If Robert Litterman were a CIO of a public pension plan he would not try to hit an “unrealistic return target”. Amanda White speaks to him about risk, quants, asset allocation and climate change.

There is a serious problem with US public pension funds and the “unrealistic commitments and unrealistic return targets” they have set, says Robert Litterman, co-developer of the Black-Litterman Global Asset Allocation model and risk expert.

“If I were the chief investment officer of a public pension fund I would definitely not increase risk to reach unrealistic return targets.”

The responsibility, he says, is with the entities backing up these promises to recognise there will be significant shortfalls in funding pension benefit promises, but the implications of that have not been acknowledged.

He says chief investment officers managing those assets should not try to hit unrealistic return targets, rather they should understand their risk parameters.

“It is not realistic that equities performance will bail you out,” he says.

Litterman acknowledges there have been advancements in portfolio management over recent years and that investors have been more sophisticated in thinking about their portfolios.

Most notably, he says there is a recognition that risk is a multi-faceted and a multi-dimensional problem. He uses liquidity as an example, noting portfolios are regularly stress tested for liquidity, something that was rarely modelled 10 years ago.

“There is not one source of risk premium,” he says, and timing those different risks makes sense as an opportunity for adding value to a portfolio.

However Litterman says those risk factors need to be actively managed, and he doesn’t believe in a passive exposures to a set of risk factors.

“On average people are holding the market then if you tilt to smart beta someone has to be tilted away,” he says. “Interest rates are an example: quantitative easing is artificially holding down interest rates, so it would make sense to have less than average exposure to interest rates but not everyone can do that – timing different risks makes sense.”

Litterman agrees with the notion there is a spectrum of risk premia with free, unlimited and available market beta at one end, and alpha at the other, and that investors should dynamically allocate to these factors.

Alpha, he says, involves skill, it is not readily known, requires execution capabilities and is usually short run.

“Alpha doesn’t sit around waiting,” he says.

The range of risk premia in the middle is a constant evolution, he says, pointing to the “value factor” as an example.

“The value factor in equities was alpha but now it is so well known and easy to do it’s not alpha, and the risks are greater because of the flows in and out so there has also been a risk/return deterioration.”

One of Litterman’s latest interests is climate risks and he’s a board member of the asset owners disclosure project, attacking climate change from a risk management perspective.

It’s good news for the market, business and society in general. As soon as a quantitative risk manager is involved the prospect of a price for carbon is a whole lot more realistic.

“This is an asset pricing problem. There is tremendous uncertainty and it requires pricing immediately. The reality of climate risk has penetrated to the point there’s little informed discussion but it is starting to sink in, so now what do we do?” he says. “Many people think it’s an ethical issue, ethics and morality doesn’t tell you the right price, science and risk management does,” he says, adding that somewhere between $40 and $60 is about the right price.

Litterman, who is a partner at Kepos Capital and was for many years the head of the quantitative investment strategies group and the global investment strategies group at Goldman Sachs, has spent much of his career around quantitative modelling (he is now also executive editor of the Financial Analysts Journal).

He admits that the returns in the quant movement as a whole was more to do with inflows of assets than fair pricing, but thinks that now quants “are a bit out of fashion, it could be a good place to be”.

His experience is that markets are becoming more efficient over time and with this in mind investors should set a strategic benchmark portfolio and then decide how to manage assets around that.

“If you think you can add value by tactical asset allocation decisions then it’s an avenue for adding value. It is very difficult to do, because markets are pretty darn efficient, but it does provide an opportunity,” he says. “It is hard to be more accurate than the aggregate market view but sometimes things happen like investors over react. It is hard though, and anyone who says it’s easy is probably looking backwards.”

What is possibly a greater consideration for large institutional investors, Litterman says, is the issue of rebalancing a strategic allocation.

“Should the strategic asset allocation be fixed over time? It’s not an equilibrium, not everyone can sell. In deciding to make an active decision to rebalance then you could be being contrarian to the average investor,” he says. “One is not better than the other but it’s important to understand which side you’re on and why.”

