Olga Pomerantz, economist at Chicago-based William Blair & Company, offered delegates at  the Fiduciary Investors Symposium reasons to be positive. Pomerantz says the factors inhibiting growth from 2009 until last year have altered and that global economic growth is starting to evolve. She notes stronger growth in developed markets, where growth in the US has been “tested” and withstood political challenges, and “stable” growth in Japan.

In the US she predicts increasingly strong private sector growth, averaging 2.5 per cent consistently and believes that as the negative impact of the government deleveraging lessens, so growth will become stronger. In Europe she says that beneath the barrage of negative news, broad-based structural change is beginning to bear fruit. Europe’s peripheral economies ran current account deficits while Germany ran an equally large current account surplus, in a level of imbalance which was “quite staggering”. Now Germany’s current account surplus is just under 2 per cent, something she calls “quite an impressive achievement.” Moreover Portugal and Spain are now running current account surpluses. “Exports are up 20 per cent in Spain compared to 2009; in Portugal exports are higher than this. Europe’s problems are not over but the impact of fundamental structural adjustments has been overlooked.”

Pomerantz attributes her positive outlook on Japan to stronger Japanese corporate profits, a growing consensus within Japanese monetary policy, plus the “deregulation side” offering much to get excited about. She predicts incentives structures will trigger changes in the way Japanese corporates operate, expecting “different behaviour” from both corporates and households.

Growth in emerging markets, now coming off cyclical highs, will be geared to growth in developed markets highlighting Turkish exports to the EU and Mexican exports to the US as examples. Emerging markets that benefit from commodity exports to China, particularly linked to China’s real estate boom, will find this “unlikely to be repeated”. Other sources of growth in emerging markets will come from local companies producing manufactured goods and industrial services. “Local companies geared towards this will benefit,” she says using India’s outsourcing market as one example.

Pomerantz advises active management to best tap these opportunities, saying indices “are inefficient”. Global indices particularly are overweight developed economies, so don’t tap growth in emerging economies. “As sources of growth change around world, active management in equity markets still makes sense,” she says.

 

Hybrid pension schemes, combining both defined contribution and defined benefit characteristics, are best for governance because they align interest of both employees and sponsors argue David Villa, chief investment officer of the $91-billion State of Wisconsin Investment Board (SWIB) and Sorina Zahan, partner and chief investment officer of Chicago-based Core Capital Management, speaking at Conexus Financial’s Fiduciary Investors Symposium in Amsterdam.

Their study, drawn from two years of research, into benefit design has developed a mathematical framework to compare the different vulnerabilities and returns within defined benefit, defined contribution and hybrid pension schemes. The model is based on option modelling.

SWIB itself is a hybrid plan, with both a defined benefit component and a defined contribution component. It’s this “sensitivity” between DB and DC in a “compromise solution” that allows for real success, they argue.

“We put everyone on an equal footing and compared the cost systems, and asked what do you see?” Zahan says, explaining their research process. “In the US the debate doesn’t ever look at the entire robustness of pension structures. We’ve tried to create a framework that compares these different structures.”

Not surprisingly the study found that DB employees with guaranteed benefits were not as subject to market risk as DC participants.

“If you want to switch from a DB plan to DC plan, make sure DC has robustness from market risk because it is the most vulnerable to market risk,” she told delegates. Their research also shows that DB plans cost less for an employer than DC schemes.

Surplus squandered

It begs the question, behind the “rush” to change a DB structure that is efficient from a cost perspective into a more costly DC structure.

“The reason is we have not observed the surpluses of DB plans,” says Zahan. “We think the answer is that a lot of surplus is squandered. DB plans are an efficient structure. The one drawback is that they require good governance.” She believes that although DB does carry market risk, with good governance and good regulation these plans are more cost-effective and generators of wealth.

Under its hybrid model, SWIB is strict on sharing any surplus.

“In Wisconsin we give our entire surplus to the employees,” says Villa, whose list of governance sins includes contribution holidays, unfunded benefit increases, unrealistic investment targets and uneconomic investment decisions.

Challenges with wholly DB or DC schemes are also revealed when it comes to shouldering risk. Employees take the risk in DC schemes, yet in a DB scheme employers suffer any loss in value because they will have to pay more in benefits – although they also benefit in value creation.

