For the Centrica pension fund, which adopts a liability-matching portfolio approach, last year was busy for appraising new opportunities arising out of the fact banks are no longer lending. This year its focus is on being more dynamic. Amanda White spoke to chief investment officer of the £5.5 billion ($9 billion), Chetan Ghosh.

The Centrica pension fund adopt a liability-driven approach, with a separate hedging portfolio, and growth portfolios which have slight adaptations for the three underlying pension schemes.

Fundamentally, instead of a strategic asset allocation as an investment objective, the investment committee sets a liability-related target.

“We are trying to set the optimal portfolio to best capture forward looking returns anywhere in the world in any market. We are conscious of our risk parameter so all the hedging must bring investments back to permitted boundaries,” Ghosh says. “It’s best ideas adjusted for risk.”

The fund targets excess returns over gilts which must be done within permitted volatility boundaries relative to how gilts move.

The allocations are driven by the best way to achieve return targets and investments are allocated to asset classes on a bottom up basis, aggregating up to percentage holdings in return-seeking and liability-matching, rather than the other way around.

At the moment across three schemes 20 per cent is allocated to liability-matching assets and 80 per cent in growth above the risk free.

Last year the fund looked at the top-down philosophical view, which matched with the bottom opportunities, of exploiting opportunities due to the fact banks are not, or can’t, lend anymore.

Some of the investments the fund assessed, and adopted, included mining loyalties, and social housing.

“Both of these played to the bank financing theme. Mining companies can’t get the financing they used to, and in social housing banks have pulled new finance. In liability matching we want long-dated cash-flow generating assets and these fit,” says Ghosh, who was educated at The Kings College, University of London where he received a First in Maths.

Within the growth portfolio bank financing was also a theme with the fund looking at niche, illiquid credit opportunities including direct lending, mezzanine financing and senior loans.

Within equities the fund appointed three new global unconstrained mandates as well as frontier equities and small cap.

The fund outsources all investment, and only has an internal team of three looking after operations and administration, managers monitoring and project research into new asset classes as well as the generation of new ideas.

One of the defining characteristics of its outsourced model is it works closely with managers, both for new ideas, but also to tailor mandates and opportunities.

For example Ghosh and his team have liked the insurance theme for some time, and the fund finally allocated to insurance-linked securities, but after a long search to find the right manager.

“We have liked it for a while but it took us a long time to find the right manager with the right fees,” he says. “We removed the performance fee as we think for that asset class it is not appropriate.”

Forming a network of trusted partners in asset management and banking for the generation of new ideas was one of Ghosh’s first priorities when he came on board in 2009.

“I wanted to build a network of trusted partners in the asset management and banking communities so we were not overly reliant on our consultant,” he says.

“We say the door is open if you have something relevant, but if you abuse that then the door will shut on you,” he says, adding that managers have all had a respectful manner in presenting their ideas.

“The last 10 things we have done have come from the internal team, through this process, rather than from the investment adviser,” he says, adding the consultant, Mercer, is still very much on board.

Since 2009 the governance of the fund has also evolved, with trustees setting liability related objectives. The advantage of this approach, Ghosh says, is that trustees are not in decision paralysis.

The fund has three independents on the investment committee which the team believes makes it easy to process ideas, which the CIO implements.

And there are mechanisms in place to converse between meetings, so that investment decisions can be made quickly.

“In the UK traditional pension schemes haven’t sought to be dynamic, but it is a priority in 2014 to enhance how dynamic we are. We want to focus on taking advantage of extreme valuations of asset classes or sub asset classes,” Ghosh says.

 

 

This paper estimates hedge fund and mutual fund exposure to newly proposed measures of macroeconomic risk that are interpreted as measures of economic uncertainty.

The academics, from Georgetown and Stern, find the resulting uncertainty betas explain a significant proportion of the cross-sectional dispersion in hedge fund returns. However, the same is not true for mutual funds, for which there is no significant relationship.

 

To read the paper click below

Macroeconomic risk and hedge fund returns

Institutional investors are sheltered by competition, which in some instances can be beneficial, but it also means they are shielded from competitive forces that drive innovation. A new paper by Gordon Clark and Ashby Monk, looks at why the current model of either insourcing or outsourcing investment management doesn’t allow for innovation, and the models of cooperation and collaboration that can change that.

