While the responsible investment field has come a long way, the majority of investors are still treating it as an overlay, rather than truly integrating it into investment decision-making.

This is not an ideal situation for the investment industry, not to mention society at large, but it presents an opportunity for those that do integrate enviroment, social and governance (ESG) issues with investments, and do it well.

For the past three years the giant Dutch pension manager, PGGM, has had a specific portfolio, the The essence of the portfolio is a long-term investment horizon that integrates financial and ESG factors with active ownership. The Responsible Equity Portfolio is worth about 3 per cent of the overall assets of €125 billion ($167 billion).

Responsible investment 2.0

Now the head of that strategy, Alex van der Velden, and a number of the team have started a new independent firm that offers strategies managed in the same vein.

It’s the “next generation” of responsible investment evolution.

“From an investment perspective you do ESG analysis to prevent the problems. When we showed up to invest, conditional on improvement of the issues, it was win/win. The effect is greater the larger the bag of money you can put on the table,” van der Velden, who is chief investment officer of the new venture, says.

He says in the past few years there have been perceived positive moves in the market regarding ESG awareness, but in reality little uptake.

“People accept principles of responsible investment and there is more open-mindedness to the concept. But it is also a façade that people can hide behind and do nothing. Most funds managers are hardly doing anything. If you ask at the portfolio-manager level, it is not happening at that level,” he told top1000funds.com in July last year.

It is a challenge that most investment processes don’t deal with qualitative processes like ESG or are involved in investee companies.

This next generation of responsible investing that van der Velden and his team are adopting at Ownership Capital integrates ESG considerations as part of the fundamental investment framework.

As at PGGM, the strategic objectives of the portfolio are ESG integration and active ownership, with the point of integration to see how ESG could add value to – or detract value from – a company. This is implemented through better stock selection of sustainability leaders and through better management of ESG risk by catalysing ESG improvements at laggards through active ownership.

There is a three-pronged analytical approach involving fundamental financial analysis, ESG integration and active ownership. There is also recognition that ESG analysis takes a substantial amount of time, not just to understand the specific facts but, more importantly, to understand their financial relevance, and the approach is active and concentrated.

Canary in the coalmine

Van der Velden says that many funds have adopted engagement with companies but that strategy falls short in fulfilling the original ambition.

“The investment decision has already been made,” he says. “It’s reactive engagement on policy issues not doing research and engagement before the investment. PGGM realised that to generate investment value from ESG, analysis need to be part of the investment process. The philosophy worked well: when we added ESG analysis or engaged with a company, we made better decisions.”

The process also revealed further problems within the company.

“A measure of success is returns but also the investment decisions you didn’t make, we noticed ESG problems were a canary in the coalmine for deeper issues the companies had.”

Van der Velden believes this process is not more pervasive in the investment industry for a number of reasons. “There is a cultural aversion to considering qualitative factors – the investment industry is quant-based and incentive structures are short term in nature,” he says. “Also, ESG is not a short-term value driver: if you only have a 12-month horizon, you won’t do ESG analysis.”

One unified strategy

The new firm has an eight-man investment team headed by Sir George Buckley, the former chief executive officer of 3M, the US manufacturing and innovation company, and van der Velden. They met when van der Velden’s team were engaged investors in 3M.

The long-time horizon fund will invest in a concentrated portfolio of North American and European equities for international institutional investors, with a target fund size of $2.67 billon. The portfolio combines fundamental financial analysis, ESG analysis and active ownership into one unified strategy with the overarching aim of identifying companies that are financially attractive, responsible and open to engagement.

In practice this means the investment process involves financial analysis and modelling, ESG analysis and measurement, in an active dialogue with investee companies from the start.

He says in many investment organisations ESG continues to be dismissed as financially irrelevant, but he believes a culture of open-mindedness must be nurtured in which both ESG and financial factors can be seen as critical and as correlated over the longer term.

Buckley, who is chairman of Ownership Capital, says the turbulent economc environment calls for shareholder engagement and a sustainable approach to business.

“The chance to chase a quick dollar (and the fear of not doing so) has distracted investors in the past, often to the detriment of long-term growth and good returns, and this simply has to change if we’re to get the economy back on track. It’s not about the next quarter or even the next year – it’s about the next decade,” he says.

“A narrow focus on buying and selling has made owning with skill something of a forgotten art,” said van der Velden says. “Our experience has shown that ‘ownership investing’ not only contributes to better corporate governance and sustainability, it ultimately generates higher investment returns.”

 

For a profile of PGGM’s approach, click here.

