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Alpha and beta rely to a large extent on exposures to systematic risk factors, so goes the “2013 thinking” of ATP in reversing the decision to separate alpha and beta in its investment portfolio six years ago.

ATP has separate hedging and investment portfolios, with the hedging portfolio significantly larger at around DKK 670 billion ($122 billion) versus DKK10 billion ($1.82 billion), and the investment portfolio has been separated into alpha and beta. The separation was so distinct that the beta team was run from the head office, but ATP alpha was on another site, and was based on a small number of independent risk-taking teams.

The beta portfolio is split into five main risk classes or factors and the alpha portfolio will now be taken into this framework within beta.

“In the main, we conclude that alpha and beta are a question of exposure to systematic risk factors. We therefore see alpha and beta together in the same portfolio. It’s a development of our thinking,” chief investment officer Henrik Jepsen says. “It’s more like smart-beta risk factors. We are internalising these deliberations and want a more coordinated framework.”

ATP alpha will now be restructured and, while it is still to be determined which strategies will be pursued and which risk factors the fund wants exposure to, it will lose half of its 35 staff.

Jepsen acknowledges that having a small number of independent risk-taking teams was both a strength and a challenge.

One of the challenges was that with a large number of small teams it is difficult to scale the size of the total risk in the alpha exposure. In this way it was difficult to scale the investment efforts, and there was also a risk of over-diversification.

“In addition, the difficulty of scaling the efforts meant it was an expensive operation to run. We think it is important to have a focus on cost because we are in a low expected-return environment,” he says. “And thirdly, and most importantly in the long term, we think we can achieve better portfolio coordination.”

“The alpha group has been a success, after all costs and taxes, but while alpha has been $310 million, the fund is $120 billion, so we want to scale even more. It’s a challenge.”

This presents a conundrum for many large pension funds that use scale for cost reduction and negotiation. This may mean that these funds can not manage such strategies internally and achieve those aims, in light of the fact that the success of some of these strategies depends on being small and nimble.

ATP will continue to use the multi-strategy investment platform it has developed in the alpha business, where it managed long-short equity, equity market neutral, global macro, foreign exchange and currency.

It’s hardly surprising that a pension fund for employees working for an organisation charged with reducing climate change and its consequences invests according to strict green criteria. Yet the investment strategy of the United Kingdom’s £2.1-billion ($3.29 billion) Environment Agency Pension Fund (EAPF) definitely has the capacity to surprise. The EAPF posted a total return of 5.1 per cent, double the average 2.6 per cent of the UK’s other 89 Local Government Pension Schemes (LGPS) last year. Since 2009 the fund, which has 22,000 members in England and Wales, has returned a total of 16.1 per cent, again beating most other LGPS schemes. “Our focus on green investments is having a very positive impact on our financial returns,” enthuses its head Howard Pearce, who lives and breathes sustainable investment. Pearce dates his passion for environmental causes from his boyhood near Manchester, when he was unable to boat or fish on the polluted River Mersey.

As awareness of environmental, social and governance issues steps up a gear, the link between ESG strategies and returns has become hotly debated. For Pearce, head of the EAPF for the last 10 years and under whose stewardship the fund has grown to over $3.29 billion from $1.2 billion, the link between ESG and performance edge is glaringly obvious: well governed companies that manage their ESG risks will, overtime, produce more sustainable returns compared to poorly governed companies, he says. Now the fund is radically increasing its green strategy even more. “So far 13 per cent of our fund investment is linked to the green economy and we are on target to increase this to 25 per cent by 2015.”

Getting real with asset allocation

The EAPF’s active fund currently portions 73 per cent of its assets to a growth pool and 27 per cent to a defensive allocation. The bulk of the growth pool, at 63 per cent, is in listed equities but the new strategy will see this gradually pared down. The total equity allocation will fall to 50 per cent in the next few years and increasingly favour actively managed emerging markets – including a mandate managed by First State – in sustainably themed equities. “We have reduced our direct UK holding to a target of around 13 per cent to improve diversification and avoid the stock concentration present in the UK,” he says. “Emerging market equities offer better, long-term growth rates and investing in global markets enables us to access a much wider range of strategies and managers, including thematic sustainability funds.” The growth fund will maintain its 5 per cent allocation to private equity, managed by Robeco-Sam, but in another, sweeping shift, aims to gradually build its allocation to real assets from 5 per cent to 14 per cent.

