From a strategic asset allocation point of view, AustralianSuper is one of the most aggressive investors in emerging markets, particularly Asia.

About a quarter of the $43-billion fund is in international equities, and nearly half of that is in emerging markets.

Equities is the vehicle for AustralianSuper’s emerging market exposure because growth remains the reason for its allocation.

“And equities are the main beneficiaries of growth,” says chief investment officer, Mark Delaney (pictured right).DELANEY_Mark-120x

Specifically the fund wants direct consumer exposure in Asia, and to do this has looked beyond a passive approach with major indexes – such as the MSCI All Country World Index – that have greater exposure to the financial and energy sectors in emerging markets.

It’s a valid strategy to look beyond passive investing in emerging markets, particularly given the mixed performance of equity markets that make up the index, and also the dominance of state-owned enterprises.

Conrad Saldanha, managing director and portfolio manager of emerging market equity at Neuberger Berman, says benchmarks are not reflective of the underlying economy – and that is true for both developed and emerging markets. But emerging markets have a number of unique characteristics which means active management is even more of an obvious choice.

Benchmarks in emerging markets capture the dominant drivers – commodities, financials and state ownership – which in some countries such as China are 90 per cent of the benchmark.

“You get the biggest capitalisation companies but it is not necessarily representative,” he says.

Where active management rules

Managing director and head of investment strategy and risk at Neuberger Berman, Alan Dorsey, agrees the beta story is not working well in emerging markets.

“It is a particularly good environment for active management. When the tide is going up and all the ships are going up, or the tide is going down and all the ships are going down, then the beta story is better. But there is mixed performance of emerging markets equities. Security selection is paramount,” he says

Phil Edwards, principal at Mercer in London, agrees there are a lot of opportunities for skilled active managers in emerging markets.

“Active managers make sense because of the risk management perspective as well, so using active managers is useful for that.”

Saldanha, pictured right, says his stock picking involves looking for quality businesses with secular growth opportunities, higher returns, lower debt with strong cash flows.Saldhana_Conrad-120x

“We want to identify, evaluate and predict cash flow for those companies with a domestic focus,” he says.

He says there are good bottom-up opportunities in emerging markets, including in mid-cap companies and frontier markets.

According to Dorsey investors should consider the MSCI ACWI index as the starting point of their overall equities asset allocation, and then have manager tilts into various countries, some of which are emerging.

But he believes the tilts should be done on a security-selection basis – not on a country basis, which requires corporate and also global analysis.

“Asset allocation generally depends on the client’s objectives and their guidelines on absolute returns and relative returns. Many investors think of the question of whether to include emerging markets in a wider international equities exposure in terms of the index,” he says. “The weighting of the allocation to emerging markets is clearly centre stage. While not all emerging markets companies are stellar, neither are all developed market companies less attractive. You need to look at company selection globally.”

Finding your ideal weight

In Europe the reduction in allocations to domestic equities has seen a subsequent uptake in international allocations, including emerging markets.

Mercer’s Edwards says there has been a more global approach and funds are awarding global active equities strategies and, as part of that, emerging markets.

Among European asset owners, Mercer’s asset allocation survey shows the average allocation to emerging markets in 2013 is 5 per cent of total assets or about 10 per cent of equities, which is underweight compared to the proportion of emerging markets within the global equities universe.

The Finnish State Pension Fund, the €15.8-billion ($20.8-billion), VER is one European fund that has been quite aggressive in its emerging market allocations, and is currently overweight its strategic benchmark.

Timo Löyttyniemi, (pictured right) chief executive of VER, says the fund was a net buyer of emerging market equities during the crisis.Timo-Löyttyniemi-WEB

“We have had a benchmark structure for a few years where half of emerging market equity exposure is in a diversified emerging market portion and the other half is in an Asian emerging market portion. We tend to have an Asian tilt as a result of that. From time to time Russia has been a key performer for us, but performance has not been that good in the last two-to-three years so it has no special prominence in our strategy at the moment. Russia used to give us a major performance bonus but other than that there are no major country picks, but more of an Asian bias in a diversified strategy.”

