A group of 16 UK asset owners with combined assets of more than £200 billion ($269 billion) have developed a guide to responsible investment reporting in public equity. The aim of the guide is to clarify the investors’ reporting responsible investment requirements as they seek to include it in RFPs, manager searches, due diligence and investment mandate terms.

The guide will be used by the asset owners supporting it, to inform their engagement with, and monitoring of, current and perspective managers.

“It is hoped the guide will be particularly useful for smaller pension funds, and once a mandate has been awarded to a fund manager, where reporting will help us to monitor how well the fund managers’ approach to RI is aligned to the broader investment strategy,” the report says.

The purpose of the guide is to encourage improvements in the quality of RI reporting for individual mandates.

While in the past many managers are reluctant to take on more reporting, the asset owners believe long-term benefits that stem from greater transparency and accountability will outweigh any short-term incremental reporting costs.

The report breaks reporting into two parts – ESG integration and stewardship – and outlines the expectations and guidelines for managers in their reporting of these two activities.

Within ESG, the guidelines cover both identifying and managing risks and opportunities, and includes benchmarking relative portfolio level ESG analysis, stock or sector decisions, identification of long-term trends and changes to the ESG integration process.

Within stewardship the guide covers both process and outcomes with regard to engagement and voting, looking at progress against engagement objectives and the attribution of engagement to portfolio risk or return.

The asset owners which support the guide believe that better reporting can help to build a better understanding of the extent to which responsible investment factors and activities can help to explain both short and long-term investment risk and performance in public equity.

The guide is designed to initiate discussion and dialogue between asset owners and their managers on the reporting metrics and whether they are applicable to other asset classes.

“Fund managers should regard these reporting expectations as a guide to help kick-start a process of reflection regarding their approach to responsible investment,” the guide says.

The asset owners supporting the guide are BTPS, PPF, Kingfisher, West Midlands, Strathclyde, SAUL, Environmental Agency, Merseyside, Northern Ireland Local Government Officers’ Superannuation Committee, Pensions Trust, Lothian, USS, Unilever, BBC, NEST and RPMI Railpen.

 

To access the guide click here

 

 

Investors should re-consider their investment processes in order to achieve the needed “step-change in efficient portfolio construction” in a low return environment, the chief executive of the A$109 billion ($83 billion) Future Fund, David Neal, says.

“It is the investment process that turns the universe of opportunities into a portfolio, and right now that process needs to be as efficient and effective as it can be,” he said.

Specifically Neal said that long-term investors should look beyond the traditional characteristics of a long-term investor – the ability to take on greater levels of market risk and the ability to accept the risk of not being able to sell.

“If the reward for the higher risk is not there, it doesn’t make sense to accept that risk,” he said, urging investors to think critically about the risk/reward trade-off, not blindly accept it.

In addition he points out that just because there should be a return for illiquidity doesn’t mean a return premium is always there in practice.

Neal advocates that investors “add to their armour” and the first thing to think about is not just where to take risk, but when to take it.

“One advantage of being a long term investor is that the task is to generate the return over the long term, which means that the portfolio does not have to be constructed to achieve that target return all the time. If the reward for risk is low, it is perfectly reasonable to take lower risk (and accept an even lower return) for a while, waiting for the time when the reward for risk is once again higher,” he said.

“This introduces the concept of inter-temporal risk management – allocating your risk taking through time.”

In addition he says the way pension funds (specifically superannuation funds in Australia) organise themselves, places considerable constraints on the allocation process which leads to less efficient portfolios.

He said the tradition of strategic asset allocation, and asset buckets, is restrictive.

“I would encourage all funds to think deeply about their processes. Do they have this ability to identify great strategic opportunities, and if so, do they have the ability to right-size them in the context of the total portfolio?”

The Future Fund has a target return, but adopts a benchmark unaware approach with no strategic allocations to individual asset classes.

Its sits alongside NZ Super and the Canadian Pension Plan Investment Board in this way of thinking, allocating assets according to a total portfolio view.

An example of how this works, is that a property investment is not thought of in terms of filling a real estate allocation, but whether it is better than staying in equities.

This approach allows investors to be opportunistic. Neal says after the global financial crisis, banks were capital constrained and so companies were finding it hard to get financing.

“With the help of our managers and other relationships, we were able to identify the opportunity and build a specific private lending strategy. This didn’t appear in any benchmark, but it forms a large proportion of our debt allocation (we have $4 billion in this strategy).”

Neal says that the process evolution he is advocating requires substantial internal resources.

“This is not an argument for building internal sector implementation which is more about cost reduction. That is fine but won’t on its own deliver a step change in efficient portfolio construction.”

