When Eugene Fama enrolled at Chicago Booth School of Business in 1960, “finance was a joke”, he says in a candid and fascinating insight into his more than 50 years as a student, academic and teacher at the university.

The essay, published by Chicago Booth’s Capital Ideas, details Fama’s own history but also a short history of finance including how the efficient-market hypothesis was born.

Fama, who is often called the “father of modern finance”, calls the Black-Scholes paper on option pricing the most important paper in economics of the twentieth century.

“No other paper has to be learned by every single economist getting a PhD and has also created an industry – the derivatives industry.”

Fama, who also got into Harvard, chose to go to Chicago because he was advised that “it was more academically oriented than Harvard”.

He is the Robert R McCormick Distinguished Service Professor of Finance, and received a MBA and PhD from the University of Chicago Booth School of Business

“I love my work,” he says in the essay. “I have no intention of stopping as long as I’m breathing – and I may even do it after that.”

To read the full essay, click here.

Two more high profile investors have punished US retailer Walmart for its anti-union stance and poor labour practices by divesting their holdings in the company. AP Funds, Sweden’s cluster of state pension funds named AP1 through to AP4 and AP6 (there is no AP5) worth a combined $140 billion, sold its equity and corporate bond holdings in the company last week. In July PGGM, the Dutch asset manager that oversees €133-billion ($174-billion) also dropped Walmart from its equity portfolio after years of cajoling failed to change the company’s labour relations policy.

PGGM’s divestment, which amounts to 0.1 per cent of the fund’s assets under management valued at around $272 million, was the culmination of a process of dialogue and disappointment, explains Saskia van den Dool at PGGM. “It is regrettable that one of the world’s largest companies takes so little interest in the concerns of its shareholders and other stakeholders. The long dialogue with Walmart had both high and low points,” she recalls. “During the highs we received positive signals that the company was considering action upon our concerns. PGGM maintained the dialogue for as long as we thought improvements were feasible, but in the end we saw no option but to divest when it became clear that the engagement did not produce the results that we aimed for.”

Similarly, AP Funds’ decision to divest follows six years of pressure dating from before the different Swedish government funds had even coordinated strategy on ethical investment via their Ethical Council, set up in 2007. “AP Funds applied pressure on Walmart via direct dialogue, issuing shareholder resolutions and by collaborating with other investors,” says Christina Kusoffsky Hillesöy, chair of the council. “Our policy is to engage with companies that violate international conventions but if we can’t improve the company, we will divest.” Both investors believe that divestment, and with it the end of any ability to affect change at Walmart, doesn’t belie any failure in their ESG strategies. “We hope our decision sends strong a message not only to Walmart and its board members, but also to other companies. We take our role as an active owner seriously and we believe that abiding by internationally accepted standards is an important corporate responsibility that ultimately contributes to the long-term success of the companies we invest in,” says van den Dool. Christy Hoffman, deputy general secretary of UNI Global Union, which represents workers from around the world through 900 affiliated unions also believes that investors have to follow the threat of divestment through. “You have to hold out divestment as the ultimate act. If you don’t divest, they won’t take you seriously.”

A series of soft blows…

Yet the impact of divestment hasn’t been felt immediately. European investors such as AP Funds and PGGM are already well known for their proactive environment, social and governance strategies. Last year PGGM voted at more than 3,100 shareholder meetings, was in dialogue with 746 companies and excluded 42 companies from investment. Most recently, the fund began a process to check the 2,800 companies in the FTSE All World Index, in which it is invested, against its own specific ESG index. Markets have factored in Walmart’s aggressive approach to labour relations ever since the retailer was dropped back in 2006, when Norway’s Government Pension Fund sold more than $400 million worth of shares citing labour issues, and Sweden’s AP2 fund became the fist in the cluster to sell its stake in the company. “Walmart will always come under pressure from unions because it provides low-paying jobs and is the biggest private employer in the world,” said one New York-based analyst who declined to be named. “But it’s hard to find such a stable company that is a better barometer of the world economy. There will always be an appetite for Walmart shares.” In contrast, he believes Walmart is more concerned with smoothing investor concerns over bribery allegations in its Mexican subsidiary. This “is more of an issue” than its poor record on labour relations, he said.

…lands an influential punch

Yet both PGGM and AP Funds are influential investors and other pension funds in the region may follow where they lead. Walmart will take years to shake off the stigma of exclusion and divestment in Walmart may add weight to other campaigns particularly those around fossil fuels, where advocacy groups are pushing investors to better climate proof their portfolios. Swedish national pension fund AP4 has just announced plans to invest in a new emerging markets-equity fund, which excludes companies with high greenhouse gas emissions and extensive reserves of fossil fuels based on a new index. “With few exceptions, carbon dioxide is now widely recognised to have a negative impact on the climate. We believe that these companies will be valued differently in the future and that greenhouse gas emissions will be associated with higher costs in the long term. Hopefully, this will also increase the pressure on companies to lower their carbon dioxide emissions,” says Mats Andersson, chief executive at AP4.

