Protecting the pension system is one of six key themes at the centre of the CFA Institute’s Future of Finance initiative as it aims to empower the investment industry to take leadership in restoring trust.

Speaking at the sixty-sixth annual CFA Institute conference in Singapore this week, president and chief executive of the CFA Institute, John Rogers, said the industry has a responsibility to lead out of the crisis, and it is a challenge that involves everyone to get involved.

“We want to look at ways to protect pension systems so people everywhere can improve their retirement,” he says. “We need to champion standards for sustainable pension systems.”

The $30-trillion global pension industry provides the investment management industry with fees of more than $87 billion a year, Rogers says.

At last year’s event he spoke of the “serious trust issue” the industry has with the people it is supposed to serve, and that more leadership was required.

“If we don’t act, the industry will lose credibility and it will be regulated into a state of irrelevance,” he says. “The crisis in trust is not behind us. We believe we have a role to play by mobilising the industry.”

To better serve society

The aim of the Future of Finance project is to shape a trustworthy financial industry that better serves society, and it is advised by an impressive board, led by John Kay.

The project has six themes of reform to focus on:

One of those is putting investors first, which should be a defining fiduciary principle of the industry.

“The industry’s oxygen is trust,” Rogers says. “When the industry breaches trust, it invites regulation.”

The first step in the project, which fits under this theme, is the launch of the statement of investor rights, which is a list of principles outlining what the consumers of financial products are entitled to expect in return for their business.

It includes rights such as objective advice, disclosure of conflicts of interest, and fair and reasonable fees.

The project also aims to raise the level of financial knowledge across the industry.

“The industry is still very young, compared to, say, law and medicine. It is very profitable and there are low barriers to entry,” Rogers says.

It also champions transparency and fairness, and has launched the principles for investment reporting; and will focus on regulation and enforcement to identify the key areas of regulation.

The sixth area of focus will be contributing ways to reduce systemic risk.

“The GFC showed the connectivity of the system, and it cost society $12 trillion,” Rogers says. “We need to drive change in these critical areas.”

Rogers called on the industry to use these critical building blocks to improve the system, and ensure the survival of the investment industry.

“These building blocks will come to life when you put them into motion.”

The CFA Institute has 110,000 members across 140 countries.

 

Q1 2013 Public Engagement Report from Hermes Equity Ownership Services (EOS). This report contains a summary of the responsible ownership activities undertaken by EOS on behalf of its clients. It covers significant themes that have informed some of our intensive engagements with companies in Q1 2013.

The report also provides information on our voting decisions and the steps we have taken to promote global best practice, improvements in public policy and collaborative work with other shareholders.

For someone whose ideas have revolutionised the Dutch pension industry and carried significant international clout, Anton van Nunen strikes a humble tone.

Widely credited with pioneering fiduciary management from its infancy, Van Nunen confesses with a chuckle that it is “quite a surprise” that the concept has grown to win over a significant proportion of the Netherland’s mid-sized funds and take root in the UK and Germany.

“If I had any idea, then I would have changed that lousy term” says Van Nunen, who is weary of explaining the irony that just about the only thing a fiduciary manager can’t do for a pension fund is assume its fiduciary responsibilities.

The benefits of diversification

For his current employer, Syntrus Achmea, Van Nunen stresses the benefits of diversification for its customers – the 34 pension funds and €64 billion ($83 billion) in assets the group guides under its fiduciary management arm. As government bonds are “far too expensive” due to lax monetary policy and spreads have narrowed on corporate credit, Van Nunen says “we have to advise funds to look at other asset classes and gain risk and illiquidity premiums.”

That sounds straightforward enough, but with the average Dutch fund having 67 per cent of assets in bonds (according to a 2012 Mercer survey), it entails a clear break with tradition.

Equities “are not that cheap any more, especially in relation to the economic circumstances,” says Van Nunen, who indicates the focus of Syntrus Achmea’s fiduciary asset strategy is making funds embrace alternatives.

“A lot of people thought that 2008 was the end of diversification, but it wasn’t. It’s one of our most important investment beliefs that it is still there and we like to use it with alternatives, among others,” Van Nunen adds.

He aims to make smaller funds catch up on giant Dutch pension funds PFZW and ABP in the alternatives space.

