Recent reflections on this month’s five-year anniversary of the Lehman Brothers collapse have focused on a variety of developments since the crisis: from reform to remuneration, sovereign debt to shadow banking, and from offshore tax to the Occupy movement.

However, one significant area that has been largely overlooked has been the rise of sustainable and responsible investment among the institutional investment community.

Since the global financial crisis struck, the responsible investment industry has grown rapidly into mainstream finance. For example, in 2008 the United Nations-backed Principles for Responsible Investment (PRI) had around 350 signatories. They’ve now tripled to over 1,200 signatories, who are estimated to manage around a fifth of the world’s capital. We’ve also seen the wide adoption of stewardship codes in the United Kingdom and elsewhere, along with voluntary and compulsory regulation to encourage transparency.

Even the banking sector has been working on its sustainability. EIRIS has extracted data from its Global Sustainability Ratings to compare the environmental, social and governance (ESG) risk management score of the banking sector and found that it has risen over five years from 2.79 to 3.06. This score is based on criteria that assess how well the board and senior management address company-wide ESG risks and opportunities at over 150 of the world’s biggest banking institutions.

That analysis is good news for institutional investors – it shows that reforms have helped make the banking sector safer and more sustainable – but it also needs to be put into context. The average sustainability score for all sectors is actually 3.3, which means that the banking sector still performs worse on sustainability than many controversial sectors such as pharmaceuticals or oil and gas. That may help to explain some of the continuing flow of ethical lapses that the sector has faced in the last few years, from LIBOR fixing to money laundering.

Another anniversary this month shows that the rise in responsible investment also needs to be put into context. That it is actually part of a longer term trend, which still has some way to run.

30-years old today

Thirty years ago today, EIRIS, the organisation I work for, was formed, helping give birth to the ESG research industry in Europe.

Back in 1983, responsible investment as we know it barely existed. Thirty years ago, we had just one asset management client (the Friends Provident – now F&C – Stewardship Fund) and it was a challenge to find any corporate information on sustainability. Now we serve 150 institutional investors and research around a million sustainability data points each year across 3,000 companies spanning 46 countries.

This sort of growth has not happened only as a response to the financial crisis. The global downturn, sparked by Lehman’s collapse, has been more of a catalyst than a creator for the boom in responsible investment.

As is the case with the banks and sustainability, there is also still a long way to go when it comes to institutional investors and responsible investment. Research by the PRI in 2011 showed that despite the large number of institutions it had signed up, still only 7 per cent of the global market was subject to ESG integration by its signatories. That’s a figure I’ll be attempting to drive up following my election to the PRI’s advisory council this month.

In the next five years responsible investment needs to make even faster progress. Rising global demand for food, energy, living space and water, as well as the challenge of dealing with climate change, mean sustainability issues will only become more material to mainstream investors in the years to come.

Banks and institutional investors alike still need to show that they can manage ESG issues in a way that makes individual portfolios, and global finance as a whole, much safer for the benefit of all participants in the investment chain.

Peter Webster is chief executive of EIRIS, an ESG research agency dedicated to empowering responsible investment. For more information visit eiris.org or follow on Twitter @EIRISNews

The herd mentality of investors has been agonised over for as long as markets have been around. The dilemma is often raised of whether to participate in or shun market trends, but the DKK150-billion ($27-billion) Sampension has succeeded recently with a selective approach. It has fully embraced the institutional diversification movement by building a significant alternatives portfolio, but has been content to move in for some rich pickings as other investors fled the bonds of outcast European sovereigns.

The fund estimates it made over $180 million in 2012 by buying Italian sovereign debt instead of Danish – at a time when investors were treating government paper from Rome with disdain. Sampension calculated calmly that the market reaction was excessive, given that the country was introducing reforms it felt were genuinely beneficial in an effort to keep yields down – and the bonus returns seemed to prove the Danish fund right.

Chief investment officer Henrik Olejasz Larsen reveals that much of Sampension’s Italian debt exposure has this year been switched to another unfavoured European destination, Spain. “We have seen a rapid improvement in the economic conditions in Spain,” Larsen says.

Beyond getting extra returns or proving to be in a wise minority, Larsen explains that Sampension’s faith in the European periphery is also motivated by a desire to hedge against future interest rate rises. “Peripheral debt will hedge rising interest rates in Denmark and Germany if the situation in Europe stabilises,” Larsen argues.

A European stabilisation is indeed what Sampension expects, as was reflected in a recent decision by the fund to slightly upweight its European equity exposure. “We think there will be improvement beyond what is priced into the markets,” says Larsen. That indicates the foundations of the fund’s European enthusiasm – not a denial of the problems the continent faces, but a feeling that investors have over-reacted. “We don’t think the euro crisis is over, but there is political will to kick the can down the road and do whatever it takes to keep the currency together. There may be small surprises ahead, but we don’t see any great catastrophes,” he states.

