Institutional investors are sheltered by competition, which in some instances can be beneficial, but it also means they are shielded from competitive forces that drive innovation. A new paper by Gordon Clark and Ashby Monk, looks at why the current model of either insourcing or outsourcing investment management doesn’t allow for innovation, and the models of cooperation and collaboration that can change that.

 

There has been a surprising lack of institutional innovation among asset owners, suggest co-authors Professors Gordon Clark and Ashby Monk, due in part to the fact the current organisation and management of these institutions has been stagnant since their establishment – in many cases 50 to 70 years ago.

This is an important observation in the context of the rapid rate of transformation in the investment management industry, and the rate of product innovation in global financial markets.

It’s a problem because the lack of innovation has transcended the behaviour of investors.

“The stasis of the sector has been such that these types of financial institutions have, on the margin, taken higher levels of risk in the hope of realising returns that could compensate or the low rates of institutional adaptation and development. At the limit, the crisis facing US public funds is illustrative of the costs and consequences of institutional stasis,” the authors say.

A new paper by Clark and Monk, “Transcending home bias – institutional innovation through cooperation and collaboration in the context of financial instability“, suggests that industry wide norms favour continuity and that investors must look to new organisational forms for innovation.

The paper argues there is now a premium on institutional innovation, whether internal or external, whereas in the past there was less emphasis on make or buy, as it was less important than issues of strategic asset allocation and investment management.

Cooperation or collaboration between institutions, they suggest, allows a space for senior managers to experiment and learn which can then be applied to their own organisations or external providers.

Clark, who is a professor at the Smith School of Enterprise and the Environment at Oxford University, says that whether managing assets in house or through an external provider, institutional investors, are not faced with an opportunity to learn a new way of doing things.

“The contractual basis for outsourcing is very sterile, the terms and conditions are so well known and are always the same, it doesn’t give you much of a relationship with providers,” he says.

Clark and Monk, who is the executive director at the Global Projects Center, Stanford University, argue the problem facing institutional investors is more than that of responding to financial instability, the aftermath of the GFC and on-going euro crisis. And that recurrent financial crises have masked a significant shift in the underlying properties of financial markets.

Responding to these circumstances requires flexibility in institutional form and function, and they argue that the current norms of in-sourcing or out-sourcing investment management don’t provide senior managers enough flexibility to respond to changing market conditions.

Cooperation, at a minimum, and collaboration, at a maximum, can be seen as opening up an “action space” for innovation otherwise denied by the norms and conventions of the sector.

While there are some barriers and costs to collaboration, as outlined in the paper, the benefits are many including giving senior managers opportunities to create, extend or modify the resource base of their organisation.

“It allows a space for in house managers a place to learn and experiment outside their own organisation,” Clark says.

The key to successful collaboration is an issue explored in another paper published last year in the Rotman International Journal of Pension Management.

In “Effective investor collaboration – enlarging the shadow of the future” author Danyelle Guyatt, tested an eight-step framework based on collaboration theory, and looked at how it worked in 12 real-world investor collaborations.

Guyatt found a number of factors underpinned effective collaboration: a high level of trust among members, a similar mindset, sharing common interests and an open atmosphere.

The groups that ranked highest in terms of effectiveness were typically smaller groups which suggests a correlation between the size and action of a group.

The effective collaborations also all shared a high level of active involvement from their members in small-group meetings, working groups, research groups and events.

On the flip side, those collaborations that didn’t work as well shared a lack of clarity about their goals, a fragmented target group, lack of trust, bureaucracy among implementation and not enough focus on outcomes.

 

 

 

 

Academics from the London Business School, Boston College and Temple University, examine the outperformance of US public companies following corporate social responsibility engagement. The paper, Active Ownership, shows that after successful engagements the companies experience improvements in operating performance, profitability, efficiency and governance.

The paper can be accessed by clicking here

This paper commissioned by the Norwegian Ministry of Finance investigates the possibilities for the Government Pension Fund Global (GPFG) to profit from liquidity premiums in  illiquid investments. It looks at the empirical evidence for the presence of liquidity effects in a broad range of asset classes: listed equities, corporate bonds, treasury and agency bonds, and alternative asset classes such as real estate and private equity.

