For many people their most memorable in situ news moment is when man landed on the moon or when John Lennon, Princess Diana or Michael Jackson died. But most Italians will remember where they were when Pope Benedict XVI resigned. A country with record unemployment, no head of state and no head of the church was an interesting location to host a corporate governance conference where issues of leadership and strategy are key.

But politics and religion aside, 280 delegates made up of asset owners, managers, corporates and proxy voting firms from around the globe convened in Milan to attend the International Corporate Governance Network event, to discuss the relationship between investors and corporations, and how to promote best practice in corporate behaviour.

The conference, hosted by Borsa Italiana, centred around the topics front of mind for investors with regard to corporate governance: remuneration, proxy voting and gender diversity on boards.

There was much discussion of the role of regulation and legislation in regard to corporate governance and Ugo Bassi, director general of internal market and services at the European Commission, says in its work on corporate governance the commission will focus on transparency but will not have prescriptive rules.

“A lot can be done through the information a company provides to an investor and vice versa,” he says.

Not surprisingly, long termism was also a key theme and how to counter the short termism in “incentive structures and thinking that is undermining capitalism”.

Bassi says that shareholder engagement is not an objective of the European Commission as such, rather it aims to create the conditions for improvement of shareholder engagement.

“We will fight short termism,” he says. “You can’t oblige a shareholder to engage but when they are willing, we want them to do it easily.”

There is scope for European legislation directing asset owners who issue mandates to service providers in Europe to say that they have “thought through” what they want their asset managers to engage with companies on, ICGN conference delegates heard.

Peter Montagnon, senior investment adviser of corporate governance at the UK Financial Reporting Council, says there needs to be improvement on the integration of investor engagement with corporate governance and corporate decision-making. He says the stewardship code is a vehicle for empowering asset owners to tell their managers what to focus on with regard to corporate governance, but there was scope for European legislation to this effect.

Montagnon was part of a panel discussing whether there is a “return on engagement”.

“Investors need good long-term sustainable returns and there is a better chance of doing that if you engage,” he says. However he did point out the reputation of institutional investors with regard to engagement was hindered by the recent vote in favour by investors of the Royal Bank of Scotland’s takeover of ABN Amro.

Speaking from the floor, chairman of GMI Ratings, Rick Bennett, asked whether the question of a return on engagement should be more on the expense side rather than return side. “The question is not whether there is a return on engagement, but is it a sufficient return for those doing the engagement? The question should be on the expense side, who’s paying for it? The return goes to everyone, so there is a free rider problem.”

Montagnon says this was an excuse that asset managers use and that it “makes me upset”.

“Your duty is to act in your clients’ interest and if that costs you then that’s part of it. Managers spend a fortune on dealing commissions without ever questioning it. When asset owners issue mandates, maybe they should outline how much they are willing to spend on dealing commissions and some of that money could go to corporate engagement.”

Montagnon says generally there is an overemphasis on executive remuneration with regard to corporate governance issues and there should be more time spent on issues of strategy, audit committees and risk.

“Stewardship is not about big rows about remuneration. It’s a pity the focus is so strongly on remuneration. You don’t get good long-term quality relationships with a company if all you talk about is remuneration,” he says.

Neither is stewardship about ESG, according to Montagnon.

“Stewardship is not about opening a door to a social policy. ESG is important but the primary purpose of stewardship is to get a deeper understanding with and between companies about risk management and decision-making, and a relationship with board and management,” he says. “We have loss sight of this, with too much emphasis on deal making, trading and short-term profits.”

Asked to vote on the most important engagement issue between companies and investors, 65 per cent of the audience said strategy, 30 per cent said risk management, and 5 per cent said remuneration.

The European Securities and Markets Authority (ESMA) has developed a set of high level principles with the aim of encouraging the proxy voting industry to develop its own code of conduct.

Speaking at the ICGN conference in Milan, the head of the investment and reporting division at ESMA, Laurent Degabriel, said it will set a deadline of two years for a code of conduct to materialise.

The high level principles are:

  • Responsibility for voting lies with the investor
  • Potential conflicts of interest should be dealt with and disclosed
  • The methodology and information behind voting policies should be disclosed
  • Local market conditions should be taken into account in voting advice
  • Investors should be informed of how advice is developed and of any limitations it might have
  • Engagement with issuers should be disclosed.

