustainability of their business model. The fund has divested from 114 companies in the past three years.
As part of the focus on climate change, the fund looked at greenhouse gas emissions from companies in the portfolio.
It says that companies that rely on value chains with particularly high greenhouse gas emissions may be exposed to risk from regulatory or other changes, leading to a fall in demand.
“Companies that produce coal for electricity generation could, for example, encounter such challenges. We divested from 14 companies in the coal-mining sector in 2014, paying particular attention to how heavily these companies were exposed to the energy markets.”
In 2014, the fund also assessed the greenhouse gas emission intensity of companies in the equity portfolio and made adjustments to the portfolio, which contributed to a reduction of the fund’s overall emission intensity.
The calculations showed that overall emission intensity was lower than for the fund’s equity benchmark index.
“We performed 917 company assessments in 2014, of which 415 were related to climate change management, 269 to water management and 233 to children’s rights.”
The companies assessed accounted for 25 per cent of the equity portfolio’s market value at the end of the year.
Guidelines for observation and exclusion from the Government Pension Fund Global
Companies that generate more than 30 per cent of their output or revenue from coal-related activities is the latest criteria for investment exclusion by the Government Pension Fund Global. It is the ninth such criteria with the others outlined below.
The fund shall not be invested in companies which themselves or through entities they control:
- a) produce weapons that violate fundamental humanitarian principles through their normal use
- b) produce tobacco
- c) sell weapons or military materiel to states that are subject to investment restrictions on government bonds as described in the management mandate for the fund
Companies may be put under observation or be excluded if there is an unacceptable risk that the company contributes to or is responsible for:
- a) serious or systematic human rights violations, such as murder, torture, deprivation of liberty, forced labour and the worst forms of child labour
- b) serious violations of the rights of individuals in situations of war or conflict
- c) severe environmental damage
- d) gross corruption
- e) other particularly serious violations of fundamental ethical norms.
Former Governor of the US Federal Reserve, Ben Bernanke, says there are no foreseeable shocks to the financial system. In any case, he says, the system itself is so much more robust than it was before the crisis, that it could weather the storm. The only possible cause for concern is geopolitical risk.
Risk taking is a necessary part of the creation of new products and industries, and as long as there is risk-taking there will be various types of upset, says former US Federal Reserve chairman, Ben Bernanke.
The trick is, he says, is it so make sure that the system is sufficiently strong that if there is upset the system remains stable.
“Sub-prime mortgages were a very small asset class, but the reason the effect was so bad was because the system was so fragile and vulnerable, it was not sufficiently resilient,” he says, adding the policy decisions that followed the crisis, such as increasing bank capital, was aimed at increasing resilience.
“The garden variety crises can be tackled by fiscal and monetary tools if the financial system is robust,” he says.
“The financial system is more stable now and oversight is better. There is not much to indicate there’s major risk to the system. Growth is slow but the system is still growing and recovering. The one thing I’d put aside is geopolitical risks – which are the biggest risks. But wherever risk comes from the system is stronger so the chance of it de-stabilising is lower.”
Geopolitical specialist, professor of history at Princeton University, Stephen Kotkin, says geopolitical risk, which is ubiquitous, is always triggered unexpectedly, then developments seem utterly obvious post-facto.
“Climate events or cyberattacks might seem the most obvious, but geopolitical risk is fundamentally about incompetence and mismanagement by statesmen. Russia’s pariah status, combined with its formidable spoiler state capabilities, poses one such grand opportunity for mutual miscalculation. China’s continuing advance inside the US-dominated international system poses another. In both instances it can be developments concerning small states – the Baltics or Taiwan – that set off the big catastrophes,” he says.
“We might soon learn about the question of China’s resiliency – or lack thereof – in the aftermath of a crash, which would touch all aspects of the international financial system. The unresolved impossibility of the European Union continuing in its current form may be the least of our worries.”
Bernanke who was a contemporary of Kotkin’s at Princeton, holding various faculty roles from 1985 until 2005, including as the Class of 1926 Professor of Economics and Public Affairs, and the chair of the economics department, says China needs to transition to an economy driven by domestic demand.
He says slowing economic growth in China is inevitable and desirable.
“China can’t grow on the export-heavy industry and construction of the past. It needs to liberalise and the necessary transition means inevitable lower growth.”
But he also sees risks including Chinese banks “expanded credit”, and some “not very good loans”, which could create problems for the system.
Bernanke, who was speaking at the World Business Forum, said that he was “glad to say there is considerable evidence that the economy is in recovery.”
Unemployment in the US peaked at 10 per cent and is now 5.4 per cent and falling.