I’ve been contemplating the “smart beta” wave the industry seems to be riding at the moment. Cynically, part of that contemplation asks whether there is any innovation at play or whether it’s simply the industry playing with nomenclature once again.

The answer is confusing, for while I’d like to be able to write it off as some sort of marketing game, there seems to be some real benefit to the end-investor of this smart beta trend.

Whenever a journalist contemplates something, it means a lot of research and part of the way I research is by talking to people. On this issue I’ve sought the insight of many people close to the trend – academics, investors and service providers.

Of those service providers whose opinion I value, State Street and AQR rate up there.

It’s not my usual practice to name service providers, in fact I don’t really even like writing about them, but the reason I rate them, and this is not exclusive, is they have a direct link with academia, applying the latest thinking to practice. And this is true of the thinking around smart beta.

If flows are anything to go by then this so-called wave is real.

The S&P Low Volatility ETF had flows of $2.5 billion in 12 months and now has the most assets under management of any ETF.

Similarly, the trend is demonstrated in State Street Global Advisors’ flows, while the bulk of it’s $1 trillion in global passive equity remains in traditional core cap-weighted indices, last year 40 per cent of its institutional inflows in this part of the business were into smart beta.

Smart beta defined

The definition of smart beta can be broad. Lynn Blake, global chief investment officer of SSGA’s global passive equities business, says it is an “objective, consistent, transparent measure of achieving some investment exposure”. In academia, smart beta really started about 10 years ago with fundamental indexing, ballooning as a topic of research, and now weighting portfolios by risk characteristics, such as volatility, has become the mode du jour.

It can be distilled into the fact that empirical evidence shows that there are certain factors that drive returns. These include price to valuation, low volatility, size and momentum.

Smart beta is implementing that thinking, so a portfolio is tilted towards one or, in the case of AQR’s products, many of these factors. AQR identifies four styles of premia – value, momentum, carry and defensive – and combines them in seven different places including industries, countries and currencies.

The benefit to investors is that the veil is being drawn back on what were often previously thought of as active strategies, so now investors can see whether there is really manager skill involved and whether it’s worth paying for.

Many active managers figured out years ago that value and momentum were drivers of return. Investors were paying active fees for that knowledge, and a tilt towards a style premia, but what smart beta now demonstrates is that knowledge is not necessarily skill.

The development of academic thinking and tools, and the application of it, is providing clarity around alpha, or the lack of it, and hopefully more transparent and fairly priced offerings.

The age of style tilts

While I think I’m convinced that alpha does exist, I know that tilting towards, say, value, is not it. So investors shouldn’t pay an active fee for that.

I must add, however, while I see an eventually bright future in product development and appropriate pricing, I also see a plethora of products about to explode onto the market, which investors will have to wade through to get to any eventual Mecca.

Apparently there are now already as many indexes as there are stocks, and we haven’t even really started on style-tilted indexes, not to mention combinations of style tilts.

As this new wave of industry development continues, investors have a chance to make some demands. Expect innovation, expect transparency, expect to pay appropriately, and expect honesty. If you don’t get it, don’t do business with those organisations. It’s simple really.

Things are suddenly looking cheerful again in the world of Dutch pensions.

The country’s famous tulip fields might not be set to bloom until April, but investors already have a harvest to delight at from a good year of investing.

For instance, Hans de Ruiter, chief investment officer of the €2.5-billion ($3.36-billion) TNO pension fund in the Netherlands, can look back on a 14.8-per-cent investment return in 2012.

It is a real sign of how positive 2012 was as an investing year that de Ruiter can label such returns as “unexceptional”. The TNO fund only just beat its benchmark after all, and de Ruiter can point to many other Dutch funds with similar or superior returns. De Ruiter says that younger pension funds in the Netherlands that follow liability-matching strategies similar to TNO’s boast even stronger 2012 results. The TNO fund, formed in 1939 by the TNO scientific research institute, has a medium average-liability duration of 15 to 16 years.

The investment returns are a definite relief in any case to the funding position of TNO’s pension fund. The fund has emerged from a deficit to post a 4.8-per-cent surplus at the end of 2012.

This surplus beats the TNO fund’s minimum requirements and therefore reduces the threat of the fund imposing benefit cuts on its 15,000 members.

It is not just a tale of miracle returns restoring the fund to health, however.

While supported by the investment gains, the 5.1-percentage-point overall boost to the TNO fund’s funding position in 2012 was largely carried by the introduction of the new ultimate forward rate in September as part of the Dutch pension reforms.

Fixed income switching

De Ruiter says that the TNO fund will be keeping its diversified, liability-matching asset mix broadly identical in the year ahead as it aims to build on recent gains. Among its alternative holdings, the fund has over 10 per cent of its assets in private equity, over 5 per cent in property and close to 3 per cent in interest-rate and currency hedges.

