In the January/February issue of the Financial Analysts Journal, Jack Bogle, founder and former chief executive of the Vanguard Group, looks at the “all-in” investment expenses including not only expense ratios byt transaction costs, sales loads and cash drag.

He highlights, in particular, how damaging these costs can be over the long run, and reaffirms the warning he has consistently given to fund investors over the years:

“Do not allow the tyranny of compounding costs to overwhelm the magic of compounding returns”.

 

Bogle is now president of the Bogle Financial Markets Research Center. His article from the FAJ can be accessed here

 

Now in its fifth year GRESB, the benchmark that measures the sustainability performance of real estate portfolios, has been influential in changing the sector’s performance and environmental impact. Now Nils Kok, executive director of GRESB and associate professor in finance at Maastricht University, says that infrastructure and private equity assets are ripe for a benchmark as well.

The real estate sector is responsible for about 40 per cent of global greenhouse gas emissions and for 75 per cent of electricity consumption in the US alone so accountability with regard to sustainability can have a huge impact in this sector.

Just how much energy is consumed in the sector is demonstrated by last year’s GRESB survey which reported on 30,690, 998 MWh of total energy consumption, and 17,188,742 metric tonnes of GHG emissions.

Since the Global Real Estate Sustainability Benchmark (GRESB) began in 2009 carbon emissions from the real estate sector have significantly reduced, demonstrating the power of benchmarking funds on sustainability.

Executive director of GRESB Nils Kok says that five years in, he can now confidently say the industry is moving forward, which can be measured in disclosure and results.

“It is most encouraging, emissions are coming down quite quickly,” he says.

By example in the 2012 GRESB report, 171 property companies and funds surveyed reduced GHG emissions by 6 per cent – this is a reduction of 432,000 metric tons of CO2, the equivalent of removing 85,000 cars from the road.

 

Changing behaviour

The GRESB survey has been powerful in changing behaviour in the property sector for a number of reasons.

Firstly it was the result of collaborative work by a group of 11 of the world’s largest pension asset managers and Maastricht University including APG, PGGM, USS, ATP and OTPP.

Their aim was to create shareholder value and reduce the sector’s substantial carbon footprint.

Kok, who is a visiting Scholar at UC Berkeley and associate professor in finance at Maastricht University, says one of the reasons GRESB has been effective is because it is a single tool used by a large number of investors.

“One of the lessons from GRESB is you really need a number of larger investor to bundle ambitions into a single tool. It needs to be standardised and you have to give in and get consensus to what you measure,” he says. “Harmonisation is important.”

GRESB is now used by more than 100 institutional investors with combined $6.1 trillion to engage with their investments to improve the sustainability performance of their investment portfolio, and the global property sector, and it now covers 49,000 assets in 46 countries.

“Investors value disclosure above performance, transparency above ranking, that’s the message investors are sending,” Kok says. “Look at the numbers we have reached, it’s a tipping point, if you don’t disclose then you’re a minority.”

There are now 543 real estate companies and fund managers participating, and while that has been partly due to the influence of investors it is also evident that being green is beneficial to the portfolio holdings and returns of managers.

Kok says that small improvements in buildings can have large effects, and the impact of energy costs directly affects tenants and investors.

The economic significance of green buildings can be seen in energy savings, but also lower insurance premiums, and it has also reputation effects which impact rent and corporate preferences.

Research conducted by Kok which looked at 28,000 office buildings, 3,000 of which are certified by EPAs Energy Star or the US green Building Council, found that green buildings have higher rents and higher selling prices.

It shows the average non-green building in the rental sample would be worth $5.6 million more if it were converted to green. Further his study has found that a $1 saving in energy costs is associated with an increase of effective rent of 95 cents, and a 4.9 per cent premium in market capitalisation, which is equivalent to $13 per square foot.

But Kok argues there are still a number of measures that can be taken to improve efficiency further. For instance, having a sustainably built building is only useful if the tenants take advantage of what is available.

“There is room to influence the behaviour of occupants,” he says pointing to Number One Bligh Street in Sydney, Australia as an example. “The building is impressive, but per square feet it is not that impressive because it is intensively used by traders and banks which have intense energy use.”

There is s still a lot of innovation that can happen, Kok says, pointing to technology improvements but also sharing concepts seen in the consumer space like Airbnb.

“Things like Airbnb work well in the consumer space, and it would be good to get some more flexible concepts in the commercial space like short leases or flexibility in the use of space.”

 

Infrastructure and private equity benchmarks

The survey, which was designed in 2009, captures more than 50 data points of environmental and social performance integrated into the business practices of each real-estate company or fund. It looks at the management of the company and also the underlying assets.

Kok believes the same could be applied to the infrastructure and private equity asset classes and that investors are showing greater interest in these areas.

“Within infrastructure you could look at the ESG that the manager applies, but then also the underlying assets and social characteristics. It is ripe for a standardised measure as well,” he says.

