The new chairman of EDHEC-Risk Institute’s international advisory board, chief investment strategist at Swedish pension fund AP2, Tomas Franzen, says institutional investors should embrace academia and be open to applying research in the implementation of practical portfolio construction.

He says that while investing is part art and part science, it is important to employ science as much as possible and have a scientific approach as part of the investment process.

“EDHEC is a nice bridge between a scientific approach and practitioners’ needs and methods for implementation in practical portfolio construction,” he says.

EDHEC was born around the same time as AP2 and Franzen says it has made a relevant contribution to his work at the fund.

In particular one of the areas of focus that institutional investors have employed is the academic work on more efficient indices and benchmarking of equities portfolios.

“We’ve been doing this in various forms at AP2 for years,” he says.

In addition, some of the research on hedge funds, in particular style attribution in portfolios, has been applied by AP2, which has been building portfolios around systematic risk premium.

“This is a huge research area and another example of the relevance,” he says. “This is about a scientific approach and dealing with the issues in a way that makes them relevant.”

He also said asset liability modelling has been a focus of EDHEC that is applicable for some investors.

Harnessing long-term investment policy

The 42-member advisory board at EDHEC-Risk Institute that Franzen now chairs is made up of investors and asset managers from around the world. Its purpose is to help the institute assess research projects for practical purposes; to evaluate research outcomes in regard to their potential impact on industry practices.

“It is important to stimulate thinking differently,” he says. “It’s easy to fall into old tracks.”

As chief strategist at AP2, Franzen says his daily duty is to think and harness investment policy as a long-term investor.

His interest is in investment policy design and asset allocation, which is also where he believes the long-term results are.

Since the global financial crisis, there has been more attention paid to dynamic asset allocation, and not just long-term strategic and short-term tactical asset allocation.

“When we think of dynamic asset allocation, it’s a question of addressing regularly whether financial risks are priced to reward taking on the risks,” he says. “It is good to have the mental preparedness to see that traditional risk premium may not be at the right price.”

To this end, AP2 has made a couple of dynamic allocations, including doubling a global credit allocation in 2007 and buying, then selling, out of convertible bonds.

Ensuring reward for risk

Franzen thinks of asset allocation in risk terms and believes there is an overemphasis on expected return in modern-day portfolios.

“It is more of risk management to be sure you get rewarded for risk. It is easier to describe than do in practice.”

According to Franzen, rather than concentrating on return, volatility and correlation, for example, valuation levels are more important in assessing equity risk in allocations over the long term.

AP2 has even integrated an investment policy roadmap, which has guided the fund.

Broadly, it allocates 52 per cent to equities, 36 per cent to fixed income and 12 per cent to alternatives.

However, he says the fund is still working towards finding the ultimate diversification. Recently it has expanded into real estate and has increased its allocation to non-traditional property such as timber and agricultural property.

Also increasing allocations to emerging markets, AP2 recently received its Qualified Foreign Institutional Investor licence to operate in China, and is now looking for investment managers to manage a domestic Chinese and Asian portfolio.

The fund has also undertaken some advice on hedge funds, which has translated to investment in more generic strategies, but with the aim of extracting alternative risk premium.

Franzen says the decision was made to gain exposure to alternative risk premium, but not invest in hedge funds per se.

The EDHEC-Risk Institute has branches in Singapore, at the invitation of the Monetary Authority of Singapore, the City of London and Nice, France.

An Australian superannuation fund with A$6.6 billion ($6.9 billion) under management has achieved number-one ranking in a global survey of how the world’s top 1000 retirement funds, insurance companies and sovereign wealth funds are responding to climate risk.

Sydney-based Local Government Super (LGS) has received the top ranking in the inaugural Climate Index of the Asset Owners Disclosure Project (AODP).

The index was built following information requests to the world’s top 1000 asset owners from 63 countries, with around $60 trillion in funds under management. The survey focused on five main categories: transparency, risk management, investment chain alignment, active ownership and low carbon investment.

“We’ve been working steadily to build a sustainable portfolio for over 10 years,” said Peter Lambert, chief executive of LGS.

“The holistic approach, in which LGS seeks to invest in line with environmental, social and government principles across all asset classes, not just a few that might be considered easier, is what sets us apart.”

Around $3.46 billion, or just over half, of the LGS portfolio is held in responsible investment strategies across Australian and international equities, property, absolute return, private equity and sovereign bonds.