The most significant recent changes have been within the bond portfolio. These have seen the fixed income holdings increased from under 50 per cent to 56 per cent of assets.

Intriguingly, government bond holdings have been increased as part of the TNO fund’s fixed income drive. At 18 per cent of the fund, government holdings still have less than half the combined presence of corporate, high yield and emerging market debt, however.

De Ruiter explained that the recent bond purchases have been inspired by a reduction in the fund’s swap overlay. Interest rate risk is now just 55 per cent hedged at the fund, a reduction of some 10 percentage points. “We want to be less dependent on swap overlays and do more liability matching through physical positions” de Ruiter says. A desire to reduce leverage and counterparty risk on the balance sheet were cited by de Ruiter as reasons for this move.

De Ruiter admits he is concerned at the low yields offered by the German, Dutch and French government bonds that make up the majority of the TNO fund’s holding of state issues. However, with European corporate debt holdings also being beefed up, he is confident that the overall asset mix better matches liabilities with this move.

Cool on bricks and hedges

Real estate and hedge funds are asset classes that have stepped aside to make space for TNO’s bolstered bond position. De Ruiter explains that the fund has underweighted real estate to 5.5 per cent of the portfolio – half its 2010 position – following a disastrous minus 16.6 per cent performance in 2011. A one-off hit from since disposed-office structured-debt investments contributed to those poor returns. The asset class is proving to be “still disappointing” for the fund, however, with minus 6.6 per cent returns from real estate being the single blemish on the 2012 performance figures.

A globally diversified real estate portfolio has not been able to help things of late. “There are clearly a lot of issues such as overcapacity in various countries which have kept us from investing in recent years,” de Ruiter says. While he feels there will be a “difficult environment” for real estate in the next few years, he remains confident in the asset class’s long-term potential.

De Ruiter is, however, less keen on hedge funds, labeling the asset class “too expensive and lacking transparency”. TNO’s hedge fund portfolio performed worse than its equities in 2011, losing 7.2 per cent of value. De Ruiter explains that since then, the TNO fund has divested from a fund-of-funds position and is in the process of incorporating the rump of its hedge fund investments into its private equity portfolio. The TNO fund, though, will retain the option of investing in hedge funds on an opportunistic basis when it can identify good managers.

Private equity for its part has been overperforming of late, with 8.3 per cent returns in 2012 following two years of double-digit returns. The fund has decided not to make new private equity investments until the end of 2013, while allowing existing mandates to expire, in order to bring the asset class down to the 7-per-cent holding that it has strategically targeted.

Sitting tight with passive equities

The 16-per-cent return on the TNO fund’s $668-million-plus equity holdings was the strongest of all in 2012.

TNO has benefited from a wide geographic spread, with 39 per cent of equities invested in US firms and 24 per cent in emerging markets at the end of 2011.

The equity portfolio has been managed completely passively since the start of 2012. “There were no strong indications of the added value of asset management over a long time horizon, so we came to the simple conclusion it might be better to invest passively, as cheap as possible” says de Ruiter.

Defined-benefit funds all over the world are focused on de-risking but the amount of innovation and players to meet this demand is wanting. Until now.

A new report by the Pensions Institute at the Cass Business School examines the emergence of medically enhanced, underwritten or enhanced, bulk buy-ins, in which trustees buy a bulk annuity as an investment of the scheme, where some or all of the members covered by the policy are medically underwritten.

The argument is that medically underwritten annuities can bring cost savings to a de-risking approach that offers an effective hedge against a range of risks including interest rate, inflation, investment and longevity risks. Read the full report below.

HealthierWayToDeRisk

According to the latest figures, an ambitious turnaround plan at the United Kingdom’s biggest supermarket chain, Tesco, has helped reverse falling profits. Last year the retailer, one of Britain’s largest private sector employers and a landmark in every town since founder Jack Cohen opened his first store in North London in 1929, also changed strategy at its £6.5-billion ($10.2-billion) pension fund to improve performance. In a bid to boost returns and reduce costs in the defined benefit scheme set up in 1973, the retailer brought management in house, setting up City-based Tesco Pension Investments (TPI). Almost a year on, a 35-strong team is now honing strategy and poised to run two-thirds of the portfolio internally. “It’s still very early days. So far the emphasis has been about building our infrastructure and recruiting the team,” says chief investment officer, Steven Daniels, who joined TPI in 2011 and was previously at Liverpool Victoria, the UK’s largest friendly society. “Coming in house was an opportunity to improve the performance and governance with a holistic approach, as well as reduce fees.” The fund now targets annual returns of between 6 and 7 per cent, and wants to get within sight of doubling the portfolio within the next five years.