It’s a concept that Litterman discussed with Bill Sharpe on stage at the CFA Institute Conference in Seattle this week, on the back of Sharpe’s 2010 paper “Adaptive asset allocation”.

The article proposes an asset allocation policy that adapts to market movements by taking into account changes in the outstanding market values of major asset classes., and avoids contrarian behaviour.

 

 

 

Defined contribution plans focus too much on the short-term accumulation of pension assets rather than the longer-term goal of securing an adequate retirement income.

This paper by the World Bank, based on case studies from a number of countries, argues that pension supervisors have not properly defined the objectives of DC pension systems

It suggests that in order to have a meaningful impact on future pensions, the supervision of DC systems needs to take a more proactive role in minimising pension risk.

This objective would require ensuring that investment risks are aligned with the probability of achieving a target pension at retirement age.

 

To access the paper click below

Pension risk and risk-based supervision in DC pension funds

Last month Harvard Management Company was the first US university endowment to sign the PRI. It has also appointed its first vice president of sustainable investing as it seeks to incorporate ESG considerations in its decision making. So how is HMC integrating ESG in its portfolio?

 

Harvard University has taken a stand for sustainability.

Many of the university’s faculty lead the world’s research in environmental science, technology and renewable energy, and developing law and policy around sustainability and climate change.

President of the University Drew Faust gave a speech last month on confronting climate change, and challenged the University alumni and friends to contribute towards a $20 million Climate Change Solutions Fund that will seed new approaches to confronting the threats posed by climate change.

She says there are three ways the University is focusing its efforts on the obligation to the planet and “our collective future”: its research and academic work; an institutional pathway to a more sustainable future and to this end the University has a target of reducing greenhouse gas emissions by 30 percent by the year 2016; and thirdly Harvard has to play a role as a long-term investor.

The $32 billion endowment has returned 12 per cent over the past 20 years, and in fiscal year 2013 it contributed about a third of the University’s operating budget.

Historically HMC has been an innovative investor. It was an early investor in private equity and venture capital (as far back as the 1970s), timberland and natural resources (1990s) and has focused strategies on absolute return.

Endowments are not usually synonymous with sustainable investing, but Jane Mendillo, the endowment’s president and chief executive for the past five years, clearly says that as a long-term investor, HMC is always focused on sustainability.

In a statement upon becoming a signatory to the United Nations-supported Principles for Responsible Investing, Mendillo said: “As long-term investors, we are by nature focused on material ESG factors and the responsible stewardship of our investments.”

There have been some negative responses by Harvard faculty to the endowment signing the PRI, with some more interested in in divestment of fossil fuels than the broad structure provided by the principles.

But Jameela Pendicini, appointed HMC’s first ever vice president of sustainable investing, views ESG considerations as enhancing the investment decision making process, not a vehicle for divestment or any other radical change or limitation in investments. It is an addition to the decision making around opportunities and risks, she says.

Pendicini, who formerly worked in the corporate governance team at CalPERS and before that at PRI, has been working to understand how the investment team already considers ESG factors, for example it already asks questions around health and safety and employment practices.

In her September 2013 endowment report Mendillo said Pendicini’s remit is to work with HMC’s investment professionals and University officials to ensure that ‘we are actively considering ESG issues while maintaining our singular focus on maximizing returns for the University”.

In an interview in the Harvard Gazette, Pendicini says HMC defines sustainable investing as “the integration of material environmental and social and governance factors into investment practices.”

“It’s about doing good business,” she says. “Which is directly aligned with our mission to provide strong long-term investment results to the University.”

In addition to meeting with HMC investment staff, Pendicini has spent the first eight months on the job meeting with university faculty and students to understand what they think about sustainable investing.

“What is really important to understand is that we’re taking a considered approach to integrating ESG factors across asset classes so that we can enhance our ability to evaluate how these issues may impact the valuation of our investments and performance,” she says in the interview. “….. It’s about both managing the short-term ESG risks as well as having a thorough understanding as to how ESG issues may impact our performance over the medium and long term.”

