David Blitz discusses research to improve existing strategies and explains how he designs new ones. “Our mission is to make good strategies even better and to design the next generation.” Head of Equity Research David Blitz has been at the forefront of quant investing since 1995 and is responsible for coordinating all quantitative equity research. Some of the key tools he has helped to develop are proprietary stock selection models and portfolio-optimization algorithms. He has also published numerous papers in peer-reviewed academic journals. Read the interview.
For Myles Allen, Professor of Geosystem Science at Oxford University’s School of Geography and the Environment, and Head of the Climate Dynamics Group in the university’s Physics Department, the most important climate change investment institutional investors can make in coming years is in technology around Carbon Capture and Storage, CCS.
Speaking at the Fiduciary Investors Symposium in Rhodes House, Oxford University, Allen argues that, realistically, economies will continue to burn fossil fuels because “leaving fossil carbon in the ground is a financial sacrifice that won’t happen.” He reasons the only way to limit global warming to no more than two degrees, the de facto target for global climate policy, is to completely cut carbon emissions to zero over the second half of the century involving massive investment in CCS technology. “Getting emissions under control is the most crucial thing and a formidable financial challenge,” he says, adding to the gathered delegates: “You own the problem, your decisions determine where we go in terms of global climate.”
In progress that he describes as “glacial” Allen urges investors to start backing CCS investment before regulation devalues their fossil fuel assets. Successful climate policy will make carbon burial compulsory at some point in the next few decades he warns. The only institutions with the resources to get carbon burial technology deployed fast enough to prevent more than two degrees of warming is the extractive fossil fuel industry and this will have to be done by regulation. “The only safeguard you have is CCS. Everyone is waiting for someone else to pay for it but the technology is too expensive to leave to tax payer,” he says.
Although CCS technology is too risky for many institutions more investors are positioning their portfolios to respond to climate change. Leaders in the field include the UK’s Environment Agency Pension Fund and Sweden’s AP4. Strategies involve supporting change within corporations to alter corporate behaviour, diversifying and building flexibility into investment strategies and choosing ESG managers. Some funds have scaled back on UK equities because of the high exposure to stranded assets in listed mining companies, other funds have committed to new, low carbon world indices and are considering green bonds.
“Just start doing it,” urges fellow panellist Ulf Erlandsson, Senior portfolio manager credit, global macro trading, Fourth Swedish National Pension Fund, arguing that doing something is “a lot better than not doing anything at all.” 35% of AP4’s global equity allocation is now in a low carbon footprint strategy with the fund “taking most risk in companies that are progressive on climate change.” Explosive growth in the green bond market which has grown over the past three years from $3.1bn to $36.9bn makes this now part of AP4’s strategy too. “On the fixed income side we are looking at green bonds as a way to diversify our funding mix. Sustainability issues are at a much senior level in corporations now,” he says.
The biggest challenge when it comes to investing in mega greenfield infrastructure projects is cost overruns, explains Bent Flyvbjerg, First BT Professor and Chair of Major Programme Management at the University of Oxford’s BT Centre for Major Programme Management, speaking at the Fiduciary Investors Symposium at Oxford University’s Rhodes House. It’s not hard to find examples of projects that have gone awry he says, citing the Channel Tunnel, Denver International Airport, the Sydney Opera House and much Olympic infrastructure as just some of the “many” overruns.
In a guide for investors on how to best navigate the risk he advises careful assessment of projects according to the type of infrastructure. “Cost overruns vary between projects.”
He counsels on distinguishing between road and toll road projects, PPP and non PPP – though doesn’t think one is more prone to overruns than the other – and different regions. “Time is of the essence. With financing costs accruing but no revenue streams, investors fall into the debt trap which is a bad place to be.”
Flyvbjerg warns that most risk management models don’t take into account the unexpected disasters in infrastructure, so-called black swans. He also warns of the industry’s natural bias towards over confidence. Illustrating this over-optimism with a photograph of a kitten looking in a mirror and seeing a lion reflected back, he warns: “Even if you know the bias is there you are still subject to bias.” It manifests with underestimated costs, overestimated benefits and an overvalued development, resulting in a need to “de-bias.” Investors should add “100 per cent” to the cost of the project and develop in house excellence when they embark on mega infrastructure.
