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.
The OECD annual survey of large pension funds and public pension reserve funds, reveals the “existence of serious barriers that need to be urgently addressed at policy level” to encourage long-term investment.
The survey, which looks at 86 institutional investors from more than 35 countries accounting for $9.7 trillion in assets, as part of a research collective into long-term investing .
As part of the OECD report on “Government and market based instruments and incentives for stimulating the financing of long-term investment”, requested by the G20 finance ministers and central bank governors, analysis is also underway on the wide range of options available to institutional investors for accessing the infrastructure asset class and how the historic models of infrastructure funds need to be adapted to accommodate the interests of investors more favourably.
To access the report click here
The world is running short of water, but what does that mean for investors? Asset owners in the Netherlands and Norway assess and manage the water-related risks in their portfolios, including the measurement of portfolio companies’ water dependence and water security.
The drought hitting South Africa’s North West Province sounds another warning shot around the dangers of water risk for long-term investors.
It’s affecting the country’s “Platinum Belt”, the source of 75 per cent of global platinum production and home to the world’s three biggest producers: Anglo American Platinum, Lonmin and Impala Platinum.
It’s just the kind of risk flagged in MSCI’s latest ESG research on water risk “A Well Running Dry: Identifying and Assessing Water-related Risk for Investors” which estimates that the total value of sales or reserves at risk from water shortages includes $221 billion for MSCI All Country World Index (ACWI) gold miners, $20.7 billion for MSCI USA Investable Market Index (IMI) electric utilities, and $7.2 billion for MSCI ACWI steel producers. It’s not surprising proactive investors have woken up to water risk.
“We are largely a passive investor so nearly all of our equity investments are invested though an index of about 3,000 companies throwing up constrains as to how deeply we can analyse any one of these companies,” says Piet Klop, senior advisor responsible investment at PGGM Investments tasked with protecting the €40 billion ($53 billion) equity portfolio from water-related risk – a challenge given the lack of data.
“Investors like PGGM need to know how companies compare in their aggregate exposure to water risk and how companies compare in their response to that water risk,” Klop says.
Only with this knowledge can PGGM first engage with companies facing water risk and then, if engagement doesn’t work, exclude those companies from the index, as per their process.
“For meaningful dialogue we need comparable information on those companies; we need metrics that are both meaningful and comparable. This combination is pretty rare still because this is still a young topic for most investors.”
At Norges Bank Investment Management, investment manager for the Norwegian Government Pension Fund Global, water management has been a strategic focus since 2009.
“NBIM is exposed to water-related risk through its investments in about 7,5000 companies many of which rely on water as an input or output factor in their operations and supply chains,” says Jan Thomsen, chief risk officer at NBIM speaking at the launch of the CDP 2013 Global Water Report.
“Within a context of increasing water scarcity and adverse water related events, the fund’s long-term returns may be impacted through company specific risks or increased systematic risks driven by these externalities. Mapping and understanding such risks can be a challenge but is fundamental in supporting investment decisions.”
At MSCI, where research centres on increasing investor understanding of water risk, developing ways to best quantify that risk and highlighting which assets are most in danger, findings have focused on three industries: global gold miners and steel industries and regional electric utilities in the United States.
“All are water intensive companies which have their asset values concentrated in particular regions in a concentration of risk that magnifies the potential impact of water scarcity on the companies’ operations,” says Cyrus Lotfipour, senior analyst at MSCI ESG Research.
MSCI calculated the total value at risk for US electricity companies by taking average state electricity prices, the generating capacity each company has within each basin, and the number of months of water scarcity these basins faced.
“From this it is possible to derive an estimated loss associated with water scarcity,” says Lotfipour. The research estimated losses of $21 billion in electricity sales, roughly 6 per cent of nationwide electricity sales.
However utilities in America’s dry and arid regions like Arizona and New Mexico faced severe scarcity with “30 per cent of their revenue at risk” but utilities in the northeast didn’t face any risk.
Similarly, MSCI found revenue from gold companies was at risk in arid but mineral rich countries like Chile and Australia where the cost of extraction often makes reserves unreachable and found that bigger companies with a diverse footprint are better protected.
MSCI also found that companies are often not implementing strategies to help mitigate water risk. “The most water intensive industries commit to water targets less frequently than the entire MSCI World Index,” says Lotfipour.
Water risk has many different manifestations.
“It’s not just a physical risk around running dry,” warns PGGM’s Klop. “It’s also about regulatory and reputational risk, risks around the disruption of supply chains and new capital expenditure or compliance costs.”
He believes that simple overlays offer valuable insight.
“An overlay can bring home the point that water risk can be material: China may not be able to get hold of its shale gas because the water may not be there. Very few mainstream investors are taking this seriously.”
Klop identifies three key steps in PGGM’s analysis of water risk facing companies. The first is to measure companies’ water dependence and their water security.
“What are the outside risks that can affect the water that they need?” he asks.
The next step is to measure companies “meaningful” response to emerging water risk flagging that companies may become “more efficient” but not necessarily “more water secure.”
Investment strategies could include “constraining the universe” by excluding companies facing water risk and with poor mitigation or tilting portfolios away from water risky companies. He also suggests targeting research towards actively managed portfolios both in private and public equity and is a “firm believer” in corporate engagement.
“Water is climbing up agenda,” he concludes.
Setting a strategy to keep an ageing pension fund in fine health is “a lot more challenging than selecting where to invest premiums flowing into a young fund,” reflects Frans Dooren, chief investment officer of the Nedlloyd Pension Fund.