“Consumers in the US are in good shape. Confidence is back to normal levels, they have paid down debt and are getting their balance sheets in good shape. Consumers are more optimistic than they have been for some time. There has been a period of growth, people feel better and it’s self-fulfilling.”
While Bernanke defends the policy choices, and quantitative easing, he admits it would have been preferable to have both fiscal and monetary tools in action.
“I want to be very clear, it would have been much better if we had a better monetary and fiscal mix so we could have had recovery with high interest rates. But generally fiscal policy in the US is very contractionary so the Fed had to support the recovery and fight off the headwinds of fiscal contractions.”
But the last word is with Kotkin.
“We cannot predict the future, of course, but we can be sure that the world as we know it will not last. It never has.”
Stephen Koktin, whose recent book Stalin, vol. 1: Paradoxes of Power was a finalist for the Pulitzer Prize in biography or autobiography, will speak on geopolitical risks at the Fiduciary Investors Symposium, Chicago Booth School of Business from October 18-20.
There is still value in infrastructure, according to ADIA’s head of infrastructure, John McCarthy, provided you adopt a flexible approach. The huge sovereign wealth fund is reviewing its strategy, including whether it currently has appropriate benchmarks in infrastructure, a question that has been prompted by its outperformance.
The natural competitive advantage that the Abu Dhabi Investment Authority (ADIA) held when it first started investing in infrastructure in 2007 – namely a direct investor with huge amounts of capital – is no longer as relevant. The infrastructure allocation at ADIA currently sits at 2 per cent of total assets.
ADIA’s infrastructure portfolio has performed very well, partly due to timing and the exploitation of opportunities after the GFC and the deployment of capital at lower prices. But John McCarthy head of infrastructure in the real estate and infrastructure department of the Abu Dhabi Investment Authority (ADIA) says that 2007 position of strength has altered.
“The competitors are significantly broader and can write significant cheques of $1 billion-plus. The points of difference in size don’t exist today and we are forced to constantly modify/adjust the strategy to try and play to competitive strengths,” he says.
The continued entrance of large investors, such as Japan’s GPIF, into the market exacerbates the problem in infrastructure – that there is a vast amount of capital chasing limited number of opportunities, McCarthy says.
“Although the limited number of opportunities is somewhat artificially created by your investment strategy,” he adds.
“There’s a time frame for those entities to complete their review (three years) and execute, but they’re slow. The slower they are the better. With any luck we’ll see a different interest rate environment, but if it doesn’t change and then they allocate to real assets, there will be a significant impact, it might be a good time to be selling,” he says.
At the moment, however, McCarthy still sees value in the infrastructure market.
“It is tough and competitive but good returns are still available for an investment strategy that’s flexible. By flexible I mean the ability to invest in emerging markets and developed markets, higher risk infrastructure and core, through funds or direct, and listed and unlisted. Flexibility is an advantage,” he says.
In infrastructure ADIA’s core focus is on assets with strong market leading positions and relatively stable cash flows, including utilities such as water, gas and electricity distribution and transmission companies as well as transport infrastructure such as toll roads, ports, airports and freight roads.
The primary strategy is to acquire minority equity stakes alongside proven partners, mostly in developed markets but with an increasing focus on emerging markets. It does not seek to control or operate the infrastructure in which it invests or owns.
McCarthy still sees that one of ADIA’s competitive advantages is the fact it has a 75-year view for when the capital is needed, so the time horizon is a benefit. This also means that it does not invest for the sake of income, but is a total return investor.
The flexibility of its approach, the fact that fees don’t drive choices and a relatively agnostic view on vehicles gives the team some freedom. Benchmarks are also an “after thought” with investment decisions being driven by bottom-up analysis on the risk and return profile.
“There are benchmarks we use to measure the portfolio but they are more of an afterthought. It comes down to if it’s a good deal. We do bottom up analysis, and come to a view of the risk of the deal, the returns available and then compare it to alternatives. We then come to a view as to the sustainability and deliverability of that return and only at the end do we look at whether it’s outperforming the benchmark.”
The portfolio has substantially outperformed the benchmark, he adds, but that the benchmark is being reviewed as part of the investment strategy review.
“We are reviewing the investment strategy as I speak, and reviewing the benchmarks as part of that. Because we have outperformed the benchmark the question is: is it the right benchmark?”
He says the infrastructure team tends to look at outperformance relative to fixed income and apply some measure of inflation to the country it is investing in.
“But it comes down to bottom up analysis on a risk/return basis. It is more of an art than a science in illiquid investments.”
The team reviews every asset on a semi-annual basis with a view to whether it continues to hold it or whether it should sell.