In what Pearce dubs a back-to-basics approach targeting tangible assets rather than “esoteric financial products”, allocations will be made to property (6 per cent), infrastructure (4 per cent), as well as farmland and timber (4 per cent) with returns targeting at least 5 to 6 per cent annually. “We already invest in property. We now intend to look at investing globally in infrastructure, sustainably managed farmland and sustainably managed forestry. We want these investments to give us capital growth, be a hedge against inflation and climate change.”

Real asset investments will eschew anything that could accelerate climate change including green-field property developments, intensive agriculture, tropical hardwood deforestation and environmentally unsustainable infrastructure. Instead the focus will be on assets like low-carbon buildings, renewables and mass transport networks. These new allocations will most likely be invested via managed funds or possibly in collaborative ventures with other like-minded pension funds, he says.

Elsewhere, the defensive allocation will gradually move out of UK gilts, dropping from 13 per cent to just 5 per cent in the next few years. The slack in the strategic fixed-income allocation will be taken up by a doubling of the allocation to corporate bonds to 28 per cent by 2014. Despite the shift, Pearce reassures that because the fund is structured around allocations oscillating between set ranges it “still has the opportunity” to switch back into gilts “should yields start to pick up.”

Sharing with the locals

Pearce’s response to concerns that the green-investment universe is still limited is suitably swift. “If we cannot find suitable investments to meet our sustainability and financial criteria, we will not invest.” He does, however, acknowledge that high quality managers specialising in these new asset classes are still thin on the ground. The shift in strategy means more allocations, all with ESG managers, are in the pipeline with the EAPF in the final throws of completing an EU-wide tender for a low-volatility global equity allocation and for a real asset manager too. “Our searches are still underway, but we hope to appoint by April 1,” he says. “Some of these new fund management contracts we will set up may be accessible by other LGPS funds.”

In this novel approach the EAPF has hooked up with five other local authority pension schemes to jointly procure and employ specialist actuarial and other advisory services. Through this pooled procurement, local authority schemes don’t lose any control or identity over their fund, consistent with the government’s localist agenda, but the strategy does allow significant cost savings. “Each fund tendering separately would have cost around $940,000 whereas the estimated total cost for the collaborative exercise was around $313,000,” says Pearce. “Going forward, funds should save around 10 per cent annually with reduced day rates, reduced costs for specific work, discounts for doing the same work for more than one fund, and added-value free services. Current estimates indicate a further overall saving of up to $1.7 million over seven years.” If the sharing approach is broadened further it could help shave costs in a fund where “100 per cent” of the assets are externally managed. “Our best performing ESG managers are Sarasin and Generation, both managing active global equity mandates,” says Pearce. The EAPF’s Pensions Committee is responsible for strategic asset allocation, investment policy and the appointment of advisors and managers, but the fund has shaped its new strategy using Mercer and B Finance.

For Pearce, whose career began in the environmental management of river systems and not, unlike many other heads of local authority schemes, in accountancy, following ESG criteria is more necessity than optional extra. He’s notched up many firsts during his time at the helm, including signing up to the United Nations Principles of Responsible Investment in 2006 and becoming the first UK scheme to produce a Responsible Investment Review in 2009. Shifting to a bigger allocation to green investment is an entirely natural progression. “Our priority is to maximise risk-adjusted investment returns but we have also seen significant changes in some corporations’ behaviour and management,” he says.

The current equity rally is not predicated on a shift in economic performance, according to chief economist at State Street, Chris Probyn, who says it would be reasonable to say the market may “pause for thought”.

Probyn says the move from fixed income to equities has been fostered by some of the “economic areas for concern” being eliminated.

These include the avoidance of a hard landing in China, and a disorderly breakup of the euro, proactive policy responses in Japan and the avoidance of the US fiscal cliff.

“These have all been ticked off,” he says. “But still growth is not great. The fourth quarter earnings reports have been good, with the notable exception of Apple, so there is some fundamental support for equities. But there is no fundamental upshift, so the size and speed of the rally is a little surprising.”

Probyn’s outlook for 2013 is for 0.25 per cent global growth, driven by a 0.5 per cent growth in emerging markets.

His economic outlook for developed markets is zero growth, which he partly attributes to fiscal policy decisions.

“We have reinvented economics, when the economy is weak we stop government spending, it is a failure of policy and we are repeating the mistakes of the 1920s,” he says.

Probyn also attributes the equity rally to a certain psychological behaviour.

“People have worry fatigue, they are tired of worrying about the same things,” he says.

State Street doesn’t have a big economics department, three people in fact. One emerging markets specialist plus two who look at the G8, defined as the G7 plus Australia (because of State Street’s presence in that country).