The next steps, using the PRI as a guiding framework, will be to incorporate ESG factors into the HMC ownership policies and practices, seeking further disclosure from companies, and integrating ESG factors into investment analysis.

All PRI signatories are now also required to publicly report on how they are implementing the six principles in their investment practices.

In addition to signing the PRI, HMC has also signed the Carbon Disclosure Project that works with governments, public companies and investors to drive environmental disclosure and performance of publicly listed companies.

 

The Harvard endowment’s policy portfolio

2008                2013

Domestic equity                      12%                 11%

Foreign equtity                         12                    11

Emerging markets                   10                    11

Private equity                            11                    16

Total equities                            45                    49

Absolute return                        18                    15

Public commodities                  8                      2

Natural resources                     9                      13

Real estate                                  9                      10

Total real assets                        26                    25

Domestic bonds                        5                      4

Foreign bonds                           3                      2

Inflation-indexed bonds          7                      3

Total fixed income                    15                    9

High yield                                   1                      2

Cash                                            -5                     0

 

 

conexust1f.flywheelstaging.com will be hosting its fourth Fiduciary Investors Symposium at Loeb House, Harvard University from October 26-28. For more information go to www.fiduciaryinvestors.com

 

 

The Australian superannuation industry is often quoted as among the world’s best. However a new report by the Grattan Institute reveals Australian funds charge on average three times the OECD median rate. The report says that superannuation fee reform is the biggest opportunity for micro-economic reform in that country’s economy.

The report, Super sting: how to stop Australians paying too much for superannuation, shows that Australians pay on average 1.2 per cent on their superannuation account balances, which is three times the OECD rate.

The report’s author, Grattan Institute’s productivity growth program director, Jim Minifie, says that the problem is structural and due to poor design. Because most members go into a default fund, despite fund choice, meaning funds do not compete primarily on fees but are “trapped in a costly game of competing on service levels, marketing and product features”.

The average Australian fund is six times bigger than it was in 2004, yet the savings that such growth should deliver have been almost wholly absorbed by rising costs.

Minifie also says that successive government reforms that have sought to expose funds to greater competition have also had little impact on fees.

The latest round of reforms, Stronger Super, is still being phased in, but it will not cut fees much. Stronger Super includes MySuper, a more uniform set of products for people who do not actively choose their funds. It makes funds somewhat easier to compare, but does little to put downward pressure on fees

In fact Stronger Super will only succeed in reducing fees by 0.1 per cent and further competition is needed to match the low investment costs achieved in other countries.

Minifie says Australian’s are paying $20 billion annually in fees and expenses and that this should be reduced to $10 billion, which could boost retirement incomes by 20 per cent. This would mean a reduction to about 0.5 per cent of funds under management.

He believes the Stronger Super reforms do not sufficiently encourage competition on fees as most employees and employers remain disengaged.

“Many [employers] are no more engaged or informed about superannuation than are their employees,” he says. “Some may select funds that offer a broad range of options at high cost to employees. Some may consider their own costs and benefits before benefits for their staff.”

He proposes that only default funds with the lowest fees be allowed to tender to employers.

This model is used in Chile and New Zealand, where funds compete on price for the right to tender to employers for a set period of two years.

Minifie calculates the average fee for superannuation (including self-managed funds) is 1.19 per cent and contrasts this with investment fees of 0.04 per cent for the Thrift Savings Plan in the US, 0.22 per cent for Sweden’s AP7 and 0.38 per cent for the UK’s Nest.

 

The full report can be downloaded here

The Grattan Institute is an independent think-tank focused on Australian public policy.

 

 

Two high profile pension funds, ATP of Denmark and HOOPP of Canada, have been very successful in managing their assets in two distinct portfolios. But the practice of fund separation, a portion of the portfolio for liability hedging and another for alpha generation, is not common in pension management. It should be.

For these two funds relative performance, to a peer group or return target, is irrelevant. Their concern is meeting their own liabilities and the commitment they have made to paying benefits. In order to meet this objective, a liability-driven approach is a natural fit.

