The impact of higher rates on equity returns is a concern for investors and to some extent an unknown. But by applying the concept a threshold correlation, as done with bond portfolios with a duration targeting framework, it is possible to better understand the complex interactions between equity returns and interest rate movements.

The latest portfolio strategy research paper by Morgan Stanley Research’s Martin Leibowitz and Anthony Bova, shows that while theoretical, uses duration targeting for equities and the concept of a threshold correlation to provide some guidance in assessing the impact of rising rates on long-term equity returns.

It finds there is a threshold correlation between equities and interest rates that can be applied to maintain an initial expected require return across a range of interest rate paths.

For a 10-year horizon the threshold correlation was found to be -0.3, so a correlation greater than that leads to improved 10-year returns for positive drift rates and to a deteriorating 10puyear returns for negative rate drifts.

Over shorter horizons, such as five years, the threshold correlation is -0.15

The study focuses on two simulations: rate-driven increases in expected equity return; and realised return drags from adverse equity/rate correlations. It uses a simulation approach with two interconnected random walks for interest rates and equity returns.

 

The detailed paper Portfolio Strategy: A Theoretical Model of Equity / Bond Correlation under Rising Rates, can be accessed in the Morgan Stanley Investment Management Journal InvMgtJournal_2014v4i1

 

From allocating assets in order to achieve a healthy funding status, to keeping up with technology that analyses portfolio risk, the challenges of asset owners are relentlessly evolving. For asset managers, like AQR, the key to their own evolution and success is how to be more relevant to clients.

AQR keeps clients’ needs firmly within its sights. In January it conducted a workshop on how to be even more relevant to clients, which among other things discussed how to better use technology to give clients’ continuous access to their portfolio’s performance.

Co-founder, David Kabiller, says clients are at the centre of the innovation at the firm, with the organisational culture centred around how to recruit the right people and create fertile ground to innovate.

“We have “applied” in our name so our work needs to be relevant and practical. We are interested in practical innovation,” Kabiller says.

All employees of AQR have deep shared values about the power of intellectual rigour, a respect for markets and a belief that there’s an ‘efficient amount of inefficiency’.

“We believe that through intensive research you can beat markets, but it’s not easy,” Kabiller says. “We believe our strategies have a statistical edge and an intellectual honesty.”

The aim is that this research-oriented approach will be economically intuitive, pervasive and persistent through time, but a business risk is “group think”.

“Every now and then we hire professionals who think differently and challenge thoughts,” Kabiller says, naming Michael Mendelson, a principal who is also a portfolio manager of AQR’s risk parity strategies, as an example.

But 16 years since the launch of the firm, something is working. The manager now has more than $100 billion under management, up from $19 billion almost exactly five years ago.

Part of the success Kabiller attributes to an innovation intensity stemming from a “depression-era mentality” earned primarily during the firm’s difficult first year and a half.

“You have to differentiate between a bad period in a good process versus a broken process – you need judgment and research to do that. In 1999 everyone was making money and we were having a difficult time, but then in 2000-01 we performed very well,” he says. “We learnt a lot through that – including humility- but also how to be better investment managers and risk managers as well as the value and importance of client communication.”

This humility, among over-achievers, is a cornerstone of the culture, with Kabiller and his co-founders constantly asking themselves philosophical questions and challenging themselves to make their processes better.

“As a firm we think we always have a lot to prove. There is no substitute for good judgement and for acknowledging that we don’t have all the answers so we have to keep asking questions, keep searching for new and pragmatic ideas,” he says.

AQR now offers 24 funds categorised across alternative investment, momentum, risk parity and equity, and while it’s tempting for a research-based, intellectually rigorous firm to innovate because they can, any innovation comes in the form of improving the offering to clients.

Ultimately, what the innovation question leads to is an enquiry about alpha. Is alpha in portfolio construction or risk control?

“When you realise alpha is ephemeral, it’s difficult to scale, it’s imperative that you properly structure betas,” Kabiller says. “We try to focus on what matters.”

One of the more successful innovations at AQR has been the examination of and conviction in factor styles, which has led to the Style Premia Alternative Fund, but also the ability to empirically decomposes investments and makes each component a building block available to clients.

