Factor investing is becoming more popular. Professional investors are increasingly considering investing strategically in certain parts of the financial market which realize better risk-adjusted returns over longer periods. The question is: “How can investors best implement this strategy?”. Read the full article.
AP4 already has US and emerging markets low-carbon mandates and plans to invest up to $1 billion across various regions. Mikael Johansson, senior portfolio manager global equities, AP4 explains how the concept of responsible investment can be integrated into the investment process of a large pension fund and the challenges in implementing low carbon mandates.
Our starting point is the position that climate change is one of the largest threats to the environment that we have and it concerns a large proportion of all the companies on the stock market and therefore we see it as one of the largest ESG risks.
The premise that according to the inter-government panel on climate change IPCC there is a limited risk in the long term may then damage the global economy with persistent poor growth. And AP4 believes this will impact pension funds’ ability to achieve their long term targets.
“We believe that it’s is likely that we will see significant increase in the cost structure of carbon emissions. This will change the relative competitiveness between companies. Our expectation is that the companies with less carbon emissions than their competitors will have an economic advantage and will have a better value performance. We see it as an investment opportunity to avoid companies that are going to suffer the most due to the increased cost of carbon emissions. Our belief is that the value of those companies will be worse,” he says.
Based on these beliefs in early 2012 AP4 started a project to develop and invest in a low carbon strategy.
Importantly as a universal owner one of the requirements were that it wanted to have full market exposure.
AP4 also decided that the mandate should have a low tracking error to a standard index. And it should have a significant carbon reduction – at least a 40 percent reduction compared to the standard index.
“Also…we needed a suitable portfolio structure for the mandate. And a final objective was that the mandate should be open to other investors in order to make low carbon investment more available. So we set up a fund with together with an external manager.”
The total investment in low carbon mandate is 7 per cent of global equity portfolio and the target is to increase that.
“Our first low carbon fund was completed in November 2012 based on the S&P 500 and we now have $580 million invested in that fund. In 2013 we continued to develop a low carbon mandate in emerging markets based on the MSCI index. And our current investment amounts to $570 million. We are currently working to make new investment in the Pacific and Europe before the end of 2014. “
The two mandates are based on two different methodologies.
The basic idea is to exclude companies with high relative carbon emission from the benchmark and to optimize the remaining stocks so as to minimize the tracking error against the original benchmark.
“We are trying to isolate the carbon price risk so it would be a passive mandate but with a low exposure to carbon price. In the USA the starting point is the S&P 500. The constituents are ranked by their carbon footprint which is defined as the company’s annual greenhouse emissions divided by annual revenues,” he explains.
“We use revenues to normalize carbon footprint in order to avoid size effects in the screening. The 100 companies with the highest carbon footprint are excluded but the exclusions in each sector cannot exceed 50 percent of the original sector weight. The reason is to avoid large sector exposures. The remaining equities are optimised to minimise tracking error v S&P 500.”
In the emerging markets mandate the starting point is global index MSCI EM. One of the key differences with this approach is that the MSCI is also using fossil fuel reserves as an input for carbon footprint. Initially companies with the largest fossil fuel reserves and emissions are excluded until 50 percent of the reserves and 25 per cent of the emissions compared with the standard index are excluded.
However, only a maximum of three companies per sector based on each parameter could be excluded. The reason for that is to limit the active sector exposures. The remaining companies are then optimized in order to maximize the reduction of carbon footprint subject to maintaining the tracking error below than 90 bps against the standard index.
There are also other constraints on active exposures to sectors and countries.
How well have these two low carbon mandates performed?
The carbon reduction in the US fund has been 55 per cent compared to the S&P which is above the target set by AP4, and the realized tracking error around 52 basis points.
Since inception the US low carbon fund has underperformed the S&P by 1 basis point.
“We have seen periods of low outperformance and low limited underperformance. The mandate has been running for 22 months and even though we think the period is too short for proper evaluation our assessment is that it looks promising,” he says.