How the shelves are stacked at TPI

In the last year TPI’s global bond and equity allocations, which account for 20 per cent and 55 per cent of the fund’s asset allocation respectively, have fared best out of the whole portfolio, with average annualised equity returns achieving 8 per cent and bond returns 5 per cent. Despite the new regime, the asset allocation follows a strategic benchmark set by the trustees and won’t change for now. Nor are there any obvious investment themes to follow that have helped signpost returns in previous years, like the plunge into technology stocks in the 1990s or more recently emerging markets, says Daniels. Instead, to hold course in today’s choppy market, which Daniels predicts “still has a long way to go before normal economic conditions return”, TPI will apply a seemingly simplistic approach. “We’ll focus on the right investments over the long-term,” he says. The fund has dropped strategies targeting quick returns and now expects to invest for a minimum of five to six years. “Take equities,” he explains. “You need to hold equities for three to five years to reap the benefit of companies’ undervaluations coming through.”

Dealing with the ticking bond conundrum will require a more nimble strategy, however. The TPI team is poised to react to ensure the value of its bond portfolio isn’t hit when global interest rates, pushed down by governments trying to kick-start moribund economies, start to rise again. “Timing the move out of bonds is a critical decision for fund managers – a question we are constantly asking ourselves,” he says. “The worry is uncertainty. There are such low interest rates around and, although we don’t expect them to go up, markets will start to build in expectations of inflation.” He is positive on the US and says he “can see recovery” in Europe and Asia, but believes the UK could be one of the most vulnerable markets although TPI doesn’t have a big gilt allocation. “Europe, America and Japan are likely to keep interest rates low for a while. The UK is not part of the dollar block or the euro block – bond markets may react to any possible rise earlier on here.”

Tail risk is another worry. To shield against an external shock triggering a sell-off coming in the guise of further recession, the break-up of the euro or more bank insolvency, the scheme uses caps and collars to make sure downside protection is in place. “We may take out the worst possible scenario,” says Daniels.

TPIs allocation to real-estate and alternatives is 10 per cent and 15 per cent respectively. The real-estate portfolio is invested both internationally and in the UK, although not London, since here the size of investment would be too big for the fund. One focus is seeking out distressed property assets from banks and insurance groups. “We are seeing these groups prepared to sell assets at discounted values to release capital.” Other strategies include hotel funds and investing in retail and warehouse space in regional cities. The alternative bucket is divided between a 9-per-cent allocation to hedge funds and a 6 per cent allocation to venture capital comprising infrastructure investment, private equity and buyouts.

In house vs external and the defined benefit scheme

Although the majority of the fund will be managed in house, TPI still plans to place a third of the portfolio with external mandates. Managers haven’t been selected yet but Daniels says external expertise will be used where it adds value and achieves the diversification within an asset class that it can’t achieve in house. Distressed debt and high-yield bonds are both areas where it “wouldn’t be worth building an internal team,” he says. Hedge fund allocations and venture capital, as well as other niche bond, real estate and equity market investment will also be placed externally. “We will be looking to use fewer external managers, but make bigger commitments to the ones that we currently work with.”

The fund will focus on active management since “it’s the job he’s been asked to do”, however passive allocations will also play a role in markets where adding value is tough. “Outperforming the S&P might be difficult,” he says. Passive allocations will also be applied where the fund goes into a market on a trial basis with no initial long-term strategy. “Markets you’re not going to be in forever and just want beta exposure.” Daniels says Japan Index Investment could be an example here.

The creation of TPI is part and parcel of a wider revamp by Tesco to get its pension scheme in order. The retailer is just one of three FTSE 100 companies still offering new employees the more favourable defined benefit scheme, but it’s a promise that has forced reform at the scheme, which is only around 85 per cent funded. Most companies have sought to limit the growth of their pension liabilities by ditching defined benefit for defined contribution, taking pension risk off their own balance sheet. Last year Tesco, which has 293,000 members of its scheme including 172,000 active workers, asked its employees to work until 67 rather than 65 and aligned the scheme with the Consumer Price Index (CPI), which excludes inflation measures such as house prices, rather than the Retail Price Index (RPI), cutting pension payouts. The hope is savings here will now be stoked by boosted returns too. “The scheme is growing rapidly – we’re looking at $16 billion in the next five years,” says Daniels.

Connecticut-based financial services management consultant, Casey Quirk, and institutional investment specialist publication, top1000funds.com, joined forces in a global chief investment officer survey to measure the sentiment of asset owners, and the extent to which the 2008 crisis has had an effect on the behaviour of internal investment teams, their outlook and corresponding asset allocation. With combined assets of around $5 trillion, pension funds, sovereign wealth funds, endowments and insurance funds all participated in the survey.

Since 2008, nearly half of the respondents (45.7 per cent) had revised their investment performance targets, with a review of objectives and expectations resulting in lower target returns.

Respondents were asked about the impact the crisis had on five aspects of investing: the investment target return, investment benchmark or policy portfolio, a focus on tactical asset allocation or hedging overlays, a dedicated tail-risk allocation, and time spent on manager research.

More than half of the respondents have increased their focus on tactical asset allocation or hedging overlays since the 2008 crisis. Some of the funds surveyed had implemented factor-based asset allocation and an active hedge overlay and, in particular, had moved towards a more dynamic asset allocation approach. And about 20 per cent of respondents had introduced a specific dedicated tail-risk allocation.

Partner at Casey Quirk, Daniel Celeghin, says the renewed focus on dynamic asset allocation and investment policy changes is very consistent with what the consultant has seen in other research.

“The discussion about dynamic asset allocation use before the crisis was settled. Funds would set their strategic asset allocation and not be market timers, they would trust the long-term and rebalance in a disciplined fashion,” he says. “That question is back open to debate. This survey very definitely shows large asset owners, globally, are willing to give dynamic asset allocation another try.”

Downward revision of benchmarks

A related trend, also demonstrated in the survey results, he says is the revision of the target benchmark or policy portfolio. “If you’re going to be doing dynamic asset allocation then your bogey, you’re tying to it also changes. A lot of benchmarks were set many years ago when real interest rates were much higher, and you could get 5 to 6 per cent.”

Celeghin says no matter what the policy portfolio is supposed to reflect – be it expected liability, peer risk, or an output of risk tolerance and asset allocation – the benchmark is coming down. Indeed one of the most significant changes measured in the survey was the number of respondents (60 per cent) who had revised their investment benchmark or policy portfolio as a result of the 2008 financial crisis. Within that revised policy, there was a noticeable decrease in domestic equities (42.2 per cent of respondents had decreased this allocation), and an increase in illiquid alternatives (46.3 per cent) and hedge funds (38.5 per cent).

In the next two years this trend will continue. Domestic equities allocations are expected to decrease further: 35.7 per cent of all respondents said they would decrease these allocations, and 42 per cent of those who had already decreased allocations would decrease them further.

Of those who responded, 42.1 per cent said they would increase both hedge funds and illiquid alternatives in the next two years. Of those who had already increased the allocations, 60 per cent said they would continue to increase their allocation to hedge funds, and 63 per cent said they would continue to increase their allocation to illiquid alternatives.

2012 Global CIO Survey Infographic

(Click to expand.)

The ins and outs of management

When it came to assessing managers, the number-one attribute as ranked by the respondents was investment leadership or the people that ran the manager, this was followed by investment performance, thought leadership, market perspective, portfolio construction advice, ownership, incentives and remuneration and finally client service and support.

Two thirds of the respondents managed at least some assets in house, with 7 per cent managing 100 per cent internally. But 41 per cent of respondents said they expected the amount of assets managed in house to increase in the next two to three years.

Cash (51 per cent) and domestic bonds (42 per cent) were the most likely assets to be managed in house, with non-domestic equities and hedge funds the most likely assets to be managed externally.

While cost was the most likely reason for managing assets in house (37.2 per cent of respondents), it was followed quite closely by control (30.2 per cent). Of the investors surveyed, the cost of external managers was much greater than internal investment resources. The most likely cost of external managers was 50 to 100 basis points (41 per cent of respondents) while more than 75 per cent of respondents spent less than 10 basis points on internal management.

With regard to asset allocation and portfolio construction decisions, the overwhelming majority (71.4 per cent) said they would rely more on internal staff, rather than consultants or asset managers, in the next four years. Since 2008 about 40 per cent of investors have reported spending more time on manager research, which has come in the form of more RFPs, more indepth correlation analysis, using the consultant and manager database information more comprehensively, and as part of a function of performing diligence on a broader range of strategies.

“This survey implies that asset managers globally need to evolve their offerings. Institutions will gravitate towards managers that have a clear role in helping meet their overall return objective, preferably in a fee-efficient manner. This could mean managers with expertise in dynamic asset allocation and risk management, as well as managers that have been able to consistently deliver returns that are uncorrelated to the broader public markets,” Celeghin says.