UK pension funds have not taking advantage of their comparative advantage as long-term investors and have not earned a positive long-run liquidity premium on their investments, according to a paper from the Cass Business School that examines UK pension funds’ monthly allocations to major asset classes over the period 1987-2012.

The authors – David Blake, Lucio Sarno and Gabriele Zinna – identify that the combination of herding behaviour of these investors and short-term automatic rebalancing towards a long-term optimal asset allocation, driven by their liabilities rather than by expected returns, can be obstacles to asset prices reaching their equilibrium values.

Published by the Pensions Institute at the Cass Business School at the City University London, the paper, The market for Lemmings:Is the Investment Behavior of Pension Funds Stabilizing or Destabilizing, finds that although UK pension funds are long-term investors they have not earned a positive long-run liquidity premium on their investments because their investment behavior is driven by different incentives.

“Pension fund managers fear relative underperformance against their peer-group, which encourages them in the very short term to herd around the average fund manager who turns out to be a closet index matcher,” the paper says.

“Further, their short-term objective is to rebalance their portfolios when valuation changes across different asset classes cause portfolio weights to violate investment mandate restrictions, while their long-term objective is to systematically switch from equities to bonds as their liabilities mature. Overall, our results show that pension fund investment behavior might be less stabilizing than previously believed.”

Analysis of the data by the authors finds that pension funds herd and, in particular, they herd in subgroups defined by size and sector type, consistent with reputational herding.

Pension funds also rebalance their portfolios in a way that is consistent with meeting their mandate restrictions in the short term and with maintaining a long-term strategic asset allocation that matches the development (in particular the maturity) of their liabilities.

This mechanical rebalancing could also be destabilizing if it has the effect of driving prices away rather than towards equilibrium values.

 

 

The paper, The market for Lemmings:Is the Investment Behavior of Pension Funds Stabilizing or Destabilizing, can be found here

http://www.pensions-institute.org/workingpapers/wp1408.pdf

The United Nations Environment Programme’s Inquiry into the Design of a Sustainable Financial System will present its interim report in Davos this week. The report has been initiated to advance policy options to improve the financial system’s effectiveness in mobilising capital towards a green and inclusive economy, and the interim report profiles innovations in five areas including institutional investment.

Here it explores policy changes in three broad areas: capital allocation, investor governance and market incentives in order to align the assets of institutional investors with sustainable development.

The report’s authors are positive about progress, saying that 2015 is poised to be the year of sustainable development, with growing focus on innovative policies to mobilise the trillions of dollars needed for long-term inclusive wealth creation.

The report identifies a number of high potential areas which could contribute to this shift including three major asset pools – banking, bond markets and institutional investors – as well as two emerging policy tools – monetary policy and ‘environmental stress tests’.

The UNEP Inquiry into Design Options for a Sustainable Financial System, now entering the second half of its two-year work program, was created to explore emerging changes and reforms to the financial system that would improve its alignment with sustainable development. Its investigations to date have revealed many innovations in financial and monetary policy, regulation and financial market standards.

The Inquiry is now half way through its work program and will complete its research and engagement at the end of 2015.

 

To access the report, Pathways to Scale, click below

 Inquiry – Pathways to Scale

The literature on how to optimally manage the investments of defined contribution funds is relatively scarce, despite the fact the growth in defined contribution continues to outpace defined benefit funds globally.

Now new research from academics at the University of Lausanne demonstrates how to perform an ALM study from a financial prospective for defined contribution plans.

The research finds that a liabilities hedging portfolio outperforms an assets-only strategy by between 5 and 15 per cent per year for the period between 1985 and 2013. This is due primarily to the fact that the optimal assets-only portfolio is typically long in cash, whereas hedging liabilities require the pension fund to be short in cash.

The authors conclude that: “This estimate suggests that allowing pension funds to hedge their liabilities through borrowing cash and investing in a diversified bond portfolio helps to enhance the global portfolio return.”

The article by Eric Jondeau and Michael Rockinger can be accessed below.

Optimal long-term allocation with pension fund liabilities

 

 

Asset owners, on average, add 15 basis points of value above their asset class benchmarks after fees, according to an extensive study by CEM Benchmarking.

The survey, which measured 6,666 data points from a global set of defined benefit plans, and some sovereign wealth funds and buffer funds, from 1992-2013.

Gross of investment fees, funds deliver 58 basis points of value added.

The study highlights why costs continue to remain a key concern for funds, with the author of the report, Alex Beath, finding that 75 per cent of that value added by funds is eaten by investment fees.

The net amount of value add on average is 15 basis points.

The study showed that if a fund was 100 per cent externally managed, and its investments were 100 per cent passively managed then it would need to be $10 billion before costs broke even.

Investment costs on average across the universe measured were 42.6 basis points. US funds had the highest investment costs by geography at 46.8 basis points, while Canadian funds were the lowest at 36.2 basis points.