“The EM low carbon fund has seen a carbon reduction of 85 per cent. The tracking error is 92 basis points. This methodology is clearly more aggressive than the other, but it is reasonable due to the nature of emerging markets. A tighter restriction on sector exposure than the standard index, that was implemented in May, that will hopefully lead to somewhat tighter tracking error. The EM fund has underperformed the standard index by 140 bps over 10 months. We think it is still too short to evaluate and we will continue to monitor it.”
Internal support key to success
Strong support from the board and management were critical to the success of the mandate design and implementation, Johansson says.
“To begin with we had very strong from the board and management all the way down the organisation. The project had high priority and it was therefore easy to implement. Another important factor was that the mandates fitted very well into our strategic portfolio with an investment horizon of three to fifteen years.”
He also identifies picking the right partners as crucial to success.
“Our partners have contributed greatly to our low carbon project and they worked hard to find good solutions both in terms of the indexes and the low carbon funds.”
AP4 plans to continue down the path of low-carbon mandates, and will invest in a Pacific region and Europe mandates by the end of this year.
Furthermore it is a target to measure the carbon exposure of the total equity exposure by the end of the year.
“We also expect investment in low carbon strategies will become more available at the same time as index providers are developing new standard indexes with carbon reduction,” he says. “In terms of policy it is difficult to predict if and when politicians will impose taxes or higher fees related to higher carbon emissions. However we expect the rhetoric will intensify.”
MSCI now has a set of Global Low Carbon Leaders Indexes, consisting of companies with significantly lower carbon exposures than the broader market.
This was developed with AP4 as well as the French reserve fund, FRR and Aumundi.
Mikael Johansson was speaking at the Australian Superannuation Investors conference in Alice Springs.
The inability to scale hedge fund exposures and risks, has led many large investors, like CalPERS this week and ATP last year, to exit their hedge fund programs. Complexity continues to be a drain on the relevancy of hedge funds, but importantly cost is driving the agendas of these investors. As AQR’s Cliff Asness admits, the hedge fund industry needs to re-invent itself to remain relevant to investors.
CalPERS’ decision to eliminate its $4 billion, 24 manager, hedge fund program, as part of an ongoing effort to reduce complexity and costs, is consistent with many other very large asset owners which can’t scale such investments.
Last year the Danish fund, ATP, decided to re-unite its alpha and beta where formerly it had a number of risk-taking teams managing long-short equity, equity market neutral, and global macro.
One of the reasons for ATP’s move was that with a large number of small teams it was difficult to scale the size of the total risk in the alpha exposure. And there was risk of over-diversification. Because of the difficulties in scaling the efforts it was expensive to run.
Other large investors, such as the $65 billion AustralianSuper, do not have any hedge funds in their portfolio.
With both ATP and CalPERS the hedge fund programs in isolation were a success. But while ATP’s alpha team added $310 million, the impact of that was drowned out by the total fund size of $122 billion.
Similarly the $297 billion CalPERS has not based its decision to exit hedge funds on the performance of the program it began in April 2002.
But costs sure played a part. In its absolute return program last year (to June 30, 2013) CalPERS paid $60.7 million in management fees and $55 million in performance fees. That’s a total amount of $115.7 million on 2 per cent of the portfolio.
This compares with external management fees of $41.7 million and $46 million in external performance fees in equities (both domestic and global) which makes up about 50 per cent of the portfolio.
The total investment-related expenses, including all consultant, custody, legal and tax fees, at CalPERS came to $1.39 billion last year at a management expense ratio of 0.51 per cent.
In 2013 the board, and executive, went through an an extensive process to determine its investment beliefs, with the idea those beliefs would guide, among other things, investments, at the fund.
Two of those beliefs now include:
- CalPERS will take risk only where we have a strong belief we will be rewarded for it
- Costs matter and need to be effectively managed.
These beliefs helped guide the decision to exit hedge funds.
“We are always examining the portfolio to ensure that we are efficiently and cost-effectively achieving our risk-adjusted return goals,” said Ted Eliopoulos, CalPERS interim chief investment officer.
“Hedge funds are certainly a viable strategy for some, but at the end of the day, when judged against their complexity, cost, and the lack of ability to scale at CalPERS’ size, the ARS program is no longer warranted.”