Fellow panellist Cressida Hogg, global head of infrastructure at the Canada Pension Plan Investment Board, manages a $14 billion infrastructure portfolio invested in around 13 assets that include riskier construction and greenfield projects in excess of $100 million. Investments are diversified across sectors including utilities and transport and regions especially Europe and Canada.
The fund mitigates risk by aligning investments with its own expertise and insisting on co-investment in greenfield projects. “We have to know our partners are confident about delivering projects on time and in budget – if not this destroys our equity,” she says.
Hogg believes governments need to do more to encourage investment in mega infrastructure. In what she calls the “elephant in the room” she argues governments need to address the subsidies they are prepared to offer on essential infrastructure projects because of the risks and uncertain revenue streams they hold. Construction risk around the UK’s Thames Tideway Tunnel, a mega sewer running under London taking sewerage out of the river Thames, includes flooding risk, a typical investor turnoff without government support.
“The government in the UK is asking investors to get involved a super sewer. It’s an essential project for London and the government needs to subsidize it.”
Discussions also centred on the lack of big infrastructure deals for investors and uncertainty around policy. Panellists agreed that demand on institutional investors to back mega infrastructure projects has grown with banks retreating from the market.
Alternative investments have become a valuable income stream and liability matching tool at UK pension fund Centrica says Chetan Ghosh, Chief investment Officer at the £6.7 billion pension fund. With current gilt yields making liability matching expensive, the fund has begun investing in alternative strategies that include solar panel installations benefiting from the government’s Feed-in-Tariff, new builds benefiting from ground rental income and social housing, explains Ghosh, speaking at the Fiduciary Investors Symposium at Oxford University’s Rhodes House.
“We are quite a young pension scheme, spun out of British Gas in 1997. It means we have no legacy of pensioners from the 1950s and 1960s and this allows us a long-term horizon. However the tensions we are trying to solve involve taking risk off the table, with a long-term ambition to meet our liabilities and the pension promises we made, but also wanting to invest to grow our asset base,” he says. The fund currently has around 7.5 per cent of assets in long-dated cash flow generating mandates, avoiding the need to buy gilts at very low yields.
Centrica eschews any fixed or static allocation to alternatives warning that an assets attractiveness – like rental income – can “change quickly” requiring a fleet-of-foot. Centrica funded its alternative purchases by selling some of its Gilt portfolio, but synthetically retaining a gilts exposure.
Its alternative allocation is characterised as long-dated and illiquid, inflation linked – although the fund is starting to look at assets that aren’t inflation linked – and with high levels of cash flow. Offering advice to other investors, Ghosh counsels patience as deploying money to alternative investments can take time, and the importance of having a manager “you can trust.” Scarcity of supply is another bugbear although he says “time is on our side to build up our allocation; we will be fussy.” Centrica’s alternatives program has also “thrown off a lot of cash flow” requiring a “continuous program of investment.”
Tomas Franzen, Chief Investment Strategist, at the Second Swedish National Pension Fund AP2 has sought out alternative investments in line with the fund’s risk management strategy to diversify.
“Our core business is compensation for taking on risk. But as we take on risk we also need to manage that, and the most important risk management tool is diversification,” he explains.
Although Franzen “isn’t trying to replicate hedge fund strategies” in his alternative portfolio, investment ideas have come from research of the hedge fund space and he admits it is a “cheaper way than investing in hedge funds.” Strategies include benefiting from currency carry or unexpectedly sharp currency depreciation, merger arbitrage, shorting volatility and insurance linked securities, he says.
Keith Ambachtsheer, Director Emeritus, Rotman International Centre for Pension Management argues that good governance begins with having “the right team in the room.”
This means robust human resource teams, the ability to address issues around understaffing and raising the effectiveness of board members.
“Board governance is still a work in progress today,” he argues, speaking at the Fiduciary Investors Symposium at Rhodes House, Oxford during a panel on governance in the investment industry. Ambachtsheer says good governance also improves returns.
“There is a return differential in favour of better governance,” he argues, linking strong governance to a strong impact on growth over time. “Those that spend that extra money produce higher returns.”