Probyn believes that in order to understand certain asset classes there needs to be an understanding of the global economic story, such as the relationship between resources and China.

He admits that for most economists it is difficult to predict exact growth numbers, but it’s more important to get “the overall story right”. Last year that overall story was further growth moderation, and that is the outlook for 2013 as well.

In 2012 there were 31 hedge fund managers on the Forbes 400 list, representing about 8 per cent of the wealthiest people in the US, up from 6 per cent the year before.

Wealthy people on the whole don’t interest me, but innovation does. And the creation of wealth, and the creation of jobs and prosperity from innovation is perhaps capitalism’s greatest virtue.

But the problem, it could be argued, is hedge funds don’t innovate. Hedge funds don’t build value, they trade value, and the rise of the number of hedge fund managers on the Forbes list is revealing.

According to the dean of the Rotman School of Management at the University of Toronto, Roger Martin, if we live in a world where trading value is more important than building value, then “we have a messed-up economic system”.

Speaking at the World Economic Forum in Davos last week, Martin had a pretty clear message – he would ban pension funds from investing in hedge funds.

“I would cut off their supply lines, which are pension funds,” he says.

Martin sees no reason for a pension fund with long-dated liabilities to invest in a vehicle that has a short-term focus and charges fees of 2 and 20 per cent.

“They swing for the fences with pensioners’ money,” he says. “I would ban pension funds from investing anything that charges fees for assets under management and carry.”

Furthermore, when many hedge fund managers get to a certain size they give back clients’ money and simply manage and trade their own wealth. This behaviour demonstrates a distortion in the alignment of interest with the long-term investor.

Endless chatter

The pension industry talks endlessly about the merits of long-term investing. At Davos there was a session on “unlocking long-term capital”, with panellists including Mark Wiseman, chief executive from CPPIB. Roger Martin, who is everywhere at the moment, also recently participated in a webinar with sustainable investing pioneer and advocate, Raj Thamotheram.

But while there is a lot of talk, there is little real action. Pension fund executives have the power, and an enormous amount of autonomy given their size, to decide where to invest. If so much academic literature and regulatory reviews such as those of John Kay recommend a focus on the long term, why don’t they just do it?

Why invest in companies that charge high fees? Why invest in companies that don’t have appropriate executive remuneration or human rights practices? Why invest in companies that don’t consider future generations or environmental impact?

Changing the rules of capitalism?

The good news is the momentum seems to be swinging towards altering the rules of capitalism.

Raj Sisodia’s conscious capitalism movement is compelling. In a TEDx Talk he argues that we need to elevate the consciousness with which we conduct business. We need to “see the whole reality, see all the consequences of what we are doing, not just the ones we are focused on”.

The announcement of a Sustainable Investment Research Initiative by CalPERS this week is also a positive move, with the fund’s sustainability agenda driving the formation of its investment principles. Global governance will be at the core of its investment decisions.

On one hand CalPERS has been slow to act; the fact a fund of that size is only setting investment principles for the first time is astounding.

On the other hand, they are now leapfrogging their contemporaries, adopting governance as a core value and recognising that pension funds have a responsibility to people. People that live in the world, not on Wall Street, and not within financial instruments, and not on Forbes lists.

This is a changing world, where dynamism and responsibility have to be core attributes, especially if you’re acting on behalf of someone else.

When John Wesley, the 18^th century Anglican cleric, preached that business practices should not harm one’s neighbour, he never imagined that his principles would guide the global investment strategy of an $18.4-billion pension fund. Today, the General Board of Pension and Health Benefits of the United Methodist Church, based in Chicago, ranks as one of the world’s leading ethical investors, with a lengthy checklist of excluded assets and required standards for the companies in which it owns stakes. “Every single fund we manage reflects the ethical values of the church,” says David Zellner, the board’s chief investment officer.

In 2011 the General Board rebranded Zellner’s division as Wespath to signal the dual purpose of the church’s mission in financial markets. According to Zellner, Wespath’s name reflects both the spirit of Wesley, who inspired the modern Methodist movement, and the unit’s goal to set the fund’s stakeholders on the path to prosperity. For the most part, they are clerical and lay church employees whose contributions account for about $16 billion of the fund’s assets, with about $2 billion in additional capital from affiliated Methodist institutions. Overall, the total portfolio grew 9.3 per cent between Dec 31, 2011 and the end of 2012, although Wespath does not publish a year-on-year return for the entire $18.4-billion asset pool. Three-quarters (76 per cent) of all assets are invested in the US, with 95 per cent of the total portfolio under external management.