Australian funds made up six of the top 10 funds. South Africa’s AAA-rated Government Employees Pension Fund, which has calculated its exposure to fossil fuel reserves through the balance sheets of investee companies, was ranked second.

Also in the top 10 were Dutch funds PFZW and APG Group, along with Canada’s British Columbia Investment Corporation.

Overall, the creators of the index sounded a warning, with AODP chair John Hewson saying that despite signs of progress, the index “paints a disturbing picture of greenwash and reckless mismanagement”.

Julian Poulter, executive director of AODP, said the index showed that many funds had their “heads in the sand” on climate change and there was a “crisis of transparency” with 91 funds having “absolutely no public information available” on their climate strategies.

In a policy to galvanise pension fund assets to help boost its ailing economy, the UK government wants funds to invest in small and medium-sized businesses. As part of its Business Finance Partnership (BFP), it has named four asset managers to run specialist funds backed by pooled government and private capital. The funds will invest in businesses that struggle to borrow from cash-strapped banks. Chancellor George Osborne announced in his pre-budget Autumn Statement an initial government tranche of £600 million ($962 million) to the scheme that will be matched by $1.04 billion from the private sector.

The nominated fund managers are M&G Investment Management, Alcentra, Haymarket Financial and Pricoa Capital, with an additional $160 million expected to be invested with a fifth fund manger in early 2013. The loans will be made to companies with turnovers of between $40 million and $800 million and promise returns of between 3 to 6 per cent above LIBOR; tenors will be between five to 10 years.

Who’s in?

Trustees have greeted the announcement with interest. Local authority schemes are expected to be the keenest investors since many have delved into the asset class before. M&G says local authority schemes were anchor investors in its first Companies Financing Fund, launched in 2009. This fund has lent around $1.49 billion to larger UK companies including power station operators Drax, logistics group Stobart and housebuilders Taylor Wimpey and Barratt Developments. M&G is matching the government’s $320-million seed funding with $400 million of its own capital, at this stage sourced from its parent group, financial services giant Prudential. “We hope to start lending through the new fund early in 2013. Each company will be assessed for suitability for the fund on a case-by-case basis,” says David Butcher, a spokesperson at M&G. “The fund is designed to offer absolute returns with high levels of security allowing clients to gain a diversified portfolio of companies.”

Investors will benefit from a cash return of around 8 per cent from day one on the interest charged, says Graeme Delaney-Smith at fund manager Alcentra, part of Bank of New York Mellon. Alcentra has matched the government’s $160 million investment in its fund, and expects pension funds to account for up to 70 per cent of its final investor mix. “Pension schemes have liabilities to meet – this cash yield is very attractive because they can use it to pay their pensions.” Once the fund is up and running, distributions will be quarterly and Alcentra will charge fees on a drawn capital basis rather than on a commitment basis.

More details, please

However, some trustees want more detail before increasing their exposure to an asset class abandoned by UK banks. “SAUL already invests in two global funds that provide finance to companies unable to access funding from the normal banking system,” says Penny Green, chief executive of the $2.4-billion SAUL fund, the Superannuation Scheme for the University of London. “We have found that it is an interesting asset class and a useful source of returns. The issue is whether the BFP will be able to put in credit analysis that reduces the risk of non-performing loans being included in the portfolio.”

The effects of “smoothing”

Other aspects of the Autumn Statement will also affect pension funds’ investment strategies through 2013. The government says it will review the way companies measure the financial health of their pension pots, potentially leading to sponsors having to contribute less to their schemes. The move comes in the wake of lobbying from the industry for the so-called “smoothing” of assets and liabilities since liabilities have sky-rocketed because of record low government bond yields. One outcome of any smoothing could be a tumble in demand for the long-dated gilts that funds have been forced to buy to cover their liabilities. “Contribution uncertainty drives many investment decisions at the moment so more certainty could mean funds grow more inclined to take investment risk,” said Schroders’ Jonathan Smith.

In another development, schemes will also have access to longer dated gilts next year with gilt issuance in the 50 to 60-year range from 2013. Investor enthusiasm may only be lukewarm however. “I can’t see these longer dated gilts being attractive,” says Cass Business School’s professor David Blake, who argues funds won’t want to lock into today’s low rates of interest. “The industry wants long-term asset to match its liabilities but they’ll want interest rates at a normal level before they show any interest in this. It’s a good idea but bad timing.”

In reading the superb editorial that backgrounds the naming of Barrack Obama as Time magazine’s Person of the Year for 2012, it is clear one of the reasons he was chosen was his ability to embrace change. In particular he shows leadership of the new America, namely people under 30, Hispanics and African Americans.