Dooren began to skipper investment strategy at the €1.2-billion ($1.6-billion) fund in 2011, taking over after his retiring predecessor’s 40-year spell at the helm.
Dutch shipping company Nedlloyd hit the economic rocks in the early 1990s and was subsequently swallowed up in mergers with British firm P&O and again with Danish group Maersk in 2005. Nonetheless, the task of paying fund members their due remained and, naturally enough, became more urgent as the numbers of active members declined.
Ensuring the investment strategy protects the downside risk is vital when close to 70 per cent of members are drawing benefits, Dooren points out. It has been made all the more essential though by a curious quirk in the pension fund’s accounts.
On the one hand, the fund has generated enough returns to defy the drain on its assets caused by a steady majority of retired members – increasing its total assets by more than 6 per cent between 2008 and 2012. On the other hand, it saw the funding ratio slip from a healthy 114 per cent in 2009 to 105 per cent at the end of 2012, just above the Dutch Central Bank’s minimum.
A double whammy of rising longevity and falling interest rates sent the funding ratio into reverse, Dooren explains. Extended life expectancies alone produced a recent 9 per cent liability-increasing hit.
That has been tough for the fund to deal with but it has gained some relief in 2013 with the funding ratio increasing somewhat in the course of the year and, Dooren reckons, “our whole funding situation will be solved if interest rates rise again”. His optimism is well grounded: the Nedlloyd fund set itself on course to greatly benefit from rising interest rates in 2010 when it exchanged its interest rate hedges for swaptions, which pay off if rates rise.
Anchoring against downside swell
Hedging has been a key part of an investment strategy designed to stop market misfortune eating into the fund’s benefits. Another pillar of this approach is the 40 per cent of the fund that is invested into a “matching portfolio” of bonds.
The fund has aimed to match 50 per cent of cash-flow liabilities with government bonds with this portfolio, but Dooren concedes low bond yields mean less than this target is currently covered – around 44 per cent of cash flow.
“Low government bond yields are making the performance of our return-seeking assets more important” as a consequence, Dooren explains. Swaps have also been used to help the matching portfolio meet its target.
Hedge caution
Interestingly, the Nedlloyd fund has made a number of alterations to its use of hedging in the past few years.
The most notable case involved exchanging interest-rate swap hedges for swaptions, although “looking at the way interest rates have continued to drop since 2010, you can probably say we went into swaptions too soon,” says Dooren. He remains confident that it was a fundamentally good idea, and one the fund would repeat if placed in the same situation again, due to the good chances of future interest-rate rises. He explains it was made not as a bold or risky macroeconomic bet, but simply to continue covering the downside should rates rise.
Currency hedging was also dropped in 2011. A key reason for that was the desperate outlook for the euro at that time made the fund less concerned about assets held in foreign currencies. Dooren explains that the liquidity restrictions that are a prominent part of a mature fund have also been a big factor for its continued aversion to any currency hedging. “We needed to put up cash for currency hedges every month and we don’t have much access to that,” Dooren emphasises. Much of the fund’s US-dollar exposure comes in the (relatively illiquid) private equity portfolio after all.
“We decided also not to hedge our equity exposure any longer with put-options as it looked too costly in the long term,” adds Dooren. This decision was made following a 2012 asset-liability management study. A 20 per cent equity allocation also meant equity hedging had only limited potential to benefit the overall funding ratio, he explains.
However, one significant increase in hedging levels was made at the time: a boost in interest rate hedging from 75 per cent to 100 per cent on a nominal basis.
Equities drive return currents
The fund comfortably outperformed its benchmark in 2012, generating 9 per cent returns against a benchmark of 7.9 per cent.
The equity allocation had an important part to play in the fund’s recent investing success, as it also ran ahead of its benchmark in 2012 and 2013.
Dooren attributes strong equity returns to the fund’s faith in active managers paying off, as it does not make any tactical calls on the asset class. “We believe strongly in the value of active management and also in building a portfolio of bottom-up managers with different style and factor exposures,” says Dooren.
A 10 per cent alternatives allocation at the Nedlloyd fund is composed mainly of private equity investments. Alternative assets are currently taking up significantly more than their strategic allocation of 4.5 per cent, but Dooren says their weighting is due to decline in the future. “We are harvesting our private equity investments now and there is a lot of liquidity coming out of them,” explains Dooren.
Keeping liquidity high is a reason for gently reducing the alternatives allocation, although Dooren stresses this is not a major issue for the private equity holdings.
The upcoming sale of the Nedlloyd fund’s hedge fund investments will enhance the reduction in alternatives, just as it ends a long but somewhat turbulent relationship with the asset class. A performance blow came back in 2009 when one of the fund of funds invested in at the time turned out to have a stake in one of Bernard Madoff’s fraudulent funds. “Hedge funds are a complex, expensive strategy and there is a reputation risk to pension funds, which is why we decided to sell,” says Dooren. He adds though that the small amount invested in hedge funds has not had a significant impact on the total portfolio.
Real estate holdings are also due to be scaled back due to help future liquidity needs, with the fund sitting on a historic 15 per cent allocation.
Overall investment returns in 2013 are down to minus 0.45 per cent for the first six months, due largely to losses on the fund’s matching portfolio. Dooren and the Nedlloyd fund therefore continue to face a challenge in ensuring the strategy keeps the promised benefits flowing. A few fingers will no doubt also remain crossed at the fund’s riverside office, situated a stone’s throw from the Port of Rotterdam, that interest rates eventually rise to bring a more favorable tide when it comes to funding the remaining obligations.