Increasingly costs are the focus of large pension funds around the globe.
A survey of 19 of the world’s largest funds from CEM Benchmarking, which rates large funds on their costs, showed the funds on average spend 46.2 basis points on their external management compared to 8.1 basis points on internal investment capabilities.
One reason for the increasing focus on costs is that staff actually have some control over them, and can rely on them. In an environment that is made up of low-returns, low-contributions and high-promise-to-beneficiaries this is important.
With the news of CalPERS exit from hedge funds, AQR’s Cliff Asness has taken the opportunity to reiterate a couple of arguments he and his colleagues have been making for some time including whether hedge funds actually hedge, arguing that they are too correlated and that they are too expensive.
Because of this he’s not surprised that some have found the broad universe of hedge funds is not an attractive enough proposition.
Asness does believe that hedge funds, and active managers in general, do pursue some strategies that are very good – such as value investing, momentum investing, trend following, merger and convertible arbitrage; value, momentum, and carry applied to macro portfolios – but “more often than not, they charge too much for these straightforward, non-magic strategies and package them, again, with too much net long exposure”.
“We don’t dismiss that some fund managers may have real skill worthy of very high fees, and that some funds that aggressively pursue many of the strategies we list above, in diversified ways, also can justify high fees. But, all considered, we are not surprised that some have found that the broad universe of hedge funds, and thus likely any very large diversified portfolio of them, is not an attractive enough proposition.”
Hedge fund managers can argue all they like about whether they are performing, but as Asness importantly says the end investor is not getting enough of that, either in terms of a fair fee or enough diversification.
The news of CalPERS’ exit from hedge funds, hopefully, will be a wake-up call to managers to become more relevant to the needs of investors.
Low-volatility investing is becoming more popular. Many professional investors currently explicitly allocate a significant portion of their portfolio to low-volatility stocks. Robeco uses an enhanced approach to increase returns and reduce risk. Read the full article.
Investors are just beginning to understand global tax issues and the risks associated with aggressive tax planning by the companies int their portfolios, Fiona Reynolds, managing director of PRI says there are a number of common-sense measures that companies should begin to put in place.
The 2014 G20 Summit to be held in Australia in November will consider a range of proposals around modernization and reform of international tax practices, as part of the wider agenda to lessen volatility risks and build resilience in global financial markets. In the eyes of many, concrete action and reforms can’t come soon enough.
The Warren Buffet-backed takeover of Canadian coffee company, Tim Horton’s by Burger King is the latest in a series of deals this year that have raised questions over corporate tax responsibility. The tax affairs of many of the world’s largest and best-known companies are coming under public scrutiny as never before – and this scrutiny is raising governance challenges for investors.
The tactics are familiar. Multinational companies shift domiciles around the world to take advantage of lower tax jurisdictions and less regulation. They pursue opaque transfer pricing arrangements between one jurisdiction or declare profits via subsidiaries that are no more than corporate shells.
They make internal and artificial royalty payments to avoid national rules and cut their tax exposure.
We must bear in mind that although these tactics may be decried, they are generally legal. Some national governments compete to make their jurisdictions as attractive as possible to international business – and corporate tax policy is a crucial battleground. This offers numerous opportunities for multinationals to undertake globally based arbitrage to reduce overall scrutiny of operations and their tax exposure.
The OECD defines these various practices under the umbrella label of ‘Base Erosion and Profit Shifting’ (BEPS) and points out that as a result of considered accounting many multinationals pay corporate taxes rates as low as 5 per cent, a sharp contrast to the rates above 30 per cent borne by smaller businesses. Unlike large corporates, SMEs are unable to optimise their tax position across multiple jurisdictions and subsidiaries.
From the shareholder’s point of view, in theory every dollar paid in tax is one dollar less available to the business, or to pay dividends. Ostensibly, company management is pursuing its fiduciary duty in minimizing – within the law – their company’s tax burden. A lower tax bill again in theory is supposed to result in higher profitability, more reinvestment or better dividends.
But as attractive as these arguments may be, a growing number of investors are becoming concerned about the risks posed by an overly dogged pursuit of tax efficiency.