The Book of Discipline

All Wespath’s investment managers must strive to operate within extensive ethical guidelines laid out in the church’s Book of Discipline. For example, they cannot knowingly invest in any company that derives more than 10 per cent of gross revenues from core businesses in alcohol, tobacco, pornography or gambling. Wespath also cannot buy stakes in companies that receive more than 10 per cent of gross revenues from the manufacture, distribution or sale of anti-personnel weapons such as land mines. Nor can Wespath invest in companies whose “identifiable ratio of nuclear weapons contract awards from the US Department of Defense or comparable agency or department of any foreign government” is at least 3 per cent. A blanket clause also covers any business that violates the church’s values on issues ranging from the use of child labour to the environment. All told, Zellner reckons that the guidelines exclude Wespath from about 5 per cent of the S&P 500 Index, measured in market value.

Yet the guidelines do not amount to a rigid investment mandate, says Zellner. “With regard to investing, church law says we are to discharge our fiduciary duties solely in the interests of our stakeholders,” he explains. “We are not obligated to follow the church’s ethical teaching.” Furthermore, only one of the seven funds in Wespath’s portfolio – the $50-million Balanced Social Values Fund – is explicitly ethical in a purist sense by only investing in companies with high environmental, social, and governance (ESG) ratings. In 2012 the fund delivered an annual return of 9.17 per cent, slightly better than its chosen benchmark.

Across the rest of the portfolio, the board expects fund managers to make a “conscious effort” to observe the guidelines, explains Zellner. In his view, they will not lose money by excluding sectors and companies that fail to conform with Methodist business ethics. “Over the 30 years that we’ve been tracking this metric – screening has had a negligible impact on our performance,” says Zellner, who joined the General Board in 1997 from Investment Research Company, an affiliate of United Asset Management.

Performance against benchmarks

The proof lies in the performance over time of the other six funds, which Wespath deliberately benchmarks against mainstream indexes that do not exclude companies and assets on ESG grounds. The US Equity Fund, with $6.3 billion in assets at the end of 2012, has slightly underperformed the Russell 3000 Index (or equivalent previous indexes) over the past 10 years, with an overall 7.5-per-cent return for the decade, compared with 7.68 per cent for the benchmark. In 2012 the US Equity Fund posted a 15.05-per-cent return, against 16.42 per cent for the Russell 3000 Index.

Over the past decade, the $2.8-billion International Equity Fund, which covers both developed and emerging markets, has registered a 10-year return of 9.48 per cent, a shade higher than its benchmark, while last year the fund narrowly beat the MSCI All Country World (excluding the US) Index with a 12-month return of 19.67 per cent. The $4-billion Fixed Income Fund, which invests in government debt, corporate bonds and asset-backed securities, has delivered a 10-year return of 6.22 per cent, slightly better than the benchmark, and in 2012 comfortably outperformed its target, with a return of 9.58 per cent compared with 6.61 per cent for the Barclays US Universal (excluding MBS) Blended Index.

Two smaller defensive investment pools – the $2.1-billion Stable Value Fund, focused on short and medium-term debt instruments, and the $2.1-billion Inflation Protection Fund – have closely tracked their benchmarks since inception. Finally, the $7.7-billion Multiple Asset Fund, which invests on a weighted basis in the equities (45 per cent), international equities (20 per cent), fixed income (25 per cent) and inflation-protection (10 per cent) funds, has narrowly outperformed its customised benchmark over the past decade, registering a 10-year return of 8.4 per cent. In 2012 the Multiple Asset Fund returned 13.76 per cent, just above the benchmark.

Walking the values walk

These results, while not outstanding for a mainstream fund manager, illustrate Zellner’s point that it is possible for an ethical investor like Wespath to do well financially and also, by its own values, do good. Wespath’s ethical investment strategy does not end here, for Wespath is on the lookout for any evidence that a company in its portfolio is falling short of the church’s ESG standards. “Our position has always been that it’s better to own the stock and have a seat at the table so that we can influence the company to make a change, rather than divesting our holding,” he says. In recent years, Wespath (or previously the General Board) says it has scored a number of significant ESG victories, from persuading McDonald’s in 2007 to support the Board’s efforts to raise the pay of migrant tomato pickers in Florida, to obtaining a commitment from Hershey’s to make all its global chocolate products by 2020 from certified Fair Trade sources.

