Hermes Ownership Principles address a simple question: What should owners expect of listed companies and what should these companies expect from their owners?

The expectations set out in this document are derived from Hermes extensive experience as an active and engaged shareholder. This experience suggests that there are a number of reasons companies fail in their primary goal of delivering long-term value. Our experience suggests there are good central management disciplines which will greatly increase the likelihood of value delivery.

Usually when the $129-billion Ontario Teachers Pension Plan makes a strategic move, the rest of the investing community pays attention.

With a 15-per-cent allocation to emerging markets and a strategic plan to increase it to 20 per cent over the next couple of years, OTPP just opened an office in Hong Kong to take advantage of opportunities in Asia.

“Something like 80 per cent of the world trade in 2025 will be intra-Asia – we just have to be there,” chief executive of OTPP, Jim Leech, says.

The pension plan’s emphasis on emerging markets is indicative of a strategic philosophy being explored by many investors around the globe.

With rapid economic growth, shifting demographics, growing urbanisation and fiscal strength it is no wonder emerging markets have attracted investors’ attention.

In the Asian engine room

Australia’s largest pension fund, the $45-billion AustralianSuper, has nearly half of its international equities in emerging markets and is particularly keen on Asia, which makes up 50 per cent of its emerging markets exposure. It recently opened an office in Beijing and has a specific Asian advisory board.

AustralianSuper argues that investors must adapt their portfolios to Asia as it matures if they are to maintain and potentially grow their exposure to the future engine room of the world’s economy.

Similarly, the equities allocation of the $39-billion Finnish fund, Ilmarinen, is on an upward trend towards emerging markets, currently at 18 per cent of equities. The fund has investment people on the ground in Shanghai and is exploring whether to send a representative to South America as it intensifies its emerging markets focus.

Overweight emerging markets

From an asset allocation stance, a view on emerging markets is one of the more strategic decisions being made by investors. In fact managing director and head of investment strategy and risk at Neuberger Berman, Alan Dorsey, believes the allocation to emerging markets is the most significant contemporary asset allocation decision an investor can make.

“The biggest strategic asset allocation decision in my lifetime will be to overweight emerging markets,” he says.

The $22-billion New Zealand Super Fund is exploring just that, and is about a month away from finalising an investigation into whether to overweight to emerging markets.

It currently has a benchmark weighting consistent with the MSCI ACWI Investable Market Index, and head of asset allocation at NZ Super Fund, David Iverson, says the fund is looking at the growth and risk profile of emerging market equities and bonds when making decisions on overweighting.

He says the investigation is slightly different to that usually taken by funds in deciding whether to overweight, as it starts with the market view.

“The strategic asset allocation to emerging markets is a combination of market views and our view,” he says. “Most funds treat emerging markets equities and bonds separately, and then have a view inside that whether it is attractive. We start with what the market’s assessment is, which is the market-cap weighting that is already captured. Then we make a view on the market’s view and whether we have a separate view to that.”

In this way, NZ Super Fund is separating the fundamental valuations of the market, whether it has confidence in those valuations, and then assessing a manager’s ability to add value.

Strengthening position

Emerging markets has moved from an opportunistic to a strategic viewpoint in the eyes of investors, according to Rob Drijkoningen, co-head of emerging market debt at Neuberger Berman, and one of the driving factors of that move has been the importance of emerging markets from an economic point of view.

The European Central Bank reports that the emerging economies’ share in global output has increased from less than 20 per cent in the early 1990s to more than 30 per cent now.

The equation is tilted even more in favour of emerging markets if purchasing power parity, which takes account of cost of living differences, is used. According to the International Monetary Fund’s World Economic Outlook, the share of emerging market economies in world gross domestic product will surpass 50 per cent this year on this basis.

Of course, the relative attractiveness of emerging markets is strengthened by problems in the developed world, and emerging markets tend to be in better fiscal shape now than developed markets, including a pretty good GDP-growth dynamic.

Domestic stability

Conrad Saldanha, managing director and portfolio manager of the global equity team at Neuberger Berman, says emerging markets have lower debt-to-GDP numbers than developed markets, in fact there is a 50-basis-point differential.