At both PGGM and AP Funds, divestment was born from the belief that better governance helps returns but also that bad governance increases risk. The funds argue that investors that passively track an index still manage to deliver on their return objectives despite exclusions which only have a marginal effect on their tracking errors. “We are long-term owners and we saw a real risk in holding Walmart,” says Sweden’s Kusoffsky Hillesöy. “We are convinced that the issues we were concerned about at Walmart will eventually have a negative effect on the company’s performance,” concludes van den Dool.

The funding crisis that hit pension funds across the world may be easing – in common with the five-year long economic crisis – but restoring healthy funding levels remains a vital priority for many investors.
The Netherlands’ €4.9-billion ($6.6-billion) UWV pension fund is one of that number. A funding ratio of 98.7 per cent at the end of August was not the lowest in the recent past, but was some way short of the 104.3 per cent that the Dutch central bank has designated as a minimum for its country’s investors.
UWV has been given until the end of August 2014 to meet the minimum as part of a recovery plan. Investment advisory committee chair, Johan de Kruijf, says the funding issue “remains troublesome” due to low interest rates and low returns on the bond-heavy portfolio. De Kruijf thinks that “if markets continue to rise, we can get on track to meeting this target”, but adds that there is also plenty of cause for concern as market volatility does not give him confidence that recent equity returns are sustainable. “Who knows what would happen if there are policy surprises or US or Chinese growth disappoints?” he asks.
While some might suggest substantially increasing the 19 per cent share that the fund invests in equities would ensure a speedier funding recovery, de Kruijf explains that this option is off the table. “You would end up running into regulatory restrictions on taking additional risk,” de Kruijf points out.
The UWV fund is sticking to the defensive asset strategy determined by its 2011 asset-liability management study. While it would have no desire to make strategic changes before a new study is completed, de Kruijf says there is an additional motivation to keep strategy changes to a minimum. “Everyone in the Netherlands is waiting for the new pension regulations to be finalised, which will likely bring a new supervision system in the next 18 months,” he says.
De Kruijf recognises that the new regulatory regime in the Netherlands is set to result in some “serious discussions” on potential investment changes. With detailed negotiations on future discount rates looking likely to set a complex artificial new rate, “it is very hard to say what the consequences of the Dutch pension reforms will be,” he says. “It looks like interest rates would be a bit higher and, by implication, there would be some room for additional risk, but on the other hand the artificial nature could present troublesome issues from a risk management perspective,” he explains. “Nonetheless, if there is room for more risk in our portfolio, it must come from the regulatory arrangements.”

Overlay play

When it comes to playing with risk levels, de Kruijf concedes that the UWV fund’s overlay strategy – worth some 10 per cent of the fund’s assets – currently gives the greatest room for flexibility. This can be achieved by changing interest rate hedging levels, although the most significant contribution of these hedges in recent times has been partially shielding the fund from declining interest rates.

De Kruijf explains that the fund’s sophisticated overlay strategy covers “the economic exposure of all elements in the portfolio”. If decreasing the level of interest rate hedging, for instance, the fund would increase holdings of futures and currency issues in order to ramp up the exposure to equities and return-seeking assets.
These overlay weightings are dynamically set on a monthly basis in relation to the performance of the portfolio relative to the market and the fund’s strategic asset allocation. A defensive position becomes automatically established if the fund is behind on both indicators, with the flipside being true if the fund runs ahead of these markers.
While enthusiastic of the benefits the overlay has brought, de Kruijf is not keen on the possibility of the UWV fund adding to its strategy with other derivatives. He reasons this would end up introducing new risks into the portfolio.

Defending the defensive

The UWV pension fund has 37 per cent invested in a low-risk fixed income-matching portfolio, with another 25 per cent invested in corporate bonds and high yield.
Keeping its defensive strategy has seen the fund continue a 60-per-cent interest rate hedge. The investor uses AllianzGI as a fiduciary manager for manager selection, but retains its investment strategy responsibilities.
Having a public sector insurer as a sponsor is a motivation for the defensive strategy, explains de Kruijf, as any financial support would be politically problematic. The ageing demographic of the fund also skews it towards risk aversion.
The biggest source of change within the static strategy currently comes within the alternatives portfolio. The UWV fund has earmarked an increase in its alternatives segment from 8 per cent to 17 per cent in its strategic allocation and has been viewing potential new assets as it seeks to reach this level. The fund has been exploring infrastructure, but is not investing just yet. “We will invest in infrastructure when we finalise the requirements and legal set-up of investment vehicles for non-real estate alternatives, including private equity,” says de Kruijf.
Unusually for Dutch investors, the fund has opted to ground its infrastructure and private equity moves in domestic law. “Using domestic law would be a better way to settle disputes if any come up,” reckons de Kruijf.
As soon as the infrastructure investments are finalised, they will join commodities (around 2 per cent of the fund) and real estate in the fund’s alternative bucket. The UWV fund is also aiming to increase its real estate exposure from 6 per cent to 10 per cent in its alternatives drive.
The fund also has a 5 to 6 per cent allocation to mortgages within its fixed income portfolio, which de Kruijf says it may increase if the Dutch government’s national mortgage bank idea is successfully implemented. Hedge funds, however, are not currently of interest to de Kruijf and UWV.
Trying out new assets and tweaking allocations as part of the alternatives drive will therefore remain the focus for the UWV fund until next year brings the deadline for both its recovery plan and pension reforms in the Netherlands.