Edwards is advising that funds look at increasing their allocations to emerging markets to be in line with the benchmark weight. The MSCI ACWI includes 24 developed markets and 21 emerging markets.

“Increasing to the benchmark weight seems sensible, and we suggest considering allocating above the market-cap weight,” Edwards says, advocating about 20 per cent to emerging markets.

In addition, he says there is an expanding opportunity set in frontier markets.

They have the characteristics that today’s emerging markets had in the 1980s, but there are limited capacity, risks and liquidity issues.”

Opening the world’s second largest economy

The changing nature and openness of emerging market financial systems mean that constant assessment of the environment is necessary.

MSCI is currently considering whether to increase the allocation of China’s weight in the emerging market index to include the nation’s A shares.

(Concurrently MSCI Korea and MSCI Taiwan Indices remain under review for a potential reclassification to developed markets).

The MSCI emerging market index currently only includes Hong Kong-listed H shares, and some China B shares.

Including the A shares in the index would dramatically change the nature of the benchmark, potentially increasing China’s allocation from around 18 per cent to 30 per cent.

China is already the largest single country weight in the index and this potential change would give it more impact. This obviously has implications for investors.

The Shanghai and Shenzhen stock exchanges have more than 2400 stocks, with a total market capitalisation of about $3.5 trillion.

Foreign ownership is only about 1 per cent of that, due for the most part to the stringent requirements of the Qualified Foreign Institutional Investor system and the slow deployment of its quota.

However MSCI is seeing enough change to conduct consultation on the country’s allocation.

Chin Ping Chia, managing director of MSCI (pictured right), says a series of developments have caused the review, including an increase in the quote of A shares available to foreigners from $30 billion to $80 billion. Chia-Chin-Ping-120x

“We see this as a signal to expand the system and allow more investors to participate.”

In addition the high qualification criteria has been amended.

It used to be that to get a licence you needed $5 billion in assets and a five-year track record. That was lowered in July last year to $500 million in assets and a two-year track record.

“This is a significant change and broadens the set of investors, which is a positive thing.”

China’s Renminbi Qualified Foreign Institutional Investor system has also been expanded from RMB70 billion to RMB270 billion.

“This is a positive message saying there is regulatory momentum to open the markets.”

However MSCI identifies a number of key obstacles that need to be overcome, including capital mobility restrictions, the small allocation associated with licences and the imposition of capital gains tax.

“China is the second largest economy in the world. It is very close to opening to international investment and we think this is the right time to be starting this conversation. But it depends entirely on the progress of the regulatory system. MSCI does not have a time frame, but we are engaging with the regulators so they consider the investment processes and needs of investors,” he says.

“It is also for investors to digest and think about the consequences. Only a small handful of investors – 200 – have QFIIs. A large number of investors haven’t taken action, so what does it mean to take action?

“In the context of every market, when they open and increase foreign institution participation it is a good thing. It mainstreams investment ideas and the market gets more efficient.”

Frank Yao, managing director of Neuberger Berman Asia, says it is a huge positive to include the A shares in the index.

“It is positive for international investors to access China. It is the second largest economy in the world, but international investors have no direct way to access it. It is also positive for domestic investors: if foreign investors come, the market becomes more institutionalised.”

In particular, he says, that would mean improvements in technology, corporate governance and transparency.

Yao says the government influence and management of the corporate sector has diminished over the years.

“There is new leadership, economic reforms and now China is being opened to the rest of the world. China will become more market driven. In many areas, like the housing and auto sectors, China is more capitalist than the US,” he says. “Last week the government announced it would open the banking sector. Five or even three years ago you couldn’t even imagine this would happen.”

While China will continue to grow, Yao says it is still an emerging market and is very inefficient.

“Investors need to have a long-term investment horizon and emerging markets are volatile. There are still significant alpha opportunities.”

The changing nature and openness of emerging market financial systems mean that constant assessment of the environment is necessary.

MSCI is currently considering whether to increase the allocation of China’s weight in the emerging market index to include the nation’s A shares.