In what Villa describes as “looking like magic” hybrid plans allocate both upside and downside risk between employees and the sponsor to achieve better alignment of interest and healthy governance. “One of the features of hybrid plans is that value creation and destruction is shared by employees and the sponsor. It produces a much better alignment of interests,” concludes Zahan.

The monthly income pouring into the $1.3-billion North Dakota Legacy Fund arrives as thick and fast as fracking technology and new pipeline networks can draw the state’s oil and gas reserves to the surface. But investment strategy at the fund, set up in 2008 when it was portioned 30 per cent of the tax dollars from the state’s rejuvenated energy sector, hasn’t been anything like as aggressive. An ultra-conservative approach with the entire fund invested in short-term fixed income earning low single-digit returns didn’t match the aspiration of America’s other legacy funds in mineral-rich states, such as Alaska’s $45-billion Permanent Fund, Texas’s $14-billion Permanent University Fund and others in New Mexico, Wyoming and now West Virginia and Utah.

New recipe for returns

A rethink in North Dakota has shaped a new allocation focused on equity in what acting chief investment officer, Darren Schulz, describes as a new dawn. “The goal was to protect and grow the corpus, but the decision to keep it in cash and cash-like equivalents was incommensurate with the fund’s investment horizon and the ability to tolerate risk,” he says. After much “educational effort”, Schulz convinced colleagues of the need for a different approach. “We are in the process of transitioning to the new policy allocation. This really is a unique opportunity to build an investment program for a newly created special-purpose fund. We’re entering a new era.”

Under the new allocation, 50 per cent of the Legacy Fund will be invested in global equity, 35 per cent in global fixed income, 10 per cent in diversified real assets, namely timber and infrastructure, and 5 per cent in US-only private real estate. “The most important thing is that we have introduced a layer of equity exposure,” says Schulz, adding that the equity portfolio comprises a 30 per cent allocation to domestic equity divided between passive and active management. United States large cap is a blend of passive and enhanced mandates tracking the S&P 500 and there is an actively managed allocation to US small caps. The remaining 20 per cent is a blend of active and passive international equity. A private equity allocation will likely follow in coming years, he says. The fund’s 35 per cent fixed income allocation is broad-based, split between core US, where the focus is on five-and-a-half-year durations benchmarked against the Barclays US Aggregate Bond Index, and a more flexible allocation to agency securities, bank loans and emerging market debt with longer durations.

Norway and the accidental chief

It’s an asset allocation that is comparable to the Government Pension Fund of Norway. Although Schulz says “he never set out to structure the fund in the same way”, executives from North Dakota have visited Norway and Schulz trawls the Norwegian oil fund’s website, which he values for a level of transparency that sees the $743-billion fund’s value updated every second. The legacy fund will continue building revenue until June 2017, by which time lawmakers are allowed to begin tapping the account, although there is no spending plan in place yet.

As the legacy fund takes off, so Schulz hopes his own internal team of 18, mostly dedicated to benefits administration, will begin to grow. “All investment is externally managed, but the growth in other non-pension assets will see us build out staff,” says Schulz. Just six months after he joined the fund from Indianapolis health insurance group Wellpoint, Schulz was promoted to acting chief investment officer at the Bismarck-based North Dakota State Investment Board when John Geissinger resigned. He hasn’t formerly applied for the chief investment officer role and says that once the role is filled, he is looking forward to sharpening his focus on investment strategy, the role he was originally hired for.

A rising-rate environment

North Dakota’s $4.3 billion in pension assets, which includes eight different pension funds, returned 13 per cent in the fiscal year ending June 2013. The biggest funds in the portfolio are the North Dakota Public Employees Retirement System and Teachers’ Fund for Retirement. Both have target global equity allocations of 57 per cent divided between domestic equity (31 per cent), international equity (21 per cent), developed markets (16 per cent) emerging markets (5 per cent) and private equity (5 per cent). Allocations to US and international equities and high yield fared best in the year ending June 2013, says Schulz. “We’ve had decent returns from US private real estate and infrastructure too, although timber hasn’t been so good,” he says attributing the poor performance in the 5 per cent timber allocation, much of it in softwoods used in construction, to a slowdown in demand from the US housing market. The target 20 per cent allocation to global real assets comprises 10 per cent to global real estate and a 10 per cent allocation to infrastructure, timber, commodities and other inflation-linked assets.

