The PRI has received many queries following the move by six Danish funds to abdicate as signatories over governance concerns. The association is holding a governance review that among other things will discuss the prospect of differential rights among signatories.

 

When six Danish funds, with a combined $300 billion, decided to leave the PRI as signatories the world looked up. It seems like a dramatic move for a nation known for its social conscious, socially responsible investing and fairness.

Their concern is not about the principles or a breach of governance or law. The funds are concerned with the structure of the association’s governance, decision-making, reporting and consequently its transparency. They haven’t ruled out returning as signatories.

“These are important issues and we are taking it seriously,” says Fiona Reynolds, managing director of PRI, adding the PRI is currently conducting a governance review.

The PRI has an unusual structure in that it has both a council, which has elected members, and a board, not elected but made up of a majority of council members. It’s a confusing and unusual structure, and is at the heart of the Danish concerns.

“I have worked in associations my whole career and I’ve never seen this structure,” Reynolds says. “But it was put in place for good reason, and had a lot to do with the evolution of the association. It hasn’t worked for a lot of signatories and we decided in October last year to have a governance review. This was communicated to the Danish funds so we were somewhat surprised that they decided to leave.”

The funds – ATP, Industriens Pension, PensionDanmark, PKA, Sampension and PFA Pension – said in a statement they would leave the PRI organisation until it re-establishes the fundamental principles of governance that existed before the organisation, on its own initiative in 2010-11, radically changed the organisation’s constitution without the involvement or consent of its members at the time.

ATP said the change in structure had meant that ATP and other affiliated investors were no longer able to influence the purpose, accounts, membership fees and work programs of the organisation.

 

Governance review

The PRI now has an RFP out for an independent provider to lead a governance review, which will be decided by the end of March, and a draft scope of the review has been sent to signatories for consultation.

Reynolds says the review will not include the make-up of the signatories and it will remain an association for asset owners, funds managers and other service providers. It will however look at the rights of those different groups, including the prospect of differential rights.

The review will also look at the council and board and what the appropriate structure should be.

And it will look at what signatories should be able to make decisions about.

“Signatories want to be consulted about the work the PRI does, and they should have a say on the strategic direction, but there has to be a balance on how to operate on a daily basis.”

There is a council meeting scheduled for July where the interim findings will be presented with the final findings presented at the September annual meeting for signatory discussion and put to a vote.

“This is a growing organisation and governance is not static, it will change as it grows and evolves. This is a good opportunity to look at governance and structure.”

The PRI has also recently completed a signatory survey, which among other things includes governance, and will feed into the strategic planning process.

 

Growth and governance

The PRI was only formed in 2006 and has grown quickly. It now has 1200 signatories with combined asset of $34 trillion.

When it was first established it sat under the UN Foundation for Global Compact and was not a separate company.

As the organisation grew, and more signatories signed, its structure changed.

Initially a PRI board was created, made up entirely of asset owners, and a constitution was established, with all rights sitting with asset owners including voting on accounts, the work plan and the elections.

When it began, there were voluntary fees but as the PRI grew and needed more staff, mandatory fees were introduced. At the same time a lot of service providers, including funds managers became signatories, and they wanted to be part of the governance structure as a result of paying fees.

In 2010-2011 as the PRI got bigger it incorporated in the UK which meant a change in legal structure and constitution, the PRI Advisory Council was formed and service providers were added to the governing body for the first time.

The council is made up of nine asset owners, four service providers including funds managers, and two permanent positions for the UN.

“It is fair to say that when those changes were made the PRI didn’t communicate as well as it could have to the membership,” Reynolds, who became managing director in 2013, says.

Further change ensued. As the council only met a couple of times a year, a board was put in place to assist the executive with decision making.

While the council is elected the board is not elected but has a majority of the council on the board.

“The Danish signatories, and others, don’t like the fact there is a council and a board,” Reynolds says. “There is something between them and the council, and they say it is not good transparency with regard to who makes what decisions. This combined with the fact they felt their rights were removed by introducing funds managers into the council. I understand their concerns. They had also been engaging with the PRI for some time and didn’t think there had been appropriate change.”

 

Public disclosure of signatories reporting

The PRI signatory reporting framework closes in March and for the first time there will be public disclosure, on the PRI website, of the signatories reporting.

“This will mean there is evidence for the first time on what investors are doing with responsible investing,” Reynolds says.

The PRI is also piloting an assessment on how each signatory is tracking across asset classes with regard to responsible investment, and they will be assessed across a benchmark of peers.

