Investing with consideration of environmental, social and corporate governance (ESG) criteria has increased significantly in recent years. However, for a long time, the perception of investors was that ESGfocussed investing detracts from investment performance. This perception is starting to change. In this paper, we show that focussing on ESG factors can enhance returns. In particular, we show that wellgoverned companies have tended to outperform poorly governed companies by an average of over 30 basis points per month over the last five years. Capturing this consistent source of value can enhance the returns of equity strategies.

This note explains our testing methodology, a breakdown of the results and describes how we integrate ESG analysis into our investment process.

There is no 3 per cent illiquidity premium in private equity, according to research by CEM Benchmarking.

A cost drag on private assets cancels out the returns of investing in private equity and real estate for those investors that outsource to external providers, the research finds.

CEM Benchmarking, which has a database of 354 pension funds from all over the globe with assets of about $7 trillion, looked at the benchmark and investment returns of those investors in private equity and real estate from 1995 to 2010.

Mike Heale, partner at CEM, says an implementation style factor is overwhelmingly dominant when funds outsource private assets and there is a cost drag of up to 7 per cent depending on the implementation style.

CEM looked at the returns of investors and the benchmarks they were using to measure their performance.

Most are using either peer-return based benchmarks, based on returns of other institutions like those produced by Cambridge, or market-based benchmarks which are not actually investable, such as the S&P500 plus 3 per cent.

In private equity market-based benchmarks dominate, with 71 per cent of investors using such benchmarks. In real estate peer-returns based benchmarks dominate with 68 per cent using these.

But these benchmarks are flawed, according to CEM.

“Most are uninvestable, they have timing mismatches and there are lags in the data and there are smoothing issues,” Heale says. “The valuations are lagged, they don’t reflect reality. And this causes a gross under-statement of risk. There is overwhelming noise in interpreting performance.”

CEM measured the performance of investors against a more “realistic” benchmark it constructed.

For private equity this was blended small cap equity index with a lag of 100 days, and for real estate it was the S&P REIT index with a lag of 200 days.

In private equity the average return of the pension funds in the CEM universe over the 16 year period was 9.3 per cent, compared with the CEM constructed benchmark of 9.2 per cent.

This is an average net value added of 0.1 per cent.

“Only 10 basis points above the benchmark over a 16 year period. The illiquidity premium doesn’t exist,” Heale says.

“Further, style matters. Whether you bother with private equity investments or not, depends on the costs of implementation.”

Those funds that are large and well-equipped to manage private equity internally, added an average of 3.5 per cent above the CEM benchmark over the period.

Pension funds with external managers added 0.2 per cent, and those with fund of fund managers had an average of 7.2 per cent, which was -1.6 per cent against the benchmark.

The results are worse for real estate where the net value added was -1.2 per cent over the period.

The same pattern of decline exists, with internally managed portfolios performing best (NVA of 1.2 per cent) with a sharp decline to external management (NVA of -1.6 per cent) and fund of funds (-3.9 per cent).

The S&P 500 for example, has returned an average of 11.3 per cent over that 16 year period.

Heale says CEM embarked on the research in recognition that funds have a hard time understanding or interpreting performance of private assets due to the fact there is so much noise in the benchmarks.

This year CEM is conducting research looking at the asset class performance targets of its clients.

The World Economic Forum’s 2014 Global Risk report, has implications for investors.

 

The report, released ahead of next week’s meeting in Davos, highlights how global risks are not only interconnected by also have systemic impacts.

The risks were broken down into economic, environmental, geo-political and social. The seven economic risks were: fiscal crises in key economies, failure of a major financial mechanism or institution, liquidity crises, structurally high unemployment/underemployment, oil-price shock to the global economy, failure/shortfall of critical infrastructure, decline of importance of the US dollar as a major currency.

The report encourages a culture of long-term thinking, by companies, investors and governments, as a way of mitigating and managing these risks.

The global risks were identified by surveying the World Economic Forum’s multistakeholder communities.

 

Ten global risks of highest concern in 2014

  1. Fiscal crises in key economies
  2. Structurally high unemployment/underemployment
  3. Water crises
  4. Severe income disparity
  5. Failure of climate change and mitigation and adaptation
  6. Greater incidence of extreme weather events
  7. Global governance failure
  8. Food crises
  9. Failure of a major financial mechanism/institution
  10. Profound political and social instability

 

 

 

 

Asset owners must step up and “join the fight” to end the focus on short-term results by companies and investment firms. Four practical steps to make this happen are outlined by president and chief executive of the Canada Pension Plan Investment Board, Mark Wiseman, and global managing director of McKinsey, Dominic Barton, in the most recent edition of the Harvard Business Review.