(Concurrently MSCI Korea and MSCI Taiwan Indices remain under review for a potential reclassification to developed markets).

The MSCI emerging market index currently only includes Hong Kong-listed H shares, and some China B shares.

Including the A shares in the index would dramatically change the nature of the benchmark, potentially increasing China’s allocation from around 18 per cent to 30 per cent.

China is already the largest single country weight in the index and this potential change would give it more impact. This obviously has implications for investors.

The Shanghai and Shenzhen stock exchanges have more than 2400 stocks, with a total market capitalisation of about $3.5 trillion.

Foreign ownership is only about 1 per cent of that, due for the most part to the stringent requirements of the Qualified Foreign Institutional Investor system and the slow deployment of its quota.

However MSCI is seeing enough change to conduct consultation on the country’s allocation.

Chin Ping Chia, managing director of MSCI, says a series of developments have caused the review, including an increase in the quote of A shares available to foreigners from $30 billion to $80 billion.

“We see this as a signal to expand the system and allow more investors to participate.”

In addition the high qualification criteria has been amended.

It used to be that to get a licence you needed $5 billion in assets and a five-year track record. That was lowered in July last year to $500 million in assets and a two-year track record.

“This is a significant change and broadens the set of investors, which is a positive thing.”

China’s Renminbi Qualified Foreign Institutional Investor system has also been expanded from RMB70 billion to RMB270 billion.

“This is a positive message saying there is regulatory momentum to open the markets.”

However MSCI identifies a number of key obstacles that need to be overcome, including capital mobility restrictions, the small allocation associated with licences and the imposition of capital gains tax.

“China is the second largest economy in the world. It is very close to opening to international investment and we think this is the right time to be starting this conversation. But it depends entirely on the progress of the regulatory system. MSCI does not have a time frame, but we are engaging with the regulators so they consider the investment processes and needs of investors,” he says.

“It is also for investors to digest and think about the consequences. Only a small handful of investors – 200 – have QFIIs. A large number of investors haven’t taken action, so what does it mean to take action?

“In the context of every market, when they open and increase foreign institution participation it is a good thing. It mainstreams investment ideas and the market gets more efficient.”

Frank Yao, managing director of Neuberger Berman Asia, says it is a huge positive to include the A shares in the index.

“It is positive for international investors to access China. It is the second largest economy in the world, but international investors have no direct way to access it. It is also positive for domestic investors: if foreign investors come, the market becomes more institutionalised.”

In particular, he says, that would mean improvements in technology, corporate governance and transparency.

Yao says the government influence and management of the corporate sector has diminished over the years.

“There is new leadership, economic reforms and now China is being opened to the rest of the world. China will become more market driven. In many areas, like the housing and auto sectors, China is more capitalist than the US,” he says. “Last week the government announced it would open the banking sector. Five or even three years ago you couldn’t even imagine this would happen.”

While China will continue to grow, Yao says it is still an emerging market and is very inefficient.

“Investors need to have a long-term investment horizon and emerging markets are volatile. There are still significant alpha opportunities.”

For more on China in the broader context of emerging markets, read the full story.

Hershel Harper received an early education in finance when he used to read Business Week in High School. The 43-year old now at the helm of the $27-billion South Carolina Retirement Systems, investing on behalf of South Carolina’s 350,000 public sector workers, says he knew back then he wanted to manage money: “I really am one of the most blessed people; I am doing what I always wanted to do.”

As the new fiscal year begins Harper, promoted internally to chief investment officer of the South Carolina Retirement System Investment Commission (RSIC) a year ago, is overseeing two shifts in strategy at the fund, both designed to simplify investment and pare down the number of managers it uses. South Carolina’s equity allocation, comprising 31 per cent to public equity and a 9 per cent to private equity, hasn’t really changed over the past year. However the US and non-US equity assets are being combined to track a single global equity benchmark, the MSCI ACWI, instead of separate active allocations to US small and large-cap stocks, non-US developed and emerging markets equity. “We are moving to a global benchmark for a straightforward approach to manage and track our largest factor exposure. I expect our global equity allocation to become increasingly more benchmark-centric, with large portions of the allocation to modest tracking error strategies, or to be passive,” says Harper.