There are still a lot of relative differences among managers and funds within real estate, but also infrastructure and private equity, and Kok says a benchmark helps.

“The question about a benchmark is does it measure the right thing, we think it does,” he says. “There are always reasons why a fund underperforms its peers and the benchmark can be a starting point for a conversation.”

While acknowledging that there is danger in a benchmark being reduced to a single number, Kok says transparency and performance of a benchmark focuses the mind especially of top management. This works for financial benchmarking and other forms of benchmarking as well.

 

Sustainability and performance

Since GRESB started collecting data in 2009 there has been a substantial improvement in the sustainability performance of real estate across the globe.  Importantly sustainability improvements also correlate with returns.

This is demonstrated in a paper by Kok and fellow Maastricht professors Piet Eichholtz and Erkan Yonder – Portfolio greenness and the financial performance of REITs – that finds investment performance of REITs is positively related to the adoption of Energy Star and LEED certification in REIT portfolios.

In a prior interview Eichholtz, who is chairman of the Global Real Estate Sustainability benchmark, says the paper shows there is a relationship between greenness and performance.

“The greener the company/portfolios the better the performance, also free cashflow was higher and risk was lower, and beta was substantially lower,” he says. “This paper shows that the relationship between financial performance and sustainability is really there.”

Eichholtz says the philosophy of GRESB is that “you can make good money by improving the world”, he says.

“Members of GRESB, the pension funds, see that sustainability and investment performance go hand in hand and they talk to companies and say get your act together.”

 

 

 

For information on the 2014 GRESB survey click here

 

Given the importance of equity risk premium, it is surprising how haphazard the estimation of equity risk premiums remains in practice.

This paper by Aswath Damodaran at the New York University Stern School of Business examines a number of different approaches to determining the equity risk premium and why different approaches yield different values. It closes by looking at how to choose the “right” number to use in analysis.

 

The paper can be downloaded here

 

 

The $6.6 billion University of Toronto Asset Management made some significant active tilts last year resulting in the return on the university’s main portfolio exceeding target return by about 10 per cent. Amanda White spoke to president and chief executive, Bill Moriarty.

 

Last year was a reasonably easy environment in which to make better beta bets, says University of Toronto Asset Management’s president and chief executive, Bill Moriarty.

However this year looks like one of “blocking and tackling” he says.

Last year UTAM made a number of tilts that worked well, including reducing government bond exposures to the minimum level within its band and substituting it for an internally customised absolute return portfolio.

“The portfolio we put together generated about 8 per cent return versus government bonds at about -2 per cent,” he says.

UTAM now has a reference portfolio, derived last year, which has an allocation of Canadian equities (16 per cent), US equity (18 per cent), international developed markets equity (16 per cent), emerging markets equity (10 per cent), credit (20 per cent), and rates (20 per cent).

In reality the actual portfolio is agnostic to implementation and has private and public market allocations as well as long/short strategies.

In addition to the move away from government bonds, the UTAM team made a significant tilt away from traditional credit, something that Moriarty says it will continue to do.

“We have moved away from investment grade and high yield and more into specialised strategies and products such as direct lending and structured credit,” he says. “Moving to areas of markets where there is complexity and dislocation but not the flow of liquidity.”

Other tilts he said that have been testament to the team working well have been the manager selection in EAFE and Canadian allocations, as well as about 50 basis points added from currency bets.

“We’ve had a had a pretty good. It’s great, but I’m conscious we should enjoy it while the sun shines, successful investing doesn’t happen in the short term, it has to be long term,” Moriarty says.

“Last year it was easy to make better beta bets, but that’s more difficult now. We are now in a period of blocking and tackling.”

What this means is that within in the individual sleeves, or within asset classes, there has to be more attention to the opportunities and strategies employed, with less attention paid to the beta or strategic bets.

For example UTAM has a 10 per cent allocation to emerging markets, predominantly in public market equities. Now the team is examining whether there is a better way to allocate within emerging markets.

“We believe in active management so we are looking at things like regional tilts or sector bets. We have taken a little out of US equities and re-deploying that. We are also still intrigued by credit opportunities, we think there is reason to believe that fault levels in credit will stay moderate and there are dislocated pockets.”

UTAM has allocated to European credit in the past year, and is also looking at what it says are considerable opportunities in China, through the A-shares market.

UTAM’s target return is 4 per cent plus inflation and in the past year returned 1000 basis points over that. Part of that has come from market return with the reference portfolio outperforming by 700 basis points, and then active management added another 300 basis points.

He investment process is to look at the underlying factors or return drivers are equity, interest rates, credit, inflation, currency and cash, and while there is no discrete allocation to private markets, in in actuality and implementation of the investments the team can choose whether the best opportunity is in a long only, long/short or a private markets manager.

“We look at the underlying risk drivers in those three and look at return payoffs,” Moriarty says. “We have a mixture of trading strategies but we like managers who are more concentrated – what their edge or approach is, active share.”

UTAM employs 19 people, about 12 of which are investment professionals. It doesn’t have

dedicated people to public, private markets, rather everyone is encouraged to think whether there will be better return from liquid or illiquid implementation.

“We work on making sure the process is thoughtful, repeatable and the people are committed to it. They don’t have to fill the bucket,” he says.

In Canada, like other markets including Sweden and Australia, there is a constant dialogue about consolidation and the fact large funds can achieve better results.

But Moriarty believes his team’s performance over the past year is testament to the fact moderate sized team and assets can generate returns above your reference portfolio.

“You don’t have to be huge to earn alpha?” he asks.

Investors are all talking about the same thing –that alpha will come from selective opportunities and implementation techniques within sectors, and the next year will be less about strategic or beta bets. Specifically credit opportunities remain front and centre of the collective investors’ radar.

Managers, it turns out, are all also talking about the same thing – unconstrained fixed income – which is the all-encompassing version of what investors are looking at.

But, at least from what I see, investors want to be opportunistic and nimble, which raises the question of whether there are constraints within the confines of an unconstrained mandate?

At least three corporate pension funds I’ve spoken with recently, in the US and the UK, have been employing interesting opportunistic and entrepreneurial spirit in taking advantage of some of the fallout in the banking sector.

Where traditional sources of lending have dried up, pension funds are acting directly as sources of liquidity, and in some cases making really good returns in short time periods.

A couple of examples include the £5.5 billion ($9 billion) Centrica corporate pension fund which has been actively involved in direct lending, mezzanine financing and senior loans.

The fund allocations are driven by the best way to achieve return targets and investments are allocated to asset classes on a bottom up basis, aggregating up to percentage holdings in return-seeking and liability-matching. It doesn’t fill asset class buckets, which means it can allocate freely and quickly.

Similarly the $28 billion United Parcel Service corporate pension fund has made new investments to structured credit, bank recapitalisation strategies, and an investigation into ownership interests.

It has a specific 10 per cent allocation to opportunistic liquid alternatives, and the lack of liquidity constraints the fund has, partly because of a young membership, combined with the ability of the private markets team to evaluate opportunities, and the flexibility to commit capital quickly has meant the fund be active.

Both these funds are very dynamic and are focusing on the ability to be opportunistic within sectors, rather than strategic. While they also have unconstrained mandates with managers, they seek to allocate opportunistically on a direct basis.

In Australia the $26 billion Sunsuper is also looking actively at direct investing, and its behaviour is testament to the shift in the way asset owners are approaching investments, acting more like a bank or a private equity firm than they have in the past.

In one co-investment deal the fund invested $15 million in and within two months it got back $45 million.

In the past couple of years the fund has increased its allocation to distressed debt which has returned 16.7 per cent return per annum since 2004.

It’s the kind of stuff the really big pension funds, like CPPIB, PPGM and APG, have been doing for years, but is now a part of the mid-to-smaller fund’s investment activities.

In addition to these pension funds acting more like lenders, this behaviour has also influenced the way asset owners are working with their providers – they are more patient, waiting for the right manager’s offering to suit the opportunity, and more willing to negotiate fees.

The University of Toronto Asset Management, which manages the endowment’s $6 billion, made a significant tilt last year away from traditional credit in investment grade and high yield and more into specialised strategies and products such as direct lending, and structured credit.

The move was inspired by looking at areas of the market which have more complexity and dislocation but not the flow of liquidity.

If the market conditions of high volatility, low interest rates and changes in government policy continue then this seems to be a natural fit for the profile of asset owners which have large balance sheets and low liquidity needs.

But the view of one investor that has been playing the credit market for some time, the $50 billion Healthcare of Ontario Pension Plan, is that corporate credit spreads are as tight as they were in 2007, which means there is not as much pay off to take risk.

Similarly the latest credit report from Morgan Stanley issues a warning about the prospect of a rise in interest rates. and the effect on the more traditional credit space.

It says that despite richer valuations, credit spreads could slowly grind tighter over the coming year or two. And it also says that high yield would also be the strongest performing asset class again.

For investors playing in credit it’s a reminder of how fickle, complicated and volatile the markets can be.

 

 

 

 

 

 

The PRI has launched a guide for ESG integration among general partners in private equity,  looking at ESG within a GP organisation and within its investment process.

The guide provides suggestions on how to incorporate ESG factors into ownership practices and processes, including seeking appropriate disclosure from these companies on ESG risks and opportunities and reporting on this to their stakeholders.

More than 50 GPs were interviewed for the guide, and selected case studies are used as examples of ESG implementation – including KKR, Blue Wolf Capital Partners, and Apax.

Limited partners can use the guide to understand the different ESG integration practices being implemented.

The guide can be accessed here

Integrating ESG in private equity