In the article, titled “Focusing capital on the long term” the authors outline four “proven” practical steps for big investors to take:

1. Define long-term objectives and risk appetite, and invest accordingly

2. Practice engagement and active ownership

3. Demand long-term metrics from companies to inform investment decisions

4. Structure institutional governance to support a long-term outlook.

Institutional investors own 73 per cent of the top 1,000 companies in the US, up from 47 per cent in 1973, so they should have both the scale and the time horizon to focus on the long term, the article says.

Asset owners need to focus on encouraging the long term focus both internally, and with the external funds managers that manage their portfolio. This includes an innovative approach to compensation and fee structures, mandates and investment structures.

The article outlines some innovative approaches that CPPIB has been experimenting with including offering to lock up capital with public equity investors for three years or more, paying low base fees but higher performance fees if careful analysis can tie results to truly superior managerial skill (rather than luck), and deferring a significant portion of performance-based cash payments while a longer-term track record builds.

 

The Harvard Business Review article is available below

Focusing Capital on the Long Term

As the growth of defined contribution plans continues to outpace the defined benefit sector, the focus for those running defined contribution plan sponsors should be on meeting objectives, good governance and investment risk management. Consulting firm, Mercer, has some advice for the DC sector.

According to Mercer establishing best practices across all areas of defined contribution plan management is critical as DC plans become the primary engine for retirement for so many people around the world. It’s 10 steps that DC plans should take in 2014 are set out below

1. Redefine success: ultimately, a plan is successful if it meets plan sponsor objectives and delivers future financial security to participants

Move beyond flat metrics such as participation levels and deferral rates. Analyse all participant behaviours that ultimately drive retirement outcomes, and develop sophisticated metrics and interventions to improve those outcomes.

2. Take a broader, sophisticated approach to investment risk: A delegated investment solution may help manage risk through the lens of plan participants

Research in behavioural finance has shown that risk management involves more than just the prudent selection of a diverse set of investment options.

Support employees by tailoring the plan’s investment risk profile to participant demographics. If resource constraints exist, consider the appropriateness of employing a delegated investment solution for all or part of the plan.

A delegated approach to developing a demographically-based investment strategy leverages time while transferring fiduciary risk

3. Understand target date fund fiduciary responsibility

As an increasingly popular asset class within DC plans, target date funds have come under heightened scrutiny by the regulators and state departments (particularly in the US).

Consider whether or not the target date funds in the plan will lead to the desired retirement outcomes for the plan’s participant base.

4. Say goodbye to revenue sharing: paying administrative fees based on each fund’s level of revenue sharing may not stand up to scrutiny.

A red flag arises if some participants pay higher administrative costs simply because their fund options carry revenue sharing. Achieve transparency and level allocation of administrative fees by reducing or eliminating revenue sharing, or by allocating it back to participants.

5. Consider the impact of inflation on participants’ retirement readiness: don’t let inflation erode outcomes

Despite the low interest rate environment from 2000 to 2013, participants’ purchasing power decreased by more than 20 per cent according to a Mercer study.

Purchasing power erosion and its effect on retirement readiness can lead to workforce planning issues. Help participants address this risk by assessing the appropriateness of offering a diversified inflation option within the plan.

6. Help participants sleep at night: financial wellness can promote a more productive workforce

Employees face significant financial burdens throughout their working lifetimes, from home buying to college saving to retirement preparation. Helping them put their financial house in order not only helps them save for retirement, but can also improve engagement and decrease stress levels.

7. Address the diversification challenge: consider implementing custom funds to increase participant diversification while keeping the investment line-up lean

In an effort to avoid participant confusion and investment choice overload, 60 per cent of plan sponsors offer participants fewer than 15 investment choices and many are looking to reduce that number to 10 or less. Custom funds can provide participants with access to greater diversification through exposure to alternatives, opportunistic fixed income and real asset strategies without adding complexity to their investment decision-making process.

8. Reassess the market: the evolution of the DC market has driven changes in vendor position, strategy and focus

How long has it been since the plan was put out to bid? In response to market pressures and financial constraints many vendors have changed their strategy and target market. At the same time, plans have grown, and their needs evolved. It may be time to explore what is out there.

9. Think Beyond Borders: globalisation is here

International markets make up a larger percentage of the investable universe than US markets. Delivering streamlined access to global investment opportunities across the asset class spectrum helps address participant behavioural biases, leading to improved asset allocation decisions and ultimately enhanced retirement outcomes.

