The new low-return, high-volatility environment requires broadly diversified portfolios, dynamic decision-making and rigorous due diligence, which is beyond the internal capacity of most small funds under $10 billion, warns Russell Investment’s global chief investment officer Peter Gunning.

He says smaller funds must decide if it is cost effective and even possible to internally manage investment portfolios that can successfully adapt to this new fast-changing environment.

“If you are not on this 24/7, in reality, you are going to miss opportunities,” Gunning says. “If you are waiting for the monthly meeting of the investment committee, markets might have been up and down a lot in between and you may have done nothing.”

Gunning believes the current market conditions are here to stay for at least the medium term and if funds are going to achieve their return objectives, they need to take a comprehensive look at their investment processes.

“I would argue if you are probably under $10 billion, it (insourcing investment management) is probably not worth doing. You can do it but you are doing it in a hybrid model,” he says.

Russell manages more than $150 billion for clients that typically outsource their investment decisions to the global asset manager.

 

Three-pronged approach to volatility
Managing the current environment requires a threefold response, according to Gunning.

The first is to look to greater diversity of assets, both listed and unlisted. This multi-asset solution should be implemented with what he calls an “open architecture”.

This approach ensures that the full suite of options is available in any one asset class to achieve a return objective, with the investment team not locked into any one manager or proprietary product.

Gunning says that dynamic asset allocation should involve a rebalancing back to the strategic asset allocation when valuations change, altering the weight of the particular asset class in the portfolio.

It is an approach that has been championed by the investment teams of such large funds as the $165-billion Canadian Pension Plan (CPP).

Secondly, funds should look to ensure dynamic decision-making that can adapt to fast-changing market conditions, both within an asset class and across asset classes.

“Volatility isn’t necessarily a bad thing. It just means that the investment process may need to adapt to it,” Gunning says.

“So, it is all about being more dynamic in terms of the asset allocation decisions across that diverse set of building blocks.”

Finally, Gunning says, due diligence has moved well beyond the sphere of manager selection and now demands ongoing oversight of operations to minimise risk.

In a low-return environment, part of this is due diligence to ensure efficient execution across a diversified portfolio so there is not what he calls “implementation leakage” because every basis point is crucial.

‘It is a whole lot of small things, particularly when returns are low, but they all add up,” he says.

 

Equities are not dead
Looking ahead, Gunning says that the fund is cautiously optimistic about equities that “may surprise on the upside”.

“We think that on a relative basis equities are a fairly good place to put your money,” he says.

Gunning has previously warned about the need for investors to actively manage their fixed income portfolios, saying that typical indexes expose investors to the biggest debtors.

In addition, he notes that fixed income investors should look carefully at their sovereign exposure, raising concerns that a bubble is emerging in some segments of the sovereign debt universe.

“There is definitely on the sovereign side a bond bubble developing. When you think about 10-year treasuries at 1.5 per cent and two-year government auctions going off at negative, TIPS – five-year and ten-year – are very low.”

“Interest rates can only go so far, we wouldn’t say that equities will come roaring back, but on a relative basis we are more positively disposed to equities than sovereign bonds. We do think there is a reasonable case to maintain positions in high quality corporates and high yield.”

In its fixed income portfolio, Russell currently has what Gunning describes as a “systematic overweight to credit”.

Regionally, Gunning sees that the US may provide better outcomes than Europe, which will be “difficult at best”, and, predicts a soft landing for China.

“On a relative basis, North America is probably providing the best opportunities, followed by Asia and then Europe, on the equity side.”

Asia will be a growing part of investors’ portfolios, predicts the chief investment officer of AustralianSuper, Mark Delaney. He is steering the $43-billion fund towards the Asian century with up to 45 per cent of its international equities now in emerging markets.

Asia represents about half of this emerging market exposure and, despite the flight from risk assets in light of recent market uncertainty, Delaney says that the fund has maintained its allocation to emerging markets.

“We still think that equities will be the main game, because growth is one of the key reasons we are going into these markets and equities are the main beneficiaries of economic growth.”

In addition to a growing focus on emerging markets and Asia, Delaney is starting a long journey towards moving Australia’s biggest industry super fund from an outsourced investment model to gradually building internal management capacity across asset classes.

Delaney describes the process as a long-term goal, which will begin with the investment team internally managing part of its Australian equity allocation.

Small cap Australian equities will continue to be externally managed, but the team will focus on the broader market.

Currently, half of its Australian equities are passively managed.

There are 40 members in the investment team, with half in operations and half in the policy part of the portfolio.

The fund is aiming to add an additional 10 to 20 additional staff members.

Moving into Asia
Along with looking at its internal capacity, Delaney says the fund has also rethought its approach to credit, recently investing in direct-credit opportunities in infrastructure and property.

The investment team has also kept to its longstanding policy of not investing in hedge funds, with the one exception of maintaining its lengthy relationship with Bridgewater.

The approach to hedge funds is to “keep things simple” and it is a method the fund has extended to its push into Asia.