“We have been spending a lot of time gearing up the organisation for mandatory disclosure and piloting assessment. If the signatories are below their peers, will say how to improve, so we are looking at our support material.”

The six Danish funds will continue to comply and back the six principles of responsible investing, but because they are not signatories will not be required to report.

The PRI also has 15 collaborative engagement projects including a project on fracking, and its continuing work on anti-corruption, and sustainable stock exchanges.

Reynolds has hired more senior staff, there are now 50 in total, including former head of policy at BT Pension Scheme, Helene Winch, to led the policy division which among other research areas is looking at long-termism and in particular how to operationalise long-term mandates.

 

This research by academics at Tilburg University and the VU University Amsterdam, looks at the hurdles of implementing factor investing. It translates those into a checklist for implementing factor investing. The research, conducted for Robeco, finds that three approaches to factor investing are emerging and conducts case studies to examine how these approaches are implemented and correspond to the checklist.

 

The paper is available below

Factor investing in practice

 

 

 

The $51.6 billion Canadian fund, HOOPP, returned 8.55 per cent for the 2013 financial year, exactly half the return of 2012. But it finished the year in a better position than the year before, demonstrating that returns are only half the story. Amanda White spoke to Jim Keohane about the funds liability-driven investment style.

 

The Healthcare of Ontario Pension Plan (HOOPP) finished 2013 with a funding status 10 per cent higher than in 2012, putting the defined benefit plan in a great position of 114 per cent funded.

A couple of years ago HOOPP moved to a liability-driven investing approach, and now divides its portfolio into two distinct parts: a liability hedging portfolio, where all the physical assets are invested, and a return-seeking portfolio, implemented entirely through derivatives.

In the past year the liability hedge portfolio lost $1.4 billion, which compares to a gain in that portfolio of $2.2 billion the year before. This year’s loss was due to the interest rate increases across the yield curve resulting in market-to-market losses on the fixed income portfolios.

The rise in interest rates also had the effect of the discount rate, used to calculate the present value of HOOPP’s pension obligation moving to 6.25 per cent, from 6 per cent the year before.

This meant that the total pension obligations were lowered by about $1.5 billion, which was offset by the change in the hedge portfolio of -$1.438 billion.

“Some of our peers may get better returns than us, we are ok with that, we have more bonds than them. Our objective is not to beat our peers but to increase our funding rates. We look at the return on our liabilities, which was 10 per cent, not the return on our assets,” the fund’s chief executive, Jim Keohane says.

The fund manages assets actively in house, making active decisions to move along the yield curve, and using futures, swaps and options to get returns.

Within the liability hedging portfolio the asset allocation is split into real return bonds (12.5 per cent), real estate (12.5 per cent), nominal long bonds (70 per cent), and private equity (5 per cent).

The return-seeking portfolio, which gets equity, credit and beta exposures through derivatives is all managed internally including absolute return strategies, making it more like the proprietary desk of an investment bank than a pension fund.

If the notional value of the derivatives was added up the exposure is something like $200 billion, but that’s not really representational because it is long/short.

“In risk terms the exposure is quite small, because they are all relative value strategies,” Keohane says.

In 2013 value was added in both portfolios, and in the liability hedge it reduced its bond holdings relative to the policy benchmark. Where the strategic position is around 70 per cent in bonds, there was a tactical active decision to reduce it to around 60 per cent.

In addition the holdings were re-positioned out of the mid-term bonds into cash and short-term and long-term bonds.

“We are adjusting our fixed income exposures constantly, shifting with the yield curve,” he says. “The risk premium is very skinny and it is hard to find things.”

HOOPP has been overweight credit and equities since 2008 and is now neutral to short on both fronts.

The house view is that US equities are about 5 per cent overvalued, and Canadian equities about 2 per cent overvalued. While this is not extreme, with 10 per cent overvaluation considered extreme, Keohane says it is a cause for concern.

“Equities have been trading at a 10-15 per cent discount, and were at a 40 per cent discount in 2008, but the market is pricing in good news now. The same is true in corporate credit, spreads are as tight as they were in 2007 so you’re not being paid as much to take risk, so we are dialling that down.”

Instead HOOPP is overweight short-term bonds, and within real estate also sees some opportunities.

Given the fund’s envious funding position, now at 114 per cent, the investment strategy is to proceed with caution.

“We are in good shape from a funding point of view, we don’t need to take a lot of risk. We’re cautious.”

The fund has, however, been doing a lot of work on factor analysis, and  has built its own risk tools with a view to moving towards a risk based approach to asset allocation rather than rules-based capital allocation approach.

“We have built the tools to look at the contribution of risk to the portfolio, and we are now looking at the language in our policy documents to move that in.”

Interestingly the risk analysis has revealed that the portfolio doesn’t have as much credit risk as the team thought, so there is room to allocate more.

The biggest contributors to risk are a decline in long-term interest rates, an unexpected rise in inflation, and equity market risk.

“Liability-driven investing is the best way to manage those,” he says.

 

Blackrock has a favourable view on equities, relative to bonds, but within fixed income it advocates an unconstrained approach. Amanda White spoke to chief investment strategist, Russ Koesterich.

 

Equities look cheap relative to bonds or cash, says chief investment strategist for Blackrock and iShares chief global investment strategist, Russ Koesterich, with the manager recommending an overweight position in equities.

While equities are stressed they are cheaper than bonds or cash on a relative basis.

“At the highest level we would be overweight equities,” he says.

Within equities the manager is overweight Europe, cutting back on its US exposure.

“Europe is politically more stable and the risks are reflected in the price, which is a good deal cheaper than US.”

Koesterich, who is a founding member of the Blackrock Investment Institute which delivers Blackrock’s insights on global investment issues, says the discount in European equities relative to the US is sufficiently cheap, and when combined with the catalysts for growth in Europe, it look attractive.

He cites the possibility of an additional stimulus by the European Central Bank at the end of the year, and a more favourable monetary environment.

“The US market is fully valued. I don’t see it as particularly expensive but it’s not a bargain. Most of the gains in the US have been through multiple expansion, through stock market expansion, and it’s become expensive.”

Quantitative easing has supported this and also impacted the long-end of the treasury curve.

The impact of this is that investors are looking to source yield in alternative places.

Within fixed income, Koesterich says it is still hard to find any bargains, although there are pockets of opportunities including the US municipal market and hard currency and emerging market debt.

Blackrock is an advocate of unconstrained fixed income, which gives the manager greater flexibility to make larger latitudinal shifts in duration.

“Adjusting against duration is an advantage of a non-benchmark portfolio,” he says.

Given the continued volatility in fixed income Blackrock argues for an unconstrained fixed income portfolio, particularly given traditional benchmarks are typically concentrated in government-related debt.

And while the future is difficult to predict, the manager says there are three factors that will shape the direction of the bond market: interest rates should move higher over the year; rates at the “belly” of the yield curve will rise more dramatically than long-term rates; and volatility among and within fixed income sectors should be high.

As chief investment strategies of the world’s largest manager, Keosterich has a big job, which is made easier by the fact the firm has a lot of scope, and he can draw on experts from every asset class.

There are often cases when Blackrock’s views are the same as other managers, but the purpose is not to be different.

“We don’t set out to have a different view but to do what is best for clients,” he says.

In terms of portfolio construction, he advises investors should always keep in mind what “they are afraid of”.

“Putting portfolios together should be driven by the idiosyncrasies of what an investor is trying to achieve,” he says.

He believes there is often too much focus on returns with risk often omitted.

“Risk is important to think about, and if investors are basing risk on the past 18 months they may be underestimating risk.”

Investors must first decide what risk they are hedging or defending against – whether it be equity market slowdowns or interest rates – and change their investments accordingly.

 

“It used to be easier to make money,” Oaktree Capital Management founder and chairman, Howard Marks muses as he discusses meeting the demands and goals of his clients in 2014.

Marks is an avid communicator, and has been writing memos to clients for 24 years. The result is his book “The Most Important Thing”, which Warren Buffett’s review on the front cover summarises as “…that rarity, a useful book”.

His January memo is a 4,000-word musing on the role of luck. In it he discusses many things including “alpha” which he defines as superior personal skill.

“It used to be easier to make money. If you look at the history of inefficiency, there were markets that people didn’t have access to, there was infrastructure that was lacking and investments that were unknown. Now everyone knows everything about everything,” he says.

There was a time, not so long ago, that high yield bonds, the asset class where Marks started his career, were considered “improper”. He rues the

fact there are “no structural inefficiencies anymore.”

“I call this process ‘efficient-isation’, and it’s the norm.”

However what does still exist is cyclical inefficiencies and he’s only too aware that “people do panic at the lows and sell, or at least fail to buy”.

“It requires a certain degree of malfunction for the market to allow an investor to find a bargain, buy it on the cheap and enjoy an excess return. But it takes a greater degree of malfunction for everyone else to fail to notice that investors’ success, fail to emulate his methods, and thus allow the bargain to persist. Usually a free-lunch counter should be expected to be picked clean,” he says in the memo.

Given this “efficient-isation” Marks believes fund managers should focus on managing the expectations of clients.

howard marks 400x200

“Investment is still very much about alpha, but it’s harder to find and there is less of it,” he says. “So expectations need to be managed.”

Marks has worked with Bruce Karsh, who sits alongside him as number 296 on the Forbes 400 list of richest people in America, for 27 years, and he believes this longevity and stability speaks volumes for the firm’s success. His other co-founders have been with him longer.

“We have lived together through three major credit cycles,” Marks says, and he believes that working closely with a team for a long period of time creates a joint philosophy and lessons learnt which facilitates a strong environment.

“It’s constructive, not competitive, and we have a conducive compensation system that stresses teamwork,” Marks says, adding a key ingredient for success is retaining star performers.

A Wharton and University of Chicago graduate, Marks’ time in the markets has taught him to be contrarian, something you can’t learn in a class room.

“It’s the human side of investing that you can’t know when you’re at school,” he says. “It’s the importance of being contrarian, keeping your emotions in control and applying second level thinking.

“Investing is not physics: you can’t apply laws and assume it’ll work the same every time. With golf you can play 100 times and learn more about how to play a given hole each time you play. But with investing the course plays back and so do the other players.”

Quoting George Soros’ reflexivity – that the actions of people in an environment alter it – Marks says that investing in large part consists of predicting outcomes, and success comes from predicting more correctly than others.

“It’s relative to the universe. The first level thinker says ‘the company is good, buy it’ but the second level thinker says ‘the company is good but as good as people think so it’s overpriced: sell it’.”

An example of this is the firm’s success throughout the financial crisis, when it put to work more than $6 billion in the last quarter of 2008 following the bankruptcy of Lehman Brothers.

“It almost didn’t matter what you bought. But it’s not just intellectual, you also have to have to keep emotion under control,” he says.

 

Oaktree Capital Management, which invests in less efficient markets including credit, distressed debt, real estate and emerging market equities and manages $83 billion in assets, went public in April 2012.

Marks says, he was looking for an alternative to public listing, and as a result the company sold stock privately in 2007 and joined Goldman Sachs’ market for unregistered equities. But that route failed to create the liquidity needed to facilitate general transition, so an IPO followed five years later.

He denies that being a public company has changed the focus of the firm, asserting there is still the same sense of responsibility to do a good job for clients.

“People ask about a conflict of interests, but I think it’s not conflict but congruence. If you put the clients, first the business will be successful and you will make money for the shareholders,” he says. “It is not right to do just anything for the sole purpose of boosting assets under management. It has to work for the clients.”

He says a great firm has to stand for something other than AUM, and for his firm that is the Oaktree investment philosophy: the primacy of risk control, emphasis on consistency, the importance of market inefficiency, the benefits of specialisation, macro-forecasting not being critical to investing, and disavowal of market timing.

“We study the markets as they are today and take our cues from valuation and investor behaviour,” he says.

Marks’ outlook is that asset prices are elevated by central banks, and that when quantitative easing unwinds interest rates will rise. His mantra today is “move forward but with caution”.

“I think long bond rates will rise moderately, with the 10-year moving perhaps to 4 per cent. I don’t think it will go to 7 per cent, maybe to 4 per cent. Short rates are low also but they will rise more.”

The firm has 18 strategies, with high yield bonds and distressed debt the “tent poles”. Real estate is growing in importance, and an asset class Marks really likes.

The firm has raised $6 billion in the past two years for strategies that didn’t exist two years ago.

“We’re raising small funds, investing carefully and trimming expectations,” he says. “Today the key lies in caution, not aggressiveness.”

 

This paper by MSCI creates a framework in order to answer the question: given a portfolio of managers, how does the active risk of each manager relate to the active risk of the portfolio?

Asset owners often measure manager risk (the active risk of each manager) and have difficulty relating it to the contribution each manager makes to the multi-manager portfolio. MSCI says it is important that the analysis of the multi-manager portfolio be coherent with the analysis of each manager in isolation.

In order to achieve this, the paper defines and calculates manager risk contribution as the product of manager weight, manager risk and the correlation of the manager’s active return with the active return of the entire portfolio.

 

To access the paper click here

Manager_Risk_Contribution_-_Attributing_Risk_by_Manager