10. Keep pushing the communication envelope: employees are accessing information in new ways. Are plan communications keeping pace?

Employees are increasingly using mobile technology, and the best communicators are engaged in generational targeting and strategies based on behavioural finance. Looking ahead, the success of gamification in education and employee training can be applied to retirement and financial education. Assess how new approaches to communications and targeting can more effectively reach the various populations within the plan to help drive engagement.

 

Chief executive of Cardano UK, Kerrin Rosenberg, is a Monty Python fan. In the same eccentric vein as the famous satirists he has a healthy disrespect for the status quo and a quirky view of how pension assets should be managed, which for most funds includes a radical change in asset allocation.

In 2010 Cardano, which is a solvency and risk management firm in the UK and The Netherlands, produced a video series with Monty Python explaining the behavioural aspects of risk management.

Now the Cardano gang are back at work with Terry Jones and co. on a documentary that helps explain why the financial crisis occurred.

It’s not often that finance journalism covers the intersection of actuarial-ism and surrealism, but it’s about time.

Chief executive of Cardano in the UK, Kerrin Rosenberg, is considered a pension thought-leader and he believes what makes the firm different is its focus on making sure the savings of the end user doesn’t blow-up. The notion just begs for Monty Python imagery.

“What makes us different is our beliefs regarding finance and in particular the behavioural finance aspects and how people think about risk, we’re trying to help the end user prevent from blowing up,” he says.

To do this requires breaking a cycle which starts with the over-estimation of returns, institutional failure, system failure and eventually the end user losing out.

In practice it means better risk management, and a focus on a more predictable, realistic result that is not reliant on an “over-achieving economy”.

This calls for a radical change in asset allocation and subsequently very little interest rate risk and equities.

Rosenberg, who was an early pioneer of the use of derivatives, unconstrained equities and hedge funds, says asset allocations should include “a lot of other things” apart from equities and interest rate exposures, including hedge funds, private equity, different types of property, pharmaceutical income streams, and lending to mining.

“When you move away from having a strategic asset allocation it removes constraints and you can look at investments on their validity to the portfolio,” he says.

 

The problem

The UK pension market is facing what Rosenberg calls a £1 trillion legacy problem, with accrued rights embedded in the system as ‘personal rights’.

“The UK fund salary market just involves two bets – long equities and short interest rates, that’s been a lousy thing to do for 30 years. Since Cardano started in the market in 2006, that there has been a £500 billion deterioration in the industry. The system is at a high chance of failure, it can’t meet the pension promise.”

While Cardano describes the November report by the Department for Work and Pensions on defined ambition as a “major step forward to solving the UK pensions problem”, the system is still over-reliant on unrealistic expectations.

“What do we need? £260 billion of employer contributions in the next 13 years and we need equities to outperform bonds by 3 per cent for 60 years. To put that in perspective this is £20 billion a year, which is nearly half of the yearly dividends of the whole stock market. If either of those don’t come out it will fail. The added problem is now is we’re in de-cumulation so it’s very sensitive to what happens in the next 15 years.”

Cardano, which acts as a large in-house pension fund, was set up with the philosophy that the risk management techniques of banks could be brought to pension funds. Part of this approach means not relying on any one economic outcome.

“It’s about very small risks, no one big approach, and accessing different types of strategies to cover your angles and being careful to size all of the risks put on.”

The approach includes having a strong top down view of the world but also analysing many scenarios.

“We have many scenarios because we know we’ll get it wrong. We fund investments that do well in an environment but won’t lose a lot in the opposite market.”

Innovative mandates with managers are also a hallmark, and if a theme or product doesn’t exist, Cardano will work with managers to create it.

The approach includes an “intense” use of derivatives to manage risks, with the firm trading from Rotterdam. The benchmark is the liabilities of the fund.

“We are fully matched unless risks are worth taking,” he says. “The most disciplined act is that every year we buy protection when it’s cheap, it’s a discipline every year.”

The approach is similar to Bridgewater’s high-profile All Weather fund, but Cardano claims to have one third the volatility, thus giving it a stability advantage.

Rosenberg speaks of the results of the firm, with the liability benchmark in mind.

From June 2008 to December 2012, liabilities in the UK market increased by 9 per cent per annum.

“Our funds were up by 11.5 per cent net of fees. The average pension fund in the UK was 2.5 per cent below the 9 per cent. Our risk has been one third of the average pension fund.”

He says their average client will get out of their deficit hole in 10 years if that performance continues.

Further, the firm’s alignment is based on the deficit, with a performance fee paid on the reduction of the liability.

A performance fee on the balance sheet? Now that’s surreal.