AustralianSuper has limited its foray into emerging markets to predominately equity exposures. Delaney notes that low yields on emerging-market sovereign debt don’t make it a compelling opportunity and he is cautious about the execution risk of investing in unlisted assets.

Candid about the fund’s capabilities in Asia, Delaney says the fund is seeking the advice of experienced operators in the region, recently hired a fulltime member of the investment team in China and is launching an Asian advisory board.

The board, chaired by former Reserve Bank governor Bernie Fraser, will advise the fund as it looks to increase the breadth and depth of its exposures to the region in the coming years.

Delaney says the advisory board is there to add to the knowledge of the investment team, and help “avoid some of the mistakes” other investors have made when putting capital to work in Asia.

Beyond passive
For Australian funds, the question of emerging market exposures always comes with the concern that these funds may be doubling down or duplicating exposures already gained through domestic holdings.

With the Australian Stock Exchange dominated by resource giants and the country’s four big banks – many of which are rolling out their own Asian growth strategies – concentrations of risk must be carefully managed.

Delaney turns this argument on its head, looking beyond blunt geographic exposures to underlying sector exposures.

He argues that Australian investors must adapt their portfolios to Asia as it matures if they are to maintain and potentially grow their exposure to the future engine room of the world’s economy.

“We think in the medium term, as Asia matures and becomes less resource-intensive, we will have to substitute indirect resource exposure for more direct consumer exposure,” he points out.

To do this the fund has looked beyond a passive approach with major indexes –such as the MSCI All Country World Index – that have greater exposure to the financial and energy sectors in emerging markets.

Delaney explains that all its international equities, including emerging markets, are actively managed.

Biding its time
However, the fund is prepared to be patient in executing its strategy; Delaney notes it avoided increasing its emerging-market equities holdings in last year’s volatility.

Emerging market equities were one of the worst performing asset classes last year and were caught up in the selling off of risk assets.

But Delaney says that moments of market pessimism can be a potential opportunity for those investors with a longer term perspective.

“Always, falling prices should make stocks more attractive in a world of relative equity allocations between emerging markets and markets elsewhere. A lot of markets have fallen,” he says.

“Emerging markets are now at a discount to developed markets, which is where they have historically traded, and the investor optimism has disappeared from emerging markets. Probably, it makes it a better time to invest than 12 to 18 months ago. We haven’t done anything yet but the preconditions are falling into place.”

Delaney says the fund has done extensive work investigating the relative merits of different ways to access the growth story of emerging markets.

One potential strategy is to look for large multinational companies listed in developed markets that generate revenue from emerging markets, in particular Asia.

The fund’s investment team looked at this option but its research revealed that the theory didn’t stack up to the reality of where the sources of revenue for these companies were coming from.

The fund’s research focused on both European and US-listed companies and revealed that between 20 and 30 per cent of revenues are derived from Asia, Delaney explains.

“For stocks listed in the US and Europe, the vast majority of their revenues come from activities in their region,” he says.

The fund has gradually increased its holdings of emerging markets equity by reinvesting income from its developed markets segment of the equities portfolio, Delaney explains.

Managing risk: in or out?

The fund has also developed an in-house risk management system that manages risk across asset classes.

“We have our own risk model that we run, and it is based predominately at the asset-class level rather than the stock-selection level,” Delaney says.

“We are not trying to add each individual stock to the total; we are trying to work on the broad asset classes and what the major risks are. We will look at the level of absolute risk we take and the amount of relative risk we take, and the components thereof.”

As part of its risk management the fund does liquidity testing, modeling how the portfolio will perform in a market downturn.

The fund has a broad objective to have only about one-third of its assets in the balanced fund, its default option, in illiquid assets.

Delaney says that liquidity is generally understood to be an asset that can be liquidated in less than three months.

In addition to its internal risk management system, the investment team looks at asset allocation and sector tilts are also decided internally.

Investment staff also set broad sector strategies, while specific stock selection is left to external managers.

“All asset classes are currently external, but we are looking to bring part of Aussie equities internal and we will look to diversify that over the next three to four years,” he says.

Delaney says that the decision to move to internal management is driven by the capacity for internal management to access a better portfolio of assets, whether it can be done cheaper and whether the strategy can be effectively executed.

“We will start carefully and if [internal management] proves to be successful, it will attract more capital, like any other manager works,” he says.

Nuts and bolts
The current strategic asset allocation in its default balanced fund is as follows:

Strategic Asset Allocation


The fund has adopted a dynamic asset allocation approach for more than 10 years, and looks at its holdings on a monthly basis.

As of June 30, the fund’s balanced option achieved a 1 per cent return for the financial year, compared to an Australian superannuation industry median return of 0.5 per cent. This followed two consecutive years of strong returns of 10.3 per cent and 10.1 per cent. The balanced option has averaged 9.3 per cent a year since inception in August 1985 and over a 10-year period has achieved an annual return of 6.4 per cent.

This paper presents two simple algorithms to calculate the portfolio weights for a risk parity strategy, where asset class covariance information is appropriately taken into consideration to achieve “true” equal risk contribution.