Rather than change the asset allocation, Schulz is planning to change implementation in the fixed income portfolio with fewer benchmark-sensitive mandates. He wants to redesign the allocation, where 17 per cent is in domestic fixed income and 5 per cent in international fixed income, to integrate some short-term durations and unconstrained mandates as a complement to traditional core/core-plus mandates. “We want more wriggle room in a rising-rate environment,” he says describing a strategy which would cave out two distinct portfolios: one in core fixed income and another in actively managed, shorter core-plus mandates.

Derivative use in the pension assets includes treasury futures to manage interest rate exposure and also synthetic exposure to the S&P500. “Passive management is our default option in efficient markets,” he adds. The pension fund is in deficit at only 62 per cent funded. Something Schulz attributes both to “the challenges of meeting actuarially required contributions” and the ravages of the financial crisis. However, he is confident he has the right strategy to get back on track. “We are back on our glide path to shrinking the deficit and turning a corner,” he says. “The state is in good fiscal health, which does put the plan in a better position to address the funding status.”

Oleg Ruban at MSCI finds that the stories behind yield rises in Japanese government bonds matter greatly. They influence the correlation between Japanese equities and government bonds, which is crucial in determining the size and direction of the impact of these scenarios on representative portfolios in different geographical segments and asset classes.

Why does this matter? It’s that old gem interconnectedness again: as the tsunami illustrated begins in Japan and roils around the Pacific, turmoil in the Japanese government bond market effects, at first, bond and equity markets in the Asia-Pacific region. As these markets are so inextricably connected to markets around the world, the impact is then felt globally.

You need to know about that. Read the whole story here.

Few industries around the world could have more reason to bemoan their fortune in the recent past than the Irish construction sector, which recently recorded its first month of growth in over six years.

The €1.2-billion ($1.6-billion) fund that invests construction workers’ pension savings on the Emerald Isle has jumped at the opportunities presented by the eventual upturn, most notably by backing Dublin’s equally beleaguered government debt.

Pat Ferguson, chief executive of the Construction Workers Pension Scheme in Ireland, says that a 2 per cent allocation to Irish government bonds was made in 2011 with 10-year yields then at the 13 per cent mark. The scheme plans to continue holding the bonds to maturity, while creaming off a coupon around the 6 per cent mark each year. While Ferguson admits the fund was tempted to sell the bonds when yields plummeted to below 4 per cent, Ireland’s finances are now in such healthy shape that it is set to leave its international bailout program in December.

Ferguson says he would recommend Irish government bonds to overseas investors hungry for yield. “Ireland is still seen as being on the periphery, but Irish bonds have improved significantly and offer a relatively secure yield,” reckons Ferguson. Being on the ground at one of the flashpoints of the euro crisis proved vital in the fund’s decision to back its government. “We decided the risk of the Irish government defaulting was just not possible despite the pressure to do so. It simply would have made no long-term sense in view of its financing worries,” explains Ferguson.

The Irish government bond allocation falls within the considerable 31 per cent of the “member fund” – the largest, defined contribution element of the scheme – that is allocated to alternative and opportunistic investments. Ferguson justifies the significant allocation as “we have to gear ourselves for low single-digit returns over the next 10 to 15 years by remaining as diversified as possible, and by looking at new asset possibilities”.

A recent $54-million investment into an Irish small-and-medium-enterprise fund launched by BlueBay and Ireland’s National Pension Reserve Fund was the latest addition to the alternatives/opportunistic segment. This joins a number of absolute return mandates, some historic venture capital investments and a fusion mandate investing in currencies, commodities and hedge funds.

“The SME fund is very much a long-term investment of the kind we can afford to make as we have greater incomings than outgoings,” says Ferguson. He praises the scheme’s absolute return funds for carrying out their function and meeting benchmarks, albeit feeling “they have not quite been up to scratch this year so far”. The strong correlation between equity and bond markets in the past few years has fundamentally vindicated the absolute return idea, he points out.

 Building the right defined contribution mix

The fund has a 44 per cent combined equity and real estate allocation, which is a neutral position within a 35 to 55 per cent bandwidth. Some 25 per cent of the member fund is invested in low-risk bonds and cash, although the fixed interest allocation rises to 39 per cent across the scheme as a whole. This is largely because there is a bond-heavy fund for the annuities the scheme automatically grants to members on retirement.

The scheme will not be tweaking or changing its strategic allocations based on any market predictions resulting from an unwinding of quantitative easing. “Going forward, we have no immediate view of changing allocations without a clear fundamental market shift,” Ferguson says.