“The shoe is on the other foot now,” he says. “There is a fiscal deficit and lower economic growth in developed markets.”

There has also been a fundamental shift in that domestic investors within emerging market countries are investing in their own markets.

“Hesitation by investors into emerging markets has come from a few angles. The market generally has been more short term and even institutional money has been fickle,” Saldanha says. “But now it is more stable because of the domestic investors.”

Saldanha says it pays to focus on the emerging markets that have been more consistent in their valuation premiums and volatility. That tends to be the countries that have a strong domestic institutional pension-investor base such as Chile, Mexico and Malaysia (as a result the manager is underweight Korea and Taiwan).

“Domestic investors buying in their own market is a big distinction for us,” he says.

Indexes and outperformance

One of the alluring aspects of the emerging market investment proposition has been its outperformance.

Over the 10 years to April 30, 2013 the MSCI ACWI IMI has returned 9.78 per cent. The emerging markets component, as measured by the MSCI Emerging Markets IMI, has returned 16.68 per cent in that time, while the MSCI World IMI has returned 9.37 per cent.

The $65-billion Washington State Investment Board uses the MSCI ACWI Investable Market Index, rebalancing to that index in 2007, which executive director Theresa Whitmarsh says gave the fund a “healthy dose” of emerging markets.

That index captures large, mid and small-cap representation across 24 developed and 21 emerging markets. It claims to cover 99 per cent of the global equity investment opportunity set.

While WSIB was quite early to emerging markets, because of the shift to the global index Whitmarsh says it would like the option to overweight but has been prevented by the difficulty finding managers to allocate to. With six emerging markets managers, WSIB is looking to propose to the board the prospect of passive emerging markets exposures because of this perceived barrier.

People on the ground

“We are not necessarily overweight but we would like the option,” she says. “There are problems in overweighting, including finding enough good external managers that are open.”

In selecting managers, WSIB has a preference for staff from those countries.

“We look for managers with homegrown talent and connections,” she says.

“One of the risks of emerging markets is that macroeconomics can look good, but the political risks are real. It is hard to assess that from the outside, it is so critical to have on-the-ground partners.”

Phil Edwards, principal at Mercer in London, says the broad range of risks in emerging markets, in particular the political risks, means the selection of managers needs to encompass those considerations.

“With regard to manager selection, we use similar rating criteria as for other markets, such as the manager’s ability to generate good ideas, put the portfolio together and implement it. But because of the political risks, we also look at managers that have access to senior politicians and figures in various economies, and reflect that in their portfolios,” he says.

“Emerging markets is quite heterogeneous and includes a broad mix of different economies, so we look for managers who have understanding and expertise of different regions and understand the differences between countries.”

While there is a continuing trend for investors to look at the emerging market weightings, the majority remain underweight emerging markets asset classes relative to developed markets, partly due to a bias towards historical perceptions of safety.

This is the first of a three-part series on emerging markets. The next two stories will explore the opportunity sets in emerging market debt and emerging market equities respectively.

Peter Wallach, head of the United Kingdom’s Merseyside Pension Fund isn’t overly worried about the recent fall in equities.

“Markets are being driven by liquidity from central banks; this is more about central banks just needing to reassure investors,” he says.

“It is bonds, to our mind, that are over-valued in the medium to long term.”

There is another reason why Wallach, speaking from the local authority fund’s Liverpool headquarters on the banks of the Mersey, can afford to play down recent jitters in global equities. Despite the £5.75 billion open, defined-benefit local authority scheme still being very much in growth mode, a strategy to iron out volatility has afforded Merseyside an extra cushion from market bouts like today’s.

The fund has a 55 per cent equity allocation; a 10 per cent real estate allocation invested in the UK and international and specialist property funds; 14 per cent in alternatives; and 1 per cent in cash. The balance is in fixed income, namely government and corporate bonds. It’s an asset mix shaped by a gradual paring down of the fund’s equity exposure and boosting of its alternatives in a strategy designed to end the volatility attached to the large equity portfolios typical of many local authority schemes where the average equity allocation is 63 per cent.

Alternative view

In 2007 Merseyside’s only alternative allocations were to private equity and hedge funds. Now its alternative holdings encompass private equity (4 per cent) hedge funds (5 per cent) infrastructure (2 per cent) and an opportunities fund (3 per cent). A seven-strong team manages the entire alternative portfolio in. In contrast the full bond and the majority of the equity mandates are run externally.

“Excluding private equity our alternatives are less correlated; there was also a feeling that bonds wouldn’t give us the returns we needed and that core infrastructure was more likely to,” says Wallach, who ran portfolios for high-net-worth individuals (HNWIs) as a private sector wealth manager before joining Merseyside.

“I suppose you could say I’ve bought a more commercial outlook.”

Within the alternatives allocation, private equity is doing best. In a strategy honed over the past 20 years, Merseyside uses advisors but identifies, implements and monitors all private equity plays in-house, holding a diverse portfolio split by geography, vintage and fund type, although Wallach notes the geographical diversity is increasingly less significant as funds become more global.

“Apart from small European or US buy-out funds, a geographical weighting is hard now because large buy-out funds aren’t limited by geography,” he says.

The shift away from regional plays hasn’t impacted returns, averaging 14 per cent a year for the last two decades.

“We are very pleased with private equity,” he says.

The infrastructure allocation is similarly global. The core allocation is in private finance initiative (PFI) funds, some backed over ten years ago, but the scheme also invests in Asia Pacific infrastructure funds that are higher risk or “development-type” funds; and in renewable energy infrastructure designed to benefit from European subsidies to the sector.

Although Wallach hasn’t ruled out investing in the government’s Pension Infrastructure Platform (PIP), Merseyside isn’t a founder investor because of the start-up nature of the fund.

“In principle the PIP makes a lot of sense and we will continue to evaluate it as it comes on stream but we wanted to get money to work more quickly and the PIP is still in its genesis,” Wallach says.

A long look at hedge funds

It is hedge funds that have been the trickiest alternative. Although the allocation has modestly outperformed HRRX hedge fund indices, lacklustre returns and a changed market prompted the scheme to take a “long look” at its hedge fund allocations six months ago, testing their case for remaining in the portfolio.

“Absolute returns in the hedge fund allocation have only been satisfactory and not as high as we would have liked over the past five years,” Wallach says.

He who attributes part of the problem to the strong equity market.

“Hedge funds need more differentiation at the stock level and dispersion of returns has been low for a long time,” he says.

“However I do think the market is starting to move back in favour of equity long short and arbitrage funds as dispersion increases.”

In another strategy to reduce volatility, Merseyside has invested in smart beta. About five years ago, around the same time it pushed its allocation to alternatives, the fund allocated 3 per cent of its equity portfolio to an actively managed European minimum variance portfolio with Swiss asset manager Unigestion.

“We think there is a lot to be said for smart beta,” enthuses Wallach.

“The idea that the greater risk leads to the greater return has been challenged by the persistent outperformance of low volatility stocks.”

Since inception, returns have been 81.1 per cent, beating the benchmark, and with a volatility of 16 per cent against the benchmark’s 21.5 per cent. Given the European benchmark has risen 66.6 per cent over the equivalent period, Wallach is quick to credit what he calls an element of luck in the timing of the investment – but he says it’s a strategy that is likely to grow at the fund nonetheless.

“It’s not a silver bullet; we’d always hold it alongside other equity strategies,” he says.

Within that broader equity allocation, all US mandates are passive.

“The US is the most efficient market; it’s very difficult to outperform here,” Wallach says.

The UK is a mixture of active and passive while Japan and emerging market equity allocations are wholly active. Merseyside also allocates its equity portfolio regionally, rather than globally in a targeted approach because “the world is an enormous benchmark”.

Tapping into growth

It is a strategy also designed to tap growth in fast-growing mid-cap stocks. Although global managers get to invest in the best companies in the world, this way Merseyside can invest in companies further down the market capitalization scale, Wallach explains.

“By default we end up looking at a larger number of stocks,” he says.

Although Wallach notes Merseyside’s gradual shift in maturity it has not had an impact on investment strategy yet.

“We have matured much more quickly in the last six years but it is not a significant worry,” he says.

“We are putting things in place to manage our maturity.”

Early signs include a shift from cash positive to cash negative in terms of payments, although Wallach says the fund has a buffer in substantial investment income. The scheme is looking at ways to hedge its liabilities more effectively but will only put such strategies in place when it’s “appropriate.” It already offers a few of its employers tailored liability matching strategies.

“There is a lot more scaremongering about the effects of maturity than is warranted,” he says.

One of the UK’s largest local authority schemes, and the first amongst its peers to adopt innovative strategies, when the time comes Merseyside is sure to lead here too.

 

A solvency ratio of 157 per cent is a clear mark of success for a pension fund at a time when so many are battling deficits. Remarkably, Sweden’s SEK90-billion ($14 billion) KPA Pension has gained this funding cushion without fully embracing the range of new asset classes or strategies often touted as the solution to funds’ problems.

KPA’s asset mix has a distinctly traditional look – 95 per cent is in bonds and equities – but much of its success can be attributed to picking the right extra investment devices at the right time.

Chief investment officer of KPA Michael Kjeller explains that gaining “very strong” interest rate protection via swaps in the build up to the financial crisis allowed the fund to thrive in 2008 and 2009 when others had their fingers burnt – the fund returned 6.3 per cent in 2008 and 11.9 per cent in 2009. A decade ago KPA could only count on a slight surplus so Kjeller is in no doubt of the “tremendous change” that this policy helped deliver.

A cautious approach after taking out the interest rate protection in 2005 helped KPA as it held the swaps through a couple of years of suffering. “You never know when the fire will start so we wanted to keep our insurance with interest rate swaps,” says Kjeller. When the flames of the financial crisis were subsequently lit, KPA then found its protection was in huge demand – it was therefore able to sell the interest rate swaps to others at much higher prices.

“Whether through luck or skill we did the right thing when there was most turbulence, and were then able to build on that position,” Kjeller says. With its solvency boosted, KPA started to delve into equity markets in March 2009. “From what we know today,” Kjeller chuckles, “early 2009 was a good starting point in investing in equities.” Stockholm’s OMX 30 index has doubled since then.

 Overlaying a solid foundation?

The current focal point for KPA is its use of overlays. Indeed, it is the main job at its central Stockholm headquarters as equities and fixed income assets are all managed externally. “We try to tailor the risk profile in equities, fixed income and foreign currency with futures and options,” Kjeller explains. Constructing overlays is not the easiest investment job, but KPA can count on plenty of experience in running the strategies and Kjeller is delighted with the results. “Overlays have helped us handle both positive and negative tail events rather efficiently,” he says.

The fund’s current asset mix sees fixed income take a 60-per-cent share, equities 35 per cent and the remaining 5 per cent is invested in a real estate-dominant alternative segment. Kjeller baulks at suggestions that this is a conservative approach, with the risk premium from equities having carried performance in the recent past. As stock indices have climbed, Kjeller says KPA is now more neutral on the asset class though. Approximately half of its equities are Swedish, with a “small chunk” of emerging market exposure in the international equity portfolio. As it focuses its internal efforts on overlay activities, Kjeller tries to “keep things simple” by gaining purely large-cap exposure in domestic equities.

Fixed income has played its part in KPA’s current health, with its relatively long-duration investments helping the fund to a decent 5.6-per-cent return in 2011. It is proving a little problematic these days: “Like any other pension fund the low yield on high-quality bonds is an issue for us,” Kjeller admits.

KPA invests predominantly in Swedish government bonds and covered bonds – 10-year Swedish government bonds have yields below the 2-per-cent mark. The fund has been unable to do much about the situation, Kjeller confesses. “We don’t want to take on new risk that we don’t fully understand.” This conservative view has led KPA to steer clear of high yield or senior debt investments as possible solutions.

Not so alternative

Conservatism, the desire for simplicity and the presence of the overlay strategy have all kept KPA away from embracing alternatives. “Overlays allow us to benefit from the market conditions in which alternative investments thrive, so our demand for them has decreased,” Kjeller explains.