Both funds divide the total assets into two portfolios which have clear and very different objectives, and so it follows their investments look very different.

By adopting this approach, these funds have been able to stay fully-funded, while much of the defined benefit fund world disappoints, and successfully meet their members’ needs even during a crisis.

But few funds have been adopting this approach, and now a new study by EDHEC-Risk Institute reveals that pension funds are focusing too much on asset management and not paying enough attention to liability management.

The study finds only 50 per cent of pension funds surveyed hedge their liabilities, while the rest of the respondents are sitting on the sidelines.

One of main findings from the study is that many pension funds have an asset-only perspective, says one of the authors, Vincent Milhau, who is deputy scientific director of EDHEC-Risk Institute.

Between November last year and January 2014, 104 investors from Europe, North America and Australia, the majority of which were defined benefit, were surveyed to determine how liability-driven investing is used in practice and the reasons that motivate the adoption or non-adoption of such techniques.

“The results were definitely surprising to us, we expected them to have some kind of ALM and to care about performance of the asset side relative to liabilities. But we found some funds don’t measure the liability risk at all,” Milhau says.

The survey found that only slightly more than 50 per cent of the respondents explicitly measure liability risk through a probability of a shortfall or the magnitude of this shortfall.

One reason to engage dynamic LDI is to protect the minimum funding ratio levels but Milhau says surprisingly the survey respondents did not take this motivation into account in managing their portfolios, rather they were concerned with the economic environment and risk parameters which are asset-only motivations.

The survey also found that even those that had liability-hedging as an objective, it was difficult to see if that was effectively achieved, as duration matching was only perceived as a desirable or a feasible target by about 60 per cent of the respondents who expressed a focus on liability hedging.

While a majority of the funds surveyed were aware of the LDI approach (80 per cent), there was little adhesion to fund separation – the approach successfully adopted by ATP and HOOPP.

Milhau says fund separation is important for a number of reasons.

“Managing two separate portfolios, one for liability matching and another for asset performance, is a source of clarification and gives each building block a clear role. It also simplifies reporting,” he says. “For those that don’t operate fund separation and manage performance and risk at the same time using the same portfolio, it becomes less clear and more difficult to assess whether the portfolio is achieving its objective.”

While the survey didn’t ask investors why they didn’t adopt a liability-hedging approach, Milhau suspects one reason could be the reluctance to invest in low-performing asset classes like bonds, which is necessary for such an approach as liabilities are dominated by interest rates.

While the liability-hedging is not necessarily being achieved by many of the respondents, the good news is that EDHEC says that the findings highlight an ever increasing awareness by market participants that pension fund investment management is very much related to liability risk management.

Trustees need practical guidance on how to implement a comprehensive investment approach to climate change. Helga Birgden, head of responsible investment for Asia Pacific at Mercer and Nathan Fabian chief executive of the Investor Group on Climate Change Australia/New Zealand,  show them how.

In the 2013 Global Investor Survey on Climate Change, more than 80 per cent of asset owners such as pension funds identified climate change as a material investment risk. Despite this only 25 per cent said they had changed their investment strategy or decisions as a result of their risk assessment. While leading pension funds are making changes, many trustee boards are yet to implement a comprehensive investment approach to climate change.

To address this implementation gap, IGCC and Mercer recently filmed real life trustees in a role-play of a board meeting of the fictitious Perfect Storm Pension Fund.

The aim was to discuss and agree concrete steps a trustee board could take to address climate investment risk. Seven areas were discussed in the form of board resolutions on: investment policy; strategic review; investment tradeoffs and timing; increasing climate sensitive allocations; measuring investment exposures; and disclosing performance to the market.

Each area is discussed below and the meeting videos and resolutions can be viewed here.

Investment Policy: Explicitly addressing trustee investment beliefs on climate risk in the Investment Policy Statement or in a separate ESG Policy is a necessary first step to activate the fund stakeholders and its service providers around the challenge of climate change.