Trimming the hedge funds

In another effort to simplify its domestic equity portfolio, South Carolina is in the process of dropping a $3.9-billion portable alpha hedge-fund allocation.

Harper,HershelEnthusiasm for portable alpha, a strategy that allows exposure to an index providing beta returns, as well as investments in uncorrelated sources of alpha, has chilled at the fund. “Portable alpha has been successful overall, however the volatility in the short term is no longer a risk we wish to maintain.We are simplifying our implementation for alpha and beta,” says Harper. Dropping the program is also part of a broader strategy to shave South Carolina’s $5.5-billion hedge fund allocation from 20 per cent to an 8-per-cent policy target of assets under management. (There is a 15-per-cent maximum allocation to hedge funds across the plan.) Part of the reorganisation of its hedge funds includes creating a smaller, dedicated hedge fund portfolio investing only in funds that have a low correlation to other asset classes including global macro, market-neutral or managed-futures strategies. Harper is also looking to better integrate hedge fund investments across the entire portfolio. “Hedge funds aren’t so much an asset class as they are an implementation strategy,” he explains.

The potential in house

Despite the potential to manage a simplified equity allocation in house, any move to boost South Carolina’s internal team of three has stalled for now. RSIC is still weighing up the cost of technology and recruiting its own expertise rather than continuing to pay outside managers, says Harper. “Managing more of the portfolio internally will save millions of dollars, which could remain in the Trust rather than paying manager fees to firms in New York or London, but we must weigh those benefits against the potential of increasing operational risk,” he says. Any move to manage funds inhouse would start with US equities, he adds. The only internal asset management is for short duration securities (3 per cent) and the cash allocation (2 per cent).

Inhouse management would provide a saving that could help plug the fund’s $15-billion deficit, another factor increasingly weighing on investment strategy. “We are only responsible for managing the asset component but we are aware of, and understand, our liabilities,” says Harper. The deficit makes holding liquid assets now more of a priority and was one of the reasons behind reducing the hedge fund allocation. Each month South Carolina pays out more in retirement benefits than it receives in contributions, amounting to about a $1-billion shortfall every year. “This gap has to be filled by the Trust and it is our job to make sure there is enough liquidity on hand to meet the benefit payments,” says Harper. It means South Carolina holds more cash than other public funds; a “cash drag” he says he is “prepared to live with in order to mitigate the risk of not meeting a benefit payment.”

Taking on risk, mitigating volatility

Neither does Harper believe a liability-driven investment strategy is necessarily the answer. South Carolina still looks at strategy from a performance perspective, locked into a legislature-set 7.5-per-cent assumed rate of return. Nor could the fund – only 60 per cent funded – perfectly use the strategy that matches assets to liabilities anyway. “We have fewer assets than liabilities, so a pure asset-liability matching strategy doesn’t make sense for us,” he says. “In a zero-rate environment, we must take on a reasonable level of risk in order to meet or exceed that mandate. We try to do that with a strategy that simultaneously includes elements of mitigation against volatility. Our primary goal is the soundness of the plan to ensure the payment of earned benefits. All of our decisions revolve around that fact.”

South Carolina’s 8-per-cent real-asset allocation is divided between real estate (5 per cent) and commodities (3 per cent). Harper sees opportunity in real estate on the debt side, lending on underperforming “good assets in good markets”. Target markets include the UK, Germany and Ireland but also peripheral Europe. “We have $1 billion in the ground, but we are underweight; our target is 5 per cent of assets,” he says. The fund’s private equity strategy, begun in 2007, has borne fruit with an estimated 14-per-cent return in the fiscal year that includes lag, although he believes the greatest bounty is still to come. “We have capital in the ground but we’re still feeling the J-curve affect,” he says. South Carolina also co-invests in private equity, portioning some funds to its private equity managers but also investing directly in the same projects. “We have several co-investments right now,” he says. “Some haven’t worked out but others have been very successful.” Harper would like to push co-investment to account for a third of South Carolina’s private equity portfolio, although he will need a budget and additional staff to do so.

Elsewhere, the fund has a 19-per-cent allocation to diversified credit comprising a mix of high-yield bank loans, structured products, emerging market debt and private debt, and a 15-per-cent allocation to fixed income. Here the allocation is divided between core fixed income, managed by Blackrock and Pimco and recently scaled down to 7 per cent from 10 per cent, and global fixed income. An allocation to opportunistic investments includes low-beta hedge funds and risk-parity strategies.

Harper believes one of the biggest dilemmas for US public pension funds in today’s low-rate environment is balancing venturing out onto the risk spectrum with staying comfortable, in turn risking increased contributions or cut benefits. South Carolina “pushed double-digit returns” last fiscal year, coming in 150 basis points ahead of the benchmark. It’s not surprising he is confident he’s got the strategy right. “We can achieve 7.5 per cent with high confidence and without taking undue risk.”

While commodities are a controversial and problematic asset class to some investors, for others they are an ideal diversifier looking more attractive than ever. A mini-revival in commodity investing among US pension funds suggests the asset class may be enjoying a resurgence. The Los Angeles Fire and Police Pension System, Municipal Retirement System of Michigan and Arizona State Retirement System have all recently upped their commodity holdings.

Don Steinbrugge, (pictured right) managing partner of Virginia-based Agecroft Partners and investment advisory committee member of the $461-million Steinbrugge,-Don-120xCity of Richmond Retirement System, says renewed interest in commodities is part of wider investment trends. “Investors are using commodities as part of a real asset bucket including such things as real estate, as an inflation hedge and also to diversify the portfolio”, he says. “Real assets stand to benefit from increased inflation, should that ensue from the world’s budget deficit troubles.”

That argument is acknowledged by the Ontario Teachers Pension Plan (OTPP), one of the earliest funds to have placed its faith in commodity investing, which is currently investing 5 per cent of its $129-billion portfolio in the asset class. Spokesperson Deborah Allan says in addition to functioning as a hedge against “unexpected” inflation, it believes that “commodities typically have low correlation to other asset classes”.

David Hemming, commodities portfolio manager for Hermes, says many pension funds are moving towards strategic asset allocations of between 2 to 4 per cent after dipping their toes in the asset class with less than that. A 2012 Mercer survey found European funds that invest in commodities indeed allocate around 3 per cent on average – a mere 8.9 per cent of European and 2.1 per cent of UK funds reported having commodity investments at the time of the survey though.

Tough times

The continued reluctance from many pension funds to invest in commodities perhaps stems from a relationship with investors has been best characterised as up and down. Money initially flocked into commodities in post-crisis diversification efforts, but sentiment then appeared to turn with some investors – most notably Illinois Teachers Retirement System – dropping investments. Returns at funds using the asset class have not always made other investors envious either, with CalPERS losing 7.2 per cent on its commodity exposure over the five years to January 2013. The Dow Jones UBS Commodity Index provides graphic evidence of a sluggish few years – the index has failed to come close to its mid-2008 peak and started 2013 at roughly the same level it started 2004.

OTPP has shrugged off a below-benchmark minus-1.2-per cent performance over the past four years in its commodity portfolio with a faith in the asset class’s ability to perform over longer time horizons, according to Allan.

Should other investors be equally optimistic? That may depend on whether they accept the reasoning for commodities’ key selling points misfiring in the recent past.

“Unfortunately we haven’t seen commodity returns keep pace with equity returns since 2008,” concedes Hemming, although he characterises this as a small period. “We saw asset classes come down across the board after the extreme events of 2008 and 2009,” says the manager, who argues a high growth and high inflation environment is one in which commodities would really flourish. “That is what you would expect to see at the tail end of an economic recovery,” he adds, “as you would expect equities to rally first and then commodities to follow through as the expectations of higher growth and inflation are realised.” He argues that the presence of this ideal environment in China in recent years has buoyed commodity markets there.

Hemming (pictured right) adds that the historically low correlations between commodities and other asset classes also broke down during the financial Hemming,David-120xcrisis and remained prevalent after with “risk-on risk-off taking hold against the backdrop of central bank interventions”. Steinbrugge feels there is ample evidence of commodities defying equity cycles though, saying that commodity-trading advisers have enjoyed negative correlation to equity-down markets over the past 15 years.

High volatility in commodities has proven another stumbling block, and was cited as a reason by the Illinois fund to ditch its commodities exposure in 2012. Hemming says there is no doubt that commodity volatility “can be a turn off for some investors and trustees”, although he argues that “with the funding levels of some pension schemes, commodity volatility could be a necessary ingredient in closing that gap”.

Steinbrugge also reasons that as a key diversifier, commodities can actually reduce a fund’s overall volatility. That is particularly the case in the US with pension funds typically running 60 to 70-per-cent equity allocations, he says, and that another flipside to the volatility is that “you don’t need much in commodity investments to get the benefits to the portfolio’s risk and return side”.

On top of sluggish returns, uncertain correlation and high volatility, even the supposed inflation-hedging properties of commodities have attracted doubts from some investors. Anton van Nunen, director of strategic pension management at Syntrus Achmea, says in his experience as an investor he has not found a “strong relationship between general inflation and commodity prices”. Hemming argues, though, that on a historical basis, spikes in energy or food prices have been clearly behind most “surprise inflation” events. Allan states that OTPP is confident too in the ability of commodity prices to “hedge against inflation over long-term investment horizons”, while acknowledging that imbalances in supply and demand can have a distorting short-term impact.

Answering the green lobby

Even if investors are sure of commodities’ investment appeal, there are further doubts about their credentials for sustainability. Commodity futures in particular have come under fire from the sustainable investing world. Murat Ünal, founder of German investment consultancy Funds@Work, says futures in so-called soft commodities – primary food products – are subject to harmful speculative investments, with liquidity often rushing to given areas to push up prices.

That argument has its opponents but “even the largest players in Germany are very hesitant to look at soft commodities” as a consequence, according to Murat_Uenal_120xÜnal (pictured right). He reckons that the reputational risk is too great for investors to be attracted to a sub-asset class, while the potential destabilisation of soft commodity markets can in any case have a knock-on effect on emerging-market equity returns via food inflation.

Legislation that effectively prioritises bond investing has also played a major part in making commodity investing usually “well below 1 per cent” among German pension investors though, he adds.

Simon Fox, director of commodity research at Mercer UK, says that investing in farm land, a commodity allocation can actually boost a fund’s sustainability credentials by playing a part in boosting global food production. Ünal agrees this can be a case, but purely in long-term commodity investments, rather than futures. He would like to see more done in social entrepreneurship funds to facilitate this.

The place for commodities

A period of performance problems arguably presents a huge opportunity for investors. “It’s better to invest in commodities when they’re not performing rather than getting involved after they have performed,” Hemming says. Talk of an end to a commodities “super cycle” as Chinese growth slows is, however, off the mark, he argues: metal prices look sustainable and energy prices remain low in the US, while agricultural prices can swing up at anytime as they are heavily dependent on weather-influenced annual crops. Should energy prices go even lower, he suggests, they would also be able to buoy other commodities by propelling economic growth.

OTPP made commodity investing part of its alpha-seeking “tactical allocation” bucket earlier this year. It invests to the Stand and Poor’s Goldman Sachs Commodity Index benchmark, which has a 70-per cent energy tilt. Allan justifies this by arguing that energy “has historically been the best hedge against unexpected inflation”.

Across the institutional investing world, a trend towards active commodity investing has been noticed as funds shy away from the volatility of indices. “The case for a passive allocation to commodities has always been relatively weak compared to other alternative asset classes,” Fox says. As a result he thinks “there is much more interest in illiquid plays in assets such as timberland and farm land”.

The expertise of an active manager can also count in the complex asset class. Negative roll yields – the dreaded ‘contango’ – remain a challenge that can only be mitigated with skill, Hemming says. While there are active managers looking to generate alpha from commodities such as OTPP, Hermes and others focus on risk-reducing beta strategies.

