UK local authority schemes are under pressure to merge. It’s their turn to suggest ways in which pooling investments, or adminstriation, could achieve the economies of scale necessary for survival, but many are resisting the notion that “bigger is better” when it comes to investments.

 

The United Kingdom’s local government pension schemes have begun to publish responses to the government’s call for evidence on how to improve investment returns and deal with deficits within the sector.

The 89 separate funds in England and Wales have combined assets of £187 billion ($301 billion) but are all run individually. Pressure to consolidate the different schemes has stepped up since Lord Hutton suggested pooling funds in his review of UK public sector pension funds.

It seems that while responses from local authority schemes acknowledge the need for change most remain lukewarm on any merged, larger schemes.

The London Pension Fund Authority (LPFA) is one of the loudest supporters of structural reform.

The local authority administrator, manager of the $7.4 billion Greater London Authority (GLA) fund and also a service provider for six additional London-based funds, promotes its vision of LGPS “super pools” in its response.

“Our solution is to create super pools on a buy-in model, where local employers are responsible both for historic deficits and for holding the super pool manager to account. The super pool is responsible for asset allocation, fund management, liability management and administration,” suggests the fund.

It proposes five regional authorities, each managing assets of around $48 billion but says voluntary groupings of local funds would also work.

The $5.6 billion billion Nottinghamshire County Council Pension Fund argues that before considering the creation of regional funds, or any other form of merged fund, proper evidence should be collated to determine whether ‘bigger means better’ in terms of investment returns.

The $8 billion Lancashire Pension Fund, one of the top 10 of the local schemes, similarly “reads nothing” into a fund’s size equating to better returns.

However it notes the increasing prevalence of framework agreements and joint working amongst schemes.

Going forward this could manifest in the creation of investment management teams shared between small funds providing access to a level of in-house resources.

This would “challenge the easy nostrums sold by many of the investment consulting firms who operate as the de facto overall managers of some LGPS funds,” says Lancashire.

Sharing expertise could include pooled investment vehicles around active equity mandates and Lancashire also suggests larger funds assist smaller funds by parcelling investments into fund of funds, selling interests to smaller funds.

“This would allow the smaller funds to achieve access to a valuable form of investment that they might otherwise not be able to achieve,” suggests Lancashire.

Barriers to a single investment strategy

The $3.7 billion Surrey County Council Pension Fund also doubts a single investment strategy would work.

“For most long term, secure LGPS employers, a common investment strategy might suffice. However, within an alternative structure, there could be increasing diversity amongst employers due to outsourcing and the resultant better or worse funding levels. Well-funded employers may be able to reduce investment risk now, while poorly funded employers may not be able to reduce risk so easily.”

One investment strategy will not fit all, and a move to multi-investment strategies within one super fund will be necessary, argues the fund.

The call for evidence asked schemes how to improve investment returns.

“There is no secret formula to improving investment returns,” says Nottinghamshire.

Chasing ‘flavour of the month’ investment strategies or changing strategies every year or two will not help provide sufficient long term returns, and could increase costs.

A sensible strategy, simply executed is far better than a complex strategy involving multiple managers in multiple asset classes, argues the fund.

“The Nottinghamshire Fund’s performance has been good partly because we have not constantly switched strategies and managers. Both need time to demonstrate whether they are working, particularly as the costs involved in changing can be high.”

The role of service providers

Esoteric investments “dreamed up by asset managers and investment banks” are more likely to create unintended consequences and cause damage to long term returns. In-house investment may help to improve long term returns as there will generally be less focus on short term gains and trends, it argues.

Schemes maintain they are keeping a lid on fees. Nottinghamshire says that its own investment management costs are already low at only 0.18 per cent of net assets in 2012/13.

The fund says simpler investment strategies inevitably mean lower fees since “managers feel far less able to charge high fees”.

Trading costs may also be lower and transition costs from one strategy to another will also be lower.

Lancashire’s response is similar: “The thinking behind the call for evidence seems to be that a smaller number of larger funds will inevitably pay less and perform better. There is no evidence to support this. The Lancashire fund already pays the managers’ lowest tier of fees due to the size of mandate which it awards and its ability to negotiate favourable terms.”

How to tackle deficits

Dealing with deficits within the LGPS, up by an estimated 15 per cent in 2012, was another concern.