The age of the fund has also played a part in the fund’s slow adoption of alternatives, says Kjeller. He says real estate was too much of a risk for the younger, smaller KPA – the fund was less than 5 per cent of its current size at the time it became the default fund for Swedish local authority workers in 2001. “In a mature pension fund, we feel real estate should account for between 5 to 10 per cent of assets”, says Kjeller, thereby indicating that its real estate holdings should grow further. KPA mainly invests directly in real estate, as it prefers the risk-return profile of that approach, he adds. A 1-per-cent exposure to private equity and renewable energy in its small existing alternative portfolio is “doing fine”, Kjeller states.

Having followed a sustainable policy since 1998, KPA has a strong record in sustainable investing. It blacklists alcohol companies in addition to arms, tobacco and gambling firms. Its activities in the sustainable space have incorporated Sweden’s tradition in gender equality, with KPA campaigning in support of a United Nations project that supports young women and opposes child marriage. Added to its strong solvency and investment record, it is clearly setting an ideal for other funds to emulate in many ways.

The London Business School’s emeritus professor of finance Paul Marsh admits that you have to be slightly mad to embark on the kind of research detailed in the latest edition of Global Investment Returns Yearbook. This year Marsh and colleagues Elroy Dimson and Mike Staunton – Marsh describes the three of them, pictured below, as “old men with an interest in financial history” – have pulled together over a century’s worth of historical data spanning 25 countries to forecast what investors can expect in the future from delving into the past. It’s a historical  perspective tracing returns in stocks, bonds, inflation and currencies that doesn’t bode particularly well for institutional investors in the coming 30-odd years. “The high equity returns of the second half of the twentieth century were not normal, neither were the high bond returns of the last 30 years, nor was the high real interest rate since 1980. While these periods may have conditioned our expectations, they were exceptional,” says Marsh.

Exuberance is over

Since the 1950s investors have enjoyed “pretty good” returns on bonds and high real equity returns of around 6 to 7 per cent. Since 1980, equities have done well apart from disappointment in Japan, but real bond returns have been “incredibly high” at close to 6 per cent. “World bonds actually beat world equities,” says Marsh. “Investors would have done marginally better in bonds over a period equities have also done very well. Even cash has been wonderful.”

But from a historical perspective, the high bond returns since 1980 were more a blip than anything normal. “Real returns will revert to 1 per cent, not the 3 per cent we have gotten used to over last 30 years of bonds,” Marsh forecasts. He puts real returns for long-term index-linked bonds at zero or marginally negative. Reflective of their riskier qualities, long-term conventional bondholders can expect a marginally positive return. The prospect for cash is marginally negative. “Don’t think of 2 to 3 per cent real interest rates on cash as something we are going to get back too.” Marsh, Dimson, Staunton

Similarly, equities offer little relief. “Equities won’t bail you out,” he warns. Colour-coded lines on Marsh et al’s historical charts indicate that low interest rates imply low prospective returns on all assets, including equities. “When real interest rates are low, real equity returns can also be expected to be low,” he says. “We have shown that there is a strong association between low real interest rates and low subsequent equity returns, and high real interest rates and high equity returns.” The trio estimate that the prospective real return on world equities has fallen to 3 to 3½ per cent per annum in the long term, disputing those asset managers promising 7-per-cent returns or higher still, as in the US where Marsh says forecasts are “plain crazy”. He isn’t swayed by the fantastic returns investors have enjoyed in equities in recent months or talk of a great rotation. “It doesn’t pull the rug from under us,” he says. “There is zero relationship between the first few months of a year and the rest of the year. Our prediction is that the rest of 2013, and the next generation, will find it tougher in terms of returns.”

Historical data shows that volatility damps down surprisingly quickly after shocks like the 1987 crash when stock markets around the world plummeted, or the recent financial crisis. “The world will not stop shocking us but the remarkable thing about volatility is that it reverts to its long-run average quickly after a shock.” He suggests that for “serious long-term investors” with horizons beyond 10 years strategies to manage volatility may not be worth the cost. Only for funds with a particular need for cash at distinct points in the future would strategies to manage volatility actually pay off.