Adapting to change is an essential part of leadership. Adapting to continued upheaval and uncertainty is a hallmark of the truly successful leader in the pension industry.

Even the largest and most successful pension funds globally are not immune to these fundamental leadership challenges and with great interest I watch the appointment of Carsten Stendevad, currently managing director and chief of the financial strategy group at Citigroup in New York, as the new chief executive of ATP.

The Danish fund ATP is considered by many to be the best fund in the world.

It is prudently managed, with meeting pension objectives the only driver of all decisions, and boasts that its business model can deal with interest rates of 1 per cent or 20 per cent.

Lars Rohde, chief executive of ATP for 14 years, is respected by many, both within and outside the organisation. His appointment, which was rumoured to be more of an official crowning, as the new Danish central bank governor, has been widely viewed as a coup for Denmark as a nation. But it leaves a big hole at the top of ATP, which has a complex and unique structure and style, reflected and formed by its leader.

Today’s leaders face unique challenges, and the new chief executive of ATP arguably faces a different leadership proposition than Rhode did when he took up the reins in 1998.

Adapting to change

In an article in the June 2012 McKinsey Quarterly, the results of global research that sought to understand the leadership challenge “in a volatile, globalised, hyperconnected age” by conducting interviews with leaders of some of the world’s largest organisations found some common themes with regard to this challenge. These include what it means to lead in an age of upheaval, to master personal challenges, to be in the limelight continually and to make decisions under extreme pressure.

“Today’s leaders face extraordinary new challenges and must learn to think differently about their role and how to fulfil it. Those who do may have an opportunity to change the world in ways their predecessors never imagined.”

In his current position, Stendevad advises corporations and sovereigns throughout the world on a broad range of corporate finance issues such as valuation, acquisition strategies, capital structure and financing strategies.

This global perspective was important to the board of ATP, with its chairman Jørgen Søndergaard saying it was essential to find a new CEO who could lead the fund from its current strong platform and take it to the next level.

“In many ways, Carsten Stendevad is the natural heir to Lars Rohde, who has done a fantastic job at ATP,” he says. “With his extensive professional knowledge, network and global vision, Carsten Stendevad can help bring ATP even more into play in a global context and ensure that ATP’s decisions are to an even greater extent based on international trends and developments – all while ensuring basic financial security for Danish pensioners, also in the future.”

However if, as Obama has proven, adaptability is a condition of leadership success, then Stendevad is well positioned. While he was born a Dane, he grew up in Belgium, and has worked in Mumbai and New York for Citigroup for the past 10 years. He speaks Danish, French, German and Hindi.

“Carsten Stendevad is a candid and thoughtful person; he has great respect for people, he listens and he is open to other people’s views. He has strong analytical skills and is an extremely convincing communicator who has the ability to set the direction and lead the way – and to motivate and inspire people around him. He has a very inclusive leadership style; he creates results with and through other people,” he says.

But probably most extraordinarily, and possibly most importantly to his leadership success, is that Stendevad is only 39, an age when innovation is still an instinct.

Last month conexust1f.flywheelstaging.com hosted a thinktank with a group of influential Australian investors to discuss the opportunities in European distressed debt. Participants included the Australian Government’s $80 billion sovereign wealth Future Fund, the $68 billion QIC, and leading asset consultants, with guest speaker sir David Cooksey, former board member of the Bank of England, chairman of the UK Audit Commission and chairman of UK Financial Investments.

 

While the continued critical political, social and economic circumstances in Europe are top of mind for many investors around the world, the Australian investors and asset consultants at the roundtable were divided on the issue. For some the confronting discombobulation is too risky, for others the volatility presents an investment opportunity.

Politics is dominating Europe and so it should. A united Europe, and the euro, is a political construction, not an economic one, and that fundamental structure underpins the risks and opportunities in Europe. However, the situation is far from stagnant and every day new agreements, laws and regulations shift the investment environment, causing many investors to keep a close eye on the assets in the region.

European distressed debt is an opportunity for sophisticated institutional investors who are able allocate opportunistically, but cautiously.

Sir David Cooksey, former board member of the Bank of England, chairman of the UK Audit Commission and chairman of UK Financial Investments. says the huge political desire to keep Europe together has resulted in the European Central Bank slowly being provided with more power.

“At the meeting of the heads of state of the European Union last month it was agreed to have banking union, which will mean that the European Central Bank is the regulator and bank of last resort for all 6000 banks in the eurozone. So, you are going to see an enormous institution being formed,” he says.