 

There has been a surprising lack of institutional innovation among asset owners, suggest co-authors Professors Gordon Clark and Ashby Monk, due in part to the fact the current organisation and management of these institutions has been stagnant since their establishment – in many cases 50 to 70 years ago.

This is an important observation in the context of the rapid rate of transformation in the investment management industry, and the rate of product innovation in global financial markets.

It’s a problem because the lack of innovation has transcended the behaviour of investors.

“The stasis of the sector has been such that these types of financial institutions have, on the margin, taken higher levels of risk in the hope of realising returns that could compensate or the low rates of institutional adaptation and development. At the limit, the crisis facing US public funds is illustrative of the costs and consequences of institutional stasis,” the authors say.

A new paper by Clark and Monk, “Transcending home bias – institutional innovation through cooperation and collaboration in the context of financial instability“, suggests that industry wide norms favour continuity and that investors must look to new organisational forms for innovation.

The paper argues there is now a premium on institutional innovation, whether internal or external, whereas in the past there was less emphasis on make or buy, as it was less important than issues of strategic asset allocation and investment management.

Cooperation or collaboration between institutions, they suggest, allows a space for senior managers to experiment and learn which can then be applied to their own organisations or external providers.

Clark, who is a professor at the Smith School of Enterprise and the Environment at Oxford University, says that whether managing assets in house or through an external provider, institutional investors, are not faced with an opportunity to learn a new way of doing things.

“The contractual basis for outsourcing is very sterile, the terms and conditions are so well known and are always the same, it doesn’t give you much of a relationship with providers,” he says.

Clark and Monk, who is the executive director at the Global Projects Center, Stanford University, argue the problem facing institutional investors is more than that of responding to financial instability, the aftermath of the GFC and on-going euro crisis. And that recurrent financial crises have masked a significant shift in the underlying properties of financial markets.

Responding to these circumstances requires flexibility in institutional form and function, and they argue that the current norms of in-sourcing or out-sourcing investment management don’t provide senior managers enough flexibility to respond to changing market conditions.

Cooperation, at a minimum, and collaboration, at a maximum, can be seen as opening up an “action space” for innovation otherwise denied by the norms and conventions of the sector.

While there are some barriers and costs to collaboration, as outlined in the paper, the benefits are many including giving senior managers opportunities to create, extend or modify the resource base of their organisation.

“It allows a space for in house managers a place to learn and experiment outside their own organisation,” Clark says.

The key to successful collaboration is an issue explored in another paper published last year in the Rotman International Journal of Pension Management.

In “Effective investor collaboration – enlarging the shadow of the future” author Danyelle Guyatt, tested an eight-step framework based on collaboration theory, and looked at how it worked in 12 real-world investor collaborations.

Guyatt found a number of factors underpinned effective collaboration: a high level of trust among members, a similar mindset, sharing common interests and an open atmosphere.

The groups that ranked highest in terms of effectiveness were typically smaller groups which suggests a correlation between the size and action of a group.

The effective collaborations also all shared a high level of active involvement from their members in small-group meetings, working groups, research groups and events.

On the flip side, those collaborations that didn’t work as well shared a lack of clarity about their goals, a fragmented target group, lack of trust, bureaucracy among implementation and not enough focus on outcomes.

 

 

 

 

Academics from the London Business School, Boston College and Temple University, examine the outperformance of US public companies following corporate social responsibility engagement. The paper, Active Ownership, shows that after successful engagements the companies experience improvements in operating performance, profitability, efficiency and governance.

The paper can be accessed by clicking here

This paper commissioned by the Norwegian Ministry of Finance investigates the possibilities for the Government Pension Fund Global (GPFG) to profit from liquidity premiums in  illiquid investments. It looks at the empirical evidence for the presence of liquidity effects in a broad range of asset classes: listed equities, corporate bonds, treasury and agency bonds, and alternative asset classes such as real estate and private equity.

