In what promises to be a transformational moment for ESG integration and investment manager accountability, CalPERS will require all of its managers to identify and articulate ESG in their investment processes.

CalPERS staff led by Anne Simpson, senior portfolio manager and director of global governance, presented the ESG manager expectations, and draft sustainable investment guidelines, to the investment committee this week.

The $307 billion fund will factor into its decisions about hiring and monitoring external investment managers the degree to which managers assess ESG factors and integrate them into their process.

“If for example a manager hasn’t addressed how to carry out an environmental impact, if that can be easily integrated, that will affect our decision,” Simpson says.

“This is going beyond asking are you a signatory to the PRI? It lifts the lid, as they have to report to us on this.”

In an exclusive interview with conexust1f.flywheelstaging.com, Simpson said that CalPERS considers managers that do not identify and manage these risks as having a “sub-par investment process”.

The purpose of the project, which has been two-years in the making, is to integrate ESG risk and opportunity considerations into the investment processes and decision making across the total fund at the same time CalPERS wishes to recognise the complexity and differences across asset class strategies.

It also fulfils fits in with the fund’s mandate of integrating its investment beliefs across all asset classes. One of CalPERS investment beliefs is that long-term value creation comes from management of financial capital, human capital, and physical capital.

“All of these have to be understood as part of value creation,” Simpson says. “If you’re investing in private equity and not paying attention to how the development might impact the community, then you’re ignoring the value drivers in the business, which are also the risks.”

As part of the planning process for the manager expectations, each asset class within CalPERS surveyed its existing managers to assess what was the norm with regard to ESG.

“In some cases they were already considering factors but they weren’t articulated to us in due diligence. In other cases managers were surprised that we were asking the questions.”

Simpson says that CalPERS considers ESG risks as material considerations to its total portfolio due to the characteristics of the fund.

One of CalPERS investment beliefs is that risk is multi-faceted and not fully captured through measures such as volatility or tracking error.

“Because of our size and the fact we are globally invested we believe it is part of the multi-faceted nature of the risks we face. At $307 billion we can’t hide if there is systemic risk,” Simpson says. “But we are not only huge in size, we are long term to the point of being virtually permanent.”

Simpson said the more that CalPERS can articulate its expectations the more the managers can use their skill and imagination to deploy implementation.

She said this is the start of a new phase of ESG integration and that managers had the chance to show their innovation.

“The industry needs to be asking a new set of questions. This is pioneering work, we are looking at what are the new questions we need to ask,” she says.

For external managers there will be a consistent set of questions about ESG integration when CalPERS is selecting and contracting managers, as well as monitoring and managing relationships.

Each asset class has developed the requirements for external managers, and it will be hard-wired into the contracting and managing process of funds managers.

“The manager requirement for ESG integration was not approached as a top-down, dictatorial idea, but was bottom-up and developed from staff in consultation with managers,” Simpson says. “It is very important we have done it from the bottom up, it’s in the plumbing of CalPERS.”

The draft sustainable investment guidelines framework considers CalPERS investment beliefs, the UN-backed Principles of Responsible Investment of which CalPERS was a founding signatory, and the Global Governance Principles, which states that CalPERS believes that ESG issues can affect the performance of investment portfolios.

While the fund has identified a set of relevant and material factors, each asset class has flexibility for integrating what’s appropriate. CalPERS invests in 47 different markets through many different strategies.

Integration considerations include internal versus externally management, active versus passive, security level versus the index, fundamental versus factor approach, nature of the assets and whether it is a legacy or strategic portfolio.

“There is a long list of potential factors, the question is how do you work out which factors are relevant, do you have the tools and data to assess that, and then whose job is it to implement. At what point through the lifecycle of the relationship do you raise these issues and when should they be managed?”

An example of this is the global equities portfolio which is largely internally managed and passive. This means the fund will not focus on deep security level analysis, rather the index and market-wide data is more important. To this end it has bought the MSCI intangible value platform, which it believes covers the broadest range of factors, and it has been loaded into the BarraOne risk system. This will be supplemented by integrating factor analysis at the sector and security level. In contrast, fixed income is actively managed and the fixed income team articulated the analytical process at the security level.

CalPERS will begin a one-year pilot of its ESG integration in June.

“We want to be intelligent as we proceed, and challenging our assumptions is very important. We have a very demanding fiduciary framework because people rely on us to pay pensions in retirement. By integrating ESG at scale we are at the frontier,” Simpson says.

The next phase of the project will be a communications plan to managers.

Large funds outperform small funds mostly mainly due to the cost savings of internal management. So when does internal management make economic sense for a fund? It’s at a much lower AUM than you might think.