“We are more likely to conclude that we made the right decision but there have been six instances where we sold assets,” he says.
There are also incidences where the time horizon of the investment might be different to a partner.
“That comes down to considerations on shareholder agreements and forces us to consider the strategy and do we want to exit or create a new exit,” he says. “So we’re in a constant state of reviewing the robustness of the investment decisions we’ve taken and I think that’s important and a good discipline to have.”
Infrastructure investing at ADIA started as a direct investing strategy, but McCarthy says he is personally agnostic to whether it invests via funds, co-investments, partnerships, or joint venture.
“I’m agnostic as we are driven by performance. Having said that we are direct because we have a skilled team to do that. The team and portfolio has evolved and is continuing to evolve,” he says. The team currently consists of 16 but will increase to around 20 or 25 people. The real estate team is 100.
This sits well with what McCarthy sees as an imminent increase in direct investment as a generation of funds raised in 2005-07 are entering points of exiting.
“We will probably see direct investments as more relevant in those assets and the profile of ownership change for quite some period of time. The shift in the ownership profile between now and 2018 will be quite dramatic I think.”
While he sees fees as a tax, or a point of leakage, they are not a reason for not investing.
“My advice is to just factor it in, negotiate the best you can. But it is not a reason not to invest or not to use fund managers,” he says.
“The market has sustained quite high fees in real estate, private equity and infrastructure for a long time. The question why private equity can charge a high fee without a benchmark that the performance fee is being calculated on, doesn’t make real sense, and the market hasn’t been able to shift it.”
John McCarthy was speaking at the Frontier Advisors Conference, “Depth and Breadth: the challenge of investing”.
The asset allocation for ADIA is:
Developed equities 32-42 %
Emerging market equities 10-20%
Small cap equities 1-5%
Government bonds 10-20%
Credit 5-10%
Alternative 5-10%
Private equity 2-8%
Infrastructure 1-5%
Cash 0-10%
Japan’s Government Pension Investment Fund, the largest pension fund in the world, has established a set of investment principles that focus on its ability to take advantage of its long-term investment horizon and the fund’s ability to make pension payments.
The ¥137 trillion ($1.1 trillion) fund is working to long time horizons, with a fiscal plan drawn up such that the reserve assets of the GPIF will be used to fund benefits and achieve fiscal equilibrium within about 100 years. According to financial projections it will be about 25 years before reserve assets will start to decline.
These long time horizons are seen as an advantage, and while the principles acknowledge market prices may fluctuate in the short term, the fund aims to achieve more stable and efficient returns by taking full advantage of its long time horizon.
The fund’s overarching goal is to achieve the investment returns required for the public pension system, with minimal risks, solely for the benefit of pension recipients from a long-term perspective, thereby contributing to the stability of the system. A failure to achieve the investment returns required for the pension system is believed to be the fund’s biggest risk.
When investing for the long term GPIF believes it is better to set and maintain the policy mix over a long period, rather than frequently changing asset allocation to short term movements.
Diversification is the fund’s primary investment strategy, and it believes in both passive and active implementation.
The GPIF approved a new asset allocation in October last year, which will have the impact of moving around 30 per cent of assets from domestic bonds and short term assets, appointing four new equities managers.
The target for domestic bonds shift from 60 to 35 per cent, domestic equities increase from 12 to 25 per cent, international bonds increase from 11 to 15 per cent and international equities shift from 12 to 25 per cent. The allocation to short-term assets will be reduced from 5 to 0 per cent, with short-term assets incorporated into the other four asset classes.
The fourth principle centres around stewardship and is aimed at increasing medium to long term investment returns by promoting enterprise value enhancements and sustainable growth is appropriate for the features of the pension reserve.
As with all investment principles, these will guide the strategy and implementation of the fund.
The fours investment principles:
- Our overarching goal should be to achieve the investment returns required for the public pension system with minimal risks, solely for the benefit of pension recipients from a long-term perspective, thereby contributing to the stability of the system.
- Our primary investment strategy should be diversification Our primary investment strategy should be diversification by asset class, region, and timeframe. While acknowledging fluctuations of market prices in the short term, we shall achieve investment returns in a more stable and efficient manner by taking full advantage of our long-term investment horizon. At the same time we shall secure sufficient liquidity to pay pension benefits
- We formulate the policy asset mix and manage and control risks at the levels of the overall asset portfolio, each asset class, and each investment manager. We employ both passive and active investments to attain benchmark returns set for each asset class, while seeking untapped profitable investment opportunities.
- By fulfilling our stewardship responsibilities, we shall continue to maximize medium- to long-term equity investment returns for the benefit of pension recipients.