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

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

“It’s what it’s all about,” he says.

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

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

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

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

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

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

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

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

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

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

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

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

It is within investors’ power to change this.

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

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

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

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

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

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

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

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

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

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

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

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

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

The second would be around incentive structures.

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

Photo: Kasey Baker/Wikimedia Commons

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

Transport for London, the organisation behind the network of buses, underground or “tube” trains, trams and bicycles that keep the United Kingdom’s capital city on the move, has a reputation for its generous employee benefits. But of all the staff perks on offer, including 30 days holiday a year and subsidised travel expenses, membership of the gold-plated, defined benefit Transport for London Pension Fund (TfL), is the biggest. Investment strategy at the thriving £6.9-billion ($10.5-billion) scheme, grown from $7.6 billion in 2010, has recently shifted with the fund nurturing a growing $1.5-billion alternatives portfolio comprising hedge funds, infrastructure, real estate and private equity in its bid to diversify and improve the scheme’s risk-adjusted returns over the medium to long term.

Strategy shift

The shift in strategy comes despite equities being TfL’s best performing asset this year. United States small cap and global equity mandates have led the field, says Padmesh Shukla, investment officer at TfL (pictured right), based in London’s Borough of Westminster. “Listed real estate has also seen a strong performance, and bonds and emerging market currencies fared well, but for the recent market pullback,” he says. padmesh-120The fund runs a large foreign exchange overlay program to hedge currency risk in the equity portfolio and active management has also helped boost returns, with 60 per cent of the equity portfolio actively managed. Active investment mandates include global unconstrained, US small cap, Japan, emerging markets and Asia, lists Shukla. “These markets are generally under-researched and have of late seen dispersions widen, making active management more optimal.” Passive investments are in markets widely regarded as efficient such as Europe, North America and the UK.

The current portfolio is split between equities (55 per cent), bonds (25 per cent), all actively managed bar a “very small holding” for rebalancing purposes, and alternative investments (20 per cent). The expanding allocation to alternatives will increase to 25 per cent over the course of 2013, primarily funded from equities. Additional allocation will be made to unlisted real estate, one or two new hedge fund strategies, “possibly” renewable energy and private equity, says Shukla.

Private equity

It’s a private equity allocation that is supported by the scheme’s “negligible” liquidity requirements, he explains. “Private equity is a way for us to extract illiquidity premium and earn higher returns, but at the same time try to reduce the market-to-market volatility of public markets,” he says. “Our private equity allocation is driven by a strong fundamental understanding of less efficient segments in the market and less desire to time the markets.” Going forward, the scheme will likely increase its allocation via a separate account format, investing in primaries, secondary and co-investments, diversified “but not overly” by sectors, managers, vintages and regions. Unlike the scheme’s hedge fund program – where it makes direct investments – in private equity, fund of funds is TfL’s preferred approach to better access more specialist and small-to-mid-size managers outside the known big names.

The fund also lacks the resources to build its own private equity specialists. TfL has an internal team of seven covering investments, accounting, finance and compliance, although it is in the process of beefing up its investment and compliance capabilities. “We aren’t FSA-authorised; all investments are done through external managers,” says Shukla.

Hedge fund portions

TfL’s hedge fund allocation is portioned to commodities, structured and distressed credit, emerging market currencies, reinsurance and global macro trends.

“Hedge funds in the distress and event driven space have performed well, both in absolute and risk-adjusted terms,” says Shukla. Over the last year new allocations have gone to Arrowgrass Capital Partners, Och Ziff Capital Management and the world’s largest hedge fund, Bridgewater Associates and its Global Macro Systematic Hedge Fund. Over half of the 4 per cent infrastructure allocation is invested in mature PPP projects predominately in the UK and with limited construction risk in an allocation managed by Semperian PPP Investment Partners.

TfL does run an LDI program, but only plans to expand its strategy to hedge out inflation and interest rate risk if “real rates go up; we believe the current levels are very low.” Although investments are also made in liability-matching proxies such as infrastructure and real estate, the fund’s long maturity profile – it boasts 83,000 members comprising 23,000 contributing members, 18,000 deferred pensioners and 42,000 dependants – means it is still cash positive. “We expect to remain cash positive for a significant period of time – an important consideration in both hedging and investment decisions,” says Shukla. Nor is the scheme weighed down by a huge deficit, with a funding level of 91 per cent compared to 73 per cent at the last triennial valuation in March 2009. “The aim is for a 100-per-cent funding level by 2020 and staging-post targets between now and then,” says Shukla.

The wrath of the European sovereign debt crisis may have left its mark on Italy in more ways than one, with both its financial and political scenes regularly sliding into crisis mode for the past year or two. However, the nation’s largest private pension investor, the €7.75-billion ($10.1-billion) Cometa fund, has firmly kept on track through the testing times though.

Maurizio Agazzi, Cometa’s director, says that whatever happens in the world outside of its Milan office, “we must not forget our mission” as a long-term investor. On being asked about any investment positions, Cometa may have taken in the heat of Italy’s crisis, Agazzi simply says, “Our asset management is based on investment plans that are long term, with no speculative choices made.”

Although Cometa is a bond-heavy investor, the fund appears to have avoided a blow from its country’s sovereign debt woes by having a global outlook. Its largest two sub funds, Reddito and Monetario Plus – which make up the vast majority of total assets among Cometa’s four funds – are dominated by mandates investing to global benchmarks, such as JPM Global and Barclays Capital Global. Cometa’s biggest sovereign debt mandate is meanwhile well diversified across the continent, with a $1.3-billion-plus investment in the Barclays Capital Euro Treasury index.

As Agazzi reels off more sets of indices, it becomes clear that identifying the right benchmark is a major focus of Cometa’s investment strategy. While Cometa wants to define what its external managers invest towards, Agazzi explains that the fund also believes in giving its managers plenty of freedom to make tactical calls and granting them full investment autonomy. “A close partnership with managers must be based on choosing the strategies best suited to achieving pension objectives”, he argues. This notion of partnership leads to Cometa keeping a close eye on its external managers – a major set of mandate awards in 2010 inspired Cometa to launch a new code of standards for managers. This built a desire to keep a tight watch on managers into the fund’s control mechanisms and has led to the fund routinely hauling managers in for meetings.

Few equities

Cometa has fewer benchmarking decisions to make in the equity space, simply because exposure to the asset class is limited. Just 15 per cent of the $5.4-billion Reddito fund is invested in equities, while the $3-billion Monetario Plus fund is 100-per-cent bond invested. International diversification defines the equity strategy at the Reddito sub fund, with 50 per cent invested in non-European stocks, a third in a European and the remainder in Italian equity mandates. Only in the small Crescita fund (with $520 million assets) do equities take a noticeably chunky share of the portfolio at 40 per cent.

The low overall equity allocation is a possible consequence of Italy’s risk-averse pension fund-investment legislation. Agazzi explains that, “Italy has a strict regulation on how second-pillar pension funds have to invest their assets, with a lot of qualitative and quantitative constraints.” One of these constraints is that Italian funds have faced limits on investments in non-OECD nations, something that appears to have held them away from the trend to emerging market investments. Cometa’s entire government bond portfolio is invested in OECD countries, Agazzi says.

You would perhaps expect an investor of Cometa’s size to relish a long-touted change in Italy’s pension investments regulations. Agazzi is wary though of the impact of a sudden liberalisation. “I do feel it is important for laws to preserve that distinction between investments for pension purposes innate in the second pillar system,” he says, “and merely speculative investment.”

Controlled enthusiasm

Alternative asset classes have traditionally been difficult for Cometa and other Italian investors to access due to their regulations. A dose of cautious interest seems to pervade Cometa’s attitude towards alternatives. It designated a strategic allocation to both private equity and real estate back in 2010, but Agazzi says it is yet to implement the moves into these asset classes pending further consideration.

Diversification was the mantra behind its 2010 mandate awards – reported to be one of the largest mandate hires in Europe that year. Agazzi explains that a full mix of passive and active mandates was sought in the big hire, together with a range of value-at-risk limits and capital protection objectives. Different risk profiles are evident in that several of Cometa’s largest mandates are invested to hedged or inflation-linked benchmarks. Extending the duration on the fund’s assets is another possible step to further diversification under consideration, Agazzi adds.

While some deem the Italian institutional investing environment as restrictive, clearly Cometa has found no shortage of ways to diversify.

With total assets growing by over $2.6 billion in the last two years, Cometa has managed to navigate a tough time in Italian economic history in some style. Being a defined contribution investor has perhaps shielded it from any funding pressures that could have resulted from tumultuous movements in government bond yield and equity markets in Italy. The Reddito fund has averaged returns of over 4 per cent between 2009 and 2011 though, figures that might make some investment managers in other pension markets envious.

 

In this paper MSCI applies its framework for defining macroeconomic risk to strategic asset allocation, labelling assets as either risk premium or risk hedging. It applies the analysis to arisk-parity portfolio, showing how its relatively high exposure to inflation shocks makes it a risk premium portfolio.

 

To access the paper click here

 

 

The emerging market story is a puzzle with many pieces. From an overall philosophical standpoint, the demographic and economic shifts are obvious reasons to have a weighting to emerging markets. But the complexity comes into play with the question of how to invest.

Investors can consider private equity, property and other direct investments as a way of investing in emerging markets, but it is via the three main areas of debt, equities and currency that most of the action occurs.

Within fixed income there has been a recent structural shift that has implications for the way investors view the asset class, and its correlations.

Emerging market economies – a structural reduction of risk, a paper by Neuberger Berman’s Alan Dorsey, Juliana Hadas and Parth Brahmbhatt, outlines emerging-market sovereign-debt issuers have migrated to investment grade credit, which has meant that emerging market debt as an asset class has seen a reduction in its correlation to non-investment grade corporate-debt indices and an increase in its correlation to investment grade indices.

This means hard currency, or dollar-denominated emerging market debt, is trading at a much lower risk premium versus high yield than it has historically.

 

Secular, not cyclical

The paper outlines the possibility that this risk premium compression is secular, not cyclical.

In other words, it may be a one-time transformation in the perceived “riskiness” of the emerging debt asset class.

Co-head of Neuberger Berman’s emerging market debt team, Gorky Urquieta, says the detail of this structural transformation is seen by looking at the comparison of external debt to domestic debt in emerging markets, as well as the emerging markets compared to developed markets.

“It is clear how there is a divergence, with emerging market debt to GDP at 40 per cent and declining, while developed markets is around 100 per cent and increasing,” he says.

There has also been an increase in local demand for emerging market debt, with debt rotating from external to internal, especially in countries such as Russia and Brazil, which has contributed to economic growth and the stabilisation of debt markets.

“Emerging markets are net external creditors – they have more assets than liabilities – that provides them with a significant buffer,” he says. “The dynamics are better than in the developed world, and achieved on much higher growth rates and better management of fiscal accounts.”

 

Performance matters

Emerging market debt issuance is at record levels, in both issuance and dollar value, as investors seek new markets with the prospect of enhanced returns in the low interest rate environment of developed markets.

Flow data shows there has been an estimated $17 billion of inflows into emerging market debt in the year to mid-March with a bias towards emerging market local currency and emerging market corporate funds.

Dealogic, an investment banking platform, reports that in 2012 the deal value of emerging market debt issuance was close to $900 billion and for the first quarter of 2013 that was already over $300 billion.

In size, it is now comparable with the US treasury market.

At a time in which investors have been desperate to find investments with decent yields, emerging market debt was a logical choice given the robust underlying fundamentals of the asset class.

Emerging debt has seen strong performance and in the 10 years to October 31, 2012: the average annual total return was 11.34 per cent based on the JP Morgan EMI Global Diversified Index, making emerging markets the best-performing fixed income asset class in the period.

But investors around the world have typically had low allocations to the emerging market fixed income space, US investors for example have around 2 to 3 per cent in emerging markets.

“In the context of any measure, it is extremely inadequate,” Urquieta says.

Historically the concerns have been around transparency and the size of these markets which has fed ultimately into liquidity concerns.

“If there is risk-off, then emerging markets are still risk assets; there is no mechanism for sovereign defaults. And corporate recoveries are lower than in the developed world,” Urquieta says.

 

Yield and structural shift

But with risks there can be opportunity.

Phil Edwards, principal at Mercer in London, says emerging market debt has gone through a transformation in recent years.

He says in 2009-2010 there was interest when yields looked attractive, especially compared to developed markets, and allocations grew quite quickly.

A Mercer survey shows that 13 per cent of European funds have an allocation to emerging market debt, with the average allocation about 5 per cent of total assets.

“Even though yield has come down materially, there is still a case for investing in emerging market equities and debt,” he says. “There is a crossover element. We have seen some, but not many, investors making use of emerging market multi-asset funds. Our preference is to access specialist expertise in each space because they are different and need different skills.”

Edwards is intrigued by the “interesting characteristics” in emerging market credit.

“Funds are seeking exposure through the same emerging-market-debt mandates but broadening it to credit, expanding mandates to allow managers to go into credit.”

The €140-billion ($183-billion) Dutch fund, PGGM, has about 5 per cent of its total portfolio in emerging market local currency debt, which relatively speaking is an overweight position.

It says that while risk premiums have decreased, markets have grown, there is more liquidity, and fundamentals have improved across deficits, debt and policy.

This means that both risks and rewards have decreased, but the giant fund still says there is added value for emerging market debt in local currency because yields are still substantially above developed market yields.

Within emerging markets there has been a structural shift away from sovereign to corporate credit. On average corporates are better rated than sovereigns (see JPM index) and more than half of the assets are investment grade.

The fixed income portfolio of the $65-billion Washington State Investment Board is positioned to take advantage of the structural shift in emerging market debt.

While it doesn’t have a set allocation to emerging markets debt, it currently has about 36 per cent in emerging and frontier market debt, about half of which is in non-denominated bonds.

This is a significant overweight position compared with the Barclays Universal benchmark which is mostly developed market bonds. (Incidentally Barclays has 12 specific emerging market bond indexes).

In addition, the WSIB portfolio has a lot of corporate debt, which it started building in the mid-1990s, and executive director Theresa Whitmarsh says the team is agnostic to geography, rather it looks at macroeconomics, fundamentals and valuation, alongside its own judgement.

“Emerging markets have a great growth story, great demographics, urbanisation trends and fiscal strength. Following the Asian crisis they had to put their fiscal shops in order, and they did, and they are in good shape.”

The WSIB bond portfolio has about 70 per cent exposure to corporates overall, and within emerging markets fixed-income allocations, only two of the top 10 holdings are sovereign debt.

 

What will emerging markets become?

The emerging markets secular trend of improving fundamentals, has different ways to play.

Emerging markets equities is one way, currency another, risk premium on emerging markets sovereign or credit or a combination, another.

Rob Drijkoningen, co-head of emerging markets at Neuberger Berman, says that in the early 1990s investment grade was a negligible part of the index, now 56 per cent is investment grade.

“It has become less volatile and credit quality has improved,” he says.

In addition, local yield curves have developed, which could create a credit culture, leading to the need for a benchmark culture, and then the pricing of other products.

“We are seeing the establishment of local yield curves,” he says.

Head of investment strategy and risk at Neuberger Berman, Alan Dorsey, acknowledges low yields but says spreads are not at all-time lows.

“Global monetary policy created low yields, but investors still need to make money, beneficiaries still need to eat. Where do you go to get that money and provide that food?” he says.

Dorsey believes emerging market debt is still something of an inefficient asset class especially if corporates are included.

And Drijkoningen believes emerging markets corporations are under-researched and undervalued.

“The market is similar in size to US high yields, but in emerging market corporates the opportunities have a long way to go.”

“The expansion of names and size is interesting,” he says.

While most investors are still looking at emerging markets as one asset class, Urquieta believes in three to five years’ time there might be the low/high investment grade split in mandates.

“For example, in the corporate universe we will see investment grade or high yield exposures. Those types of enquiries, such as investment grade only mandates, are taking place.”

It is possible in the future that mandates will look like a best-idea investment-grade mandate across emerging markets and developed markets.

But a word of warning from Moodys says that assessments of corporate credit risk in emerging markets can also be affected by broader sovereign risk considerations, given the strong links between corporates, financial institutions and sovereigns.

This means that determining risk credits will rely more on qualitative rather than quantitative assessments.