Is chasing lower taxes really a strategy for long term sustainable value creation?
Should a board and senior management teams be always looking to short term tax breaks or concentrating on decade long directions that more closely align with institutional investor expectations?
Another nagging question remains. If these various arrangements are entirely legitimate, ethical and add value, why is there such dogged resistance to the OECD Action Plan with its implicit proposals for greater information sharing, transparency and disclosure by international corporations?
At the UN-supported Principles of Responsible Investment (PRI), we are analyzing the results of our new comprehensive reporting exercise.
With 814 investor signatories reporting in 2014, these results are a global barometer for what investors are doing to create sustainable capital markets. These investors, who collectively manage more than $40 trillion of assets, have committed to consider environmental, social and governance criteria in their investment decisions, and to report on how they do so.
This first-of-its-kind snapshot shows that tax is high on many of our signatories’ agendas, with no fewer than 100 of them including a reference to taxation in their responses.
Investors see the risks in aggressive tax planning by the companies in their portfolios. The first is that they risk damaging their brands, or losing their license to operate – and this risk is especially acute for public-facing companies in the fast-moving consumer goods markets.
Tax avoidance has risen to the top of the list of public concerns about corporate behavior, according to a well-regarded survey of the British public carried out last year by the Institute of Business Ethics. It’s hardly surprising with pensions and other social services around the world being cut, that tax payers are outraged that they have to pay their fair share of tax revenue, while some multi-nationals are allowed to avoid paying theirs. In the US there is a grassroots campaign underway, which is targeting some US corporations who are engaged in tax minimization as being “anti-American”
To illustrate the severity of these risks, Starbucks, for example, reported last October its first drop in UK sales after 16 years of strong growth, during a period when it faced a consumer boycott and parliamentary criticism over its tax affairs.
This highlights an additional exposure – to regulatory intervention, either collectively or individually. No company wants to find itself the subject of intense scrutiny by the tax authorities, with the attendant distraction to corporate management. Google found itself raided by French tax authorities, which have subsequently served the company with a tax bill which could reportedly hit €1 billion.
Collective action also seems increasingly likely. In June, the European Union announced a probe into whether Ireland, the Netherlands and Luxembourg were offering improper tax breaks to Apple, Starbucks, and the financial arm of the Italian carmaker Fiat, respectively.
The OECD is in the middle of a two-year programme, set up at the instigation of the G20, to help governments amend national tax laws to ensure they can collect the taxes due from global corporations.
Large investors are also mindful of the fact that there is also a wider social good served by companies paying fair levels of taxation – and from which they stand to benefit as global investors. Taxation funds government services which all companies ultimately rely on, including education, infrastructure, scientific research, healthcare provision and protection of intellectual property.
In emerging markets, healthy government tax receipts can be vital in creating successful economies with consumers wealthy enough to afford the products and services supplied by multinationals.
So what stand should investors take? These issues are complex and it can be difficult to differentiate between legitimate tax planning and aggressive practices.
Many investors are just beginning the process of understanding global tax issues, and engagement between companies and investors on the subject is at an early stage. But there are a number of common-sense measures that companies should begin to put in place.
Improving transparency and disclosure has a strong foundation in governance and gives institutional investors an opportunity to make their own judgments.
The OECD proposals are a step in this direction.
Ultimately, sustainable, well-run businesses should pay a fair level of tax, and avoid the reputational, legal and financial risks posed by overly aggressive tax planning. Doing so is in their interests, the interests of their shareholders and the interests of the long-term health of the global economy.
At the end of last year, 47 per cent of global pension assets were in defined contribution structures. As the trend towards defined contribution continues, one of the newest DC funds, the UK’s NEST, has some clear messages on what makes a defined contribution fund work. Chief executive, Tim Jones speaks with Amanda White.
The Towers Watson Global Pension Asset Study this year showed that in the past 10 years defined contribution assets in the largest seven pension markets have been growing at a rate of 8.8 per cent per year, outstripping growth of defined benefit of 5 per cent a year.
DC assets now account for 47 per cent of total pension assets and many traditional defined benefit funds are now offering defined contribution options.
