Complexity is, well complex. And as trite as that sounds, it’s something investors, even professional investors, don’t understand well enough, according to Tim Hodgson, head of the Thinking Ahead Group at Towers Watson.

The Thinking Ahead Group (TAG), as has been reported here before, gets paid to think – a gig conexust1f.flywheelstaging.com is envious of. In the past year or so, the focus of that thinking for the group, based in London but with representatives from Towers Watson around the world, has been on complexity, risk and sustainability, producing multiple papers that reflect those themes.

“We don’t understand complexity well enough,” Tim Hodgson. “The CFA is still teaching modern-portfolio theory but today that is not a good model to describe the world. I’ve drunk the complexity Kool-Aid.”

The group, which has now also been recognised internally by the Towers Watson insurance group and will be hiring two new members, doesn’t look at traditional risks and opportunities but recognises that the world is interconnected, and that politics, economics, society, the environment, technology and finance all interact in different ways.

 

Manage expectations

One of their recent papers, The Wrong Type of Snow, has this notion of complexity underpinning it and basically surmises that “risk could be more wild than you’re planning for”.

Similarly the paper, We Need a Bigger Boat, which describes the detailed Telos Project done in conjunction with Oxford University, is premised on the fact the world is on the cusp of significant economic, political and capital-market transformations.

This is seen through market deleveraging, increasing resource scarcity and degradation, and an ageing population, all creating an “extra dimension”.

The relevance for the industry is that the paper says the portfolios and strategies judged to be well suited for present-day conditions will prove unsuitable in the future.

It goes on to discuss an alternative way that includes four key implementation elements: organisational design; risk management and governance; factor-based thematic and asset-allocation approaches; and mandate design for asset owners.

“My working hypothesis is it’s hard to create returns given this environment, so it’s better to manage expectations,” Hodgson says. “I’m known for being a bit bearish.”

 

Average really is average

While Hodgson describes those two papers as “weighty documents”, TAG has also done some “lighter stuff” including a paper called The Impossibility of Pensions, which concludes that not only are past returns not a guide to the future, they are not even a reliable guide to the past.

If that’s not complex enough, then there’s the paper The Irreversibility of Time, which Hodgson describes as “potentially geeky” and has the sub-title Why you shouldn’t listen to financial economists.

This paper found the theoretical underpinning for 2009’s Extreme Risks paper, which identifies 15 extreme risks, and when it was updated last year, two new risks were added: resource scarcity and infrastructure failure.

“There is an assumption in finance that we have infinite lives and we live them in parallel. It’s a version of the St Petersburg paradox. But actually we should run these events in series not in parallel. Arithmetic average is used because it’s easier, but it’s only an average.”

“If there’s a finite supply of investment projects, then when you move money chasing them, it will increase the price, which equals less than return. We aim to challenge people’s mental models,” he says.

And that can only add to the tool kit for decision-making.

There is a positive correlation between the investment performance of REITs and the “greenness” of their portfolio holdings, according to a new paper by Maastricht University’s Piet Eichholtz, Nils Kok and Erkan Yonder.

The paper – Portfolio greenness and the financial performance of REITs – finds that investment performance of REITs is positively related to the adoption of Energy Star and LEED certification in REIT portfolios.

The paper investigates the effects of the energy efficiency and sustainability of commercial properties on the operating and stock performance of a sample of US REITs proving insight in the net benefits of green buildings. It calculates the proportion of green properties for each REIT over a period from 2000-2011. Via a regression model it documents that the greenness of REITs is positively related to three measure of operating performance- return on assets, return on equity and the ratio of funds from operations to total revenue.

Further, it concludes that REITs with a higher fraction of green properties display significantly lower market betas. The findings, that REITs with a greater percentage of efficient, sustainable properties display significantly lower market betas, is explained by the fact that “green” properties may be less exposed to business cycle volatility and may be less prone to occupancy risks.

Eichholtz, who is professor of real estate finance at Maastricht University and chairman of the Global Real Estate Sustainability benchmark, says the paper shows there is a relationship between greenness and performance.

“The greener the company/portfolios the better the performance, also free cashflow was higher and risk was lower, and beta was substantially lower,” he says. “This paper shows that the relationship between financial performance and sustainability is really there.”

Eichholtz says the philosophy of GRESB is that “you can make good money by improving the world”, he says.

“Members of GRESB, the pension funds, see that sustainability and investment performance go hand in hand and they talk to companies and say get your act together.”

Eichholtz says there are some companies in the real estate sector who have acknowledged this, and benefited from it. In the latest GRESB Report, he points to a company called Big Yellow in Europe, which is a self-storage company and a sustainability leader.

“The chief executive of Big Yellow, who is also the largest shareholder, is not interested in saving the planet but he’s very interested in making money. His company was the number one in sustainability – he’s totally pragmatic.”

“The leaders are not the full green niche, but it’s the mainstream property companies that are the green leaders. This is another sign that anyone can do this.”

The power of benchmarking funds on sustainability is demonstrated by the fact 171 property companies and funds surveyed in the 2012 GRESB benchmarking report reduced GHG emissions by 6 per cent – this is a reduction of 432,000 metric tons of CO2, the equivalent of removing 85,000 cars from the road.

The Global Real Estate Sustainability benchmark, an industry-led organisation supported by institutional investors including the Swedish AP funds, AustralianSuper, Ontario Teachers, USS, Norges Bank, PGGM and ATP, is the only sustainable benchmark that captures nearly 50 data points measuring sustainability, including environmental and social factors. The aim is to assess and reflect the sustainability performance of an institutional investor’s real estate allocation.

According to the report, the 2012 results show that real estate investors and managers are sharpening their focus on sustainability issues. Of the respondents, 60 per cent collect and report energy consumption data, compared to just 34 per cent in 2011, and 51 per cent of respondents include green building certificates in their portfolio. The 171 funds that were in the survey in both 2011 and this year reduced energy use, GHG emissions and water consumption.

Further the “green stars” reduced all of those outputs by more than the overall group.

Piet Eichholtz, chairman of the GRESB Foundation and professor of real estate finance at Maastricht University, says only if you start measuring things will you improve them.

“There are ways to make the industry accountable, including government regulation and pointing the finger at the industry, but only the industry itself can see that if it makes money things will really change, it’s a profit motive,” he says.

The number of survey members has increased from 19 to 35 in the past year, with the amount of institutional capital now $3.5 trillion (up from $1.7 trillion).

Eichholtz says it is important that the number of participants has increased, especially in the US. The real estate sector is responsible for about 40 per cent of global greenhouse gas emissions and for 75 per cent of electricity consumption in the US alone so accountability with regard to sustainability can have a huge impact in this sector.

“This is being taken more seriously. It means there are more funds that have information and can do something about it.”

The 2012 survey has been broadened to include more social and governance aspects, more details on sustainability and more checks.

“Now we ask if they people did something, what they did. The current survey is a lot deeper and more robust than surveys in the past.”

The 2012 benchmark looked at 36,000 properties worth $1.3 billion from 443 respondents.

The survey weights 34 per cent to management and policy and 66 per cent to implementation and measurement.

“The survey asks providers if they have the infrastructure in place – the management, systems and strategy – to improve sustainability,” Eichholtz says. “We question the industry about getting that translated into action, sustainability reduces costs and better performance for investors. The traditional approach to sustainability was finger waving, but that only gets you so far. What we do is more productive and more positive.”

The survey divides companies and funds into four quadrants – green starters, green talk, green walk and green stars. The number of green stars is about 20 per cent, the same as last year, while 55 per cent were considered green starters.

However there is room for improvement. 40 per cent of the property companies and funds are still considered green starters with limited disclosure of sustainability performance towards the investment community. This represents substantial upside potential in reducing opportunities costs

The survey points to two examples of “exemplary reduction targets and achievements”.

Investa Property Group, which has achieved significant cost savings since 2004 including a 31 per cent reduction in greenhouse gas emissions and a 30 per cent reduction in electricity use; and Hermes Real Estate investment Management which set a carbon reduction target of 40 per cent 2020, and has already achieved that in 2012.

The GRESB scorecards for participants will be available this week.

The industry needs to be better at thinking how responsible investing can be accessed by smaller funds or those lacking sufficient internal resources, David Russell, co-head of responsible investment at the UK’s Universities Superannuation Scheme, says.

Russell, who will join a panel at the Fiduciary Investors Symposium in Santa Monica produced by Conexus Financial, publisher of conexust1f.flywheelstaging.com, speaking about “revisiting corporate governance practices to support expanding portfolios and constituencies”, says many large funds are now well resourced across the issues.
“But the RI practices we have developed at USS, which employs six people to address the issues, may not be suitable for other funds. The industry needs to look at how to help develop RI in all funds irrespective of size,” he says. “It is not just a large fund issue; RI issues are relevant to all asset owners.”

He notes that more needs to be done to develop the tools that funds can use to encourage both their consultants and their asset managers to integrate ESG into their processes. USS has been an early adopter of ESG assessment across its portfolios, first developing a responsible investment policy in 1999 and appointing its first in-house responsible investment adviser the following year.

ESG materiality, current and future

The £34-billion fund recognises that integrating ESG factors into the investment approach is challenging, and so it looks at “extra financial factors” into asset selection and risk management. Its most recent review of responsible investing was in 2006, and it now has a strategy that seeks to protect and enhance the long term value of the fund by ensuring USS is an active and responsible investor.

“Our view of fiduciary duty hasn’t changed,” notes Russell. “We believe ESG issues are material and should be taken into account in investment processes. Unfortunately, given the time scales over which public equity investments in particular are made, and how the market considers ESG issues, they’re not always material to an investment decision is made today.”

To address this, USS has multiple approaches to RI, integrating ESG issues where they can be, and engaging with companies or even policy makers when they are not obviously material now.

Call it before it happens

Russell believes corporate governance is something that fund managers are more attuned to.

“Whilst governance isn’t easily quantifiable, it is something that fund managers are used to incorporating into their investment decisions”.

Russell believes that this isn’t yet the case with environmental and social issues, which are just as difficult to value, and where investors, policy makers, and society as a whole still need to recognise the financial implications of poor management.

Over recent years, Russell says there have been many examples of how such mis-management of environment and social aspects have materially impacted the value of companies. He points to BP, Vedanta, and Olympus whose share prices were all affected by either poor governance or poor internal management.

“The more there are such obvious examples where poor ESG management impacts value, the more likely both pension funds and their fund managers will do something to address them” he says. “The real trick will be to be able to call them before the happen.”

While the trend for most large institutional investors is to insource asset management, the $85-billion Washington State Investment Board (WSIB) has decided to take a different path.

Much-cited CEM Benchmarking research shows that funds with internal-management platforms are better performers after cost, and this is largely driven by the lower costs of internal management.

Many of the Canadian funds manage the majority of their assets in-house including OMERS, OTPP, CPPIB, and HOOPP, which manages all of its assets internally.

More broadly, AustralianSuper, New York City Retirement System and CalPERS have all made moves in recent months to bring more assets in-house, in line with CEM’s study.

However, the $85-billion WSIB is bucking the trend, which comes after much executive research on the topic and debate with the board, says executive director of the fund, Theresa Whitmarsh.

“The fundamental point is the CEM work is good but I don’t find it a definitive case for insourcing,” she says.

 

Staff in the house

One of the reasons for this is the case for talent, she says.

“Many of the funds CEM cites are unique because they are in Toronto and they can attract the talent. Toronto is like pension Mecca, like a Silicon Valley for pension funds; it has a labour market that’s reinforcing and that is completely different to Washington State and Olympia where we are based.”

In addition, many US public-pension funds are restrained by their budgets.

By way of example, CEM reports in its organisational design study of the world’s largest 19 funds, that the average salaries of investment departments in Canada was $536,000, in Europe it was $246,000, for the US$148,000, and in Australia and New Zealand $139,000.

In June, the WSIB board approved a compensation plan for investment staff, which it says will make progress in closing the 42-per-cent compensation gap between WSIB investment officers and the average investment officer of its peers.

Clearly this is an obstacle for the fund to hire more staff, which would be necessary to bring more assets in house, despite the potential future savings.

“At the board level, if we do more internally, we will need more legislative authority for budget, and that’s a non-starter in this market,” Whitmarsh says. “We’re succeeding under the current structure. I’m not completely convinced the insourced model is proven out.”