Nottinghamshire, which has 38,000 active members, 35,000 deferred members and 30,000 pensioner members, argues the problem lies in how the deficit is calculated.

“Focusing on one liability figure, affected hugely by the assumptions within the discount rate, is unhelpful and creates unnecessary concern within the wider public. Pension funding is not a simple issue and shouldn’t be treated as such.”

A movement of just 0.1 per cent in the discount rate changes our liabilities by over $201 million, says Nottinghamshire.

“As one of the main components of the discount rate, increasing bond yields could, at a stroke, wipe out the deficit. Across the LGPS as a whole, such movements in liabilities would far outweigh any cost savings that can be achieved through merged funds.”

Reform should focus on finding a better way to assess the financial position of funds and their ability to pay future pensions, it concludes.

Local funds were also asked what was needed to encourage more investment in infrastructure.

Once again fund’s demanded independence to set strategy themselves.

“Whether to invest in infrastructure is a decision to be made on the basis of the valuation and the return requirements of each fund. An assumption that infrastructure is good for all funds is wrong. Regeneration is not a primary role of pension funds and the risk/return profile of infrastructure investments must be considered,” says Nottinghamshire.

Consensual consolidation among local authority schemes still feels a long way off.

How could you integrate ESG into a portfolio of 7,000 stocks? Behind the Strategy Council’s report to the Norwegian Ministry of Finance on responsible investment for the Norwegian Government Pension Fund Global.

 

The Strategy Council, led by Professor Elroy Dimson from the London Business School and Cambridge Business School, has advised the Norwegian Ministry of Finance on the responsible investment strategy for the giant Norwegian Government Pension Fund Global, focusing on its strategy, issues of transparency and a more integrated approach to responsible investing.

One of the key findings is that the responsibility for managing the investment exclusions moves into Norges Bank Investment Management, which as part of the other responsibilities of asset management.

At present, the Norwegian Parliament decides what will be excluded and on what basis, and the council thinks this should remain.

However the responsibility for implementing that is done by the Council of Ethics separate to the investment management activity.

This would allow for a more integrated approach.

Rob Lake, a consultant and former director at the Principles for Responsible Investment sits on the five-member strategy council.

He says it wasn’t within the council’s mandate to look at the rules for exclusion, they are set by the Norwegian Parliament, but it looked at the process for exclusions made on the basis of those criteria and the relationship between exclusion process and engagement. The aim was to increase efficiency and effectiveness.

“NBIM does all engagement but the exclusion process is done by a separate entity – the Council of Ethics – which is not part of NBIM,” he says. “We recommend there be stronger linkage between the research by the Council of Ethics and engagement.”

He says the council tried to look at what makes sense in terms of ESG given the funds characteristics including its size, the highly diversified nature of its holdings and the fact it is very long term.

The NWPFG has more than 7,000 stock holdings, which at the end of 2012, translates to about 1.2 per cent of the world’s stocks.

“Given the fund’s size, high diversification of holdings and long-term nature, it has all the elements of a universal owner,” Lake says. “It needs to focus on issues and activities that makes sense in the long-term value of the portfolio.”

As part of that Lake says the fund needs to have a good understanding of the long term implications on the value of portfolio at the macro level, things like climate change and water scarcity (which is already one of the fund’s investment principles).

“There is a need for responsible investment to be tied to the long term issues of value creation in the portfolio,” he says.

“The conventional corporate governance agenda still clearly important and given the size of the portfolio and the significance of some of the holdings it makes sense to engage with individual companies. But there is also the more macro issues, such as market stability, and increasingly funds are putting effort into those activities.”

One of the key questions addressed by the council in this regard was getting the right balance between the focus on individual companies and the more market wide, macro, issues.

“There are parts of the portfolio where there is significant exposure to individual companies, essentially active management. So there it makes sense for the fund to understand all the factors for that company’s long-term value creation, including ESG. But that is a relatively small number of companies in a 7,000 stock portfolio, so the fund also more broadly needs to look at more market wide issues.”

But the council was not asked to give prioritisation to that, or to look at the NBIM structure or resources, it was purely a strategic objective.

However it does recommend the need for a structured and transparent process for identifying those priorities.

“Transparency is critical for the fund given its size and scrutiny. It needs the trust of the people of Norway but those needs to be met in an appropriate way,” he says. “The fund needs an integrated range of tools. To engage with individual companies and policy makers and regulators depending on the nature of the issue.”

 

The Ministry of Finance will conduct a public consultation on the recommendations and then take a formal proposal to the Parliament in the Spring. A review of active management will also form part of the Ministry of Finance’s presentation.

 

What constitutes fiduciary duty is an ongoing discussion in the pension sector. The UK Law Commission has weighed in on the debate with its own interpretation.

 

 

Pension funds mulling the definition and obligations of their fiduciary duty can now refer to a consultation paper from the Law Commission, Fiduciary Duties of Investment Intermediaries.

The principle enshrined in law that requires clients’ interest are put first, that charges are reasonable and disclosed and that conflict of interest is avoided, is often difficult for pension funds to interpret and enact.

It was one of the issues highlighted in last year’s Kay Review of UK equity markets and Long-term Decision-making.

The UK Law Commission has added its weight to the debate with its own insight into how far the law reflects an appropriate understanding of the scope of beneficiaries’ best interest and the idea around fiduciary duties requiring trustees to maximise financial return in short-term gains.

It also asks to what extent trustees can consider other factors, such as environmental and social issues in their fund’s investment strategies; whether fiduciary duties can encompass investment in ethical strategies even where this may not be in the immediate financial interest of beneficiaries.

The Law Commission has found that fiduciary duty is interpreted differently throughout the pension sector.

On one hand the term is used by pension trustees to emphasise their ethos to act in the interests of the beneficiaries.

Many trustees link their status as fiduciaries with a sense of altruism, says the paper. Trustees contrast their special status as fiduciaries with the focus of others in the investment chain on making money.

“Many interpret it in the strict legal sense of a relationship in which the principal is reliant or dependent on the knowledge, expertise and discretion of an agent, and to which the strictest duties of loyalty and prudence are applicable. Others however use the word fiduciary to describe a more general duty of care,” found the Law Commission.

Paddy Briggs, trustee at the £13 billion ($20 billion) Shell Contributory Pension Fund, has adopted a pragmatic approach to a role he has held for the last four years.

“Whatever the law says it is just as important to apply common sense and natural justice,” he says, adding that a successful pension fund involves co-responsibility between the sponsor, professional managers and advisors and trustees.

“You have to have this three way acceptance of responsibility. The natural tendency is not to look at the law but at what makes sense.”

The Commission found lawyers tend to think of fiduciary duty in terms of litigation, meaning investors should be able to sue based on breaches of the standards within the definition.

“There are elephant traps but it is unlikely that a well managed fund would fall into one,” says Briggs.

Chris Hitchen, chief executive of the £19 billion ($30 billion) Railways Pension Trustee Company who served on the advisory board of the Kay Review, offered his definition of the term when he spoke at the Business Innovation and Skills Committee earlier this year.

“I would say that fiduciary duty is a concept that occurs a few times in Kay’s report and it really goes to the core of my job. It is not the same thing as doing what your members want you to do; it is doing what is in their best interests, and those two things are not always the same.”

 

Short termism

The Commission suggests that regulatory pressures in defined benefit schemes, and limited resources in both defined benefit and defined contribution schemes, are mostly to blame for short-termism.

It’s a view that the National Association of Pension Funds agrees with.

“We are of the view that the fiduciary duties of trustees of pension plans are reasonably clearly understood and there is sufficient scope under current law as currently understood for trustees to take a longer term view,” says Will Pomroy head of corporate governance at NAPF. “If encouragement of longer term investment strategies is a goal then reforms to accounting standards  (IAS19) would be a more effective way to combat the causes of short-termism.”

But speaking back in March, Hitchen did urge for new ways for funds to measure success.

“Success should not be about beating the market today or tomorrow. To an extent that makes it incumbent on us as trustees and trustee representatives to find different ways of measuring success. It would probably have to be around: “Have you contributed real value to my pension schemes assets over many years? Rather than, “Have you beaten the market last quarter.”

The Commission found that trustees may take environmental, social and governance issues into account, but they should not attempt to “improve the world in some general sense” if this is possibly at the expense of future savers.

It’s an idea expressed in the £34 billion ($54 billion) University Superannuation Scheme’s responsible investment strategy, shaped around the idea that the fund can and should take ESG issues into account in its investment decision making, but only where the issues are material to performance.

“USS is not permitted to make investment decisions based purely on an ethical or moral stance,” according to the fund documents, and it has developed an active engagement approach, but does not undertake ethical screening or operate exclusion policies.

The debate will continue long after the Law Commission’s final report appears in June 2014.

 

 

Academics from Columbia and Yale Universities examine the expected and actual returns of US university endowment portfolios and the role of alternatives in generating alpha.

 

To access the paper Investment beliefs of endowments

As an outsourced provider, fund managers make a series of promises to investors. Anything that tempts the promise to be broken is a conflict of interest, according to chief executive of Carne Group, John Donohoe, whose organisation has conducted a survey of institutional investors’ attitudes to conflicts of interest.

In a survey of global allocators of capital with combined $9.5 trillion, conducted by Carne, 90 per cent of respondents said they would like asset management fund boards to consider and address conflicts of interest as a matter of routine.

For some funds managers conflicts have been difficult to hard to understand, but the emphasis by regulators including those in the UK on supply chains has helped defined the impact of those conflicts.

“Every single company promises a certain experience to its customers. Management needs to focus on what that promise is, what might happen to break that, who are the people or what is the supply chain that makes us break that promise – there will be conflicts,” he says. “It becomes easy when you think about it like that.”

The “Dear CEO” letter issued by the UK’s Financial Services Authority, following a review of asset management firms’ enforcement of internal conflicts of interest policies, identified that many had failed to establish an adequate framework for identifying and managing them.

One of the key findings of the FSA’s review was that team culture is central to identifying conflicts of interest. But Donohue believes many asset managers “struggled to get it” when it came to the impact of their culture.

“The “Dear CEO” letter on conflicts of interest is at the heart of governance. If you understand that, then you will meet your promises to investors,” he says. “The reality is there are forces that will try and entice you away from doing the right thing. But people are starting to understand how you keep your promises to investors.”

Donohue believes that an independent board member helps to ensure that decisions are made in favour of the investor not the management. One of the core activities of his firm is providing independent directors to fund boards, typically cross-border funds such as Cayman funds.

“An independent director should be a leading force in that. But not any independent person, competence is a big factor.”

In the Carne “Fund governance and conflicts of interest survey 2013” respondents identified a risk background as critical to a director’s skill. Two years ago when the survey was done, a legal background was the key element.

“The results showed that you need to identify risks and then you can see where the conflicts occur,” he says.

 

Investors demands

In the survey the areas of conflicts cited by many investors include:

  • Trading error identification and reporting to investment management fund boards
  • Investment or other guideline breaches by the investment manager
  • Deviation from promised investment strategy and investment risk, including portfolio diversification, eligible assets and liquidity, especially when investment opportunities are scarce or managers are overly optimistic about an investment opportunity.

The survey also revealed that investors were in favour of a global governance framework, and they certainly don’t want more regulation.

There are other groups looking at industry led governance standards including the CFA in its Future of Finance project which is essentially helping managers to become long-term sustainable businesses.

“The key to a sustainable business is to treat your customers and your investors really well. Then everyone wins, including management,” Donohue says. “Good governance is essential for managers to become long-term sustainable businesses. Look after your customers and you look after your business in the long term.”

In the UK it is difficult for investors to point the finger at asset managers when their own governance needs work.

Donohue says pension funds in the UK are like the health system, “everyone knows it’s broken but there are so many conflicts of interest”.

“There are some pension funds that are really well run, but there are many where the trustees don’t have the skills or the board is not run well,” he says.

A pension fund collapsing will be the catalyst for radical reform, he says.

“Again it’s like the health system, a lot of people need to die before there is reform. In 20, 30 or 40 years’ time a lot of employees won’t have much of a pension, this could lead to social unrest and eventually reform.”

There is a difference in the opinions between managers and investors, but Donohue says appointing blame doesn’t solve anything.

“It’s like a marriage, there is difference of opinion. But it is important that blame is not put at the door of the managers. The important thing is to help them in how to run a good marriage. There’s a difference and you need to get to the heart of the difference,” he says.

Independent directors on boards can act as that guidance counsellor for managers.

