The first valuation and risk measurement model created for unlisted infrastructure debt has been developed, with the release of a paper showing the valuation of illiquid infrastructure project debt, taking into account its illiquidity and the absence of market price feedback, can be done using advanced, state-of-the-art structural credit risk modelling.

The paper by EDHEC-Risk Institute is part of an ongoing research project aiming to create long-term investment benchmarks for investments in infrastructure.

EDHEC has previously said that improving investors’ access to infrastructure requires the creation of new performance measurement tools that can inform the asset allocation decisions of investors in infrastructure and help them integrate assets like infrastructure debt into their respective risk and return frameworks.

The paper proposes to address the challenges of illiquid investment performance measurement including the information scarcity of illiquid investments. Without market prices or large cash flow datasets, performance measurement is not straightforward. At the moment there is an absence of relevant performance measures.

This latest paper focuses on private project finance loans, as EDHEC says they constitute the largest proportion, by far, of illiquid infrastructure project debt, and are well-defined since Basel II.

The paper looks at the appropriate pricing models, return and risk models and defines minimum data collection requirements.

EDHEC shows that the valuation of illiquid infrastructure project debt, taking into account its illiquidity and the absence of market price feedback, can be done using advanced, state-of-the-art structural credit risk modelling, relying on a parsimonious set of empirical inputs.

Further, the data required to evaluate the performance of illiquid infrastructure project debt can provide the basis for a reporting standard for long-term investors.

Research director at EDHEC-Risk Institute in Singapore, Frederic Blanc-Brude said the model  is practical and useful, for example it predicts the probability of default in infrastructure project debt as reported by Moody’s even before calibration with actual defaults or cash flow data.

Blanc-Brude said in the coming months, EDHEC will continue to implement its roadmap to create infrastructure debt investment benchmarks, which includes data collection to document and calibrate cash flow volatility and the creation of a reporting standard, which is effectively covered by the data collection requirements identified in the paper.

 

The paper can be accessed below

Unlisted infrastructure debt valuation and performance measurement

 

This year’s Global Real Estate Sustainability Benchmark (GRESB) reveals that sustainability reporting has improved in coverage and quality of data, with the average overall score increasing due to increasing implementation and measurement.

The average score is now 47 (out of 100) which is up nine points this year. The benchmark collects data from 637 listed property companies and private equity real estate funds, covering 56,000 buildings with an aggregate value of $2.1 trillion.

GRESB found that collectively, in 2013, the commercial real estate sector reduced its energy consumption by about 0.8 per cent, carbon emissions fell by 0.3 per cent, and water consumption fell by 2.3 per cent.

Sustainability is assessed annually by GRESB with a focus on: executive decisions, plans and policies; performance measurement; and stakeholder engagement.

The data provided by GRESB allows pension funds and other institutional investors to incorporate responsible investment principles into their decision-making. It is a source of portfolio-level sustainability data for the real estate industry, with  more than 40 institutional investors, representing $5.5 trillion in assets under management, using it for timely, actionable information about the sustainability performance of property portfolios.

Five years after the launch of the benchmark in 2009, GRESB participation has become standard practice for many of the world’s fund managers and listed property companies. There has been a more than 220 percent increase in response rate since 2009.

To view the results click here

 

John Pearce recently notched up five years in the role of chief investment officer at the $37 billion Australian fund, Unisuper. Here he explains his fund’s bias to domestic equities and explains the parameters of the fund’s in house management program. David Rowley reports.

John Pearce has a side bet with a member of his investment team that the Australian equity market is going to outperform the US equity market over the next year.

When most people are talking about the end of the Australian boom, uncompetitive labour costs, an expensive currency and a lack of momentum, Pearce stands this thinking on its head.

He points out that since the global financial crisis there has been a disconnect between GDP growth and share price growth. So while Australian GDP growth has been superior to the US, the US stock market has outperformed Australia.

The reason, he says, is that the US has benefited from the tail winds of a lowly valued currency, quantitative easing, low interest rates and a healthy labour market which have allowed historically high profit margins. But in Australia, these factors have been working in reverse, with relatively high interest rates being a drag on profits and a high currency hitting trade.

“Arguably the US is coming out of that phase,” he says. “Interest rates are going to be a headwind for them and their currency is now starting to appreciate.”

