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.

http://www.nestpensions.org.uk/schemeweb/NestWeb/includes/public/docs/improving-consumer-confidence-in-saving-for-retirement,PDF.pdf

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.”

 

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.