Too many companies are unprepared for the growing threat of a cyber attack. Investors have a role to play in ensuring this risk is firmly on the agenda.
In this edition of the Gemologist, we’ll look at the likely trajectory of the world’s second biggest economy in the light of this, argue why low growth could be better for investors – and show where we are finding value.
Investing with consideration of environmental, social and corporate governance (ESG) criteria has increased significantly in recent years. However, for a long time, the perception of investors was that ESGfocussed investing detracts from investment performance. This perception is starting to change. In this paper, we show that focussing on ESG factors can enhance returns. In particular, we show that wellgoverned companies have tended to outperform poorly governed companies by an average of over 30 basis points per month over the last five years. Capturing this consistent source of value can enhance the returns of equity strategies.
This note explains our testing methodology, a breakdown of the results and describes how we integrate ESG analysis into our investment process.
There is no 3 per cent illiquidity premium in private equity, according to research by CEM Benchmarking.
A cost drag on private assets cancels out the returns of investing in private equity and real estate for those investors that outsource to external providers, the research finds.
CEM Benchmarking, which has a database of 354 pension funds from all over the globe with assets of about $7 trillion, looked at the benchmark and investment returns of those investors in private equity and real estate from 1995 to 2010.
Mike Heale, partner at CEM, says an implementation style factor is overwhelmingly dominant when funds outsource private assets and there is a cost drag of up to 7 per cent depending on the implementation style.
CEM looked at the returns of investors and the benchmarks they were using to measure their performance.
Most are using either peer-return based benchmarks, based on returns of other institutions like those produced by Cambridge, or market-based benchmarks which are not actually investable, such as the S&P500 plus 3 per cent.
In private equity market-based benchmarks dominate, with 71 per cent of investors using such benchmarks. In real estate peer-returns based benchmarks dominate with 68 per cent using these.
But these benchmarks are flawed, according to CEM.
“Most are uninvestable, they have timing mismatches and there are lags in the data and there are smoothing issues,” Heale says. “The valuations are lagged, they don’t reflect reality. And this causes a gross under-statement of risk. There is overwhelming noise in interpreting performance.”
CEM measured the performance of investors against a more “realistic” benchmark it constructed.
For private equity this was blended small cap equity index with a lag of 100 days, and for real estate it was the S&P REIT index with a lag of 200 days.
In private equity the average return of the pension funds in the CEM universe over the 16 year period was 9.3 per cent, compared with the CEM constructed benchmark of 9.2 per cent.
This is an average net value added of 0.1 per cent.
“Only 10 basis points above the benchmark over a 16 year period. The illiquidity premium doesn’t exist,” Heale says.
“Further, style matters. Whether you bother with private equity investments or not, depends on the costs of implementation.”
Those funds that are large and well-equipped to manage private equity internally, added an average of 3.5 per cent above the CEM benchmark over the period.
Pension funds with external managers added 0.2 per cent, and those with fund of fund managers had an average of 7.2 per cent, which was -1.6 per cent against the benchmark.
The results are worse for real estate where the net value added was -1.2 per cent over the period.
The same pattern of decline exists, with internally managed portfolios performing best (NVA of 1.2 per cent) with a sharp decline to external management (NVA of -1.6 per cent) and fund of funds (-3.9 per cent).
The S&P 500 for example, has returned an average of 11.3 per cent over that 16 year period.
Heale says CEM embarked on the research in recognition that funds have a hard time understanding or interpreting performance of private assets due to the fact there is so much noise in the benchmarks.
This year CEM is conducting research looking at the asset class performance targets of its clients.
The World Economic Forum’s 2014 Global Risk report, has implications for investors.
The report, released ahead of next week’s meeting in Davos, highlights how global risks are not only interconnected by also have systemic impacts.
The risks were broken down into economic, environmental, geo-political and social. The seven economic risks were: fiscal crises in key economies, failure of a major financial mechanism or institution, liquidity crises, structurally high unemployment/underemployment, oil-price shock to the global economy, failure/shortfall of critical infrastructure, decline of importance of the US dollar as a major currency.
The report encourages a culture of long-term thinking, by companies, investors and governments, as a way of mitigating and managing these risks.
The global risks were identified by surveying the World Economic Forum’s multistakeholder communities.
Ten global risks of highest concern in 2014
- Fiscal crises in key economies
- Structurally high unemployment/underemployment
- Water crises
- Severe income disparity
- Failure of climate change and mitigation and adaptation
- Greater incidence of extreme weather events
- Global governance failure
- Food crises
- Failure of a major financial mechanism/institution
- Profound political and social instability
Asset owners must step up and “join the fight” to end the focus on short-term results by companies and investment firms. Four practical steps to make this happen are outlined by president and chief executive of the Canada Pension Plan Investment Board, Mark Wiseman, and global managing director of McKinsey, Dominic Barton, in the most recent edition of the Harvard Business Review.
In the article, titled “Focusing capital on the long term” the authors outline four “proven” practical steps for big investors to take:
1. Define long-term objectives and risk appetite, and invest accordingly
2. Practice engagement and active ownership
3. Demand long-term metrics from companies to inform investment decisions
4. Structure institutional governance to support a long-term outlook.
Institutional investors own 73 per cent of the top 1,000 companies in the US, up from 47 per cent in 1973, so they should have both the scale and the time horizon to focus on the long term, the article says.
Asset owners need to focus on encouraging the long term focus both internally, and with the external funds managers that manage their portfolio. This includes an innovative approach to compensation and fee structures, mandates and investment structures.
The article outlines some innovative approaches that CPPIB has been experimenting with including offering to lock up capital with public equity investors for three years or more, paying low base fees but higher performance fees if careful analysis can tie results to truly superior managerial skill (rather than luck), and deferring a significant portion of performance-based cash payments while a longer-term track record builds.
The Harvard Business Review article is available below