“We can offer a menu of different risk profiles and exposures to clients. By doing this we can make investment more understandable because we can decompose it. Then our clients can pick and choose, reassemble and customise according to their own risk appetite and need,” Kabiller says.

It’s one way the question of how to become more relevant to clients is being answered.

Principal and head of the global alternative premia group, Ronen Israel, describes the breakdown of the building blocks as consisting of four styles and six asset groups all being captured in a consistent long-term framework.

“The building blocks possess the characteristics we’re trying to capture. Characteristics change through time and the underlying positions can change, sometimes frequently for style rebalancing,” Israel says.

A lot of work has gone into determining, and agreeing to the building blocks: the four styles of value, momentum, carry and defensive and the six asset groups of stocks, industries, equity indices, bonds, currencies, interest rates, and commodities.

“We picked those four styles because they can be applied across those multiple asset groups, they have the most long-term evidence and can be implemented in liquid portfolios,” Israel says.

For Cliff Asness, managing and founding principal, it’s personal.

“A lot of years went into getting the four – to agreeing to those factors I can plant my flag on and say we will get it right seven out of 10 years,” he says.

Asness says the advantage is this building block approach is an exposure to the characteristics it is trying to capture can consistently be achieved.

It’s shifting the focus from specific stocks to factors.

“We can fairly guarantee, in the individual stock world, that no one stocks’ event will kill us or make our year,” he says. “We can’t guarantee this is always going to work but we are taking out small idiosyncratic exposures we don’t have an opinion on.”

Israel says the empirical and economic evidence of the four underlying factors is very similar so allocations are spread equally among all of them in order to avoid a long term tilt. It’s a market-neutral long /short strategy across the six asset groups and four styles.

One of the client/manager crossroads at AQR is about market views and timing.

Given its quantitative nature, most of what AQR employs has little to do with market views. But as Asness points out: “clients care so we care”.

Interestingly the quant nature of the firm, and Asness biases, doesn’t stop him having a view on markets, however.

“It is a fair global statement to say that US stocks and bonds are expensive relative to prices in the last century or so. However we don’t use that information for market timing, we use it for setting expectations. And if we are forecasting 10-year returns then stocks and bonds look expensive versus the history,” he says.

Many of AQR’s clients are US pension funds, which on an average have an 8 per cent return target.

“This is unrealistic,” Asness says, making a quick calculation.

According to his numbers US stock 10 year numbers are 4.5 per cent real, with inflation of 2.5 per cent, that’s 7 per cent on 60 per cent of the portfolio. Bonds are less with real yields barely positive. This means 60 per cent of the portfolio at a 7 per cent return, and 40 per cent at 3 per cent, gives 4.2 per cent plus 1.2 per cent which is a return expectation of 5.4 per cent before fees.

“There is nothing to save us, but realistic expectations and more contributions,” he says of pension funds.

 

 

Even though there has been dramatic globalisation over the past 20 years it still makes sense to segregate global equities into “developed” and “emerging” market buckets, according to a paper by Columbia and Duke academics.

The research, which has important policy implications for institutional and pension fund management, shows that while correlations between developed and emerging markets have increased, the process of integration of these markets into world markets is incomplete.

Emerging markets account for more than 30 per cent of world GDP, but they only account for 12.6 per cent of world equity capitalisation. They argue this incomplete integration along with the relatively small equity market capitalisation creates potentially attractive investment opportunities.

 

To access the paper click here

 

This article by Arthur Wilmarth from George Washington University Law School uses Citigroup as a case study to demonstrate the question of whether bank executives and regulators are able to supervise and control today’s complex megabanks.

The study shows that post-mortem evaluations of Citigroup’s near-collapse revealed that neither Citigroup’s managers nor its regulators recognized the systemic risks embedded in the bank’s far-flung operations. Thus, Citigroup was not only too big to fail but also too large and too complex to manage or regulate effectively. Citigroup’s history raises deeply troubling questions about the ability of bank executives and regulators to supervise and control today’s megabanks.