CEM Benchmarking analysed a universe of 186 pension funds globally. That universe is split into four groupings: 77 funds with an average of £1 billion, 56 with an average of £10 billion, 30 with an average of £20 billion and 23 with an average of £50 billion.

The analysis of these various cohorts reveals a large difference in the costs, with the £1 billion funds total costs at 25 basis points more than funds with £50 billion in assets.  The difference – 69 basis points versus 44 basis points – is due to a large degree to the level of internal management.

John Simmonds, principal at CEM says that the difference between the investment costs of small and large funds goes straight to the bottom line return.  He puts the cost differences down to three factors .

“One third of the saving comes from having more internal management but paying less for external management and using less fund-of-funds are also important” he says.

“The larger you get the more money you can save using internal management and by going from fund of funds to limited partnerships or even direct deal making in private markets. The reason large funds typically outperform smaller funds is cost.”

In private equity, for example funds with £1 billion paid 384 basis points where funds with £50 billion paid 215 basis points. The difference is largely due to the type of vehicle, with 61 per cent of funds with £1 billion accessing private equity through fund of funds. Less than 8 per cent of funds with £50 billion use private equity fund of funds.

One of the implications of this is that small funds need to look at asset allocation and implementation techniques very differently to large funds.

“Small funds are often accessing private markets through expensive structures,” Simmonds says.

Small funds are copying large funds, but they don’t have the resources or scale to implement at a reasonable cost.  “Don’t copy the large funds unless you are sure you can invest cost effectively,” Simmonds says.

The data shows that on average, internal management beats external management due to cost, so the natural next question is ‘when does internal management make sense’?  Many funds have been grappling with this question.  Of course there are many considerations for managing money internally, but the economic rationale is one that funds should consider closely.

CEM suggests that internal management is justified economically at surprisingly low size thresholds.

“When does internal management make economic sense, it’s lower than we anticipated,” Simmonds says.

CEM looked at whether there was a rule of thumb, or criteria, for a minimum size for internal management.

On average, those funds that have internal management employ one front office full time employee (FTE) for every £0.5 billion in public equity.

“We worked on the hypothesis that, getting started, you would want at least three front office FTE to mitigate some of the key-man risks,” Simmonds says.

For every front office FTE, CEM’s data reveals that funds need a further two in the back office.  That makes a minimum of nine FTEs – three in the front office and six in the back office.

According to CEM, the global average all in cost, including all overheads, of each full time employee is £250,000. That equates to a total budget of approximately £2.25 million to get started.

“An average cost for active external management across all public equity asset classes is around 50 bps” explains Simmonds.  At £1 billion invested in public equity that equates to fees of £5 million.  Simmonds explains that the actual ‘crossover’ point, when it makes economic sense to build an internal team is therefore around £0.5 billion for public equities.  For fixed income the minimum size is closer to £1 billion.

“Of course, the fact that it makes economic sense at that point doesn’t mean that every fund of that size should do so.  There are a host of factors that need to be considered alongside cost,” Simmonds says. “At least we now know the starting point for having the conversation.”

 

 

Given annuitisation of retirement income is no longer compulsory in UK defined contribution funds, NEST has set out to uncover what best practice retirement income distribution looks like. The solution is a hybrid of flexibility and insurance – at low cost. Amanda White spoke to NEST chief investment officer, Mark Fawcett.

One of the newest defined contribution schemes to be set up globally, NEST was faced with a conundrum when the playing field changed dramatically in the UK and it was announced in the UK Budget of 2014 that annuities were no longer compulsory.

The fund reacted as it does with much of the business decisions it is faced with and consulted, with peers, regulators, employers, consumers, academics and its members.

A consultation paper, The future of retirement, aims to uncover best practice for investing for members in the new regulatory environment, stating the opportunity as a once in a lifetime chance to start with a blank piece of paper.

The fund sought to gather evidence to understand the design and retirement solutions that its members wanted and needed. One of the defining characteristics of the consultation and its conclusions is there is no longer a binary debate between annuities and drawdown, rather the solution looks at how both can be combined.

One of the important considerations for NEST is that the way it now manages its members money has been turned on its head.

Under the existing pensions and tax regime it assumed that most members of NEST would use 75 per cent of their retirement pot to buy an annuity and take the remaining 25 per cent as a tax-free cash lump sum.

“We’ve been investing the retirement pots of members approaching retirement in line with this assumption. For members who have recently joined the scheme and are close to their scheme pension age, we’ve assumed that they’ll take their relatively small retirement pots as cash. The changes announced in the 2014 Budget have caused us to reassess whether these assumptions are suitable in a new world of greater freedom and flexibility,” the report says.