“It is a new thing for us to come up with a code of conduct, and it is important that it is drafted and owned by the proxy voting industry. We are at the beginning of the process. If after two years the result is dissatisfactory, ESMA can consider a different regulatory approach or the EC may consider taking action,” Degabriel says.

The proxy voting firms participating in the panel, Glass Lewis and ISS, both agreed with concept of a code of conduct. Katherine Rabin, chief executive of Glass Lewis, which is a fully owned subsidiary of the Ontario Teachers Pension Plan, says she was very supportive of developing a code of conduct. “We think it will facilitate a better understanding of the voting process,” she says. “I’m also excited about the prospect that the code will create a platform for other issues, particularly the ‘plumbing’ issues that effect many participants.”

The panel also discussed the misunderstanding of the role of proxy advisers among the wider community, as well as the use of them by investors. Frank Curtiss, head of corporate governance at RPMI Railpen, says the fund uses many advisers, including Glass Lewis and Manifest, as well as Governance for Owners for engagement in Europe and Japan.

Railpen, which has been an active voter of its UK holdings since 1992, also has a voting and engagement alliance with fellow UK asset owner, USS. If the two investors are to vote no or abstain from a vote, they write to the company beforehand to explain why. “We are invested in 2000 stocks around the world, and we have a team of two people on voting and engagement. We have to have a system of filtering and streamlining that, so we turn to external proxy advisors,” he says.

Curtiss says this activity does not bypass its funds managers – all of its assets are managed externally – and it expects its funds managers to do direct engagement.

He says the work of ESMA, and the focus on full transparency is a good thing and a code would be helpful.

For a pension fund that describes itself as “ponderous”, the $154-billion California State Teachers’ Retirement System, CalSTRS, has moved uncharacteristically swiftly in recent months. The second largest public pension fund in the United States, the plan for teachers and faculty is in the process of divesting its holdings in gun manufacturers following the massacre at Sandy Hook Elementary School in Newtown, Conneticut last December. “CalSTRS is a teachers plan, so for our members it hit home that teachers were killed protecting their students,” said general counsel at CalSTRS, Brian Bartow, during a recent webinar hosted by ESG research and ratings provider, MSCI ESG Research. Adding how the tragedy had extra resonance given California’s own stricter gun laws, he said: “Because the weapon used is illegal in the state of California, we asked ourselves should we own this asset?”

CalSTRS’ initial step, instructing private equity firm Cerberus to sell its 2.4-per-cent stake in Freedom Group, the manufacturer of the Bushmaster rifle used at Sandy Hook, happened quickly. “Cerberus decided to sell the asset. They are finding another buyer for their stake in Freedom Group,” says Bartow. Now the fund is in the more complicated process of trawling its entire portfolio, including a 50-per-cent equity allocation and a 14-per-cent private equity allocation, to locate all exposure to gun makers.

As CalSTRS tracks down its different firearm holdings, it is applying a so-called 21 Risk Factor Policy, adopted in 2008, which seeks to flag social and geopolitical concerns regarding investments. “It is not a divestment list as such, but is there to trigger thoughtful evaluation of our investments,” says Philip Larrieu, senior investment officer at CalSTRS. Stress tests include gauging whether a risk factor is “violated over a sustained period of time”, whether the asset causes the fund to lose revenue or the investment “weakens the trust of members”. The divestment process begins with the fund pursuing “active and direct” engagement with the company “to try and bring about change” – a process that soon hit the buffers when gun makers Sturm, Ruger and Company and Smith and Wesson, identified within CalSTRS roster of investments, declined to meet. “We reached out to two groups publicly but no dialogue ensued. Others have answered questions by email,” says Larrieu, adding that shareholder meetings weren’t a viable alternative approach either. “We couldn’t wait for this,” he said. In a final step towards selling off the assets the fund is currently evaluating input from a cohort of managers, advisors and experts, with the ultimate decision to divest taken by the board investment committee, meeting this April. “We are still in the divestment process, gathering all the information the board needs to make an informed decision. The actual divestment comes at the end of this process,” said Larrieu.