Learning to live after the golden age of returns

Marsh qualifies their findings: “The projections we have made for asset returns over the next 20 to 30 years are simply our own best estimates. They will almost certainly be wrong, but we cannot predict in which direction. There will also be large year-to-year variations in return and they should be viewed strictly as long-run forecasts.” They aren’t compatible with short-term optimism or pessimism about particular asset classes, he says. However, as long-term forecasts for the next 20 to 30 years, he is convinced their estimates are realistic.

His advice to investors in a low-return world is diversity. He doesn’t recommend any smoothing of assets and says pension schemes should put away a lot more now than they did in the old days. He also warns funds to be wary of consultants peddling strategies that are more likely to increase costs rather than returns. Funds seeking yield are also said to be on the wrong track. High yielding equities or risky corporate bonds take investors into higher risk areas. “High returns need higher risk strategies, but these don’t guarantee higher returns,” he says. His message to investors is to “live with it”.

Part of the challenge is the fact institutional investors have grown used to a golden age of returns. But Marsh says the returns are still there to be had. “If we are right and investors get an equity risk premium of 3.5 per cent over the next 20 years, they will still double their money over any cash returns.” All figures are also in real terms, so add inflation and returns on equities look bigger. “Other academic figures agree with us. We might be gloomy in our predictions, but we are not alone.”

Pension funds or any investor holding a slug of long-term fixed income needs to factor in some capital losses soon, says Princeton academic and former vice president of the Federal Reserve, Alan Blinder.

“The timing is difficult to predict, but three or 15 months, it doesn’t matter. It is predictable,” he says. “The unpredictable part is the risk spreads. When interest rates increase what happens to spreads between US treasuries and AA bonds, or US and Brazilian bonds, you name it, it is not very predictable.”

What is obvious is there will be a pure capital loss on holding duration.

Blinder says interest rates have to go up but the timing of when that will start is uncertain.

“There is zero uncertainty around the fact that interest rates will go up substantially. That’s important because if you were running a pension fund, usually you can’t say that with certainty. The timing of when it starts and how fast they will rise is uncertain,” he says. “But they will start sooner and go up faster than central banks want it to go. Markets will get hyper-excited and overreact. There is no doubt Ben Bernanke would like to see a gradual normalisation. My worry is the markets’ reaction.”

More worried than confident

Blinder says it is a “close call” whether to invest in credit, but he probably wouldn’t. And part of the game changer is that central banks are now working on the long end.

“It used to be a simple story,” he says. “If the economic climate is getting better, then you wouldn’t expect risk spreads to widen, but if because central banks are generating it, then spreads would widen.”

In the US he says he is less confident about the economic outlook than market opinion.

“The market swings too whimsically in both directions. It is too euphoric about fickle indicators like confidence,” he says. “I’m more worried than confident about the US economy in the next two years. In the long term I’m confident about the US’ ability to supply goods, but in the short term we need buyers.”

More generally, he is bemused by the actions of governments and the way they are acting as dampeners of demand.

“It is unprecedented to see governments contracting in period of economic weakness. Greece can blame the IMF, but the US can’t, the government should be spending.”

A paradox of public opinion

Blinder says there is a paradox of public opinion with regard to fiscal rectitude.

“The voters love it at the level of lip service, but hate it at the level of implementation. Politicians need to craft the message – don’t come in talking Keynsian and say we want to raise the deficit, say our bridges are falling down or people are starving.”

Similarly, in Europe Blinder thinks it should be abundantly clear that fiscal austerity doesn’t work.

“This is an opportunity for investors to be suppliers of capital,” he says. “If I was a Belgian investment fund, I would think of sending money to the US.”

From a monetary point of view, Blinder was one of the economists who advocated that the European Central Bank was the only institution that could stand behind the euro.

It is astonishing to him now that president of the ECB, Mario Draghi, just had to pledge that “he’d do whatever it takes”, without actually doing anything and have an effect.

“It’s a great time to be teaching economics. Unconventional monetary policy; it’s a new field.”

Blinder, who was vice chairman of the board of governors of the Federal Reserve System from June 1994 until January 1996, is the Gordon S Rentschler Memorial Professor of Economics and Public Affairs at Princeton University. He was also a member of former president Clinton’s original council of economic advisers.

His latest book, After the Music Stopped, looks at the 2007 crisis, asking not who done it but why they did it.