A widening of the investment lens to focus on protecting a portfolio and enhancing opportunities by opening access to growth is what is required. Investment beliefs need to be driven by evidence, conviction and reasonable consensus. Addressing the relationship between climate change and fiduciary duty, corporate governance and the materiality of environmental and social issues to company performance depends on it. The evidence of climate related economic risk, government policy and technology change is more comprehensive than ever. Many leading funds have taken this step already.

Strategic Review: In the strategic review, both near and long term impacts from climate change on existing investments across asset classes, regions and sectors should be reviewed.

Information for the review can be gained from research and analysis via fund collaborative research studies, from research conducted by the fund’s portfolio management teams, asset managers and specialist advisors. Strategic asset allocation and portfolio reviews tabled at board meetings allow trustees to participate in the consideration of systemic risk factors which may be material to the overall fund’s performance and its investment strategy.

Tradeoffs and timing: Next, tradeoffs between climate impacts and mitigation pathways should be assessed and assumptions built in to mandates.

Less mitigation action by governments, businesses and investors will mean worse climate impacts. Strong mitigation steps may avoid the worst climate impacts, but will change investment returns from emissions intensive activities.

The important questions are whether physically vulnerable assets are at risk, whether emission intensive assets and related supply chains are at risk, or both? While investors are not scientists there is sufficient information available for investors to make a judgment about how climate and regulatory impacts will play out and position their fund accordingly. Some public company boards are embracing this conversation on tradeoffs in their strategy and capital deployment activities.

Investment allocations: To implement policy means allocating capital.

There are a number of ways that leading funds consider allocation, including risk mitigation at the portfolio level and identifying growth opportunities in sustainability related sectors and markets. The former includes how managers address climate risk and opportunity within their investment framework, the latter how managers are gaining exposure to various themes and new ideas to capture revenue and alpha opportunities in responding to climate change.

Pension funds can also allocate to environmental themes by focusing on solutions to environmental problems and resource scarcity, for example in renewable energy, energy efficiency and clean technology, water and waste management and agriculture.

Environmental themes can be accessed through either pure play investment strategies, which focus on one particular theme such as energy, or through a broader approach, combining various environmental themes. There are now many options for pension funds to allocate capital to climate sensitive activities in public and private equity, in fixed income, infrastructure and real estate.

Measuring exposure: Forming good investment strategy relies on good information. Analysing exposure to greenhouse gas emissions and to low carbon assets is the first step in a necessary internal review by pension funds.

The questions that such analysis should provoke include how to best assess the risk and return implications of reducing emissions exposure and whether hedging against climate impacts can occur while maintaining returns. Without asking these investment questions or being prepared to change allocations, portfolio footprinting is a solitary step that has provided limited benefit to the funds that have performed it.

Disclosure: Finally, investors rely on well functioning markets. Low transaction costs and high deal flow rely on high quality and available information.

It is in the self-interest of pension funds to create a market for emissions reduction investment opportunities and encourage more low carbon deal flow and business activities. Disclosing carbon exposures of funds will help to develop a market for responses to these problems. Disclosing exposure by using emerging metrics on financed emissions will provide more information for markets and options for funds to respond to climate risk. Disclosing information about low carbon investments will also help the market to develop more of the opportunities that funds favor and less of those that they don’t.

Conclusion

A trustee board that implements each of these steps will be making climate sensitive investment decisions in practice.

Difficult tradeoffs will still need to be assessed, but the necessary information and tools are now available to guide trustee boards.

The science of climate change is relatively clear, the economic impacts are well understood and the quality and quantity of investment analysis is reaching investment grade. While some uncertainties remain on government policies, changes in markets and future technology trends, these issues should be addressed at the tactical investment level, rather than at the strategic level by trustee boards.

Given that so many pension funds already identify climate change as a material risk, following through with a comprehensive investment approach is the necessary and prudent response. The seven example resolutions discussed by the Perfect Storm Pension Fund Board can provide the basis for a comprehensive response to climate change by pension fund trustees.

The Perfect Storm Pension Fund board meeting role-play can be viewed here.