 

The paper can be accessed here

The Norwegian Government Pension Fund’s potential for capturing illiquidity premiums

How to implement ESG into portfolio construction and implementation is an ongoing challenge for asset owners. Mercer has come up with a number of strategies including the best way to use ESG ratings, active ownership, and tailored strategies that play to sustainability themes, including its own unlisted investment solution. Amanda White spoke to Jane Ambachtsheer, global leader of responsible investment and Nick White, global director of portfolio construction research.

 

Much of the advancement in sustainable investing implementation has been at the big end of town; among large sophisticated asset owners with the ability to devote resources to the risks and opportunities.

But a back to basics approach by Mercer is now making ESG integration accessible for all investors, and has resulted in a new paper, “An investment framework for sustainable growth: capturing a broader set of risks and opportunities – integrating ESG and sustainable themes”, which outlines adoptable methods for ESG integration. (download the paper here ESG Framework)

“We wanted to take a step back to first principles and make sure we were not leaving too many people behind,” says Jane Ambachtsheer, global leader of responsible investment.

While there are still big regional differences both in sustainable philosophies and regulatory requirements, Ambachtsheer has seen a lot more interest in the implementation of ESG ideas in asset owner portfolios.

She stresses that no matter the path chosen that the first part of the process is a beliefs and implementation plan to make sure ESG takes on an appropriate role.

Essentially sustainability can be implemented through three tools: risk management, active ownership, and specific investment solutions.

From a risk management perspective, there are now up to 5,000 strategies with ESG ratings from Mercer, with only 10 per cent receiving the highest ratings (ESG1 or 2).

Nick White, global director of portfolio construction research, says investors need to understand what is going into those ratings, and how they can be used.

“A manager with a highly rated portfolio of ESG stocks might not be a good performer because it is not making the most of that,” he says. “By the same token we ask whether a quality manager, which has a great level of robustness, can be strengthened further by strengthening ESG.”

Mercer first began using ESG ratings within the responsible investment team in the late 2000’s. It soon became evident the ratings would be more powerful if they sat with the analyst and in 2010 they were integrated into research at the manager level.

Ambachtsheer’s team produced a lot of documentation around the expected investor behaviour for high rated ESG managers, and prepared case studies and questions for the researchers to ask. There was a lot of education and training of the Mercer analysts as the ESG ratings were integrated.

Now White says the ESG ratings are a complement to the conventional manager assessment, and while they are not an absolute determinant of an overall manager rating, if there are two A-rated managers, the one with the higher ESG rating will be preferred.

One of the services Mercer will engage with a client is a benchmarking, and gap analysis of their portfolio’s ESG ratings.

This then identifies the managers that are not performing and gives clients tools to either turnover the manager or influence them to change through engagement.

Engagement is the second tool that Mercer says that clients can use to implement sustainability, and Ambachtsheer says this comes back to the asset owners beliefs and priorities and it is important that time is spent on those so that engagement is not reactive.

“Engagement has made the most progress for asset owners,” she says, pointing to recent engagement by asset owners with oil and gas companies over expenditure on new reserves research. “But it is difficult to decide to engage until you have thought through your own position.”

The third area, and one where Mercer has spent a lot of time, is capturing the sustainability theme within investment solutions.

It is now in the manager selection stage of an unlisted global sustainability product that includes infrastructure and private equity around a broad range of sustainability themes including water, waste and natural resources.

It is essentially the implementation of Mercer’s Climate Change Asset Allocation Study.

“ESG is a factor like momentum or value. Targeting a sustainability theme is looking at where the growth is coming from,” White says. “We think it’s about understanding how the world is changing.”

There is a massive spectrum of understanding among investors about ESG, and White says the scrutiny around proof is so much more emphasised than in other sectors, but he believes there is a lot of evidence to say there is alpha in ESG, and points to the DB Advisors paper on Sustainable_Investing_2012.

“Alpha is revealed in different forms, for example it looks at ESG funds and shows they have lower cost of capital and higher accounting and market based performance,” he says.

Mercer is also seeing a lot of innovation in passive investment and is reviewing in detail the processes of passive managers, and will produce ESG ratings of passive managers later this year.