Alternative bedrock

Sampension has also notably developed a 13 per cent alternatives allocation. Larsen says that its above-average stake in the asset class has been made possible by its large size bringing added capacity and also an unusually stable membership reducing liquidity needs. Half of the alternatives bucket is invested in real estate, with the remainder taken up by private equity, infrastructure, forestry and global macro hedge funds.

Larsen has found that Sampension’s alternatives portfolio has risk/return qualities common to more liquid assets, with the exception of private equity, which has been offering superior returns. He is confident that the broad scope of assets invested by Sampension’s alternative team gives it potential to quickly adopt promising new assets. That is something the fund will likely need to do too as it eyes a 20 per cent alternatives allocation to reflect an increased risk budget, resulting from the continued development of its new unguaranteed pension offering.

Like most Danish pension investors, Sampension is aiming to extend its infrastructure allocation, which currently amounts to a small exposure to listed infrastructure funds. It has been actively seeking unlisted funds and projects for direct investing without any success so far, as risk/return qualities have yet to appeal, says Larsen. He has pledged to intensify this effort, reflecting that “we were spoilt for choice for a long time with real estate and credit opportunities, but these are drying up now”.

Sampension has joined its fellow Danish funds in lobbying the government for greater public-private partnership opportunities. The supply of projects so far has been “disappointing” though, Larsen says. Another setback came as Sampension was part of a consortium offering to fund a real estate project on Copenhagen’s harbor front, only for the government agency in charge of the process to pull the plug due to a lack of other bids. Discussions about getting Danish institutional funds into infrastructure projects are ongoing though, and Larsen floats the possibility of national projects in the construction and maintenance of public buildings as a potential breakthrough.

Beyond infrastructure, Larsen reveals that Sampension is also looking into offering direct lending in lieu of banks. “We have been trying to find exposure by negotiating with banks, but nothing has come of this so far,” he says, although Sampension is now finalising a European senior real-estate-loan fund investment.

Sticking up for CLOs

Another way in which Sampension seemingly bucks majority thinking is in its continued enthusiasm for investing in AAA collateralised loan obligations (CLOs). Larsen thinks they offer a decent hedge against a rise in government bond yields. “CLOs’ bad reputation during the financial crisis is not reflected in our good experience of them,” he argues. In his view, solid internal processes helped Sampension avoid losses on these assets, but Larsen reckons the poor sentiment towards CLOs is fundamentally undeserved.

On the whole, Sampension has some 69 per cent invested in bonds – although Larsen explains other asset classes are becoming more significant as guaranteed-liability products become less prominent in Sampension’s offering. While the equity allocation is low across the board, a substantial recent 10 percentage point increase in equities for young unguaranteed pension savers reflects Larsen’s future market outlook. “We will see a prolonged underperformance in low-risk bonds and a lower risk for a setback in equities,” he predicts.

Another key part of Sampension’s investment strategy has been interest rate hedging. While this helped the fund to huge returns of over 20 per cent for its traditional guaranteed offering in 2011, Larsen says this position has resulted in substantial investment losses in 2013. These investment disappointments have been fully compensated for by reduced liabilities, however.

A negative result for the guaranteed product can be expected at the year-end, Larsen reckons, with a healthier 3.8 per cent result coming for the first half of the year across the unguaranteed product. He remains optimistic that as Sampension’s unguaranteed offering becomes more important, there will be plenty of chances to explore new alternatives and make more shrewd investment calls within an increased risk budget. Given the fund’s recent success in judging market overreactions, there may well be other investors casting an interested eye on its future calls.

Roger Urwin, global head of content at Towers Watson and governance specialist, says most organisations don’t spend enough time on it, but transformational change is all about giving time to investment governance.

Culture and leadership, for example is so self-evidently important in people organisations and yet it is understated in asset owners, he says.

“The soft stuff really matters. You have to get the right people on the bus, but you also have to get the wrong people off the bus,” he says. “Culture and leadership, and talent and reward are not talked about. Why not? They are key to asset owner performance. This industry has strong managers, but not strong leaders. Leadership is principled, prioritised and very personal, and we need it in the community.”

Effecting change

Before a board embarks on investment policy work, Towers Watson’s transformational change model says mission, values and goals need to be established, and organisational effectiveness needs to be looked at. This includes culture and leadership, talent and reward and the value chain relationships.