According to the article, Citigroup’s original creators – John Reed of Citicorp and Sandy Weill of Travelers – admitted in recent years that Citigroup’s universal banking model failed, and they called on Congress to reinstate the Glass-Steagall Act’s separation between commercial and investment banks. As Reed and Weill acknowledged, the universal banking model is deeply flawed by its excessive organizational complexity, its vulnerability to culture clashes and conflicts of interest, and its tendency to permit excessive risk-taking within far-flung, semi-autonomous units that lack adequate oversight from either senior managers or regulators.

The paper can be downloaded here 

 

As the chief executive of a financial services media and events business, Colin Tate* benefits from the growth in the banking sector. But at the same time he is perplexed by their bad corporate behaviour, large pay packets, and secret negotiations. It’s time, he says, for institutional investors to demand change.

 

I’m not a bank basher. To the contrary, I benefit from the financial system, arguably more than many. I am the major shareholder of Conexus Financial, which publishes five media titles and hosts a dozen conferences, and many of our clients are banks or subsidiaries of banks.

That said, I am disturbed by the seeming lack of real lessons learned, as demonstrated by a lack of behavioural change from the financial crisis.

The “greed is good” mantra that emanates from those trusted with (mostly) other peoples’ money, is disconcerting. It makes me question whether the American-mindset is out of touch with the rest of the planet.

I understand this commentary will be offensive to some of our readers and many of our advertisers. Good.

This has gone on long enough. It’s time to have a frank and open discussion about the behaviour of banks and other financial institutions, and indeed the inactivity from the institutional investors which have the ability to influence this behaviour, and don’t.

Underneath the layers of players we must remember that this is mostly workers capital; the worlds’ retirement savings.

This past month a new scam has been uncovered, in which a major global bank, the venerable Credit Suisse, has been in cahoots with US citizens in illegal tax avoidance – but it says it was the work of a small number of “rogue” bankers.

Meanwhile, RBS has announced an $8 billion loss, but somehow found the wherewithal to pay $576 million in executive bonuses, while still majority-owned by the UK taxpayer.

What is perhaps more surprising are recent comments by UBS global chief, Sergio Ermotti, who at the recent Davos World Economic Forum said critics of banks should ‘back off’.

Quoted in the Wall Street Journal a clearly exasperated Ermotti said: “Life is hard enough, and I think this constant lecturing on ethics and integrity by many stakeholders is probably the most frustrating part of the equation. Because I don’t think there are many people who are perfect. We are far from being perfect…but it’s not going to be very helpful to be constantly bashing banks.”

UBS has been bailed out by tax payers, suffered huge losses, endured a rogue trading scandal, and has admitted a central role in the manipulation of the London interbank offered rate (LIBOR) – paying a $1.5 billion fine to regulators in December 2012 as a result.

Is he for real?

But maybe the Oscar should go to JP Morgan and its chief: Jamie Dimon.

Dimon took home an 85 per cent increase in bonus in 2013, pocketing $18.5 million worth of restricted stock (his base salary is “only” $1.5 million), up from $10 million the year before, and following a period when the bank’s fines totalled a reported $18.6 billion, relating to “inappropriate or illegal” behaviour.

The bank attributed the pay increase to a number of factors including Dimon’s role in cutting a deal with Washington.

What am I missing? What are we rewarding here? Besides the staggering size of the dollars involved and the staggering size of the bonuses awarded while these organisations downsized and laid off staff globally, why are we not more strongly questioning the ethics?

There is always fertile ground for debate when it comes to ethics, an issue which in my mind goes beyond the letter of the law. Institutional investors and the value chain of investment players have a fiduciary duty to act in the best interests of those whose money they manage.

Ethics and investment is at a crossroad. The CFA Institute and others are looking to re-establish trust in the industry, but it is also up to the individual players to do their part.

Institutional shareholders must answer some serious questions. Are you caught up in a fantasy that some institutions literally are too big to fail, or even to question? Do you own shares in the parent, or run money with their investment management arm or have a custody mandate with the firm?

Or am I just out of touch? Maybe Warren Buffet is right and Jamie Dimon is worth an even larger pay-packet.

But the sad part is that even senior employees I talk with inside these organisations are often embarrassed by the behaviour, the total lack of responsibility and the conspicuous absence of individuals in jail for the spectacular failures and sometimes the outright fraud of the GFC.

And banks keep asking us to ‘back off’.

While mums and dads, the media and some governments agitate for change and reform, what are the major institutional owners of these organisations doing to say: enough is enough?

 

To make a comment on this story you can email comment@conexusfinancial.com.au or make a comment below

*Colin Tate is the chief executive of Conexus Financial, the publisher of conexust1f.flywheelstaging.com

 

Celebrating active ownership day, Simon Howard the chief executive of the UK Sustainable Investment and Finance Association, describes the business benefits of active ownership.

 

Active ownership by investors is becoming increasingly recognised for delivering a range of business benefits from helping to protect corporate reputations, to increasing share prices.

Active ownership funds, i.e. those that use voting and engagement as part of their investment strategy, are estimated to be worth at least €1.9 trillion in Europe and $4.7 trillion worldwide, according to the Global Sustainable Investment Alliance; and this year a record number of shareholder proposals on environmental, social and governance (ESG) issues at listed US firms have been reported.

To acknowledge the growing momentum behind active ownership as an investment strategy, this week investors in the UK will mark Ownership Day – an initiative dedicated to raising awareness of its benefits

 

Turning active ownership into a business benefit

There are numerous examples of the business benefits of active ownership from reputation improvements to increased shareholder value.

For example, award-winning research co-authored by London Business School Professor Elroy Dimson analysed investor engagement with US companies over 10 years to 2009.

The research concluded that share prices rose by an average of 4.4 per cent in the year after an investor engagement was concluded.

It also found that companies experienced improvements in operating performance, profitability, efficiency and governance following active ownership by shareholders.

One of the world’s most high-profile active owners is CalPERS (California Public Employees’ Retirement system), the largest pension fund in the US.

Each year CalPERS engages with a selection of companies (known as their focus list) judged to be performing poorly in areas such as corporate governance. Over a period from 1992-2005, CalPERS calculated that their focus list activism helped create shareholder value of over $3 billion.

The benefits of active ownership extend to wider society too. For example, in 2001 a group of investors in Gap submitted a resolution at the company’s AGM asking the company to address poor labour practices within its supply chain in order to avoid its brand becoming at risk from a consumer boycott.

This active ownership triggered several years of work that has resulted in steady improvements and now 99% of Gap factories being closely monitored for poor labour standards.

Starting in 2009 a collaborative engagement facilitated by the UN-supported Principles for Responsible Engagement saw investors engage with 16 major consumer electronics companies to ensure the companies’ supply chain policies and practices were transparent and sufficiently robust to address risks of involvement with conflict minerals in the Eastern Congo.

The engagement resulted in scores for overall company performance in this area increasing by an average of 23 per cent from 2010 to 2011. Improvements were seen in the area of public disclosure and in implementation of measures to monitor the activities of suppliers.

Recently Carbon Action was formed, an investor-led initiative that engages with companies to make year-on-year emissions reductions, implement carbon reduction emissions and set targets.

This targeted engagement has led to more than half of 256 targeted companies setting tougher targets for emissions. Companies with targets have been shown to achieve year-over-year absolute reductions in CO2e of more than double the rate of companies without targets, as-well as being 10% more profitable than those without targets.

 

Growth of active ownership in the UK

More than £800 billion of assets are now invested this way in the UK and over 200 asset managers, including 30 of the biggest, have now signed the Stewardship Code – a set of Principles supported by the UK Government to encourage active ownership by institutional investors.

According to a survey by the UK’s National Association of Pension Funds, over 96 per cent of pension funds now support the belief that as investors they should have stewardship responsibilities.

But much more still needs to be done. Only 21 out of 100 individual Local Authority Pension Funds have signed up to the Stewardship Code, as these are significant funds they will not only benefit from significant financial returns but also improved reputation if shareholders become active owners. It now makes business sense for all public funds to sign up or incorporate the Code’s expectations within their Statement of Investment Principles.

If it achieves nothing else, I hope that Ownership Day raises awareness about the benefits of this strategy among pension funds and asset owners, and encourages them to demand more high-quality ownership services from their managers and consultants.

That not only helps protect their returns in the long run but, ultimately, can encourage more responsible capital markets.