Fellow panellist Roger Urwin, Head of Content at Towers Watson believes an organization’s culture lies at the heart of its ability to improve governance.
“Culture is the fuel to how organizations are powered: culture is hugely important.” He argues that culture is specific to individual organizations, ruling out any “single best practice,” although he says culture together with leadership are the two conduits to good governance.
Organizations 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 organizations “actively manage” culture so that it is vibrant and established enough to withstand buffeting from the immediacy of business in what he calls “a balancing act.”
He also believes that incentives are the prerequisites for governance change within an organization. “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.”
Another block to good governance is the typical longevity that comes with long-established institutions.
These organizations are rarely buffeted by what Urwin calls “creative destruction” or “a burning platform.” He argues that although asset owners have capacity for taking on change, they rarely take “truly transformational” measures around governance.
Panellist Gordan Clark, professor and director of the Smith School of Enterprise and the Environment, Oxford University argues for “a revolution” in the governance and oversight of the contracts drawn up between owners outsourcing the management and investment of their assets.
Clark highlights the problems many smaller asset owners, lacking the resources to build up their own internal teams, face around outsourcing.
“Contracts for services are served up on take or leave basis with no right to negotiate a contract in a structure that privileges the supplier over the buyer,” he says.
Many smaller asset owners also lack the internal expertise to understand the contracts they have signed. Highlighting cases of external managers having a legal claim to the entire assets of fund if things go wrong, Clark wants governance to comprise “negotiating contracts, sharing pain and gain without leveraging the entire assets of the organization,” in what he calls a rewriting in favour of asset owners.
“This contract is the centre piece of the governance relationship,” he says.
He notes the trend amongst bigger organizations to bring asset management in-house because of the cost of outsourcing and the ability to oversee multiple relationships.
In an insourcing process he calls “replacing a service contract with an employment contract” Clark argues organizations have to apply their culture and values to their in-house investment teams.
Investment teams need to work to a central mission and follow “the purpose of the organization” with “integrity and sense of meaning.” He suggests investment teams have different employment contracts to other parts of an organization and warns against one function “being pitted against another”.
Speaking at the Fiduciary Investors Symposium at Oxford University’s Rhodes House Fiona Trafford-Walker, director of consulting at Frontier Advisors argues that Australian investors are operating in a changed environment and need to “get used to slower economic growth.”
Speaking as part of an expert panel on how the continued environment of slow growth and low interest rates will affect global institutional investors, and the best asset allocations to protect their portfolios, Trafford-Walker puts forward the Australian view.
She argues that Australian funds are entering a “brave new world” where returns will be much lower.
The slowdown in China has hit demand for key Australian resource exports with iron ore prices down 60 per cent from their recent highs. Australia’s funds face demographic challenges with a growing elderly population which will also hit GDP growth, she warns.
“By 2025 this demographic wave will cost 0.4 per cent of GDP.” Australia’s mining boom “hid structural problems in our economy which now needs to diversify and become more services led,” she says.
Strategies for Australian funds include reducing target returns and changing asset allocations, she suggests.
Funds could also take on more risk and pursue more active management strategies to “take them over the line.” She notes an appetite amongst funds to “creep up the risk curve to get returns” and a “huge amount of interest in infrastructure,” plus a continued appetite for equity investments but also “equity substitutes” in the hedge fund space. She expects “much greater use of derivatives to offer diversification and to protect downside risk.
Roger Gray, chief executive of USS Investment Management is similarly circumspect.
“We live in period of wealth elusion,” he warns, saying that perceived wealth is greatly exaggerated and funds need to tailor their asset allocation to “make a better job of navigating through a low return future.” Gray says investors are looking at a world where bond yields are significantly lower, “below nominal GDP growth,” and that funds need to diversify better, and more widely, developing alternative beta strategies. USS is pursuing more active strategies and structured positions, he says.
Over investment themes suggested by panel speaker Toby Nangle from Columbia Threadneedle Investments included Japanese equities which are currently “cheaper than they have been” where he suggested “investing tacticly round the edges.”
Short dated sterling debt which he described as “anchored, not volatile” is another investment theme.