Mark Fawcett, chief investment officer of NEST, says for many members flexibility in the early stages of retirement is key, as they will simply not know what their income needs will be.

“Given annuitisation is not compulsory, we asked ‘what’s best practice’?” he says. “In practice, in the early years, people need flexibility. Their needs are different to later in retirement, they might not have stopped work entirely so they might still be contributing, and their income needs differ.”

While in the early stages of retirement flexibility is desirable, as retirees get older they need less flexibility and longevity risk becomes the most important risk.

“In this context then it’s time to get protection,” Fawcett says.

The solution is a hybrid that is a blend of drawdown in the early years and insurance in the later years.

“It doesn’t have to be the same product, but how do you make what’s a complex product understandable and easy to use. The cognitive capacity of retirees diminishes through time, and providers shouldn’t be asking people to make complex annuity decisions at age 85.”

While NEST will publish a full consultation response later this year, Fawcett says it is reasonable that best practice for a defined contribution default would be a combination of existing products.

He believes it needs to be seamless so there are not many tough decisions along the way. A blend of drawdown in the early years and protection, with opt out options, later in life.

From an investment viewpoint Fawcett sees some growth allocation, but not as much as in the accumulation phase of the fund.

“Property is quite attractive for the drawdown phase and some equities. Sequencing risk is greater however, so the allocation would be more like 40 per cent growth,” he says.

“Volatility management is a regulated activity so pension schemes like NEST would have to outsource this.”

Fawcett says in the US some funds are partnering with insurance companies to provide deferred annuities that kick in at age 80 or 85, but in the UK the deferred annuity market is non-existent.

Importantly, whatever the final solution, Fawcett believes it should be good value and costs should be as low as possible.

“One advantage of this solution is the drawdown phase is at a similar cost to accumulation but with some additional risk management techniques.”

One of the challenges Fawcett sees in keeping costs low is to encourage insurance companies to compete on price, and again points to the US where a panel of providers is sometimes used.

“De-cumulation has been somewhat neglected,” Fawcett says, “but we’re looking closer and what can be best practice for our members.”

 

 

NEST’s six principles for designing retirement defaults for auto enrolment savers are:
1. Living longer than expected and running out of money is the key risk in retirement and a critical input into retirement income solutions
2. Savers should expect to spend most or all of their pension pots during their retirement
3. Income should be stable and sustainable
4. Managing investment risk is crucial as volatility can be especially harmful in income drawdown-type arrangements
5. Providers should look to offer flexibility and portability wherever possible
6. Inflation risk should be managed but not necessarily hedged

As equity trading becomes more fragmented, and more trading is done outside exchanges, it is prudent to assess whether alternative liquidity pools contribute to well-functioning markets. Norges Bank Investment Management has done the work for you, analysing the contributions, structures and functions of trading venues with limited pre-trade transparency. One of the benefits of liquidity pools, according to Norges, is they aid in limiting the rent extraction ability of intermediaries.

Non-exchange trading venues are characterised by limited pre-trade transparency about their intent to trade, but Norges argues they differ substantially in their organisation structures, their matching protocols and the way they are used. This means closer, more nuanced, analysis is necessary to assess their contribution to equity markets.

The paper, Sourcing liquidity in fragmented markets, argues that liquidity pools have several characteristics which have the potential to contribute to well-functioning markets

  1. They can efficiently facilitate block trading between institutional investors
  2. They can serve as competitive checks on exchange monopoly power
  3. They can be tailored to specific market participant requirements, and innovate rapidly.

Typically liquidity pools and their impact on market quality have been characterised by the pricing mechanism, the nature of the order flow and the type of counterparties in the pool. But Norges says it is more meaningful to classify them according to the stage of the investment process in which the venue is used, or in other words whether it is early or late in the investor’s execution plan.

The institutionalisation of investment management, and the advent of very large asset managers, has meant there are typically fewer but larger orders. In this context block crossing orders are increasingly attractive, according to Norges, with the benefit of minimising the rent extraction of intermediaries.

Sourcing liquidity from other venues requires ongoing qualitative and quantitative assessment, according to the paper, and means the investor has to direct the broker not only on trading strategy benchmarks but also on permissible venues.

“For example we do not believe that the liquidity from high frequency trading ping destinations is worth the information leakage costs.”

Norges actively uses block crossing venues as one of its preferred methods of execution, but also delegates execution to brokers and has a white list of permitted trading venues.