Then investment policy work, including strategy, asset allocation, manager selection, and client delivery, can be honed. Execution, which includes actions and decisions, and measurement and review is the last step.

Urwin has recently worked with RailPen in the UK, CalPERS in the US and a large UAE sovereign wealth fund on transformational change and says execution plays a key role in success.

“These funds are all interesting to learn from. They all had big journeys and have come out feeling confident about their future. The key is execution; not what you did, but how you did it.”

This is all supported by a research paper conducted in 2007 by Urwin and Professor Gordon Clark from Oxford University that shows the key differentiator of the top performing funds was they were excellent in execution: whatever they did, they did well. But Urwin says it has to be self-generated change.

“We are living in a world of complexity and competition. There is a war for talent, it’s a low-yield environment and there is intense competition for returns. Also the bargaining power of external managers means large asset owners have an opportunity to do something different.”

The strength of differentiation, alignment of strategy and good execution are all part of this journey.

“Funds need to recognise the importance of investment governance, incorporating a new investment model, transforming organisational design and behaviours through top-down and bottom-up work.”

Super majority rules

Urwin works with boards, investment committees and the executives of funds to facilitate change.

He says investment beliefs have to be established at the board and executive level then brought together in a system that allows for the ambiguity within which investment decisions lie.

“Consensus is the lowest common denominator in boards, but it’s the dominant governance model,” he says. “There is a lot of inertia around the existing situation and not a lot of action. That’s a culture that’s grown up which should be challenged. A super majority is a good ploy.”

In establishing its investment beliefs, the CalPERS’ board recently used this strategy, with the votes requiring a two-thirds majority to be passed.

“Investment is decision making under uncertainty, so it is always marginal. A 3:5 vote is commensurate with that type of situation.”

The big elephant in the room, according to Urwin, is that investment committees tend to have many promising discussions, but few good decisions are actually made.

“It’s not time well spent on committees. There is too much oversight without insight. There needs to be more insight and engagement with executive teams who are increasingly senior people, so the investment committees need to be more like peer-to-peer relationships.”

 

The National Employment Savings Trust, NEST, the UK government-backed pension scheme set up a year ago with the introduction of auto-enrolment, developed a new allocation to real estate this summer. Now it is planning to add infrastructure to its illiquid allocations in a move reflective of a change of thinking to embrace more risk. NEST’s infrastructure foray is most likely to be via a blended infrastructure fund investing in both listed and direct infrastructure, explained chief investment officer Mark Fawcett at a recent National Association of Pension Funds (NAPF) investment strategies conference in London, where he urged defined contribution schemes to “break the mould” and push greater diversification. “We might add other illiquid assets and we are looking at infrastructure,” says Fawcett, who joined NEST from boutique investment manager Thames River Management. “There are good parallels between infrastructure and real estate. We are looking for growth-seeking and income-generating assets.”

With £11 million ($17.6 million) under management so far, NEST’s assets are forecast to reach $240 billion by 2050. Allocations in the Growth phase portfolio are divided between equities (50 per cent), real estate (20 per cent) and fixed income (30 per cent), where the portfolio includes corporate bonds and emerging market debt. Although NEST has been in talks with the NAPF’s Pension Infrastructure Platform (PIP), which says it is keen to have defined contribution investors, its need for continuous cash flow and the challenge of infrastructure being “lumpier than real estate and the cash flow varying” makes a blended fund a more likely model. The challenge is to now find the right low-cost manager, says Fawcett. “We are not in the business of paying 2 and 20.”

The property push

The push into infrastructure follows on from NEST’s 20 per cent real estate in the Growth phase allocation made last July. “It did raise eyebrows because it is a high allocation for a defined contribution fund, but it makes sense,” says Fawcett, adding that in Australia the allocation would “be double”. It’s an exposure that comes via Legal and General Property’s Hybrid Property fund in another blended strategy gaining exposure to listed and unlisted property. Here the hybrid structure comprises a 70-per-cent weighting to a UK direct property fund, with the remainder weighted to passively managed listed real estate via a global real estate investment trust (REIT) tracker fund. The addition of the global listed fund enables access in a daily priced, daily dealt manner with a greater amount of liquidity. The management charges are lower, the spread is reduced and there is international diversification, explains Fawcett. “We chose the hybrid because it is cash-flow positive and we thought direct real estate could be lumpy. We will think about a global direct allocation over time. We are aware of the leverage in REITs and that the shares are more volatile because of that leverage.”