The report looked to determine to what extent institutional investors added value above their benchmarks and aimed to deconstruct whether this was alpha or really beta in disguise.

Of the value added, around 65 per cent was due to beating the benchmark within asset classes, and about 35 per cent was due to tilting in the long or short term.

“There is some gamesmanship in this, as it depends on what benchmark is chosen,” Beath says.

In many instances the asset class determined whether the value added was beta or alpha.

“For example within fixed income investors on average produced “alpha” above the benchmark, but really they were overweighting credit to government debt. A lot of value added comes from what might be beta decisions not alpha and is dependent on the benchmark chosen.”

In other asset classes investors were making more active decisions such as geographic tilts or decisions like a mandate ex- Japan or parts of Europe. Then in other asset classes like REITs or small cap there are inefficiencies there were beta decisions that didn’t help them at all.

While the funds in the report varied greatly in their size, asset allocation, portfolio construction, the amount of indexing and the assets managed internally, all of which have an impact on their ability to add value.

Not surprisingly however the report made some clear findings with regard to size, active management, internal management.

CEM found that active management makes sense after costs, showing that if a fund was 100 per cent actively managed it would increase the net value added by 39 basis points relative to 100 per cent passively managed funds.

It also found that funds that are 100 per cent internally managed increase their net value added by 22 basis points relative to 100 per cent externally managed due to reduced investment management costs.

There is also a significant size effect, with funds increasing their net value added by 8 basis points for every 10 fold increase in assets, due to a decrease in investment management costs.

 

 

 

Governance of institutional investors and the lengthening investment chain causing  bigger distances between assets’ beneficial owners and those involved in executing investment strategies was one of three practical issues raised by the OECD general secretary as a barrier to more investment in long-term investing financing.

Speaking at the OECD Project on Institutional Investors and Long-term Investment roundtable, Gurria gave an update from the recent Brisbane G20 Leaders Summit as well as the future agenda for institutional investors and long-term investment in view of the future Turkish presidency of the G20.

In his speech, he said the G20/OECD High-Level Policy Principles on Long-Term Investment Financing by Institutional Investors provided a solid starting point for tackling the issues but there needed to be policy solutions to remove the obstacles to long term investing.

An extract of his speech is below:

“Following the guidance of G20 Leaders in Brisbane, we now need “to walk the extra-mile” and move “from solutions to actions”.

To this end, let me briefly address a few practical issues:
First, we need to address the issue of the governance of institutional investors. The lengthening ‘investment chain’, with bigger distances between assets’ beneficial owners and those involved in executing investment strategies, necessitates well-aligned incentives for every link in the chain.

We must remember that most of the money that circulates in this investment chain ultimately belongs to ordinary working people. Money they save for retirement or perhaps their children’s education. Similarly, those executing the investments also need to have the right skills and expertise to be able to expand their investment universe to alternative asset classes, in particular those that can support infrastructure investment and green projects.

Second, we need to address the question of financial regulation and its impact on the ability of institutional investors to provide financing for growth.

There is a need to balance stability and transparency against the need to ensure that institutional investors can act as proper financing channels for investment. For example, strict solvency rules, and related ‘mark to market’ accounting, may inadvertently put a brake on productive investment. More generally, governments need to ensure that the “conditions for investment” reduce legal and regulatory uncertainty.

Third, there is a clear need for more in-depth discussion on what are the most relevant and efficient financial instruments for long-term investment. We need to look at project financing needs across the entire life-cycle of investments to identify the optimal “division of labour” between different providers of finance.

“Pooling” mechanisms to get large and small institutions to participate in debt and equity financing can also play an important role. To facilitate these discussions, the OECD is developing a taxonomy of techniques, instruments and vehicles that policymakers can use to leverage private sector financing in infrastructure.

Ultimately, these three issues are just a sub-set of the much broader question as to what type of financial system we wish to construct. In advanced, emerging and developing economies alike, there is a need to enhance the role of fair and transparent capital markets. We need to consider concrete steps like the development of local currency bond markets; the issuance of project bonds; and the development of appropriate hedging instruments.

On these and many other issues, we are working together with the incoming Turkish presidency of the G20 on how best to advance the LTI agenda to promote stronger, fairer, greener growth.”

 

For the full speech click here

2015 is poised to be the turning point as a number of key issues relating to environmental, social and governance (ESG) issues take centre stage says Fiona Reynolds, managing director of the Principles for Responsible Investment.

 

First and foremost is climate change. With the Paris talks scheduled for December 2015, it’s an issue that is top of mind for governments, investors and companies alike. Climate change is one of the biggest challenges facing the world today because of its potential to seriously impact water, food, land and biodiversity—all of which can have enormous consequences for the health and well-being of humankind, and the sustainability of the global economy.

With overwhelming scientific evidence supporting the increased rate and level of climate change, it is essential that governments act now and make climate change a top priority.