“Also, in principle, the countries of the eurozone have agreed to fiscal union, which means that there will be a single authority for tax and spend across Europe.” Change is afoot.

 

Airing the balance sheets

Cooksey says there are a number of forces working in unison that are creating a mismatch between demand and supply of debt opportunities across Europe.

There is a very different culture in banking across Europe from country to country and very different legal structures for dealing with default or insolvency, with Britain being the most US-like.

In addition, the International Financial Reporting Standard, which requires assets to be marked to market, has been adopted in the UK and is slowly being adopted in Northern Europe.

Furthermore, the requirements of Basel III are fundamental as a driver, which essentially requires more regulatory capital as well as risk weighting of assets to be applied.

“The adoption of risk weighting is going to mean that the banks are going to push very hard to get the higher risk-weighted assets off their balance sheets,” Cooksey says, adding that the size of the issue is “quite enormous”, estimated to be around €2.5 trillion. Some of the assets will be written off and some will be worked out but – either way – it is quite an opportunity.

“It won’t all be defaulted debt but there will be a large amount of defaulted debt there, and it won’t come out into the market in a single rush – countries all move at different paces – but it is going to happen in the next five to eight years.”

“If you are in the position of SVP, it is sensible to go to the highest risk-weighted assets because they’re the ones that the banks really want to get rid of. The truth is you haven’t heard a lot about actual transactions because the banks don’t want to disclose the write-offs they’ve taken.”

 

Democracy and the paymaster

John Brumby says he can see that increased powers of the ECB will help resolve the fundamental imbalances in the banking system in Europe, but that a fiscal union with a fiscal transfer is essential to grow the economies of Europe.

“As I see it, in the medium and longer term, if you want a distressed asset now to become a valuable asset in the future, then Europe needs to continue growing and the key to that is the fiscal union,” he says.

Cooksey says that Jean-Claude Juncker, head of finance ministers in Europe, was right in his comments: “Juncker happens to be premier of Luxembourg but he’s head of the finance ministers as well, and has said ‘we all know what to do but the only problem is we can’t get re-elected if we do it’. I think there’s gradually a realisation emerging in Europe that austerity on its own isn’t going to work. I mean you can’t move an economy from failure to success if you’re shrinking the economy the whole time. I think this is the fundamental point worth making.”

Cooksey says Germany is driving, and will be largely responsible, for the fiscal changes that are necessary. “They know they are going to have to be the paymasters. The German banking system has always been very strictly regulated compared with the rest of Europe and as a result, on the whole German banks didn’t get caught as badly as some of the others in Europe,” he says.

“The truth is the weaker countries can’t afford to rescue their banking systems.”

An example of how pervasive the problem is in Europe took place in the past two weeks when banking giants Deutsche and UBS both announced bad banks of €250 billion and €325 billion, respectively.

 

The largest economy in the world is not going anywhere

Steve McGuiness, formerly of Goldman Sachs, says there are a lot of sales going on in Europe.

“We are monitoring or in discussion or watching approximately 235 names and the total value of those credits or corporate debt situations is $380 billion. A lot of these we probably won’t go near, but a lot are very solid from old-line industries and are very key to life and business in Europe. So, the thing is you have to pick the spots and be choosy about it because business will go on. There is a lot more to come,” he says.

His colleague at SVP, Jean Louis Lelogeais, agrees.

“Europe is the largest economy in the world, it’s not going anywhere. But you cannot plough through Europe; it’s almost sifting through a bunch of stuff and saying no to most things.”

 

Go and fish somewhere else

However, investors have mixed opinions when it comes to assessing the distressed debt opportunities across Europe.

David Neal says the fundamental problem in deciding to invest in Europe, particularly as a long-term investor, is the uncertainty around the political decisions that need to be made.

“There may be things that look like good value opportunities, but why would you invest if you can’t predict the result? There are such massive changes that could go in either direction. Why would you not just go and fish somewhere else? There are other investments to make. With something that’s so unpredictable, why wouldn’t you just minimise your gross exposure to Europe?” he asks.

 

The price is right but is the place?

Cooksey believes that those risks have been priced into the assets, and he also highlights the importance of geographical discretion in choosing investments in Europe.

“The pricing of the deals reflects this uncertainty to a great extent, therefore there is more opportunity on the upside if you get it right. It is also pretty clear which countries are going to be in trouble, those that are levering themselves out of the downturn. I think that if you restrict your area of investment to certain countries in Europe, then you’re taking advantage of the uncertainty in terms of better pricing, and also riding on the back of what will be expansion of these countries as they emerge from economic distress.”

