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

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

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

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

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

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

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

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

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

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

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

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

 

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

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

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

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

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

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

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

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

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

Endless chatter

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

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

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

 

Changing the rules of capitalism?

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

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

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

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

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

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

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

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

   The Book of Discipline

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

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

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

   Performance against benchmarks

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

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

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

    Walking the values walk

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

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

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

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

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

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

Three kinds of capital

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

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


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

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

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

Governance transformed

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

“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.