Towards the end of 2014, we saw the US and China signing an agreement to reduce carbon emissions, which was a huge step forward for global climate action.

We also saw thousands of individuals taking part in climate marches, as well as institutional investors wielding their financial muscle to try and get policymakers to move swiftly on this issue.  At PRI, we initiated the Montreal Carbon Pledge in September 2014, which asks our signatories to understand their exposure to carbon risks by taking the first step to measure the carbon footprint of their portfolios.

Finally, in December, we had the Lima climate talks, which tested the political will of agreeing a global climate deal.

The Lima talks put a strong foundation in place for the Paris climate talks, due to take place at the end of 2015, as the world tries to set the first ever guidelines around greenhouse gas emissions.

The World Wildlife Fund (WWF) expected that governments coming to Lima would act with urgency to close the emissions gap, including by scaling up renewable energy consumption to 25 per cent and doubling energy efficiency by 2020.

Post-Lima and into next year, there will be many obstacles to overcome,  including the new Republican-led Senate in the US, and how to address the continued division between rich and poor nations when it comes to issues such as de-forestation, the latter issue being highlighted during the Lima talks.

There is also the issue of the growing divisions between the EU and the US, with the former favouring legally binding elements on carbon emissions and the latter preferring the “buffet option,” that would contain some legally binding elements but allow countries to determine the scale and pace of their emissions reductions, even if this calls into question the aim of keeping temperature rises below 2 degrees centigrade.

One encouraging sign is the fact that contributions made to the Green Climate Fund in 2014 now total more than $9 billion, short of the target of $10 billion to $15 billion, but contributions ramped up significantly in the last months of the year. The funding, which would help developing nations cut emissions and adapt to climate shifts already happening, is seen as another way to open the door to a global climate agreement.

Multinational tax reform

Headlines abounded in 2014 about multinational companies—Yahoo, Google, Apple, Starbucks, Amazon—which were seen not be paying their fair share of taxes.

In the autumn of 2014, the G20, during its final meeting of the year, received from the OECD its first recommendations for a coordinated international approach to combat tax avoidance by multinational enterprises. The recommendations come under the G20 and OECD Base Erosion and Profit Shifting Project designed to create a single set of international tax rules to end the erosion of tax bases and the artificial shifting of profits to jurisdictions to avoid paying tax.

The G20 is expected to enact the measures in 2015.  If they are passed, companies will no longer be able to employ many commonly-used practices to shift profits into tax havens. Under the measures, companies operating in more than one country will have to tell the tax authorities where their money is generated.

There is also a persuasive business case for closing tax loopholes.  Oxfam, the international aid agency, estimates that developing nations lose $114 billion in tax revenue each year. While most countries feel the impact of tax avoidance, this deficit takes a particular toll on low-income countries.

At the end of 2014 in the Autumn Statement, UK Chancellor George Osborne   launched a crackdown on tax avoidance by multinational technology firms such as Google and Amazon, by imposing a 25 per cent levy on profits which are generated in Britain but “artificially shifted” abroad.

In 2015, all eyes will be on the Forum of Tax Administrators, where we will be able gauge whether tax reform on a global scale is likely to happen.

Shareholder activism on social issues

A final issue that will undoubtedly continue to gain ground in 2015 is shareholder activism, which saw a number of high profile cases during 2014 around a variety of social issues.

The trend for shareholder engagement has been fuelled in part by growing concerns about the environmental impact of business, as well as by the widespread questioning of modern capitalism since the credit crunch of 2008.

According to recent data from Citigroup, globally, the pace of public activist campaigns in 2015 is on track to exceed that of prior years. In the US, almost one-sixth of companies in the S&P 1500 since 2006 have faced a public shareholder activism campaign, with some of these experiencing multiple campaigns.

Outside the US, shareholder activism has a foothold in the UK and is also gaining some traction in other regions. Moreover, there are a significant number of activist investors in every market who primarily engage with target companies behind closed doors. This is particularly the case in Europe, where research on activism suggests that nearly 45 per cent of all campaign activity is private.

Shareholders area increasingly turning to activism as a way to try and effect change on a number of social issues. For example, during an AGM held in 2014 by AMEC, a global engineering and project management firm, shareholder activists raised the issue of the company’s position on the UK Living Wage.  Activists were able to confirm that all employees at the company earned above the minimum wage but the company did not know if they earned a UK Living Wage. This is something that AMEC has promised to address.

We will have to wait and see if real progress on ESG issues can be achieved in 2015.

But one thing is clear, investors should continue using their financial clout to engage policymakers on effecting change, rather than simply waiting for governments to act.

The PRI has produced a new guide “The Case for Investor Engagement in Public Policy”, which includes practical steps investors can take to effectively engage policymakers. It’s through investors coming together, working collaboratively and ensuring that their voices are heard, that we will see change and move from awareness to impact.