Regulation and the members’ market

One of the biggest hurdles facing the pension provider’s new illiquid allocation is the daily dealing and pricing requirements placed on defined contribution schemes – that not the norm in defined benefit funds. These tend to rule out any type of unlisted property fund. One answer has come via NEST’s own internal market and its ability to trade illiquid assets between its own members, with older members selling assets to younger ones able to take on more liquidity. “We are doing this with real estate and are thinking about how to do it with infrastructure to ensure fair transfer between different members,” says Fawcett. NEST is currently working with another pension fund that has set up an everyday proxy to measure the price for infrastructure assets using an index which tracks the daily price movement.

Phase-sensitive allocations

Investment strategy at NEST, where Fawcett says the emphasis is “to get away from the peer group comparisons”, is honed for three distinct periods. For young savers in the Foundation phase, strategy is low risk, aiming for returns that match inflation and encourage saving. The Growth phase, typically lasting 30 years, targets returns of inflation plus 3 per cent in a diversified strategy. The final Consolidation phase invests in inflation-matching assets to de-risk. It seems that in the Growth phase, real inflation-linked assets are increasingly attractive over gilts and bonds. “Big defined contribution schemes should expand into other asset classes,” says Fawcett. “Defined contribution has not got to grips with what real estate has to offer.”

To be a long-term investor requires thematic investing because markets and economies are complex adaptive systems, according to Tim Hodgson, global head of the thinking-ahead group at Towers Watson.

Hodgson told delegates at the Towers Watson Ideas Exchange in Sydney that economies and markets are complex and adaptive, their path is not random and the future is not predictive.

“We don’t live in a linear world. We must hold truths in our head while we navigate the future. A single market price cannot reflect this,” he says.

Towers Watson believes that there are a number of interconnected issues that will converge in the next decades, and which it outlines in its 2013 secular outlook on thematic investing, which will require transformational change.

“It is coming straight at you: the asset owner and you have to deal with it whether you like it or not,” he says.

Recognition of the interconnectedness of these issues is essential.

Hodgson says traditional investment thinking is drawn heavily from economics, which has separate disciplines. The micro side of economics is well developed and the industry is disciplined in how to optimise a portfolio, value a company or price a derivative, all in isolation. But the macro side, including the emergence of bubbles, is almost completely unknown.

Complex system, complex thinking

Hodgson advocates for complexity thinking when it comes to finance, which comes from the study of complex adaptive systems.

Those systems have these common elements:

  • They have simple individual components, but rich complex behaviours.
  • They are adaptive, not in equilibrium and the system behaviour changes in response to external environment.
  • There is signalling and information processing between the components.
  • There is no central control, rather systems are not controlled by any coordinating body, but there is complex collective behaviour.

“Complex systems are where the whole is greater than the sum of the parts. You can’t break it down to understand it and put it back together again,” he says. “Markets and economies are complex systems.”

By way of example, he says academic textbooks in finance teach that everyone is making individual decisions in isolation, but that is not true.

“Markets are coupled and interacting; my trades change your prices,” he says.

He also says markets have multiple scales in time and space, and that fat tails are created by market participants.

In this regard, markets do not have a normal distribution, rather a “power law” distribution where the tail is much fatter.

“We shouldn’t be surprised by the large price moves. If you are, you’re using the wrong distribution.”

He also says that market returns are not random and “rejects” the random-walk philosophy.

“Economics and markets are complex and adaptive; the future is not predictive. As a long-term investor, you have to anticipate this otherwise you are at the whim of market prices.”

“Equilibrium is dead. It is the interconnectedness of finance that categorically matters. Tail events are normal,” Hodgson says.

Not alone

Further, his argument is that finance is not the only industry that is complex.

Health, crime, pollution, climate, economies, urbanisation are all complex and all coupled.

In its 2013 secular outlook on thematic investing, the Towers Watson investment committee outlines six key elements: economic imbalance, adverse demography, degradation and natural capital, innovation and technology, business nexus and government.

While acknowledging the thinking is the easy part and a lot of implementation of these ideas is still to come, he believes it will see a shift from dull market-cap portfolios to bright thematic portfolios.

Hodgson says this cannot be achieved by putting in place one or two themes and hoping it all works out. Rather, the themes need to encompass a complex and wide range of outcomes, with an option-like payoff.

 

 

The SEK150-billion ($22-billion) AP7 fund supplies the cream on the top of the Swedish public pension system. It essentially delivers premium pensions (in addition to the much larger pay-as-you go component) with a generous dose of equities. It has been able to further sweeten its offering by leveraging the main chunk of its portfolio.

AP7 chief investment officer, Christian Ragnartz, concedes that the leveraged approach has been made possible by the freedom of the fund’s position in the pension system and its directive from the Swedish government. AP7 has the freedom to set its own risk/return profile in order to seek the best possible long-term returns.