At the end of December 2014, the Future Fund’s asset allocation was Australian equities 8.8 per cent, developed market equities 20.9 per cent, emerging market equities 9.4 per cent, private equity 9.5 per cent, property 6.3 per cent, infrastructure and timberland 7.4 per cent, debt securities 10.8 per cent, alternative assets 14 per cent, cash 12.8 per cent.

David Neal was speaking at the ASFA Investment Interchange.

While divestment is a useful tool to communicate concerns of climate risk to stakeholders, it is not an optimal investment strategy, in part because it ignores short-term benchmark risk. A research paper by MSCI provides a framework for evaluating ways to reduce two dimensions of carbon exposure – current carbon emissions and potential future emissions embedded in fossil fuel reserves – and explores new and more financially viable ways of managing carbon risk.

Institutional investor responses to how to tackle climate change have tended to centre around probing the long-term portfolio implications of “carbon stranded assets”.

As MSCI outlines companies’ carbon exposure consists of two dimensions: current emissions and fossil-fuel reserves which represent potential future emissions.

In the MSCI ACWI Index, utilities, materials and energy companies accounted for more than four-fifths of the total current carbon emissions. Not surprisingly, Energy companies represent more than 80 per cent of total fossil fuel reserves.

Up until now, much of the pressure to manage carbon stranded assets risks has focused on divesting from companies in the fossil fuel sectors. But MSCI argues that from a financial perspective, the strategy is not optimal as it can create significant short-term risk by potentially deviating sharply from market risk and returns.

In addition, such an approach largely ignores fixed assets from non-energy sectors in the portfolio that are at risk of being stranded due to their dependence on burning fossil fuel reserves, such as coal-based power plants.

The shortcomings of the divestment approach have led major asset owners to seek more financially practical solutions to managing carbon risk.

Instead, investors are starting to turn to strategies that re-weight the market-capitalisation portfolio to effectively minimise broad carbon exposure while using optimisation to reduce tracking error. These approaches take into consideration both current emissions and fossil-fuel reserves, thus aiming to capture a broader exposure to carbon-intensive companies while seeking to minimize short-term risk.

To read the full research paper click below

Research_Insight_Beyond_Divestment_Using_Low_Carbon_Indexes

A neat little story of investment flows, asset allocation changes, and relationship and service demands is emerging from the third annual Top1000funds.com/Casey Quirk Global Fiduciary CIO Survey. If you’re a CIO of an asset owner what that means is more control but also more responsibilities and the demands of more internal resources. For managers it means changing your proposition for a more customised approach.

The third annual Top1000funds.com/Casey Quirk Global Fiduciary CIO Sentiment Survey seeks to measure the sentiment of asset owner investment teams around the world.

Conducted with the expertise of the financial services management consultant, Casey Quirk, the 2014 survey looked at the changes in asset owner structures and investments, and specifically measures the behaviour of internal investment teams, their outlooks and corresponding asset allocations.

The survey included responses from more than 110 investors, from a wide range of participants including pension funds, sovereign wealth funds, insurance companies, endowments and foundations, with a combined assets of $2.1 trillion.

The overwhelming trend emerging from the survey is that investors are shifting in two ways. There is a broad divergence in risk on versus risk-off investing, driven largely by the investor’s investment objectives and how far they are from meeting those objectives. Secondly there are changes in how asset owners are building portfolios ranging from full investment outsourcing to significant investments insourcing.

The combination of these two dimensions means many asset owners will need to rethink their operating model to appropriately resource and govern the investment engine and many investment managers will need to tailor their client engagement model to reflect diverging preferences.

One of the key findings of the survey is that risk and return objectives are being driven by unique outcomes.

Across all respondents, 59 per cent of investors have an absolute return target which is up from 42 per cent the year before.

The funded status among pension funds is creating a divergence in risk appetite. The best funded plans are reducing their international and high-yield exposure, and anticipate a large shift into domestic and non-domestic fixed income.

Tyler Cloherty senior manager at Casey Quirk says there is a push towards absolute return metrics, with more institutions pushing an outcome-oriented approach.

There is a pretty significant de-risking among the better funded plans, which is having an impact on asset allocation. When this is explored further, there is a difference in the activities of pension plans according to type.

“The better funded plans are corporates, and they are de-risking and moving towards LDI. But the public pension funds are pushing towards more aggressive assets,” Cloherty says.

Within the aggressive assets, alternatives usage is beginning to bifurcate by channel and objectives, with the de-risking corporates increasing fixed income and real assets, and public plans increasing alternatives at the expense of equities, with a projected increase in alternatives of 3.1 per cent by 2017.