Trigger-happy divestors

CalSTRS’s move has encouraged other funds to flex their financial muscles and push the issue of gun control. New York State Common Retirement Fund has frozen its holdings in firearms makers and the $254-billion CalPERS, the biggest pension fund in the US, has approved divestment of assault weapon makers in its portfolio. Client requests for ESG and screens relating to firearms manufacturers and retailers have also spiked. “We have seen a surge in interest from clients post-Newtown,” says Christopher McKnett, vice president and head of ESG at State Street Global Advisors.

In other examples, New York City, Chicago (where Mayor Rahm Emanuel is urging all city plans to divest from firearms makers), Philadelphia and Los Angeles are all conducting divestment reviews. Funds aren’t just targeting the US firearms industry either. “We’re evaluating foreign companies and have told our managers that we can’t purchase these securities either,” says Larrieu.

Fixing the sights

But defining the firearms sector and gauging where to draw the line on a spectrum that ranges from ammunition manufacturers and retailers to unpicking complicated corporate structures is challenging. “Some clients have their own internal capacity to decide their investment universe or they will rely on managers to provide the information,” said McKnett. Screening out firearms manufacturers in actively managed equity funds also means having to find returns elsewhere. “Active funds are already using screens to select stocks. If you exclude a favoured investment the challenge is replacing that alpha,” he said, adding: “If an active portfolio has an exclusion, we don’t adjust the return budget.”

That said, firearms companies aren’t significant equity weights, with only three firearms companies carrying a market capitalisation above $3 billion. Fewer than half of the 20-odd publicly traded companies worldwide that manufacture firearms and ammunition are large enough to be included in commonly held indices. Total portfolio exposure of firearms companies in the main indices is typically well below 0.50 per cent on a market-capitalisation-weighted basis, according to MSCI. Similarly, most firearms groups issuing bonds would be too small to be captured in fixed income index, Barclays Capital Aggregate Bond Index. However, if funds choose to screen out retailers it will have a bigger impact on the portfolio, explains McKnett. Gun retailers, like supermarket giant Walmart, the largest gun retailer by virtue of its size, can be much larger. The retailers tracked by MSCI say firearms sales account for less than 15 per cent of their total sales – Walmart says less than 1 per cent of its sales come from firearms.

It’s too early to measure the impact of screening out some, or all, of these groups on portfolio performance. But by beginning a divestment process, big institutional investors have made gun control a campaign that could sit alongside the likes of apartheid, terrorist links or tobacco. “Other issues have carried more advanced warning and we have known about them ahead of time,” said Bartow. “This issue has evolved very rapidly, but it really is something that public pension funds can look at.”

Having a breakfast meeting with Cliff Asness is a wake-up call. He will let you know if you’re late – something he holds in very little regard. He admits he has to constantly remind himself that just because he’s 20 minutes early to everything that others are not automatically then 20 minutes late.

Asness is open, he’s entertaining, even funny. And he also possesses the rare combination, at least in this industry, of intellectual genius and social libertarianism. It’s very engaging and you quickly get the feeling that you’re only scratching the surface of his intellect as he changes from political activist to quantitative mathematician to social philosopher.

Social justice is also good business

Having two sets of twins is an almost perfect justice for a man who revels in the competitive game of statistics – he’s clearly an overachiever. But while he boasts about the competitive achievements particular to quantitative investment managers, his intellectual reach doesn’t stop there. His social and political interests include gay marriage and tax.

“I believe in all forms of small government, not just economic. Gay marriage is something I just believe in,” he says. “I believe in treating people equally under the law, economically and socially. It’s my overall life philosophy.”

He takes this issue of fairness to work with him, and questions the industry in its approach to clients.

“Too many funds charge alpha prices for what is really beta,” he says. “Our firm charges fair fees for strategies that deliver beta-like returns.”

While this is in line with his intellectually honest approach, it’s also good business.

“Acting like this will build a business with more long-term value. You want to be honest with people, they’ll know when you’re being honest and they’ll pay 2:20 when it’s appropriate.”

Asness seems to have an idea every minute or so and is happy to express them.