I’ve always been frustrated by interviewing consultants and the lack of conviction they have about their decisions.

“What would your ideal model portfolio look like?” I constantly ask.

“It depends on the client” is the predictable and consistent answer.

That may be valid, even true, but it speaks to a wider problem.

Consultants are hired to give advice. But most consultants don’t seem to want to put their hand on their hearts and back that advice or stand for it. Advice with conviction, which may at times include saying they got it wrong, would surely be more sought-after than peer-group or bland advice.

Consultants have been picked on in the media for the past couple of weeks, with the New York Times column Dealbook and the Financial Times article Billions of dollars wasted on investment advice both picking up on research by Oxford University’s Said Business School, Picking winners? Investment consultants’ recommendations of fund managers.

The research analysed what drives consultants’ recommendations of institutional funds, what impact these recommendations have on flows, and how much value they add to plan sponsors.

“We find that consultants’ recommendations of funds are driven largely by soft factors, rather than the funds’ past performance, and that their recommendations have a very significant effect on fund flows, but we find no evidence that these recommendations add value to plan sponsors,” the report says.

According to Andrew Ross Sorkin’s article in Dealbook: “Ultimately, Mr Jones wrote, the lesson of his research ‘would be to require investment consultants to provide the same high level of disclosure as that which is provided by fund managers on their performance, or the same level of disclosure provided by research analysts on their stock recommendations.'”

Adding cost

One of the key points to pick up on in this conversation, is that not only do consultants not add value, at least according to this research, but they do add cost.

Ron Bird and Jack Gray have written a lot about the agency problems in the investment industry and are due to publish a paper in Rotman International Journal of Pension Management entitled Principles, Principals and Agents.

The authors surveyed the chief executives of pension funds in Australia and subsequently non-Australian funds, with the responses revealing “the depth and complexity of the agency ecosystem in which the superannuation system is enmeshed; a system that imposes substantial costs on members’ retirement benefits”.

(Interestingly there is a footnote which explains that both authors have been and continue to be agents – consultants, investment managers and advisors.)

The paper seeks to better understand the structure, role, influence and costs of agents in superannuation and asked questions of the chief executives such as who are the agents and what do they do, how do agents justify their decisions and actions, and what are their supposed benefits to members.

It looks at trustee/directors, asset consultants, internal investment staff and external investment managers.

While the research found that the costs of consultants (10 basis points) was small compared to other agents, it worryingly reported agents’ costs have increased much more than funds under management and have doubled relative to agents’ reported influence.

The high level of relatively negative views about agents suggests that the superannuation system is far from optimally structured in members’ best interests, the paper concludes.

In many jurisdictions, pension funds as institutions are a relatively new phenomenon. In Australia for instance, the system is only 20 years old, and it is common for agents, or outsourced partners, to be used by the funds as they “grew up”.

Ill equipped

In fact funds have relied on consultants as they have evolved as institutions for good reason: they can’t make decisions themselves.

It is remarkable to learn how many large investors have very poor decision-making processes.

For the most part, the sophistication of the internal decision-making, governance structure and resources is not commensurate with the asset size of large institutional investors.

There are exceptions – such as the Canadian Pension Plan, the Australian Future Fund and New Zealand Super – but on the whole pension funds are not equipped to make decisions.

As funds take responsibility and ownership of this, create the functions and fill them with the resources necessary to make good decisions, the role of agents will diminish.

A review of the number and role of agents should be on the radar of all funds as they evolve into institutions.

At the United Nations-backed Principles for Responsible Investment conference Cape Town on October 1, general secretary of the International Trade Union Confederation Sharan Burrow delivered a speech entitled Push the Reset Button – a Line Between Speculation and Investment. She discussed the stability of the global economy, the necessity for investors to shift to long-term thinking and the crucial role of pension funds in truly sustainable investment. At the heart of Burrows’ speech is the centrality of workers’ capital – the money that funds the industry that feeds us – and the respect that deserves.

Read the full report here.