A targeted pooling of assets allows Syntrus Achmea to help the smaller funds under its fiduciary management to access illiquid alternatives, even though it primarily runs funds on a segregated basis. Van Nunen believes Syntrus Achmea’s expertise in manager selection can also help funds access the famously exotic and challenging asset class.

Fittingly for a proponent of continued diversification, a variety of alternative investment options enthuse Van Nunen. Real estate remains “one of the best” he says, expressing optimism of a market turnaround in the next couple of years.

Infrastructure on the other hand combines risk and illiquidity premiums, as well as highly coveted index-related returns with the potential for partly replacing debt-handicapped governments. Private equity and hedge funds also both “fulfill a role, but require excellent selection capabilities”.

He regrets the opposition from NGOs that are making investments into agricultural land scarce. Only in commodities do you find alternative assets that Van Nunen is “not that fond of” as he argues “there is not an underlying source of income, nor a strong relation between general inflation and commodity prices”.

Defining risk budgets

Van Nunen’s passion for alternatives operates within a strict framework for managing interest rate risk that Syntrus Achmea tries to implement for the funds under its fiduciary management.

“We don’t hedge interest rate risk by definition, we manage it – if you hedge risk you are acting as an insurance company,” he says, emphasising his view that a balance needs to be struck to keep attention on returns. To put this philosophy into practice, most of the funds Syntrus Achmea manages are divided between hedge and return portfolios.

The former combines government bonds, credit and overlays, and defines the level of hedging a fund is comfortable with.

Making this hedge a priority is a consequence of the “profoundly” changing attitudes Van Nunen has seen in his time promoting the fiduciary management concept.

“Ten years ago you could say as a pension fund we would like an average yield at 6 per cent and structure the risk around the return,” he says. “Now it is the other way around and we first advise our clients to define their risk budget – while we will devise the best strategy around that, they have to accept the return that results.”

Maximising the lone asset

Nonetheless Van Nunen argues that “the one asset pension funds have is their risk budget” and indicates a desire for Syntrus Achmea to deploy that as efficiently as possible. Risk budgets, and therefore strategic allocations, vary greatly along with funding status, risk appetite and the sizes of the funds under their fiduciary management – the smallest currently being $645 million and largest $19 billion.

Van Nunen says that the overall risk level remains muted though, pointing out that funds under a 105-per-cent coverage ratio are forbidden by Dutch regulation to increase their risk budgets.

According to Van Nunen, bonds remain the first asset class that Syntrus Achmea examines as part of funds’ return-seeking portfolios. High yield and emerging market debt are both “attractive asset classes” that Syntrus Achmea tries to introduce to the funds under its management.

Risk premium assets, usually equities, are the next component to the return portfolios followed by risk and illiquidity premium assets, namely private equity and other alternatives. Absolute return options such as hedge funds are the final building block to Van Nunen’s ideal “diversified portfolio that uses the risk budget to the optimum sense”.

Syntrus Achmea’s penchant for diversification naturally makes it favor wide geographic spreads in equity and bond investments. Van Nunen explains that it has also been able to diversify within the asset class of hedge funds by using different styles.

Another way in which Syntrus Achmea tries to crowbar return potential into the restricted risk budgets of the funds it manages is to take active tactical management decisions.

Varying asset allocations from their strategic weightings can help, Van Nunen says as “changing the weighting between return and hedge portfolios gives you leeway to take advantage of temporary disequilibria in markets and good returns.”

As the world’s fifth largest fiduciary manager, Syntrus Achmea’s formula clearly has many fans and Van Nunen is confident that sticking to its diversification mantra will enable it to flourish further.

Just when you thought you were safe, the next reiteration of risk parity has arrived. AllianceBernstein’s tail risk parity takes the concept of risk parity, reallocating assets uniformly according to risk, but it uses tail risk, not volatility, as the core measure.

The concept of risk parity is a portfolio diversified according to risk, rather than capital allocations. Traditionally, risk parity has used sources of volatility as the risk measure, but now it is being argued that this is not very helpful in times of stress. The newest iteration of the risk management technology is tail risk parity, which enables diversification of the sources of tail risk.

“If you believe that all markets are normal and there are no risk tails in any asset classes, then risk parity will work. But by their nature asset classes do exhibit fat tails, so because of that volatility doesn’t work,” says Michael DePalma, New York-based chief investment officer of quantitative investment strategies at AllianceBernstein.