Among the investors surveyed, in-sourcing continues to rise due to cost and control benefits. In particular the larger funds are planning more in-house management of investments. Around 36 per cent of assets for large funds are now managed internally, and 60 per cent of respondents plan to increase this. The largest shift in insourcing is in core equity and fixed income.

In 2014 respondents showed that around 40 per cent of fixed income assets are managed in-house, up from 22 per cent in 2013. In domestic equity around 23 per cent of assets were managed in-house, up from 9 per cent.

“Insourcing continues across plans of all types,” Cloherty says. “The downstream impacts on CIOs of this will be around staffing, internal operations, investments whether active or passive. All of this will have an impact on career risk. It’s hard to find the talent, and an easier route might be to use a third party.”

The use of passive management is heaviest among in-house managers, which is also effecting the huge dispersion in costs between external and internal mandate costs.

In 2013 the difference between external and internal costs was 46.3 basis points for external versus 7.1 per cent for internal, a difference of about 6.5 times.

This difference has doubled to 13 times, caused by the reduced cost of more internal management coupled with more alternatives being managed externally. The 2014 average costs were 53.4 basis points for external mandates and 5 basis points for internal.

Partner at Casey Quirk, Jeff Levi says the further spread of fees is due to the growth in alternatives and more esoteric asset classes, where there is less fee pressure.

“With the alpha and beta separation and more passive management of core assets in-house, there is a story of polarisation of where investors are willing to spend on alpha,” he says.

“This has huge implications for managers to alter their capabilities.”

Interestingly while cost is a driver for investors to bring assets in-house, it was control of assets that was the number one reason for insourcing.

“With the increased focus on risk and absolute return investors don’t always have complete transparency especially in unconstrained strategies. By bringing assets in-house they have more understanding of, and control around, what they are managing,” Cloherty says.

The in-house trend is not without nuance. Casey Quirk identified that a bifurcation of in-house capabilities is creating new institutional segments, and identified four types of investors.

The “in-house investor” where on average 44 per cent of assets were managed internally with internal staffing of 15. These investors conducted investment and manager screening in-house and used co-investment as well as direct investment for alternatives.

The “sophisticated investor” that had in-house manager selection capability and used consultants selectively. On average they had 9 per cent of assets managed in-house and a team of around 6 split between investment and research.

The other two types of investors were the “mainstream investor” which was consultant driven and used traditional products and asset allocation, and an “outsourced investor” which third parties having investment discretion. Both of these types of investors didn’t manage money in-house.

As the dynamics in the industry change, the survey finds chief investment officers will need to manage a growing array of investment methods, from co-investment to in-house management, to execute on their allocation guidelines.

Casey Quirk predicts that in the future, asset owners will measure the success of their in-house asset management capabilities, not by business profitability, but by the cost savings against external mandates and by their ability to meet cash-flow objectives.

Meanwhile, external parties, including managers and consultants will be expected to provide growing customisation and knowledge sharing.

The survey found that investors consistently valued deep knowledge of investment strategies as the most important trait in a manager, followed by access to investment professionals.

“A lot of consultants are being forced to rethink their business model as many asset owners diverge in their investments approach: either more in-house discretion where consultants provide input and data or a more outsourced model where consultants may be asked to act as a fiduciary.” Levi says. “There are also big implications for managers, as each investor group wants different products and research focus. Managers need to plan and think about out how to service the different groups, whether the service they are giving is too technical or not technical enough, this could lead to a lot of challenges.”

The finance industry is slow in its willingness to innovate around technology, and is behind other industries says Jessica Donohue executive vice president, chief innovation officer and head of advisory and information solutions at State Street.

And the cost of that inability, or stubbornness, around technology innovation is not inconsequential.

State Street recently released its 2014 Data and Analytics Survey which analyses data analytics as a strategic priority for 400 investment organisations, including asset owners and asset managers.

The result is a clear divide in the industry between data starters, data movers, and data innovators.

The data innovators are treating data as their top strategic priority and are mastering a range of advanced data capabilities. They have the edge on electronic trading, extract commercial insight from their data and can adapt faster to business needs, the survey finds.

“Mastering data is both a huge challenge and opportunity for today’s investment organisations. Companies in the survey with the most advanced data practices believe they already have a significant competitive advantage. They can analyse risk and performance across today’s complex multi-asset portfolios. They have systems that streamline compliance and allow them to adapt to new stakeholder demands. And they have the flexible infrastructures and data skills to keep pace in a fast-changing environment,” the report says.

An important point between starters and innovators, Donohue says, is there is not a firm which doesn’t acknowledge it’s important, but the differences come from a firm’s ability to invest or elevate it to the number one strategic priority.