The defined contribution nature of the fund, together with its long-term horizon, gives it the potential to take on a “substantial element of risk”. It has recently changed the profile of its “lifestyling” asset mixes so that members up to the age of 55 are now invested in corporate rather than government bonds for their progressively increasing fixed interest allocation. “The return on long bonds wasn’t giving members fair growth,” says Ferguson.

Nonetheless, the fund is happy to keep members on an 80 to 90 per cent fixed income and cash allocation in their final years before retirement. This is done to reduce the threat of volatility eating into pension pots, as any drop in bond prices would also be reflected in cheaper annuities.

 Fencing off financials and real estate

The fund has resisted any temptation to take on added risk by dipping further into the depressed Irish real estate market, according to Ferguson. Its real estate investments amount to 7 per cent of the fund, held directly across six office and retail properties in Ireland and in two European funds. “Our Irish properties have lost substantial value over the past few years, of course, but with our long-term focus we are content to wait until the market improves,” he says. Steady rent yield is another crumb for comfort despite those valuation losses.

Interestingly, the Construction Workers’ Pension Scheme shuns financial firms in its corporate debt investments. This is done in order to “take some of the risk out of corporate bonds,” explains Ferguson.

The fund aims for a “cash plus 5 per cent” return target. “As long as our model is working, we are not unduly focused on returns though,” states Ferguson, clearly relishing the freedom that the defined contribution model offers. That also gives the fund a bit of patience with its asset managers. Ferguson argues that it would always prefer to analyse whether a manager’s strategy is sound before dropping one for performance. It relies on Accuvest for investment advice and shortlisting managers.

The Construction Workers’ Pension Scheme has returns around the 5 per cent mark so far for 2013 on top of a 8.9 per cent performance in 2012. It will clearly be looking wide across the asset allocation spectrum to keep returns at that level in the future. It would surely please Irish construction workers to see that at least something they have been building recently has had a nice orderly increase in value.

The following article is a letter from United Food and Commercial Workers’ John Marshall in response to our recent article, Walmart takes divestment blows to the body.

 

I read with interest the excellent article on the Swedish AP funds’ recent divestment from Walmart based on concerns about the company’s systematic abuses of workers’ rights in the United States. As you may know our union has been very engaged with the company on these issues and has supported the workers currently organising in the Organisation United for Respect at Walmart (OUR Walmart).

In my role with the United Food and Commercial Workers’ capital stewardship program, I am in regular communication with a number of investors and analysts about concerns related to the company’s poor labour practices. In that context I was intrigued by the quote in this article from an unnamed analyst referring to the perceived desirability among portfolio managers of holding Walmart stock, apparently due to the belief that Walmart is a good proxy for the global economy.

That perspective is very different from what I would characterise as the prevailing view among analysts, specifically that Walmart stock over the past several years has been attractive to the extent that it is a countercyclical asset and, in particular, that it is insulated from risk in the eurozone. This perceived insulation and Walmart shares’ close correlation with the defensive consumer staples sector, which has rallied over the past several years, explain most of the relatively modest gain in Walmart shares during that period.

Indeed, despite this favourable macroeconomic environment for Walmart, its stock has significantly underperformed its retail peers, including unionised retailers such as Costco and Kroger, over the past one, three, five and 10-year periods.

WMT vs PEERS

As for the impact of labour concerns on the company’s share price, we have pointed to two direct areas of concern for investors: the well documented operational problems associated with understaffing and underinvestment in training, as well as the lost sales and slowed expansion resulting from reputational harm. For a fuller discussion of these issues, please see this report we published last year.

Over the past two years, in the face of Walmart’s apparent unwillingness to reassess its hostility toward its own workforce, several large investors – including APG, PGGM, Mn Services and now the Swedish AP funds – have taken the decision to divest their Walmart shares. Prior to these divestment decisions, while these investors were engaging Walmart as owners, representatives of each of these funds travelled to the US and met personally with Walmart workers to hear their perspectives.

Although we do not advocate divestment as a strategy and view the continued engagement by other investors as critical to the long-term effort to change Walmart, the Dutch and Swedish funds have earned the gratitude of thousands of Walmart workers for simply listening to them and taking these concerns seriously. Perhaps someday Walmart’s leaders will do the same.

 

John Marshall, CFA

Senior capital markets economist

United Food and Commercial Workers