“We believe that skewing the broker’s objective function – through the imposition of price benchmarks, as well as through active limitations on the set of permitted execution venues – is a critical fiduciary duty of investment managers.”

It says that block crossing venues should have greater prominence and Norges is actively working on establishing and strengthening such venues.

One of the benefits of the market evolution is it keeps rent extraction in check, the paper argues.

“We view the emergence of liquidity pools as an example of such beneficial evolution. However, they in turn introduce novel avenues for rent extraction, primarily through insufficient transparency. Asset owners and managers need to show continued vigilance and a proactive research-based approach to analysing and adjusting potential excesses.”

 

To access the paper click here

 

Robeco will launch the world’s first multi-factor credit fund, after academic research by its quantitative research team reveals that size, low-risk, value and momentum factors have economically meaningful and statistically significant risk-adjusted returns in the corporate bond market. David Blitz, co-head of quantitative strategies at Robeco in Rotterdam, tells Amanda White why an active approach makes sense in credit.

Robeco, which manages €1.2 billion in equity factor portfolios and a total of €25 billion in quant equities strategies, has a history of being a first mover, with its low-volatility equities, low volatility credit and emerging market quant funds all first to market.

The manager has €3 billion in its low-volatility credit fund.

David Blitz, co-head of quantitative strategies at Robeco in Rotterdam, says all of the talk of factor portfolios is in equities, but research at Robeco has revealed the same factors apply to credit.

Robeco takes an evidence-based approach to investing, with its strategies and products firmly centred on academic evidence. In equities it believes that only value, momentum and low-volatility have enough robust evidence to be proven as investable factors. Others such as small-cap or quality are not yet proven, although Robeco is exploring the academic evidence in quality as a factor to add to the mix.

Its multi-factor equities fund is equally weighted among the factors.

Blitz says Robeco supports the work of Andrew Ang, professor of finance at Columbia University, who was one of the first academics to “say out loud” that active manager performance comes from factors.

“Instead of having factor exposures as a result of manager selection, investors should turn it around and choose the factor exposure first and then the manager,” Blitz says.

The credit factor research by Robeco’s Patrick Houweling and Jeroen van Zundert uses monthly constituent data of the Barclays US Corporate Investment Grade index and the Barclays US Corporate High Yield index from January 1994 to December 2013. In order to evaluate the factor portfolios they use the excess return of a corporate bond versus duration-matched Treasuries.

The research finds that factor portfolios in the corporate bond market earn a premium beyond the default premium and that these premiums are not a compensation for risk. It also shows that factor premiums are still present after accounting for transaction costs.

Blitz says a multi-factor credit fund is an extension of equities but acknowledged the Robeco fund was a “blue ocean strategy” because there no benchmarks and no products that have been launched in credit yet.

Blitz says that active factor managers should be measured against broad benchmarks but also compared to the factor benchmark, or what he calls the “cheap alternative”.

However he also cautions against blindly accepting indices, as he sees them as quite arbitrary.

“There is a research paper that shows if you rebalanced the RAFI in August not February of 2009 there would be a great difference in returns, and in fact there would be no outperformance in 2009. But the index rebalanced in February which meant a 10 per cent outperformance, it was lucky timing,” he says. “Investors have to be aware that indices have the same element of chance.”

“Our proposition is that indices are good but we also see their shortcomings, for example low volatility index valuation is on the high side, whereas momentum is weak if you buy the index. We are more selective.”

Blitz says it adopts a different approach with each client, depending on their starting point.

“The client’s beliefs are the starting point. For example in the Middle East they don’t like low volatility, in Netherlands low volatility is popular because of the liabilities.”

As the landscape for investment changes rapidly, so too does the notion of fiduciary duty. Fiona Reynolds, managing director of PRI, argues that using the status quo as a reason not to adapt to changing perceptions and new demands from investors is no longer possible or acceptable. The PRI will publish a fiduciary duty roadmap for long-term investment, in conjunction with the UNEP FI, UN Global Compact and UNEP Inquiry, this autumn.

 

Fiduciary duty was one of the recurring themes at the Fiduciary Investors Symposium held at Oxford University from April 19-21.

Fiduciary duty exists to protect the interests of beneficiaries. In the pensions fund world, one of its roles is to protect beneficiaries’ retirement funds from conflicts of interest with the trustees and asset managers who take care of the trust funds.

In today’s increasingly complex financial and economic world, the decision-making process by trustees has become ever more challenging. One of these challenges has been the increasing importance of evaluating so called “non-financial” considerations such as environmental, social and governance (ESG) factors, which has added another layer to the decision-making process.