In the UK one of the most recent defined contribution funds is NEST, set up by statute and run on a not-for-profit basis by an independent trustee. It is one of the pension schemes employers can use to meet their new duties of automatic enrolment, and the only one with a legal duty to accept any employer who comes to it. The reforms have been introduced slowly with large employers first and by 2018 they will cover all employers via different staging dates.
Employers need to automatically enrol all workers not already a member of a workplace pension, aged at least 22 but under state pension age and earning more than £10,000.
The fund has spent a lot of time tailoring its offering with its members in mind, looking at its investment design and how it communicates with members and how to best work within the defined contribution parameters.
“Defined contribution is sometimes characterised by the pot holder, the individual, having all this work to do and not being equipped to do it. It’s really important that we express that NEST is a million miles away from that. When you buy a car you don’t have to design the engine. This is a complicated business that requires a focus, we don’t expect members to direct that, and we will be transparent in communicating,” chief executive of NEST, Tim Jones says.
About 99.8 per cent of members are in NEST’s default structure and Jones says “we think that is fantastic”.
“What we have learnt from defined contribution is that a good percentage of the UK working population have little interest or expertise in investing and expect you to do this for them.”
The fund spends a lot of time on its messaging – in communication and marketing materials – cognisant its target market is approximately 90 per cent of the UK working population.
“Going from defined benefit to defined contribution means most funds will have disengaged members. So this means you need to offer a competent default structure and be able to explain why it’s appropriate for them,” Jones says.
NEST’s default is made up of 47 single-year target date funds, risk managed for each year of retirement. It also has a range of focused funds including ethical, Sharia, lower growth and higher risk options that have the same low charges as the default funds.
“We like the target date structure because it’s a great way of managing volatility through a lifetime,” Jones says, “but we quickly rejected mechanistic funds for a dynamic approach because to not take care of market conditions is careless.”
The fund is relatively low cost with all members charged the same fee of 30 basis points plus 1.8 per cent on contributions, which is roughly equivalent to a total cost of 50 basis points.
“Scale and automation allows us to deliver a high quality defined contribution product at the equivalent of 50 basis points,” Jones says.
Jones does not under-estimate the importance of communication in what the fund does – both in tailoring offerings with the investment approach based on research into members, and in outbound communication to members.
It’s latest survey in July this year, on the back of government changes to pension arrangements which abandoned compulsory annuitisation, shows that pension providers must seek to understand the root causes of savers’ concerns and tailor products and communications accordingly in order to build trust and confidence in pension saving.
The research report revealed that there is a gulf between the traditional approaches to defined contribution pensions and consumer expectations. And that communication is made all the more difficult by the fact that consumers find pensions both dull and, counter-intuitively, emotive.
The research unpicks what lies behind consumers’ attitudes to pensions, their appetite for greater certainty of outcome and what they are and are not prepared to trade off to achieve it.
It also explores how an understanding of savers’ fears and expectations can help providers develop communications that mitigate potentially harmful emotional responses to risk and investment.
One of the surprising results of the survey is that most consumers think that pensions are already guaranteed and they are not prepared to pay more for greater certainty of outcome.
In addition, another challenge for providers particularly in the defined contribution context, is that the survey found consumers are looking for a level of certainty in response to the question “what will I get in the end”, that isn’t possible for providers to give.
Pension providers in the UK are all undergoing product design transformation as they investigate how and what to offer members in retirement.
The government recently announced that from April 2015 annuities are no longer compulsory.
In the past providers such as NEST would need to manage the annuity conversion risk, and Jones says this was factored into the design of its target date funds.
But now that members can take a lump sum, at their marginal tax rate, it will impact the fund offerings.
“It is a very significant change and we are currently looking at what we are going to do to assist our membership.”
Jones is keen to further the conversation about the “U-shape” of retirement spending – the fact that consumers initially spend, then sit and don’t spend, and then have another high spending phase with healthcare costs.
“My view is there is nothing wrong with annuities as a product but not to buy them at age 65. Maybe keep saving until 70s or drawdown until 70s then buy an annuity. We are having a lot of conversations with people here and overseas about this.”