As one of the largest institutional investors in US equities, Wespath also regularly votes in support of Say on Pay disclosure resolutions, without setting an overall ceiling for executive rewards. “So long as shareholders are receiving appropriate value for what is paid to executives then we are comfortable with high levels of compensation,” says Zellner. Wespath’s ethical scrutiny extends to vetting the portfolio’s external managers. “We examine the magnitude of their exposure to companies or properties that would violate our values,” Zellner explains. “If we determine that it’s not going to be significant, then we’ll go ahead and invest.” The same rule applies to private equity firms in which Wespath is a fund investor. “In some cases we write into the contracts that if they invest above a certain percentage in certain companies or sectors, then it’s outside our guidelines, and they should exclude us from those investments,” he says.

True, there remain ethical investing hurdles that even Wespath is obliged to bypass. In emerging markets, where Wespath’s principal external managers are Genesis Investment Management and Capital Guardian, it is frequently impossible to conduct due diligence on every individual asset; the lack of transparency is simply too great. On the other hand, Wespath would be failing in its fiduciary duty if it avoided higher growth countries such as India.

For Zellner, Wesley himself is the most important benchmark for checking whether Wespath is striking the right balance between Christian morality and financial performance. “I frequently ask the United Methodists on the corporate relations team to tell me if they see anything in our investments of which Wesley would not have approved,” he says. “All three will tell you that Wesley would be proud of the results we’ve achieved.”

Launched this week, CalPERS’ Sustainable Investment Research Initiative (SIRI) will drive the development the $250-billion fund’s first set of investment beliefs. While difficult to believe a fund of its size, reach and history could invest without a set of investment beliefs, it is encouraging to see that sustainability will be a core part of that development. The SIRI aims to drive innovative thought leadership to advance CalPERS’ understanding of sustainability factors and the impact they have on financial performance.

At CalPERS sustainability has expanded beyond the notion of the environment to stabilisation in capital markets, and in the past couple of years it has undergone a comprehensive review of sustainability culminating in the board adopting a total-fund approach last year.

Three kinds of capital

Within three forms of economic capital – financial, human and physical – the fund has identified the strategic themes of alignment of interest, human capital and climate change that set the framework for the fund’s environmental, social and governance integration.

“We came up with the framework for CalPERS in the financial capital, physical capital and human capital. The question is what does that mean for strategy for allocating capital? Through this enquiry, and looking for thinking, research and debate, we will set out investment beliefs in July,” Anne Simpson, senior portfolio manager and director of global governance at CalPERS, says.

“When I arrived this was defined as corporate governance and was in global equities. That has moved to a portfolio-wide strategy integrating ESG into sustainability and linking it into financials. That has not been done before, at least not in the US. Our job is to be breaking ground. This is a significant moment.”

The fund is also calling for papers to contribute to a debate on ESG and long-term value creation and capital market stability. It will work with the University of California Davis Graduate School of Management to assess the papers, which will co-host a Sustainability and Finance Symposium on June 7 with Columbia Law School’s Millstein Center for Global Markets and Corporate Ownership. Following the symposium, the board will review the findings and finalise its investment beliefs for a July deadline.

“There is a huge amount of anecdotal ad-hoc conclusions and we need definitions of what is relevant. Once we have decided what the relevant factors are, we want to know how to allocate capital. Investment beliefs need to be something on which you are willing to act.”

Governance transformed

In the three years that Simpson has been at CalPERS, the governance program has been transformed. It has stopped calling the program corporate governance, and is looking at the governance agenda in a broader way, reflected by its new name, global governance.

Simpson has previously said that investors need to put the “F into ESG”, referring to the integration of financial and ESG analysis, a point that many institutional investors globally need to overcome. They want to integrate ESG factors, and see the value of a sustainability lens, they just don’t know how to do it.

Simpson says that for CalPERS, sustainability is simply defined as the “ability to continue”.

“If you start to take on board the view that you’re a century of liabilities, then you look at risk and return through a different lens,” she says. “If you believe risk is always rewarded, then you will behave in a certain way. We have never had investment beliefs.”

While CalPERS has been vocal and influential with regard to legislative change such as the Volcker Rule and derivatives reform, Simpson says that has not been done within a wider framework.

In addition, CalPERS has started its triennial asset-liability modelling, a process that will take all year. “We pay pensions in cash but invest over a very long term; it’s an interesting debate about assets and liabilities,” Simpson says.

The seven tenets of investment

In May last year the risk management group at CalPERS presented a list of seven recommended investment beliefs to the investment committee of the board. They were: