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.

“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,” she says.

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:

  1. Strategic asset allocation is the dominant determinant of risk and return
  2. A return premium is required to take on risk
  3. Premium is required for illiquidity
  4. Long-term investment horizon is an advantage
  5. Inefficiencies in the market create investment opportunities
  6. Costs matter
  7. Risk is multi-faceted and not fully quantifiable.

 

For more information on the Sustainability and Finance Symposium and to submit a paper, click here.

For an academic view on the importance of investment beliefs and how, in particular, beliefs relating to risk can impact performance, click here.

“We have to move faster than our competitors,” says the chief executive of French retirement fund Union Mutualiste Retraite, Charles Vaquier. It is a phrase that you can hear uttered by business leaders at all sectors and levels, but one that institutional investors rarely emphasise.

In chatting about its investment strategy, it soon becomes apparent that Vaquier and the €8-billion ($10.6-billion) UMR are not afraid to use their need for speed to make brave investment calls. “You don’t make a good deal when you sell; you make a good deal when you buy” is how Vaquier explains UMR’s approach to value investing.

One way in which this attitude impacts its investment strategy is an underweighting of government bonds. While many pension funds in Europe currently find themselves lumbered with low-yielding government debt, UMR made clear moves years ago against sovereign paper. Appalled at the risk-reward ratio of French or German debt and other “safe” sovereign bonds, UMR holds just 10 per cent of its $5.3-billion bond portfolio in sovereign paper.

Lower rated corporate debt is favoured by UMR in its hunt for yield, according to Vaquier. Some 27.6 per cent of bonds in the biggest of UMR’s three separate pension pots, Corem, was either BBB– or high yield at the end of 2011.

Despite investor fears about yields being tightened at the lower end of the credit spectrum, Vaquier feels high yield is still an attractive option. Strikingly, just 3.7 per cent of bonds held in Corem were AAA rated at the end of 2011.

Risk and real estate in Europe

A mere mention of 2011 is still enough to make Vaquier wince. That year was a true annus horribilis for UMR’s investments, which sustained heavy losses across the board.

One particularly grating loss was a $199 million write-down of an investment in an Austrian bank that was caught up in 2008’s financial meltdown. UMR is still embroiled in a legal battle over the terms of the investment, and hopes to recoup up to $133 million of those losses. Another major hit in 2011 came as the fund clung on to significant holdings of Greek government debt in a move that defied a tide of investor opinion. The position lost UMR around $133 million. Having its fingers burnt by events on the European periphery would be enough to convince many investors to shun the region out of fear for further losses.

That has not been the case for Vaquier and UMR, however.

The fund has recently upped its holdings of Italian government bonds to make 3 per cent of its total debt portfolio in paper from Rome. Vaquier argues that the systemic risk that has driven yields in Italian sovereign debt skywards in the recent past is present in all European government bonds, without carrying the same reward. “If Italy goes bankrupt, all the eurozone would be bankrupt, banks and states would be bankrupt,” he says.

Consequently, UMR can reduce risk for its members by saddling them with the eurozone’s inherent risk via Italian government bonds, according to Vaquier, rather than through core government issues that yield less than the inflation rate.

In real estate, Vaquier says UMR is eyeing up opportunities in Spain, one of Europe’s most devastated property markets. “Office and commercial properties in some regions of Spain will be interesting,” he says. “Prices are still dropping and we believe that the Spanish economy will take off again in 2014 and after that.” A recently announced hiring drive by Renault in Spain is a sign that production costs are becoming increasingly competitive there, he adds.

Spreading its bets

Vaquier hopes that UMR’s positions on Italy and Spain turn out to be as shrewd as a deployment of “hundreds of millions” into equities that was made while stock indices were mired in the post-crisis slump.

The pension fund’s equity portfolio delivered a spectacular 17-per-cent return in 2012, and Vaquier is hopeful the asset class can deliver 10 to 15-per-cent growth through 2013. Going overweight on emerging market equities helped UMR to outperform the CAC 40 in 2012, with the main Paris stock index growing 15.2 per cent over the year.

UMR is contemplating taking this fondness for emerging markets over to its bond portfolio. “Emerging market govvies will be useful diversification,” he says. “Some of these emerging market governments have good economic profiles with low debt and currencies growing in strength against the euro.”

Another focus for UMR is infrastructure, which Vaquier says is set to be the fastest growing asset class in the next few years.

As a sign of things to come, UMR recently made a $133-million investment together with the European Investment Bank in Brisa, a Portuguese highway operator and toll collector. The investors will get a fixed return of 6 per cent for five years followed by 13 years of 4.5 per cent plus inflation.

A new investment in 5.75-per-cent yielding 14-year bonds for a French retirement-housing company is a further indication of UMR’s interest in infrastructure. Vaquier says UMR will preferably look for 15 to 20-year duration infrastructure investments.

Land and timber are also attracting the attention of UMR as possible new asset classes. Global population strains should see agricultural land return close to inflation, Vaquier reckons and, while he is confident in the fund’s existing bond portfolio, he concedes that reduced yields are making debt less attractive than in the past and forcing a search for increased diversification.

Basel III, liabilities and the future

UMR will be a satisfied investor if its strategy can continue the gains from 2012. In addition to the overperforming equity portfolio, bond investments returned 5.7 per cent on the year with real-estate returns also likely to be above 5 per cent when results for the year are finalised.

Vaquier has been one of the most vocal European investment figures in his warnings of a lingering danger on the horizon, however. The European Commission is making plans to revise the directive governing European pensions that could place a solvency premium on holding high-yielding bonds, equities and other “risky” asset classes. Vaquier says the plans as they have been presented could kill the European economy. “Banks can’t invest in the European economy because of Basel III, so who else is going to invest when states don’t have the money?”

Such is Vaquier’s anger at the proposals that he does not want to be drawn into discussing how they might shape UMR’s investment mix. “We have always said that there will be no impact as our investment strategy is based on our members’ liabilities, full stop, and if we follow regulations we would have to reduce their benefits,” he says defiantly.

Vaquier would prefer regulation to force pension funds to gear their investments towards their liabilities, rather than questions of solvency. UMR takes a typically engaged approach in the matter of how its investment strategy becomes shaped by liability calculations, deploying software to constantly monitor the liabilities owed to its 400,000 members. Changes to liabilities through longevity increases or other factors are then brought into the investment decisions on an annual basis.

While environmental, social and governance factors may be all the rage in investment strategies, the right tools to measure results of their implementation would make tangible what skeptics might think are the emperor’s new clothes.

Cue researchers Zoltán Nagy, Doug Cogan and Dan Sinnreich from MSCI with their December 2012 paper, Optimizing ESG Risk Factors in Portfolio Construction.

The trio of researchers analyse the effect of ESG ratings on portfolio performance from February 2007 to June 2012. Using MSCI’s World Index as a performance benchmark and asset universe for the optimised portfolios, they also employ the Barra Global Equity Model to build and analyse three families of optimised ESG-tilting strategies.

While the study’s design was initially an enhanced indexing exercise, the researchers also found three possible strategies that can raise ESG ratings and improve active returns. Read on to discover whether ESG factors remain in the world of the fable or bring fabulous returns.

 

 

The findings from the first review of the Finnish pension system, commissioned by the Finnish Centre for Pensions, were handed down by Nicholas Barr from the London School of Economics and Keith Ambachtsheer from the Rotman International Centre for Pension Management last month.

Although Helsinki in January is far from a party Ambachtsheer and Barr reached celebrity status in presenting the findings, with their photos on the front page of the newspaper and more than 250 people showing up for a workshop.

The purpose of the evaluation was to get a forward-looking external view of the Finnish pension system from an international perspective, and to specifically get recommendations on improvement.

According to Ambachtsheer and Barr the Finnish pension system is comprehensive and robust. However, the population structure and an increasingly global economy call for further development of the system. Retirement needs to be postponed, and pension asset investments need to seek higher returns.

The first recommendation relates directly to efficiency and cost, and Ambachtsheer is of the opinion that larger pension providers, or stronger co-operation between providers, would facilitate a drop in administrative and investment costs.

 

Value creation

The system costs about €1.1 billion a year to operate, (with total benefit administration of about €440 million) which is roughly €107 per member and is significantly higher than the average €60 per member of an international peer group assessed by CEM Benchmarking.

However it is worth pointing out that the pension administration costs cover both pension pillar one, the universal old age pension, and pillar two, employment based pensions. This is unusual compared to other countries.

Nevertheless, Ambachtsheer says that a value creation/cost reduction target of €400 million a year is not out of the question.

Further he says if €150 billion in Finnish pension assets were moved into long-horizon return-seeking investment strategies there is a potential €1.5 billion a year incremental return potential.

These two actions combined are equivalent to a potential 1 per cent gain in Finland’s GDP, the report says.

About a third of the system’s assets are invested in Finland, and Ambachtsheer says the system, and its beneficiaries, would benefit from being more global.

One way to do this is to be more cooperative with other funds around the world and syndicate investments.

“They need to think about Finland’s funds as part of a cooperative of international funds that invest all over the world,” he says.

Interestingly the Finnish pension organisations outsource a significantly smaller proportion of asset management than their international peers – around 35 per cent, compared with an average 88 per cent in the CEM database.

The report also found that the Finnish pension organisations currently spend less money on the internal investment oversight function than their international peers, and also have lower levels of compensation of senior pension executives.

 

What makes a sustainable system?

More broadly Ambachtsheer believes there are three tenets to a sustainable pension system.

The first is that you need as many instruments as there are goals. So for example affordability and payment certainty are two goals and so need two instruments.

Secondly, is what he calls the John Nash principle. (Nash is the Nobel Prize winning mathematician who was the subject of the movie “A Beautiful Mind”. He specialises in game theory). Ambachtsheer says that a situation has to be win/win all of the time, even in the bad times, which means if situation changes the solutions need to be dynamic.

And the third aspect is borrowed from Einstein, keep things as simple as possible but no simpler.

With regards to the pension industry, Ambachtsheer says there is a tendency to add a layer of complexity to solve the problems.

In the South African city of Pretoria, 50km outside Johannesburg, the sense of history is pervasive. The city was the capital of the apartheid regime and the site of Nelson Mandela’s presidential inauguration. It’s also home to Africa’s biggest asset manager the R1.17 trillion ($0.12 trillion) Public Investment Corporation, a state-owned body founded in 1911 which invests on behalf of the country’s biggest pension fund the Government Employees Pension Fund (GEPF), a defined benefit fund underwritten by the government. Fittingly, the PIC is also making history with the biggest shake-up in its investment strategy since it was founded 100 years ago. After a century of confining investment within South Africa it has begun a foray offshore in search of bigger returns in the wider continent and outside Africa altogether.

“I believe we are entering our golden age,” enthuses 49-year old chief executive, Elias Masilela, a trained economist who joined the PIC from private sector insurer Sanlam where he was head of pension policy, and whose youth and responsibility at the helm speak of the new South Africa.

“We’re venturing outside South Africa opening up to new challenges and expectations.”

GEPF’s mandate allows the PIC to allocate 10 per cent of its assets outside South Africa, split between a 5 per cent allocation to other African economies and a 5 per cent global portion outside the continent.

So far the PIC has only placed 1 per cent of its African allocation. Masilela says they are “still exploring” the best options in an investment strategy that aims to capture Africa’s economic growth and emerging middle class. It will be managed in-house with the PIC “going it alone” building its own, specialist African team. It has snapped up a $250 million, 20 per cent stake in Africa’s biggest banking group EcoBank in an “investment that optimizes our footprint across the continent in one fail swoop” and also made a private equity investment into an expanding Tanzanian cement group, Simba Cement.

Given the lack of liquidity in many sub-Saharan markets much of the investment will be via private equity.

“We won’t prioritise or rank countries though – we’ll invest according to opportunities that avail themselves,” he says.

The PIC has outsourced management of its 5 per cent global allocation in passive equity and bond mandates. It tends to manage most assets itself with an in-house team of 80 but does use private sector managers where needed. Masilela says this global allocation will switch to active management; then his team will “start to have more involvement.”

 

Africa calling

Although the PIC’s off-shore incursion is still tentative, Masilela believes the GEPF will ultimately portion much more Africa’s way.

“I believe there is at least another 20 per cent to go – the ceiling will be relaxed if we do well.”

South Africa’s Regulation 28 of the Pension Funds Act governs funds’ asset allocation, stipulating that funds can’t invest more than 25 per cent of their assets outside South Africa. “Although it does use Section 28 as a reference point, GEPF is not bound by the same regulation,” he says. South Africa still uses exchange controls to stem capital flight but Masilela is adamant the PIC, which targets returns of 3 per cent above inflation in rand terms, would struggle to grow more confined to South Africa “You need to go outside for returns; it’s one of the reasons to go offshore.”  .

It’s a point underscored by the PIC’s dominance across South Africa’s investment landscape. Its assets comprise a 50 per cent allocation to listed South African equities, a weighting that accounts for 13 per cent of the capitalisation of the Johannesburg Stock Exchange. The inability to invest elsewhere left the fund limited in its ability to shelter from the global downturn that buffeted South African stocks.

“South African companies have seen their trade and exports hit; imported inflation and the general slowdown in economic activity have been a problem. We’re not isolated from the rest of the world.”

 

Internal management

Around 75 per cent of the equity portfolio is managed internally on a passive basis allowing “significant savings” in management fees. In keeping with its hybrid structure the remainder is externally managed in active mandates by local asset managers.

“External mangers are important for us in generating alpha. Internally it’s just beta,” says Masilela. “We’ve found that over time the cost of asset management is high compared to in-house management yet the returns are comparable. Externally managed funds don’t deliver as well as we want them to.”

It’s this “low-cost operation” that he believes makes it unlikely the PIC will be challenged by private asset managers bidding to run GEPF assets, or the other public sector funds it invests. The GEPF accounts for 90 per cent of PIC assets with the balance made up from other South African funds like the Unemployment Insurance Fund and the Guardian Fund.

A 30 per cent allocation to the local debt market includes government bonds, state-owned companies and corporate entities, all managed in-house. It’s an allocation that has shrunk back in recent years with a shift to diversify and not just “fund the government deficit.” The PIC uses the All Bond Index (ALBI) and the STeFI (short-term fixed interest) index to benchmark performance. “Our goal is to outperform these indices and we always have.”

A 5 per cent property allocation is managed through spin-off PIC Properties and spread across diversified assets from commercial office, retail and industrial space to low-income housing. In some cases the properties are held on GEPF’s balance sheet, others are owned indirectly with GEPF a shareholder in unlisted property companies. It also partners with other private sector entities, including black empowerment developers, the South African government’s initiative to address the inequalities of apartheid by giving disadvantaged groups economic advantages.

 

Favouring co-investment

The Corporation also has a 5 per cent allocation to Isibaya, its return-seeking fund that seeks a developmental impact. Investments range from R2 million to R2 billion including affordable housing and healthcare, transport initiatives, telecoms and renewable energy, plus lending to small and micro businesses via private equity.

“We tend to co-finance deals and not be the single largest investor. Investments are made either through third-party managed funds, joint ventures or retail intermediaries,” says Masilela who can’t hide his enthusiasm for “the real change” private equity reaps in these areas in a way listed equity investments can’t. “Every rand you spend in a small business generates higher returns in jobs than a big business; it is the key to unemployment.” PIC impact investment also draws others to new asset classes; investment flocking into low-income housing with returns of between 8-10 per cent is a case in point, he says.

Masilela says the philosophy and energy behind Isibaya is pervasive throughout the fund with the entire portfolio considered from an ESG point of view, and investment strategy honed to benefit “workers in their retirement but also in their productive years.” It will be the same principles that guide much of the PIC’s investment in the wider continent where it hopes to use its size and strategic position to find ways to make a difference. “We are a leader in sustainability and won’t compromise or change our standards just because we are operating outside South Africa.”

2012 was a year of battles for European pension funds. An ongoing war was waged against a severe regulatory challenge from the European Commission in the shape of Solvency II-style legislation. Aside from the uncertain struggle of that campaign, major European investors gained plenty of credit from standing up to corporate boards in the “shareholder spring”.

The prolonged offensive against perilous funding states also saw some notable success with pleasing, if not spectacular, returns.

Top1000funds.com spoke to Matti Leppala who, as secretary general of Pensions Europe, is effectively European pension investors’ commander-in-chief, to hear some tales of a momentous year. Pensions Europe is an umbrella organisation of national pension fund associations in 20 European countries.

Beware the IORP!

The threat facing European pension funds from the European Commission’s Pension Directive review remains “very serious” says Leppala. Proposed changes to the Institutions for Occupational Retirement Provision (IORP) directive could lumber pension funds with similar new solvency restrictions as insurers, and place a premium on holding equities and other traditionally “risky” assets.

Leppala criticises the “false sense of security” behind the framework of the review, which assumes that pension funds can boost their solvency by becoming more reliant on government bonds.

While Leppala adds that the days of pension funds in the UK or Netherlands having most of their assets in equity markets are over due to the de-risking of schemes, the proposed IORP directive review threatens an unwelcome jolt to the investing landscape. “We think pension funds should be able to take risk in the long term and provide capital for growth and employment”, says Leppala.

He argues that at a time when banks and insurance companies can’t invest in riskier assets, denying pension funds the right to step into their place would both close the door on a valid investment opportunity and threaten the struggling European economy. A healthy European economy is in turn vital for any investing strategy, he points out.

A final lobbying push is in store over the next few months, with the European Commission set to outline a final proposal for the review in June or July 2013.

What’s wrong with the directive

Leppala regrets that a “political exercise not based on facts” could transform the well-established European institutional investing landscape.

An apparent failure to appreciate the differences in pension markets across Europe or between pension fund models is another point that irks him in the proposals. “It’s a very diverse landscape in the way investments are run and the needs differ wildly between huge Dutch funds and small Irish defined-contribution schemes, for instance,” he says.

The experienced Finn rejects a view, however, that politicians have turned against investors en masse since the crisis. Plenty of support for investors’ priorities can be found in the opposition from the European parliament to the likely nature of the changed IORP directive, as well as a unanimous front against this from British politicians, employer groups and unions.

It remains to be seen whether this support has any impact where it counts – at the European Commission.

Leppala sees some positive political influence away from the IORP debate, with attempts by governments to encourage pension funds to invest in long-term projects, such as the UK’s infrastructure fund that began to take shape in 2012.

The short-term attraction of European governments struggling with sovereign debt to pension-capital concerns remains an additional threat to investors across the continent, explains Leppala. The nationalisation of Hungarian pension funds and redirecting of pension capital from investors to the state in Poland, Slovakia and Ireland are all cited as instances of this.

Pensions Europe’s Brussels secretariat is undoubtedly a great location to check the pulse of efforts to revive Europe’s debt-laden peripheral sovereign debt issuers.

A return to some normality in bond yields towards the end of 2012 has of course relieved many investors faced with difficult choices on their holdings of troubled high-yield bonds and low-yielding core bonds.

The possibility of a further calming of the European sovereign-debt waters in 2013 opens the door for pension funds to profit from their government bond holdings, while playing a positive part as investors in the healing process, says Leppala.

Shareholder spring and renewed market health

Leppala perceives 2012’s “shareholder spring” as a definite sign that Europe’s institutional investors are beginning to throw their weight around as shareholders. A number of companies in Europe and the US saw their executive pay plans rejected by institutional investor-led shareholder rebellions, while heads rolled at the top of other firms. He sees major pension funds in the Netherlands, Scandinavia and the UK as driving forces behind European investors’ new taste for shareholder activism, and also cited the UK’s Stewardship Code and the participation of European investors in US class-action suits as underlying signs of a shareholder awakening.

In Europe, he stresses that “many countries are very undeveloped” on shareholder activism, particularly in countries without very large investors lead the way. Being a large investor brings increased public scrutiny along with capabilities for activism, Leppala says.

Differences in the definition of investors’ fiduciary duty explain why many European investors still appear to take a back seat on activism, compared to their North American or Australian counterparts, Leppala reckons.

A healthy year for European equity markets has relieved the pressure on several pension funds that had faced funding difficulties in the aftermath of the financial crisis. “I think there is a breathing space now, there is confidence, which is very good,” said Leppala. He spoke on the same day that the Austrian pension fund association, one of Pensions Europe’s member groups, revealed that the country’s funds returned 8.39 per cent on average in 2012, as opposed to minus 3 per cent in 2011.