“We believe that leveraging a global equity portfolio is a good long-term strategy for delivering returns,” says Ragnartz. He strikes a confident tone – and as well he might, with equity markets hovering around all-time highs this year and AP7 boasting bumper 17.4-per-cent returns in 2012. These comfortably beat the average 2012 returns for private Swedish premium-pension providers of 5.7 per cent.

Ragnartz’s enthusiasm for the 50-per-cent leverage – placed on the major part of the portfolio that is invested towards the MSCI All Country World Index – is based on much more than the current high equity prices though.

“If you have a very long-term horizon, then you should try to capture the equity premium as effectively as possible,” he stresses. AP7, after all, invests mandatory pension contributions (on a defined contribution basis) for Swedish savers from their early 20s onwards. It invests on behalf of anyone in the country who amasses contributions but doesn’t opt for a private premium pension provider.

“Efficient device”

Ragnartz recommends equity leveraging as an “efficient device” for other investors, as long as their circumstances and liabilities make it a suitable ploy. He stresses, however, it is important to work on the legal details of a leverage and be in a position to handle marginal calls. Ragnartz outlines regularly posting collateral while paying attention to both “reasonable thresholds” and credit ratings of counterparties as being the best ways to manage counterparty risk.

AP7 uses swaps for its leverage, which Ragnartz feels have been relatively easy and efficient despite a mixed experience with pricing. “We are looking into alternative ways of leveraging, depending on new regulations, to be sure of the best cost efficiency,” says Ragnartz. AP7 is also exploring possible legal action over the impact of LIBOR manipulation on swap prices. “Manipulated prices naturally create some winners and losers but, if it is proved we have lost out, it is our duty to aim for compensation for our savers,” Ragnartz adds.

Ragnartz argues that AP7’s leveraged position is fundamentally “not much more risky” than a lot of specific non-leveraged country funds. “A global portfolio has a much lower volatility than most specific funds, so the diversification element holds true,” he says. AP7 proved how serious it is about reducing volatility by taking measures to abandon any home bias in the portfolio in 2010.

Nonetheless, “of course there will be bumps along the road,” says Ragnartz on the inevitable volatility of an equity position leveraged by derivatives. These include the “stressful” experience of quizzical reactions from the press and public when equity markets plummet – most recently experienced during 2011. “If you have a clear view backed by a mission that matches that, it is easier to argue for this though,” he posits. AP7 can also fall back on pointing to returns that are 22 per cent above the Swedish pension authority’s indicative PPM index over time.

Escaping bubbles

The current buoyancy in equity markets has provided AP7 with the cushion it was looking for from the outset for protection from a market shock, according to Ragnartz. “Hopefully we can be even further ahead of our private competitors before the next crisis,” he says. “Something will happen, but nobody knows when”. That caution comes despite this revelation: “I have a slightly positive view of equities over the medium term. There are challenges, but Europe seems to be on a positive track and there are positive signs from Japan and the US.”

AP7’s global index-linked strategy sees it follow a neutral position on all regions, allowing Ragnartz to stay calm on region-specific concerns. For example, emerging market equities – a key part of AP7’s strong returns in recent years – are expected by many analysts to face difficulties if quantitative easing is unwound. “We’re not particularly nervous on emerging markets as you can say we believe in them, just as much as the aggregate market, as potential difficulties should be priced in by now.”

The fund has been working hard on a nascent tactical element in the portfolio. “There are times when markets act irrationally and we want a layer of analysis to counteract this,” Ragnartz explains.

This newly developed tactical element could lead to AP7 downweighting its leverage at times that equity valuations are too high. “Ideally we would like to avoid being caught up in bursting equity bubbles,” says Ragnartz, “but history has proved that this is extremely hard.”

The global equity portfolio is managed entirely by external managers on a passive basis to help the fund rely on its “cornerstone belief” of cost efficiency. AP7 implements the leverage internally.

Alpha and beta

Alongside the “beta engine” provided by the leveraged portfolio, AP7 has nine unfunded long/short alpha equity mandates in its sophisticated fund, as well as an internal alpha centre. As these mandates invest only long/short, it is difficult to put an exact value on them, but Ragnartz says they account for around 25 per cent of the portfolio.

He is pleased about the fund’s experience with these positions since their introduction in the past few years. “We strongly believe that our managers get comparative advantages and fewer restrictions by working with both the long side and the short side,” he states.

The fund recently hired Invesco to run its first global alpha mandate and added another Japanese alpha mandate.

AP7 runs a relatively small fixed income portfolio (less than 6 per cent the size of the equity portfolio) to enable lifecycling for savers close to retirement. It also invests 3 per cent of its beta equity fund in private equity.