 

The paper can be accessed here

The Norwegian Government Pension Fund’s potential for capturing illiquidity premiums

How to implement ESG into portfolio construction and implementation is an ongoing challenge for asset owners. Mercer has come up with a number of strategies including the best way to use ESG ratings, active ownership, and tailored strategies that play to sustainability themes, including its own unlisted investment solution. Amanda White spoke to Jane Ambachtsheer, global leader of responsible investment and Nick White, global director of portfolio construction research.

 

Much of the advancement in sustainable investing implementation has been at the big end of town; among large sophisticated asset owners with the ability to devote resources to the risks and opportunities.

But a back to basics approach by Mercer is now making ESG integration accessible for all investors, and has resulted in a new paper, “An investment framework for sustainable growth: capturing a broader set of risks and opportunities – integrating ESG and sustainable themes”, which outlines adoptable methods for ESG integration. (download the paper here ESG Framework)

“We wanted to take a step back to first principles and make sure we were not leaving too many people behind,” says Jane Ambachtsheer, global leader of responsible investment.

While there are still big regional differences both in sustainable philosophies and regulatory requirements, Ambachtsheer has seen a lot more interest in the implementation of ESG ideas in asset owner portfolios.

She stresses that no matter the path chosen that the first part of the process is a beliefs and implementation plan to make sure ESG takes on an appropriate role.

Essentially sustainability can be implemented through three tools: risk management, active ownership, and specific investment solutions.

From a risk management perspective, there are now up to 5,000 strategies with ESG ratings from Mercer, with only 10 per cent receiving the highest ratings (ESG1 or 2).

Nick White, global director of portfolio construction research, says investors need to understand what is going into those ratings, and how they can be used.

“A manager with a highly rated portfolio of ESG stocks might not be a good performer because it is not making the most of that,” he says. “By the same token we ask whether a quality manager, which has a great level of robustness, can be strengthened further by strengthening ESG.”

Mercer first began using ESG ratings within the responsible investment team in the late 2000’s. It soon became evident the ratings would be more powerful if they sat with the analyst and in 2010 they were integrated into research at the manager level.

Ambachtsheer’s team produced a lot of documentation around the expected investor behaviour for high rated ESG managers, and prepared case studies and questions for the researchers to ask. There was a lot of education and training of the Mercer analysts as the ESG ratings were integrated.

Now White says the ESG ratings are a complement to the conventional manager assessment, and while they are not an absolute determinant of an overall manager rating, if there are two A-rated managers, the one with the higher ESG rating will be preferred.

One of the services Mercer will engage with a client is a benchmarking, and gap analysis of their portfolio’s ESG ratings.

This then identifies the managers that are not performing and gives clients tools to either turnover the manager or influence them to change through engagement.

Engagement is the second tool that Mercer says that clients can use to implement sustainability, and Ambachtsheer says this comes back to the asset owners beliefs and priorities and it is important that time is spent on those so that engagement is not reactive.

“Engagement has made the most progress for asset owners,” she says, pointing to recent engagement by asset owners with oil and gas companies over expenditure on new reserves research. “But it is difficult to decide to engage until you have thought through your own position.”

The third area, and one where Mercer has spent a lot of time, is capturing the sustainability theme within investment solutions.

It is now in the manager selection stage of an unlisted global sustainability product that includes infrastructure and private equity around a broad range of sustainability themes including water, waste and natural resources.

It is essentially the implementation of Mercer’s Climate Change Asset Allocation Study.

“ESG is a factor like momentum or value. Targeting a sustainability theme is looking at where the growth is coming from,” White says. “We think it’s about understanding how the world is changing.”

There is a massive spectrum of understanding among investors about ESG, and White says the scrutiny around proof is so much more emphasised than in other sectors, but he believes there is a lot of evidence to say there is alpha in ESG, and points to the DB Advisors paper on Sustainable_Investing_2012.

“Alpha is revealed in different forms, for example it looks at ESG funds and shows they have lower cost of capital and higher accounting and market based performance,” he says.

Mercer is also seeing a lot of innovation in passive investment and is reviewing in detail the processes of passive managers, and will produce ESG ratings of passive managers later this year.

 

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

 

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

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

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

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

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

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

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

 

Governance review

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

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

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

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

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

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

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

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

 

Growth and governance

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

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

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

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

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

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

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

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

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

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

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

 

Public disclosure of signatories reporting

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

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

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

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

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

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

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

 

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

 

The paper is available below

Factor investing in practice