Donohue says the data innovators tend to be funds managers, not asset owners.

“This is no surprising because asset owners are more complex and have many sources of data. They also have tended to outsource decisions and data to managers,” she says. “Asset owners have also not had a commercial imperative to manage their data. But as they are trending towards self-managing their assets they are being pushed into solving their data problems.”

State Street believes that advanced data tools and practices will be one of the most powerful agents of change in the investment industry over the next 10 years, and Donohue also says it is a natural extension of State Street’s business to bring data to the front office, and plays to its strength in its back and middle office services.

Asset owners are starting to look seriously at the technology tools for a total portfolio view of their assets, partly because regulators are creating the imperative. But performance will, over time, be a driver as well.

“It’s hard to get a portfolio view, and a lot of asset owners haven’t required that from providers. But that’s just historical risk, even the most sophisticated investors and fund managers can’t do forward looking risk. There are a number of CIOs sitting without a full portfolio view of their risk. This should make us all sit up straight,” Donohue says.

State Street is taking technology innovation seriously, evidenced by the chief technology officer of the State Street GX Lab being located in Silicon Valley.

The GX Investment Labs convert State Street’s most widely followed research ideas into practical and interactive tools and include a Risk Lab, a Liquidity Lab and a Portfolio Lab.

Donohue says the over-arching aim is to create a platform that clients can use at any point in time and have a complete view of the entire portfolio and test ideas in real time.

“Imagine more willingness to trade because you know why you are trading and the risks involved. There is paralysis now because people don’t understand the risks so they stand still. Increased activity without productivity is not good, but more liquidity in the market would be great,” she says.

State Street has been using gaming technology to build the tools which will be open architecture and built in modules to accommodate technology upgrades.

“A big issue for the industry is it is full of black boxes instead of transparency. Quant models, pricing models, vendor data, they’re all black boxes. If you want historical prices you have to pay for it. It’s not free, I really don’t get that,” she says.

The system will allow investors to “preserve scenarios” so there is a record of back-testing which is good data governance.

“Governance and security of data will preoccupy people’s minds more,” Donohue says, “which is also an imperative to invest in technology. If you don’t know where or what the data is, then you don’t know it’s secure.”

Transparency is at the forefront of data analytics, she says, particularly given as a fiduciary, clarity is important.

“The healthcare industry has really embraced data and analytics and really moved the dial in a substantial way. Car companies now use chips in cars that are gathering huge amounts of data from things like movements in the steering wheel. They are collecting data to understand behaviour. The finance industry has real legacy system issues, but so did those other industries. We haven’t made it a priority,” she says.

Donohue believes the tools and innovation in finance will change with a generational change.

“They are used to visualisation and gaming technology and then they’ll walk into finance and expect to be able to use those tools. We are focusing a lot on dash boarding and visualisation. The next generation learns through graphics not spreadsheets.”

The survey asked the industry data questions around infrastructure, insight, adaptability, compliance, talent and governance. State Street aims to benchmark the industry with regard to data capabilities in these areas. It is also creating an APP so clients can benchmark their activities against the survey results.

Investors say they  like to, and want to, focus on the long term, but they often don’t know how to change their practices to orient their governance and investments to do so. Now, finally, a guide has been developed for investors to use as benchmark for implementing strategies for long-term investment.

The guide is an output of the Focusing Capital on the Long Term initiative, which has input from 20 investment professionals from managers and asset owners including CPPIB, OTPP, PGGM, New Zealand Super and Washington State Investment Board, all of which contributed to the guide with case studies of long-term “ideas in action”.

For any asset owner wishing to put in place an effective set of implementation strategies and tools to help realise their aspiration to be long term, this is a must read.

The guide focuses on areas where asset owners and managers have the ability to act immediately, and outlines examples of that in practice through case studies of institutional investors.

The areas of focus in the guide are investment beliefs, risk appetite, benchmarking process, evaluations and incentives, and investment mandates.

 

The Long-Term Portfolio Guide is an output of the Focusing Capital on the Long Term (FCLT) initiative. Its development was led by Anuradha Gurung with co-editor Colin Carlton and a working group, co-led by Caisse de dépôt et placement du Québec and Canada Pension Plan Investment Board. The working group was comprised of more than 20 experienced investment professionals from BlackRock, Caisse de dépôt et placement du Québec, Canada Pension Plan Investment Board, Capital Group, GIC, New Zealand Superannuation Fund, Ontario Teachers’ Pension Plan, PGGM, and Washington State Investment Board.

 

To read the paper click below or go to www.fclt.org

FCLT_Long-Term Portfolio Guide