Previous implementations of risk parity either (1) used a naïve 1/vol solution, which ignores asset class correlations, or (2) computed “true” risk parity weights using relatively complicated optimizations to solve a quadratic minimization program with non-linear constraints.

The two iterative algorithms presented here require only simple computations and quickly converge to the optimal solution.

In addition to the technical contribution, we also compute the parity in portfolio “risk allocation” using the Gini coefficient. The researchers confirmed that portfolio strategies with parity in “asset class allocation” can actually have high concentration in its “risk allocation”.

To read the paper click here

Anyone who thought ESG was a passing fad can think again.

The announcement this week that Mercer, which has led the consulting industry on standalone ESG ratings, will now integrate those factors across its ratings process has cemented ESG as an important investment risk and return consideration.

The consultant rates more than 20,000 investment strategies globally, oversees more than $5 trillion in assets under advice and has $60 billion of assets in its multi-manager products.

The move will mainstream ESG in the investment manager community, whether the managers are ready for it or not.

The Mercer researchers will look at ESG factors alongside their other research considerations, and the expectation is that managers should do the same.

It reflects the powerful position that consultants maintain in influencing manager behaviour and investment trends. It will only be a matter of time before other consulting firms follow Mercer’s lead.

Mercer looks at ESG ratings across the generation of investment ideas, construction of portfolios, implementation of active ownership practices through voting and engagement, and the demonstration of a firm-wide commitment to ESG issues.

It now rates 5,000 investment strategies on ESG factors, with only 9 per cent of those receiving the top ESG rating.

Of its entire universe of 20,000 strategies about 10 per cent receive an A rating, or recommendation status. Of these 80 per cent have an ESG rating, and it won’t be long before that figure is 100 per cent.

In this fourth part of an OECD working paper, researchers look at the potential that portfolio rebalancing by financial investors can contribute to spreading financial turmoil in a major market event such as the global financial crisis or ensuing sovereign debt crisis in Europe.

In International Capital Mobility and Financial Fragility – Part 4: Which Structural Policies Stabilise Capital Flows When Investors Suddenly Change Their Mind, researchers test for the change in sentiment that contributes to financial contagion.

The paper used bilateral bank data and an instrumental-variables technique that allows for focusing on changes in investors’ country assessments that are unrelated to fundamentals. Changes in investor sentiment are found to drive capital flows.

Sentiment-driven capital flows are found to be smaller in countries with a tougher regulatory stance, such as stricter banking supervision or enhanced financial transparency.

To read the paper, click here.

Mercer will integrate its proprietary environmental, social and governance (ESG) ratings across all of its manager-search and performance data, cementing ESG as a key investment consideration.

The consultant rates more than 20,000 strategies, oversees more than $5 trillion of assets under advice and has $60 billion in its multi-manager products.

Mercer has led the consulting industry on standalone ESG ratings and will now integrate those factors across its ratings process.

About 10 per cent of the strategies rated by the consultant receive an A rating, or recommendation status. Of these, 80 per cent have an ESG rating.

Separately it rates 5000 investment strategies on ESG factors, with 9 per cent receiving the top ESG rating.

Rich Nuzum, president and global business leader for Mercer Investment Management, says the move is a response to client demands, particularly from sovereign wealth funds, which want an objective approach to comparing strategies and asset classes over time.

“For managers, it encourages reporting on ESG but that is an indirect outcome. The main thing was we wanted an objective approach that applies across strategies,” he says. “This creates an incentive and dynamic around that.”

By providing the ESG research as part of its client communication, Nuzum says Mercer is enabling smaller clients – who may not be able to afford the dedicated resources necessary for ESG – to benefit.

 

Universal ownership
Mercer has spent time and money on training its research analysts on ESG factors. While the consultant has a separate ESG research team that focuses primarily on policy and strategy, the ESG ratings are incorporated in the research process conducted by all analysts.

“The manager-research team integrates ESG into its research process, and we expect managers to do the same,” Nuzum says.

“ESG factors are different from financial-statement analysis but most analysts would also look at other things as well and many have been considering corporate governance factors for years. I don’t buy the argument for a second that a manager needs different skills to analyse ESG.”

He says many analysts have been considering ESG factors, such as political and regulatory risk, in their risk and return considerations for many years.

“There are lots of things that are not in financial statements that process needs to look at.”

Nuzum believes there is ESG alpha at the individual strategy level, but is also focused on a more universal ownership argument.

“Most clients own a proportion of the global economy. A focus on ESG factors can get management teams to take these externalities, such as treatment of employees or child labour, into account. If there is improvement at individual companies, the compounded effect is felt across overall GDP growth,” he says. “There is alpha at the individual strategy level but there will also be higher expected returns to most asset classes if universal owners get company management teams to behave better, everyone’s returns will go up. There will be a higher beta.”

Mercer looks at ESG ratings across the generation of investment ideas, construction of portfolios, implementation of active ownership practices through voting and engagement, and the demonstration of a firm-wide commitment to ESG issues.