 

 A study ranking the world’s stock exchanges against disclosure on sustainability themes ranks the BME Spanish Exchange at the top. But the study’s author managing director of CK Capital, Doug Morrow, says stock exchanges need a nudge by regulators to enforce tougher disclosure standards.

 

The world’s stock exchanges “need a bit of a nudge” from regulators to enforce tougher sustainability disclosure standards, according to Doug Morrow, managing director of CK Capital.

Morrow is lead author of a new report that ranks stock exchanges on their disclosure practices and analyses the best policy environments for improved disclosure.

“I’m sensitive that stock exchanges are in the business of listing companies and tightening standards could discourage some entities,” he says.

Morrow criticises this as a frequently aired “knee-jerk response” before contending that “I find a lot of exchanges haven’t really investigated whether potential listings would actually be discouraged by tougher disclosure requirements.”

Morrow feels the growing demand from investors for sustainability disclosure requires more action from exchanges.

He argues that more investors are asking how much energy or water that listed companies use.

“I don’t think this burden is heroic,” he says.

In evaluating its value to institutions, Morrow supports the view that sustainable investing helps meet investors’ fiduciary duty to maximise risk-adjusted returns.

“If you look at some sustainability criteria, they are actually predictive of alpha and are as effective as some of the conventional ratios that analysts now use to predict stocks,” Morrow argues.

Monitoring companies’ energy over revenue or health-and-safety data can be every bit as useful as looking at trailing P/E ratios or enterprise values, he reckons.

“Just because this is a new kind of data it does not mean performance on sustainability metrics are at odds with risk-adjusted returns,” says Morrow, “and if you agree with that, clearly the more data that is disclosed by companies, the better.”

 

Real disclosure in Madrid

The CK Capital study “Trends in Sustainability Disclosure: Benchmarking the World’s Stock Exchanges”, ranked the world’s stock exchanges by checking their listed companies against disclosure on seven themed sustainable elements.

It looks at seven “first generation sustainability indicators” which are employee turnover, energy, GHGs, lost-time injury rate, payroll, waste and water.

The BME Spanish Exchanges emerged as the leading bourse in the world, followed in the top five by the Helsinki, Tokyo, Oslo and Johannesburg exchanges.

One striking feature of the report’s rankings is the dominance of European stock exchanges at the top.

This is particularly apparent relative to North American exchanges, which scored rather unimpressively against the report’s criteria, with as many as 16 European exchanges rated better than the best North American bourse (Toronto in 30th place).

Morrow confesses the European flavour at the top of the rankings came as no surprise and European countries have been at the forefront of sustainability disclosure for a long time.

“Both European institutional investors and governments deserve plaudits for encouraging more advanced corporate disclosure,” he says.

US and Canadian regulators have some catching up to do due to a “relative dearth of substantive disclosure policies in North America”, argues Morrow, despite praising the SEC’s “pretty interesting” 2011 environmental disclosure guidelines.

One of the reasons, he says, has been less integration of sustainable criteria into institutional investment selection in North America – with some incredible exceptions like CalPERS – has also kept demand for heightened disclosure from companies in the region relatively low.

It demonstrates the impact, and influence, of the institutional investor community.

A trend that Morrow keenly emphasises is that the rankings, in their second year, show a rapid closure of the sustainable disclosure gap between the developed and emerging world.

“Listed companies in emerging markets are catching up on our indicators with many emerging market exchanges eking out leadership positions,” Morrow says.

Exchanges in India, Singapore, the Philippines and South Africa have been particular active on disclosure.

Part of the reason is the greater freedom that regulators have to act in many emerging markets is a key advantage, reckons Morrow. Increasing recognition of the need for companies to compete globally for investment is another major driver, he adds.

 

Policy signpost

The CK Capital report suggests that sustainability disclosure is aided by “super policies”– defined as mandatory, prescriptive and broad.

It recommends basing these policies on standards developed by the likes of the Global Reporting Initiative.

“When you look across the world there are a lot of examples of these kinds of policies already out there,” says Morrow.

Praise is given to France’s Grenelle II policy, which sets disclosure obligations on as many as 42 sustainable fields for all companies with more than 500 employees or €100 million in revenue or assets.

The Indian Security Regulators’ Business Responsibility Reports initiative is meanwhile held as a shining example of how emerging markets can forge the way ahead.