“With risk parity you are ‘smooshing’ the tails in. It gives you a smoother ride, but it reduces the left and right tail. The cost of risk parity is you give up the upside,” he says. “In tail risk parity, by focusing on the left tail risk as a measure of risk, you can retain proportionally more of the upside.”

In this way, he says, tail risk parity is a positive skew, as it is reducing the skew to the left tail risk.

Natural evolution

Alliance Bernstein is saying, while this is a unique approach to a problem, it is also the natural evolution of thinking around diversification benefits and protection.

DePalma says the popularity in risk parity strategies is due to the ability to solve a number of the shortcomings of a static rebalanced portfolio such as concentrated risk exposures and they maintain a constant risk target over time.

“Maintaining a risk target over time means you can harvest returns when you’re best getting paid for it,” he says. “But there are problems that risk parity hasn’t solved such as diversification failing when normal correlations are used to structure portfolios.”

Conventional risk parity strategies use volatility as the measure of risk, this works when markets are “normal”, DePalma says, but when markets are under stress then volatility doesn’t help you at all.

“When equity markets are exhibiting left tail risk, then 80 to 90 per cent of the time commodities are in their tail and credits and infrastructure will also have a bad return,” he says. “But in the middle 80 per cent, or normal times, it is 50:50 whether other asset classes do well or not.”

The collective wisdom of the options market

The AllianceBernstein strategy, which was developed with contributions by Myron Scholes, Nobel Laureate and co-creator of the Black-Scholes option-pricing model and currently the Frank E Buck professor of finance, emeritus at Stanford University, computes the tail risk for each asset class, which is implied from the options market.

“Using the collective wisdom of the options market, rather than building a measure, we come up with the market-implied level of tail risk,” DePalma says.

The strategy takes the universe of assets to include in the portfolio and assigns each asset class to one of three risk buckets – growth, safety and inflation – to ensure macro diversification. It then imputes the expected tail loss or the computed tail risk from the options market, and forms parity across the buckets with each contributing one third of the tail risk of the portfolio.

The tail risk level that is set is maintained using leverage in the form of futures and swaps.

The process, including the options market-imputed expected tail losses and tail risk allocations, is reviewed daily, but the manager doesn’t necessarily trade every day.

While most investors have looked at risk parity allocations as part of their alternatives allocations, DePalma says there is also an option to include the tail risk parity strategy as an overlay.

“At its core, this is a risk measurement and management technology. We can use futures and swaps across the portfolio and re-allocate the tail risk from the existing assets to create a balance,” he says.

Point of difference

The idea of downside protection is not new, but the strategy combines it with the existing advancements in asset allocation strategy that risk parity provides.

In addition, it claims to be more cost effective than buying protection directly in the options market. (This is laid out in the paper by Scholes, DePalma and AllianceBerntsein’s Ashwin Alankar, An introduction to tail risk parity: balancing risk to achieve downside protection).

But while DePalma says tail risk parity is a unique approach to solving a problem, it doesn’t solve all the problems of risk parity.

For one, the approach takes a certain measure of tail risk, namely the options market. So it won’t protect a portfolio against a flash crash or an earthquake.

However, DePalma says the largest risk is it may make the portfolio overly conservative.

“The biggest risk is the opportunity cost. I’d love to find a way to reduce that,” he says.

“This is a unique approach to solving a problem, and it may get the competitive juices stimulated and investors can expect more innovation,” he says. “In risk-managed solutions everyone is taking a slightly different approach and it behoves investors to look at a suite of offerings.”

You would expect one of the biggest names in global finance to have a sophisticated pension fund, and on that measure the €7-billion ($9.2-billion) contractual trust arrangement (CTA) for Deutsche Bank’s German employees does not disappoint in the slightest. It has carefully engineered a diversified bond-led liability-driven investment (LDI) strategy that is supported by a vast overlay portfolio.

Having a managing director of a firm that has a massive $1.22 trillion under management at the helm has to be a distinct advantage too. Georg Schuh, managing director of Deutsche Asset and Wealth Management and chief investment officer of the CTA, says that since his first involvement with the fund in 2002, “We have seen a continuous transformation from an absolute return to LDI strategy”. The fund currently has an 85-per-cent fixed income weighting, some 10 per cent in equities and alternatives and a 5-per-cent cash pile. Schuh explains the bond dominance by pointing out that in a pure implementation of LDI, “You theoretically only need bonds and some inflation hedging”.

Schuh characterises the CTA’s fixed income portfolio of consisting of “a broad range of spread products”. The focal point is long-duration European investment grade bonds, but the fund has recently looked away from its home continent to make US investment-grade credit close to 11 per cent of the fund – in addition to also taking a small 2.8-per-cent position on US high yield.

Fascinatingly, the fund has a lower allocation to developed world sovereign debt – 6.3 per cent – than it has to emerging market sovereigns at 10 per cent. This marks a distinct transformation from a position several years ago of European sovereign debt being the dominant asset in the fund. Schuh explains that using a unique new benchmark has facilitated this radical change – the fund now measures its investments against a benchmark that incorporates its own inflation measure (a deduction of the break-even rate from inflation swaps), AA long-duration corporate bonds and 13-year-modified interest rates.

 Emerging market enthusiasm

In explaining the fund’s enthusiasm for emerging market, Schuh (pictured right) says “all spread products are in demand due to the environment of quantitative easing and the hunt for yield, but we think the situation is a little more stretched in the high yield and corporate credit space than emerging markets”. Because of its more attractive liquidity, Latin America is the most significant destination for the Deutsche Bank fund’s emerging market debt investments, followed by Eastern Europe.

The fund has exposure to emerging markets in its smaller equity holdings despite not having a strategic emerging equity allocation. It instead aims to access emerging markets across its three “very actively managed” equity mandates, with Asian, German and European small- and mid-cap focuses. “We prefer an Asian mandate to a pure emerging market focus, partially because we are more cautious on Latin American emerging market equities,” Schuh says.

Generally positive on equities

With Frankfurt’s DAX index reaching an all-time record high on the day Schuh spoke, he says he is “generally positive” on equities within the tight constraints of the fund’s risk budget – which allows a maximum of 15 per cent to be invested in equities and alternatives.

Schuh says he is confident the equity rally can continue until Germany’s federal election this September. He grounds that view on the belief that “the tail risk of the eurozone crisis is not imminent in the coming months, while the increased quantitative easing and recent ECB rate cut all support the idea of liquidity driving risky assets.”SCHUH_Georg_EDM

Which begs the question, can an LDI-focused strategy thrive in a low interest rate era?

“For the next quarter I would say yes, and until the middle or end of 2014 we do not see an exit strategy being implement by central banks. With the strategic long-term horizon of a pension investor, I think the time will come in the next few years though to radically rethink the concept of liability matching,” Schuh says.

“We are lucky that the central banks are giving us some certainty for a while, but perhaps the first exit of this QE strategy could be in the US and then things could get ugly,” Schuh argues. Schuh confides that should a sudden spike of yields become a major risk, he would consider asking the fund’s sponsor to increase the risk budget.

Alternatives hard to justify

The fund has 2.7 per cent invested across an alternatives portfolio consisting of real estate, commodities and hedge fund investments. Alternative investments have been hard to justify, says Schuh, due to their low correlation with the CTA’s unique benchmark. While the fund is looking to increase its real estate holdings, he says “you have to be very picky” in European markets, adding that “my 20 years’ experience has taught me that it is very tough with commodities to earn money in an absolute way, or fulfill the kind of diversification or LDI that we aim for”.

Alternatives is the only area where the Deutsche Bank CTA uses an external manager, with the rest of the fund tapping the expertise of Deutsche Bank’s own legion of asset managers. The entire fund is invested actively.

The fund completes its strong LDI approach with equity hedging, a tactical asset allocation overlay and a desire to get foreign currency risk “as close to zero as possible”. Separate overlays covering CDS, inflation and inflation-linkage currently total around $13.2 billion.

Deutsche double happiness

With the CTA not being a catchall pension fund for Deutsche Bank’s pension liabilities, it has no direct funding ratio. The CTA is investing currently to a discount rate of around 3.5 per cent, revised on a monthly basis. Schuh says Deutsche Bank Group’s total global pension liabilities of $19.3 billion are 98-per-cent funded, indicating that its intricate LDI approach is doing the job for now. He is confident that the fund can continue to benefit twice from the full range of financial skill at Deutsche Bank – by a sophisticated investment approach that keeps the fund healthily in line with liabilities and by the added support of a successful sponsor.

 

There are two things that drive the newly appointed global chief operating officer of State Street Global Advisors, Greg Ehret, in his bid to improve the client experience: the retirement business is a cause worth working on and the clients are the reason the business exists.

Ehret was appointed to the new position at SSgA, which manages $2.2 trillion, in September 2012, and as COO he is responsible for delivery to clients, which means operations, technology, client relationships, sales and marketing all report to him. It’s basically everything except investments, and there are 440 investment professionals, and 2350 employees in SSgA, so it’s no small task. He and the chief investment officer, Rick Lacaile, report to chief executive, Scott Powers, and interestingly both are based in London despite the firm’s strong Boston heritage.

He believes in what he is selling

Ehret is a State Street man, he believes in what he is selling and says that all evidence he can see points to the fact the manager is the best in the world at passive management.

But he’s not an index tragic. He believes in innovation and business evolution because he is driven by solving clients’ problems.

“Our goal is to be relevant to our clients. Passive is a core strength of SSgA, we are the best indexers in the world. But our goal is to be relevant in facing off clients’ problems, and those problems have changed, so the solution can be indexed, or alternative beta, or active strategies,” he says.

“Many pension funds are under water and there is a real need for alpha and to use efficient sources of beta. ‘Core and explore’ is a key tenet of ours and while I think the secular trend to passive is a long-term core trend, we offer tools to get alpha and efficiently deliver the core.”

Ehret looks at three core concepts – interest rates, returns and risk – and how the needs of clients have changed as those three issues shift.

Driving client solutions

Meeting those changing needs then drives client solutions and product innovation.

One such example is the recent launch of senior debt exchange traded funds developed by SSgA and GSO Capital Partners, the global credit business of The Blackstone Group.

“Rates will be back up eventually; it’s not sustainable for them to be so low or negative,” he says. “The challenge is looking for income now, but in the future we will diversify away from interest rates.”

He says liquid alternatives will become more important in the product-suite offering and points to the hedge fund manager, SSARIS, which is a State Street Global Alliance company, the joint initiative with APG.

“In their multi-strategy and single strategy they have developed strategies that are divergent trades, they go long volatility. In their investment discipline, they are consistently diversified with long volatility and, over the long term, they have lower risk and higher return,” he says. “Volatility is so much more important to clients. We are working on a number of different strategies in alternatives, and liquid alternatives will become more important to us. There is great talent available, so we can do it organically.”

Business savvy

Ehret is a 20-year veteran of SSgA, holding a number of executive positions in operations, sales and product development, including as co-head of the firm’s industry-leading SPDR exchange traded fund business.

While SSgA is fundamentally an institutional investment manager, Ehret says his background means he looks at things differently.

“It’s a roundabout way of getting here, and it’s given me a different view,” he says. “I started in intermediary, not institutional, and the intermediary business is becoming more important to the business. Our initial foray was in ETFs and now the intermediary is asking what else we can do for them, whether it be advice, product differentiation or delivering an outcome to customers. It shows how the firm has changed.”

Service has to be impeccable

Ehret’s goal when he started as global COO was to “improve the client experience”, and first and foremost in that mission is to have a relationship between the client that is spotless.

A new initiative to help benchmark that is the introduction of a new process in which clients are surveyed when they are new and “onboarded”.

Ehret is also emphasising the power of communication and the delivery of good direct, transparent communication about the firm and the portfolio.

“It has to be good communication, up to date and on time. We have to get in the client’s shoes and remember that delivering a report is not the end of it, rather making sure everyone in our value chain understands the impact on the client. By the way that’s why we’re here,” he says. “Service has to be impeccable, integrity is really important.”

Ehret says that asset managers are partners of their clients, and are frequently asked to do a lot of value added in the investments solutions team.

This includes such things as total portfolio analysis, or liability hedging analysis, or the appropriate use of leverage or derivatives.

SSgA also participates in some unique conversations such as with the chief financial officers of listed corporations to talk about their stock so they can get the opinion of the buy side.

State Street also recently launched Global Exchange, which provides data and analytic solutions.

“We’re in the retirement business; it’s a cause worth working on,” says Ehret.