He believes alpha exists, including some at AQR, but not nearly in the quantity the industry claims, and stresses that to utilise it you don’t just need to believe in it, but find it before the fact and net of fees.

However, he is passionate about the trend being advanced by his firm and others to tailor fees to the risks and rewards of the strategies a client chooses.

“In the active management world a lot of strategies are smart beta, but for a long time have been sold at alpha prices,” he says, using value and momentum as examples. “The good thing is this trend is bringing the veil back, and saying this is what we know and can invest in.”

 Smart, without the beta

And this trend to smart beta, is kind of the industry playing catch-up with some of the ideas AQR has been touting for some time – one of the manager’s ongoing themes is the existence of beta, hedge fund beta, and alpha, and the fees applicable depending on the outcome. He sees it as a client-friendly trend; if something is called a style premium then the fees will be different to an active fee.

Style premiums are increasingly being used as a tilt on beta by many offerings.

AQR has taken this idea and run with it. Its latest offering, that currently just has investments of the partners of the firm, combines the four factors of value, momentum, carry and defensive across seven asset types (industries, stocks, countries, bond markets, currencies, commodities and short term rates), producing a combination of roughly 25 different long-short strategies.

Asness says it’s smart without the beta, a concentrated version of the tilt without the benchmark.

“One of the advantages of quant strategies is you can do many things at the same time,” he says. “It is important to have them all in the one place, if you do each tilt separately it’s not efficient. A single smart beta can’t be as consistent as four smart betas in seven places.”

AQR continues to be innovative, taking the same themes Asness has been talking about for decades and reinventing new products. It will soon launch a long-only version of its quantitative stock selection product, which will have value, momentum and growth tilts.

“We’re doing something traditional, as many investors still need this structure, but our fees will be lower than the long-short ‘smart without the beta’ version,” he says.

From spending time with Asness, you can also assume certain things about the other co-founders of his firm. For instance, AQR could not be the success it is if David Kabiller did not have skills that complement the acute personality and thinking of Asness. Turning ideas into a money-making reality requires a partnership. Asness is one side of that coin.

 

Emerging market investing and sustainable investing easily rank as two of the most substantiated of the many investment trends of the past decade. However, the two styles of investing are far from natural bedfellows. Christian Ragnartz, as chief investment officer of the $17-billion-plus Swedish pension fund AP7 – which has 13 per cent of its equities invested in emerging markets – knows all about the pitfalls. “Environmental, social and governance (ESG) challenges remain huge in some emerging markets as some are very non-transparent,” he says.

As a gauge of the issue, Brazil and South Africa are the best performers in Transparency International’s 2012 Corruption Perception Index from the popular BRICS grouping. They both rank a modest sixty-nineth place, level with Macedonia but behind Lesotho and Romania. That is not to assume that all emerging market companies neglect sustainability norms, that developed market firms are immune from environmental, human rights or governance breaches or indeed that all established markets are better. Italy, for instance, is ranked behind Brazil and South Africa on the 2012 Corruption Perception Index.

So, how can funds continue to persuade a skeptical public of their sustainable investing credentials while taking advantage of the emerging market boom?

Ragnartz concedes that while sustainable investing considerations were a factor AP7 discussed “at some length” when defining its emerging market strategy in 2007, there was not a “huge impact” on its initial investment choices. Part of the reason for this, he says, is that the lack of transparency made it more difficult for AP7’s sustainable investing experts to perform their usual filtering work.

He explains that “the scarcer information and restrictions on press actually made it hard for our consultants that help us screen these markets to objectively verify violations to international norms”. Enough information has been gathered though, Ragnartz adds, to blacklist some emerging market firms.

From little things…

AP7, if not among the emerging market pioneers, was among the first wave of investors interested in the region, shifting exposure from around 2 per cent of equities in 2007 to the 13 per cent today. The dramatic pace of flows of institutional investment into the developing markets certainly shows little sign of relenting. According to a 2012 Mercer survey, the number of European pension funds with emerging market debt allocations increased more than fivefold from 2010 to 2012, making it the most common alternatives asset class among continental European funds.

Enhanced investor interest has helped to focus sustainability experts’ attention on the emerging world. Alka Banerjee, vice president of global equity indices at S&P Dow Jones Indices, says it is simply a case of major investors with large exposures to emerging markets trying to ensure that their portfolios maintain consistent sustainable criteria.

This has created real pressure in the markets, with the largest inflows of investment, says Banerjee, resulting in a “large and concerted push by governments, exchanges and companies to set high standards and try to emulate them”.

According to Mike Lombardo, a sustainability analyst at Calvert Investments, South Africa and Brazil provide examples of practices improving to such an extent that they are models which some of the developed can look up to.

Lombardo, who has spent time exploring corporate disclosure in South Africa for a United States Forum for Sustainable and Responsible Investment (US SIF) project, says that the ESG requirements of the Johannesburg Stock Exchange for listed companies are “world class”, with a new integrated reporting requirement boosting disclosure standards further in 2011. The presence of a burgeoning environmental technology industry in China along with stricter environmental legislation is another development that challenges popular perceptions.

Ragnartz agrees that “the situation is better these days as the emerging markets have matured.”

On the one hand, the tricky task of assessing emerging market firms against sustainability criteria has become easier with the experience gathered at AP7, he says. He echoes Banerjee in adding that the companies have also put more resources to handling these factors due to stakeholder demand.

Approaching disclosure

Despite the progress, those involved in promoting sustainability in emerging markets agree that there is room for improvement in many places. Discrepancies between emerging markets is a frequent concern. Differing attitudes are certainly indicated by the experience of the Carbon Disclosure Project (CDP). It has gained a markedly lower response rate from Russian and Chinese companies than South African firms in its attempt to gauge corporate climate change policies.

Emma Hunt-Jones of Towers Watson says that while transparency, corruption and environmental damage might seem the most pressing emerging market concerns, coming to terms with unfamiliar governance and ownership structures is often a greater investor priority. Emerging market companies with elements of family or state ownership can be a “red alert” for investors, she says. Jessica Robinson of the Association of Sustainable and Responsible Investment in Asia adds that those investing in real estate in the region tend to become cagey on government involvement in projects due to fears of corruption. And, there are investors who have become more trusting of the positive virtues of unfamiliar practices such as family ownership, Hunt-Jones says.

Among all these challenges, investors who are able to be proactive and get the data they need for sustainability in an emerging market gain a distinct advantage, according to Hunt-Jones. Lombardo adds that getting the full picture means investors’ sustainability analysts need to make an honest appraisal of the drawbacks. Understanding the cultural context and weak structural issues in a given market, such as corruption or lax enforcement of the law, is vital, he says.

Going local without turning native

The history of sustainable investing has shown that the largest funds are those most likely to take a lead on policy engagement and most comfortable in divesting from particular countries or sectors, Hunt-Jones points out. For instance, major US retirement funds such as the Kansas Public Employees Retirement System have been instrumental – along with asset managers such as Calvert Investments – in the Conflict Risk Network. This grouping has persuaded companies to avoid indirectly supporting violence in Syria and Sudan.

CalPERS’ policy of blacklisting certain markets in the past has proved more controversial. Hunt-Jones points out though that a decade after it pulled investments from Malaysia, the country is now considered to be one of the stronger emerging markets on sustainability.

Robinson says a choice to exclude certain companies might not have the desired impact: a company omitted due to poor transparency could still have strong sustainable practices.

Whichever way it is formed, sustained engagement in emerging markets is a resource-sapping job for even the biggest institutional investors, with air miles and specialist knowledge usually needed in plentiful quantities.

There are other options, though, for reducing the sustainability risk of emerging market investments that smaller funds might naturally find more appealing. One is looking beyond emerging market equities or bonds to focus on corporations in domestic or established markets with operations in emerging markets or other exposure there. Another is investing in the socially responsible emerging market funds that many asset managers, who might have extensive sustainability screening capabilities, now offer.

AP7 was prepared to take on the ESG risk, says Ragnartz, via its emerging market investments as it made an effort at the same time to boost sustainability screening for these markets. For him, the biggest sustainability concerns have moved away from the established emerging markets onto “frontier markets”. Only time will tell if companies in these markets will be able look to those that came of age at the start of the century as beacons on the pathway to sustainability.