One of the reasons for geographic disparity in distressed debt opportunities is the very different culture in banking across European countries. There are also broadly variant legal structures for dealing with default or insolvency.

“There are signs that Northern Europe is taking its medicine and is beginning to move forward. Quite frankly, in the distressed debt market that is the area that I think there are opportunities. I wouldn’t invest in Spanish real estate, even at 10 cents in the dollar, because you don’t know if you’ve chosen the right asset or not, and the legal framework for unscrambling insolvency is very imprecise at the moment. But that will come, and I think you’ll find that the governments of Europe do see that they’ve got to inject funding because it is necessary to get growth back into their economies,” Cooksey says.

 

Caution: keep talking

VFMC is also cautious, with Justin Pascoe emphasising the importance of looking at distressed opportunities globally. However, he sees the merit of being invested as it allows for access to different types of conversation and allocates as part of an opportunistic bucket.

“Having a toe in the water, I think, is an interesting proposition because it gets you having different conversations with people, rather than looking at it externally and having nice theoretical conversations. If you’re actually involved in the marketplace, it does change the nature of how much time and effort you spend digging in those issues.”

His VFMC colleague, Paul Murray, is feeling the fallout of 2008 and is worried about a potential catastrophe because the banks can’t process what needs to happen.

But Cooksey says the regulatory capital situation is much different to 2008, with banks today holding up to four times the amount of capital compared to their total assets then.

“So the cushion is much better than it was then,” he says.

At its most recent board meeting Hostplus approved investment in direct lending, but Sam Sicilia says the fund is unlikely to go into distressed debt because of regulatory and political uncertainty.

“One of the reasons we chose direct lending rather than distressed debt is that the companies can be distressed because their lender is distressed. When the world is running perfectly fine, the investment matrix dominates. But when you’re in the kind of situation the world’s in at the moment, in particular continental Europe, there are non-investment considerations that could make the investment case evaporate,” he says.

 

Case by case

Lelogeais says this is a view that resonates in other parts of the world, with European investors cautious of the risks. However, he says many sophisticated investors in Europe are investing and SVP has a $500-million mandate from a Dutch fund to invest in European distressed debt.

QIC is also an investor and Adriaan Ryder says the opportunities are an asset-by-asset approach.

“Volatility gives rise to investment opportunities, that’s the great advantage of investments,” he says. “Because of the macro risk associated with this, the opportunities are all bottom-up, and it is going to be asset-by-asset, and it doesn’t matter if the debt is in distressed real estate or distressed infrastructure. The investment opportunities will be bottom-up and we are going to factor that into the risk/return.”

But Ryder does emphasis the importance of manager selection, and complete transparency, in investing in distressed opportunities.

“We won’t deploy money unless we’ve got confidence in the execution and it is done in a measured way. There’s a lot of debt-laden stuff out there and at some point in time they could turn into great opportunities, but you need patience,” he says.

 

Flexibility and caution

The Future Fund’s Neal has certain expectations of how managers should work with the fund and advocates flexibility.

“You’re not entirely sure where the best opportunities are going to come from, but clearly there are these big pressures and you’d expect something to occur. You need the ability to be as flexible as possible, which means probably not being that enamoured with very narrowly defined strategies,” he says. “Larger funds are going to be pushing for more flexibility and more control when and if the capital gets deployed, which means mandates and the ability to turn the tap off. Those are the types of conversations we are having, and we are finding them quite difficult because there aren’t very many managers who have shifted to that type of mindset where they’re prepared to be more flexible with capital. But that is what we’re looking for and trying to push for in such a dynamic.”

Lelogeais agrees and says other sophisticated investors, including Canadian funds, have similar expectations.

Other roundtable participants, particularly the consultants Allison Hill and Graeme Miller, were cautious about investing in distressed debt.

“There’s an extraordinary amount of opacity around the issue in terms of how best you might want to invest,” Hill says.

Similarly, while Telstra Super has some distressed allocations, Kate Misic says “we’re worried on almost every level”, but there is a continuous conversation about the opportunity set.

Miller says Towers Watson has recommended investments in lower hanging fruit in the debt sector, but they may be drying up.

“Institutional investors have actually done very well by investing in garden-variety credit over the last 18 months or so. This is much less complex and has much fewer risks. But I think the reality is that a lot of those opportunities have now dried up.”

 

 

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