Such thinking has led to Unisuper being one of a dwindling number of funds owning more domestic than international equities, the latter only makes up 40 per cent of its equity holdings. The strategic allocation for its balanced MySuper fund is 36 per cent Australian equities, 20 per cent global equities, 30 per cent cash and fixed interest, 9 per cent property and 5 per cent infrastructure and private equity.

He believes global macro indicators are also being overlooked when people state that equities currently look expensive.

“The people who talk about overvaluation of equities usually cite metrics like current versus historic price-to-earnings Schiller adjusted,” he says. “It is typically based on some bottom-up analysis. What is completely missing is any reference to the macro situation.” He cites quantitative easing in the USA, Europe and Japan as creating an “insatiable desire for yield”, which makes equities look cheap, even if the profit to earnings multiples are expensive historically.

The fund’s bullish stance on domestic equities has led it to build up a 10 per cent stake in Transurban. The toll road operator, along with AustralianSuper and Tawreed Investments, the Abu Dhabi sovereign wealth fund, purchased a big chunk of Queensland motorways in April for $7.05 billion, a figure that is around 28 times earnings.

Pearce says Unisuper did not bid and thereby raise its infrastructure allocation as it already gets its exposure to Queensland motorways through Transurban. He adds, the price was fair given that Transurban would not have to duplicate its operations in running the roads.

“We believe there was a discipline where their cost of capital was still sufficient,” he says. “The market obviously agrees as the share price has done well.”

The large holding in companies such as Transurban backs up Pearce’s third contrary view of equities. The fund does not have any explicit downside protection and is currently not looking to add any, despite the talk about equity-put options being cheap.

“We have this quality bias in the portfolio,” he says. “So, I have a degree of comfort our portfolios will outperform and in the event there is a sell off they will recover quicker. It does not mean their share price will not go down.”

This approach played out in the GFC, where he says the quality companies did not “miss a beat” on dividends and their share price recovered in a couple of years.

In-house management

Pearce writes monthly investment bulletins, but is a stranger to domestic conferences and not being a public offer fund, Unisuper does not make the public utterances as AustralianSuper.

In this way, Pearce has not seen the same hostile reaction senior executives of AustralianSuper received from some in the investment community, after they publicly explained their intention to manage more money in house. By contrast, over five years at Unisuper John Pearce has quietly built up internal management to 40-45 per cent of all assets.

The ability to bunker down and focus on maximising returns is what appeals.

“I did not appreciate how liberating working for a profit for members business would be,” he says. “Because we are a closed fund I do not spend much time at all on the marketing and sales front.”

Pearce has now spent five years as chief investment officer, which he seems surprised by.

“When I took the job I gave myself three years, some people gave me two years, but those five years have flown. I did not think I would love it as much as I do.”

This job satisfaction has been his sales pitch to team members too, who he describes as a team that “just love to manage money”.

“That is why I have been able to hire some top quality guys who arguably could command much higher salaries outside, but they are coming for the same reasons I am, they do not want to be distracted.”

This love of their jobs must be strong as Unisuper does not offer its team the long term incentive arrangements found in fund managers. The pay-off is that they are running their own money, without the marketing and business spend of a fund manager and with no profit drag on returns.

Part of the logic for running money in house is that the best managers of Australian assets cannot be easily bargained with on fees. Many are at capacity and can be choosy about clients. “We can negotiate fees, but popular managers can look elsewhere,” he says. For this reason he foresees growth in managing large cap Australian equities in-house, chipping away, as he puts it, from some of their existing managers in that space.

The other logic is to avoid what he describes as the rent seekers paradise of managers that add more and more funds to a strategy with a “reasonably” fixed cost base and charge fees that rise in accordance with the volume of assets managed.

The in-house team manages domestic assets, from large and small caps, to infrastructure, fixed interest and property. Pearce expects the proportion of assets to grow in-house within these strategies. “If I put on another billion dollars of Aussie equities, my cost base is zero I am still paying the same team to pay an extra billion plus few bps in custody.”

There is no set target for this growth, however.

“If I have a target I can reach it, which I do not think is the right thing to do.”

He says in-house management is all “performance based” and that his “in-house guys” have to justify their existence. Once a year the in-house teams report to the investment committee about whether their strategies are a hold or a buy. Two strategies were dropped in 2013.

“We sacked ourselves in two of our strategies as we did not believe it was performing to expectations,” he says, admitting how much this upset the two members of his team affected. “No one likes having money taken away from them.”

The money was diverted to other internal strategies and some to a new Japanese equities manager.

He is doubtful the in-house strategies will move into anything exotic.

“We are not going to get to a situation where I say ‘how about we experiment by getting a team to manage global small caps?’. There are good managers out there that we cannot compete with, we do not have the resources.”

Domestic assets are chosen by the internal team for their quality and stability. Pearce reasons, that they are managing life savings and different to how one would manage a discretionary managed fund.

So large top 100 companies with strong balance sheets, sustainable and robust earnings are favoured.

This strategy has inadvertently led to a lower than average portfolio turnover and therefore lower than average management fees.

“If the average portfolio turnover of the market is 30 per cent or whatever, I don’t say I want 15 per cent. We do not target that. It is an outcome.”

“If you are taking big positions in high quality companies, as long as they do not get to ridiculous valuations, you do not want to be turning these things over that much.”

This approach is why Unisuper have been “getting out of private equity for some time,” he explains. Moving away from high fee investments is another reason for the reduction in expensive alternatives. “We want to be a low cost provider,” he says.

 

 

As the fixed income asset class undergoes rapid change and the opportunity set expands, unconstrained bond funds have become popular. But as this article examines, with that expanded opportunity set comes new considerations including a wider risk/return spectrum among managers.

 

Trends in the global investment universe tend to come around every six months or so. Think risk parity, smart beta, and now, unconstrained bond funds.

As measured by Morningstar in the US, assets in unconstrained bond funds grew by 80 per cent in 2013 to $123 billion, and of the 70-odd funds measured, more than 50 have track records of less than five years.

Whenever a trend is so strong as to be the competitive factor that managers are collectively pitching, there’s a need to investigate. Sometimes the risks are ignored, as the allure of diversifying sources of alpha hypnotises investors.

There’s a persuasive argument that it is difficult to construct a diversified, risk-controlled portfolio within the confines of a traditional core fixed income strategy.

Fixed income is an asset class that has undergone much change, partly because of the political influence, but also because of changes in emerging markets and new securitised instruments.

Are Unconstrained Bond Funds a Substitute for Core Bonds?, a paper by Wurts & Associates, a US institutional investment consulting firm, does a good job of outlining the risks of unconstrained bond funds.

It admits that unconstrained bond funds do play an important role in portfolios that rising interest rates would not negate, including acting as a diversifier of equity risk, stabilising a portfolio’s value in falling equity markets. However it points out that the universe of managers offering these unconstrained strategies have substituted credit risk for interest rate risk.

The idea is that these go-anywhere funds allocate to assets on perceived attractiveness and so don’t have the limitations of benchmark sensitive assets.

And Wurts says that while in principle unconstrained bond funds are capable of playing the role that core bonds serve in an overall portfolio, in practice they don’t.

This is because they substitute credit risk for interest rate risk, and credit risk is highly correlated with equity risk. This means by taking on additional risk in seeking yield, they have failed to serve the role of core fixed income in offsetting equity risk and protecting capital.

As managers increase the number of bond sectors they can choose from the amount of necessary research and decisions they must make also increases.

A paper by Rick Rieder and Ann Marie Petach at BlackRock, Unconstrained Fixed Income – why, how and how much, talks about the importance of a dynamic approach in adjusting exposures and outlines the need for manager skill and resources in doing this.

For example, the opportunity set in the Barclays Global Aggregate Bond Index is 15,000 securities, compared to the 8,500 securities in the US Agg, requiring a good deal of resources to cover the opportunities adequately.

It also means a risk budgeting process is a necessity. And this is the point that both BlackRock and Wurts agree on. You need to know what you’re investing in, and adjust it dynamically, to meet the goals of the portfolio.

Wurts says that the differences in macro views and how managers execute their views have implications for the risks investors in unconstrained bond funds are exposed to and the role bonds play in a portfolio.

This is not a beta play, manager selection is paramount.

By way of example when the Barclays Aggregate bond index returned -2 per cent in 2013, the PIMCO unconstrained bond fund lost value, but the JP Morgan Strategic income fund produced positive returns. Both funds were unconstrained, in that they had the ability to go anywhere, but they had made very different choices in their holdings of treasuries and high yield bonds.

As BlackRock says, a flexible fixed-income strategy is not a cure-all, but it is a tool for the times.

But with that comes an increased spectrum of possible risk profiles and return outcomes among fund managers.

 

Rick Rieder, managing director, chief investment officer of fundamental fixed income and co-head of Americas fixed income at BlackRock, is one of the speakers at the conexust1f.flywheelstaging.com Fiduciary Investors Symposium to be held on campus at Harvard University from October 26-28.

 

 

 

There is a shift towards allocating to the factor premiums momentum, value and low volatility. However, since common factor indexes are a suboptimal way to harvest factor premiums, this paper shows the improved results of a more sophisticated approach. Factor strategies developed by Robeco lead to higher returns, while lowering the risks, resulting in higher Sharpe ratios. Read more about this white paper.

In the last of a series of articles exclusively for conexust1f.flywheelstaging.com, Roger Urwin, head of global content at Towers Watson examines the asset owner investment models that are recognised as best practice, questioning whether there are patterns to the models of success.

The best-practice investing model could either involve how you do it or what you do. In reality a successful model is about both, and how they line up. The rest of this article seeks to find the patterns that will make certain models successful. The secret is that there is no single answer; the best model depends very heavily on context.

In seeking answers to the question posed in the title, it seems important to list the characteristics that make asset owners distinctive types of organisations. First, they are very pure people businesses; they must be centred on effective governance, generate creative ideas and have streamlined processes. All three disciplines – governance, ideas and process – require talent.

Secondly these institutions work in not-for-profit forms in the long term, so avoiding the shorter-term ‘creative destruction’ of the for-profit sector;  they also have remarkably long time horizons in their missions; and are blessed with permanent capital with limited competition in gathering assets.

Thirdly, asset owners rely on a complex chain of external providers, notably asset managers (I’ll call it the ‘value chain’ from here).

It’s these characteristics that speak loudly to the best-practice question. This can explain how the ‘endowment model’ came to be a pin-up of its time and why it needs adaption in future.

The launchpad to the model was the exceptional investment thinking embodied in David Swensen’s ‘Pioneering Portfolio Management’.  It recognised the importance of good governance. It showed understanding of other investors’ limited recognition of the new field of private markets. It captured the rich early seams of the illiquidity premium. It worked the fertile areas in its value chain and did so with a talented investment team that had its specialisations but managed to integrate well with the external investment industry, particularly the private market sector.

Subsequently, however, in many places private markets have become over-crowded, making thinner pickings for illiquid assets. The investment thesis burns less bright as a result, but it has not been extinguished.  Taking advantage of long time horizons and differentiating yourself from the traditional index-centric asset class investment strategies has still got an attractive pattern to it.  Crucially though, this investing model needs to be supported by an organisational model with an uncompromising reliance on investment talent – both internal and external. As Yale have observed themselves in their most recent annual report, “while alpha is not dead, opportunities to access it may not be available to all investors”.

So where else should investors look for investment model inspiration?  A global search might well throw up the Canadian and Norwegian models; also there are notable examples in the Netherlands, UK and Australia.

But, before we look into these we should parse the finer distinctions between the different approaches. Earlier in this series, we discussed the overarching issues that we believe will shape the investment industry in the coming years (see “Challenges facing the world’s biggest funds”).

These are about differences in risk philosophy on private and public markets, the shape and philosophy in the value chain and the organisational design as regards integration or separation.

 

The managed risk route to higher performance

The risk budget can take on two areas of high conviction. The biggest opportunity is in how large the move away from bulk beta to produce high diversity is (that can be both in public and private markets), and there is also how long the decision-making time horizon is in both design and implementation.

As many investors seek better returns, reduced concentration on (equity and bond) bulk betas is a natural move. In public markets the obvious move is to commitments in alpha. But there are also opportunities in factor investing, other smart betas and liquid alternatives.

Investors can also go further with the esoteric and exotic:  think of reinsurance, volatility investing and alternative credit. While asset allocation as practiced a decade ago was making allocations to maybe eight or 10 asset classes, some now see allocation to around five buckets (grouping into risk premia, for example equities, credit, duration, real assets, skill) but as many as 25 allocation classes.

A distinctively different strand of this is the private markets area where there has been a rise in the popularity of real estate, infrastructure and private equity. These investments are symptoms of a more competitive pursuit of excess returns.  Of course the endowment model is associated with 50 per cent or more in private market assets; the more common version of this among the pension funds and sovereign funds is a 20 – 30 per cent allocation.

A longer time horizon sits well with these ideas.  Thematic opportunities around trends and discontinuities such as emerging wealth, ESG, resource degradation and scarcity, and demography can offer longer-term investment theses for further effective departures from the norm.

 

The organisational design route to high performance

The current organisational design debate pits integration against specialisation, and internal structure against external. These simple tags mask many subtle differences. The most significant issue concerns the specialisation drift of big funds. Specialisation carries a competitive edge and specialist teams may capture better alpha from their domain excellence.

But highly diverse strategies lose something in specialised silos, as tightly benchmarked asset class teams will forgo some opportunities in the merging mandates, horizontal themes and total portfolio areas. The approach adds together a series of bite-sized pieces.  There will be overlaps and inefficiencies as these are pieced together.

Increasingly favoured is the integrated model where the whole portfolio is considered as one.

This involves balancing factors, exposures, risks, correlations and thematic thinking over an entire fund; a significant, but logical, shift in approach. Every idea is tested in its risk return impact to the portfolio. The team can come together to compete with their ideas. This is not about filling buckets and managing tracking error – both concepts that have drawbacks in the specialist teams approach.

This ‘one portfolio’ approach offers a unique oversight into true risk exposures, whilst also allowing investors to have impact with thematic positions.  So it works well with the philosophy of multiple lenses to risk.

In the internal against external debate, there is no substitute for strong internal capabilities. This is particularly the case when it comes to private markets. The extent of external management is a value chain decision but a strong external model can never be complemented successfully by a weak internal model.

The model fund has to be uncompromisingly tough on the value chain.

It can look to drive out any cost excesses and value-add blemishes from the value chain by considering embedded costs alongside explicit costs, and ensure that they achieve value propositions in all situations.

In many cases this analysis may lead funds towards the conclusion of increasing internal management. Funds by and large on my calculations spend too much on external strategies that border on hope. Hope is not a strategy.

 

Investment rigour and alignment

We now come full circle to the two must-haves in the model: rigour and alignment.

Rigour combines deeply-held beliefs, coherent investment processes and diligent execution. The governance binding these elements is critical.

Board governance often undermines strong executive management. The alignment connects the competitive position of the fund, the intellectual rigour to the positions taken, and the organisational design and value chain.

We have good examples of this alignment in the frequently quoted Norwegian and Canadian models.  Each is a joined-up mix of features. The Norwegian model is based around strong cost-controlled governance, a select internally-oriented team and narrow breadth in active management. The Canadian model is based around strong value-driven governance, specialist internally-oriented teams and wide breadth in active management

The third model (the one with no name, I’d try ‘Australian model’ after Future Fund) is the one based on strong long-term governance, integrated internal and external team, and wide breadth in active management. Wellcome Trust is another exemplar here.

We should also debate one other dimension – the sustainable investing model.

The concept of sustainability in investment is concerned with strategies that are designed to be effective in the short and long term, recognising the complex linkages between short and long term while balancing the financial and non-financial factors. ESG lies at the prosaic end of sustainability; the more meaningful end is broader, being keyed into a long-term sustainable mission.

One of the best examples here is the Dutch pension fund PFZW (managed by PGGM).

Their philosophy is to take some ‘responsibility for contributing tangibly to a sustainable world’ while assuming ‘a sustainable world is a necessary condition for generating adequate returns over long investment horizons’.

That is basically an articulation of the ‘universal owner’ model that a large asset owner with a long horizon and globally diverse investment ownership should contribute to the economic and sustainable well-being of society because it is ultimately in their financial and non-financial interests to do so.

Asset owners of course will find themselves in unique circumstances, particularly those born of constraints from scale, politics, governance and culture. There are unique objectives, history and resources to factor in.

It seems questionable then to posit a series of ‘investment models’ (let alone just one) as a way to position investors to compete for the returns they require. None of the above models is fit for exact imitation but all create clusters of attributes worthy of study.

The model needs to be one that matches compelling perceptiveness and depth in thinking and understanding, while taking control of the value chain with depth and quality at both ends – internal and external.  The model is both what you do and how you do it.

By Roger Urwin, global head of investment content at Towers Watson