Fiduciary duty is often given as the reason for why pension funds decline to look at ESG issues, with trustees declaring that their only responsibility is to look at financial data.

However, recent studies have broadened the interpretation of fiduciary duty away from the narrow confines of past definitions, and have emphasised that there is no conflict between fiduciary duty and ESG considerations, with a growing recognition, that ESG issues are in fact financially material to a portfolio.

If the economic downturn has taught us anything, it’s that merely looking at financial performance is insufficient to give a full picture of a company’s health. Financial performance does not tell us, for example, if a company is dumping toxic waste, mis-managing their tax exposure or dealing with supply chain risks—issues that can have enormous impact on both the company’s reputation and share price.

Ten years ago, the landmark UNEP FI (United Nations Environment Programme Finance Initiative) report, “The Integration of Environmental, Social and Governance Issues into Institutional Investment” was published.

The report concluded that ‘integrating ESG considerations so as to more reliably predict financial performance is clearly permissible and is–arguably required – in all jurisdictions.’

The freshfields report added that when exercising their powers, trustees must take into account all relevant considerations and ignore any irrelevant considerations.

This is the duty of adequate deliberation, and concerns the nature of trustees’ decision-making process rather than the scope of the power itself. There are no “hard and fast rules” as to what might be relevant. For example, it is fairly well settled that the tax consequences of a decision will usually be relevant.

The findings of the freshfields report were crystallised in a study released in 2014 by the UK Law Commission, which looked at how the law of fiduciary duties applies to investment intermediaries and to evaluate whether the law works in the interests of the ultimate beneficiaries.

Prior to the Law Commission report, the Kay Review of UK Equity Markets, published in July 2012, found that investment chains were too long, with growing numbers of intermediaries between an investor and the company in which they invest. Professor Kay argued that this led to increased costs, misaligned incentives and reduced trust.

According to Professor Kay, who also spoke at the Fiduciary Investors Symposium, the central problem was “short-termism”, in which many investment managers “traded” on the basis of short-term movements in share price rather than “investing” on the basis of the fundamental value of the company.

Furthermore, shareholders did little to control bad company decisions. To overcome the spectre of short-termism, Professor Kay recommended calling an end to quarterly company reporting, and the focus on short-term corporate performance.

Last year, The Financial Conduct Authority in the UK scrapped the rule requiring public firms to release interim management statements, as part of the Government’s push to encourage more long-term thinking in the stock markets.

 

Fiduciary duty and climate change

We know that climate change is one of the biggest issues facing investors in the coming years. Given that trustees are legally required to look at risks in their investment strategy and prudently manage those risks, climate considerations must be a part of this framework.

For example, if a trustee was to consider investing in an energy company, it is part of their fiduciary duty to consider the long-term risks associated with such an investment and focus attention on investments on companies, for example, that invest in renewable energy and are trying to achieve emissions efficiency.

When we think of pension funds, with their long investment horizons, there is also an obligation to manage risks and look at investments over the longer horizon. This means looking at all risks, including climate change.

Despite the outcry from those in the anti-climate change camp, climate change has now been recognised by myriad experts as a real and present danger.

According to the American Association for the Advancement of Science, “The scientific evidence is clear: global climate change caused by human activities is now and is a global threat to societies.” And in 2013, a new survey in the journal Environmental Research Letters of more than 12,000 peer-reviewed climate science papers, the most comprehensive survey of its kind, found that 97 per cent of scientists agree that global warming is manmade.

In Australia, a majority of surveys show that most Australian trustees now believe that addressing climate risk is part of their fiduciary duty.  (The Climate Institute and Australian Institute of Superannuation Trustees, Asset Owners Disclosure Project (Australia) Funds Survey Results, 2011). So like it or not, climate change and its concurrent risks are a reality as is the economic materiality of climate risk.

Not recognising the financial consequences of climate change is a clear breach of fiduciary duty.

Finally, trustees must recognise that the rapid growth of the pensions industry worldwide is leading to changing expectations regarding long-term sustainability and the way in which investments should be made. Using the status quo as a reason not to adapt to changing perceptions and new demands from investors is no longer possible or acceptable.

This autumn, PRI will be publishing a report, in conjunction with the UNEP FI, UN Global Compact and the UNEP inquiry, covering fiduciary duty across eight geographies—US, UK, Canada, Germany, South Africa, Brazil, Japan and Australia.

We hope that this report will serve as a global roadmap – or action plan – for long term investment including ESG integration across the financial services sector and help to finally eliminate the remaining barriers around ESG and fiduciary duty.