The Los Angeles Fire and Police Pension System reportedly decided to split a commodity-derivate portfolio in order to carry out both an enhanced-index strategy and an “active-constrained” approach when deciding to enter the asset class.

Steinbrugge adds that commodity exposure is also being picked up in global macro and hedge funds strategies. Clearly the ways into the asset class are every bit as divergent as the views on it but there is no doubting the faith commodities proponents place in its value as part of a sophisticated asset strategy.

 

Al Gore, former US vice president and co-founder with investment banker David Blood, of Generation Investment Management, said sustainable capitalism is not an argument that pension funds should sacrifice value in return for values.

Rather it is consistent with the core fiduciary relationship to match liabilities.

“It’s what it’s all about,” he says.

Gore defends capitalism, saying it is at the base of every successful economy: it efficiently allocates resources, it is congruent with freedom, and importantly it is the one system that unlocks the future of individuals with incentives that unlock ingenuity. However, he is despondent at how capitalism is being pursued.

“No wonder with those virtues that everything’s going great in the world’s economy,” he says ironically. “If capitalism has all these strengths and is hegemonic in organising economic activities, why do we have these problems?”

“In the US for sure a public pension crisis is pending, California, Rhode Island, go right down the list. The conspiracy of the present against the future is bigger than I imagined,” he says. “If we are trying to predict into the future such a narrow slice of information we ignore the possibility of ruining civilisation as we know it, there’s something wrong with the way we’re pursuing capitalism.”

In an interview with Top1000funds.com he notes the distribution of income is not measured, and rising inequality is not measured in the assessment of the economy.

“We’ve made our choice for capitalism – now the focus is on how we pursue capitalism. The concept of sustainable capitalism is not an argument that pension funds should sacrifice value in return for values. Rather they should start from a premise that it should be best practice because you’ll get better returns over time.”

He says a wider scope of information assessment and processing is crucial to sustainable capitalism.

“As vice president in the White House for eight years, every morning for an hour I got a review of the military information, from many sources. What we see with our eyes is not all that is there, we can organise ourselves to include more information,” he says. “We are used to focusing on quarterly reports, number metrics are all important but only a narrow source of the value spectrum. If companies ignore the people associated with their supply chains or environmental impact then there is brand damage, that information is directly relevant to the value of the equity assessment.”

(As an aside Apple Inc, of which Gore is a long-time board member recently hired former head of the US Environmental Protection Agency, Lisa Jackson to head up its environmental effort.)

Gore believes there is a governance crisis in the world today.

“Democracy having become accepted as the best form of government has been failing to meet the test of leadership required in 21st century,” he says.

“The US has been the de facto leader but in the last decade the quality of US governance led to a crisis of confidence in the US leadership. The world is relatively rudderless.”

Specifically, he says that US public pension funds have taken some immense risks by allocating large percentages of their portfolios to high risk assets, because governance structures reward them for doing so.

It is within investors’ power to change this.

Gore’s partner at Generation Investment Management, David Blood, says long-term asset owners have a critical role to play, and must first assess what is in their best interests.

“What will they support to realise more value?” he asks. “It is a challenge to get them together and get them to listen. Investors are uncomfortable in the conversation around sustainability. What has frustrated us is we always thought it gets a better sense of the company.”

Gore quotes the psychologist, Abraham Maslow who says if the only tool you have is a hammer then every problem looks like a nail.

“The same is true if the only thing you use to assess a company is a price tag.”

In its seminal paper, Sustainable Capitalism, Generation outlined mandated integrated reporting as one of five recommendations to move towards sustainable capitalism.

“Financial statements are one perspective in the value of the business. You need to look at the sources of capital – physical, intellectual, and social capital – and only one of those is on the balance sheet,” he says. “Other forms of capital don’t come equipped with a price tag. It doesn’t mean quantitative analysis can’t be incorporated but you have to use different systems.”

Gore urges pension funds to start asking corporations questions, saying it will “have a profound effect” on the behaviour of companies.

“Pension funds can be the most important driver of the new phenomenon, by asking questions, and engagement. When pension funds are evaluating what to invest in, start asking questions, it will have a profound effect,” he says.

“But I want to repeat a central point. This is not social engineering or getting pension funds to take on social policy or government reform. But you should do it because it improves your performance, and matches your vision with a wider spectrum of what reality really is.”

Five recommendations of Generation Investment Management’s Sustainable Capitalism white paper

  1. Identify and incorporate risks from stranded assets
  2. Mandate integrated reporting
  3. End the default practice of issuing quarterly earnings guidance
  4. Align compensation structures with long term sustainable performance
  5. Encourage long term investing with loyalty driven securities

If investors were to focus on one aspect of the five recommendations, Blood says that identifying and incorporating risks of stranded assets would be the first choice.

“The most relative commercial issue in portfolios is to mobilise capital to low carbon,” Blood says.

The second would be around incentive structures.

“If incentive structures are short term and rewards are reinforced by short term performance then the ability to see the long term is damaged,” Gore says. “I’ve only been in the asset management business for 12 years but I have learnt that people will do what you pay them to do.”

Photo: Kasey Baker/Wikimedia Commons

Designing and implementing concentrated, long-horizon investment mandates would support longer term thinking, align pension organisation’s goals with its stakeholders, and reduce transaction costs.

This was one of the recommendations of a two-day workshop in Toronto last month, attended by a delegation of 80 pension fund executives from around the globe.

Aimed at uncovering the meaning and application of a 2012 Generation Investment Management white paper, Sustainable Capitalism, the workshop was co-hosted by the Rotman International Centre for Pension Management and the Generation Foundation.

It specifically wanted the funds to explore the practical implementation of the white paper’s recommended action plans, which were:

  1. Identify and incorporate risks from stranded assets;
  2. Mandate integrated reporting;
  3. End the default practice of issuing quarterly earnings guidance;
  4. Align compensation structures with long-term sustainable performance; and
  5. Encourage long-term investing with loyalty-driven securities.

The participants were broken into small groups and asked to think about what micro actions their pension organisations might take internally, and what collective macro action they would join in a larger industry, national or international collaboration.

The participants recommended that their own organisations design and implement concentrated, long horizon investment mandates, and ensure that they have the necessary resources to successfully implement them.

They also said they wanted to develop a “model investment mandate” through an organisation like ICPM that could be widely shared and reported on by investors.

The participants, that included representatives from funds such as the Washington State Investment Board, Ontario Teachers’ Pension Plan, the Canadian Pension Plan Investment Board, PGGM and APG, thought that a model mandate would force the development of new performance measures and incentive compensation schemes and challenge the dysfunctional inertia that continues to exist in many pension organisations.

Commenting on the investor recommendations Keith Ambachtsheer, director of Rotman ICPM and Rob Bauer, associate director of Rotman ICPM programs, said such mandates would be a radical departure from the traditional Keynesian “beauty contest” style of active management, and also from the broadly-diversified “formula” of passive management.

The key concept, they said, was the broad adoption of “concentrated long-term investment mandates” that require investor engagement.

The funds agreed that they would commence and advocate the adoption of integrated reporting of their own organisation’s results and for assessing the long horizon prospects of investments.

They would also focus on yearly results in one-on-one meetings between investors and corporate management, in a bid to end the focus on short term earnings.

Ambachtsheer says the next step in the process, to facilitate change and to really have a profound effect in the bid to make sustainable capitalism mainstream, is collaboration.

“We need to take an activist approach to the conversations with a collaborative model. Investors as a group should make four or five choices about how to change behaviour and all get behind it,” he says.

ICPM has written papers in the past on successful models of collaboration concluding they need to have clarity, common interest, an executive function and a budget, and the ability to track success and adjust plans accordingly.

Ambachtsheer uses asset management incentive structures as an example of potential change via collaboration.

“If asset owners insisted on new structures then managers would do it because they wouldn’t have a job,” he says. “If they think in the short term they will get away with it they’ll do it, it’s easier, more exciting and they get feedback immediately. If enough of an investor base changes their expectations it will create demand.”