 

At a deeper level

Whitmarsh believes it is critical to look beyond peer statistics and to the circumstances that created the success.

“It’s not that simple. Success is not just governance and structure, but it is also asset allocation and the talent that could manage that. You have to look at it at a deeper level.”

She says the success of OTPP and CPPIB are often attributed to their insourced model, but it is also due to asset-allocation decisions and the organisations’ maturity.

“OTPP has had a high allocation to fixed income, which ruled last decade, and in the early 2000s CPPIB was not investing, so they missed the 2001 crash. Washington State has always been top-quartile with a largely outsourced model.

“What they’ve accomplished is excellent, but is it replicable for us just based on the insourcing model?”

The WSIB manages investments for 17 retirement plans, and at the end of June 2011, 31 per cent of its assets were in fixed income, 35 per cent public equities, 18 per cent private equity, 10 per cent real estate, and the rest allocated to tangible assets, innovation and cash.

The fund will conduct an asset allocation review in 2013.

Theresa Whitmarsh will join a panel on the insourcing debate at the Fiduciary Investors Symposium in Santa Monica. For information, click here.

To find out more about in-sourcing and other management options, click here to read The scope of financial institutions: in-­sourcing, outsourcing and off-­shoring.

There are three major behavioural shifts occurring among investors that will have significant impact on asset allocation in the next 10 years, according to a year-long study by global head of research at State Street’s Center for Applied Research, Suzanne Duncan.

An increase in investor sophistication, re-evaluation of the risk/return trade-off and more discernment over fees have been highlighted as trends in investor behaviour.

State Street’s research was derived from thousands of industry participants including retail and institutional investors, service providers such as consultants, and government and regulators from 68 countries. It is part of a one-year study looking at the investment-management industry over the next 10 years and will be released in November.

 

What exactly am I paying for?

Duncan believes the study clearly debunks the belief that investors have inertia.

“Investors are really looking for the service providers to show them the value they’re getting. On the institutional side investors are clambering for clarity with regard to value,” she says. “That’s different to price sensitivity. This is about being discerning, investors are becoming more sophisticated and they are willing to pay but only if they are shown the value they’re receiving for it.”

She says when providers demonstrate that value, it’s not necessarily commensurate with the fees being charged, and this may result in a continued movement from active to passive management.

“Investors are disenchanted for a reason. When we apply this level of sophistication of investors, we will see sizeable asset-allocation shifts.”

In other trends, the asset class with the largest allocation over the next 10 years for retail investors will be cash, while for institutional investors it will be alternatives.

Further, as alternatives allocations are increasing, so are allocations to direct forms of investments, which Duncan says shows a “disintermediation play”.

“Investors are questioning the value that professionals can provide,” she says. “There is no transparency around the value they’re receiving. Some of this is cyclically tied to the crisis, but those three behavioural trends are ongoing.”

 

Clash of best interests

Transparency continues to be a key theme for investors in terms of communication about products. Part of this is about the complexity of the products, but a lot is also about simplifying the message.

Investors thought that this problem may be exacerbated by regulators, with more than 50 per cent of them thinking current regulatory initiatives will not help to address the current problems.

“We may end up with information overload – not the right information. It’s not about volumes of information, but digestible forms of information,” she says.

The project, which has been nicknamed the “influential investor”, shows investors want to see the detail, the fine print, but they also want two sentences that are relevant to them at the macro level.

One worrying outcome of the research has been the mismatch between investors’ wish list and the preparedness of service providers.

“The investor wish list is the same list as the items listed as the top funds-manager weaknesses,” she says.

Further, only one third of investors believe that providers are acting in their best interest.

 

Restoring trust

However Duncan says the good news is that the industry recognises there is a big gap at the macro and micro level and is looking for creative ways to tackle it outside of the industry.

“This is interesting because they think the solution is not within this industry. I’ve been researching this for many years, and I’d say no one industry stands out but there are stand-out companies including Procter and Gamble, Apple and Audi, which are all about the experience,” she says. “The industry wants to look at what they’ve done and lessons learnt from them.”

The State Street research shows that what is driving the desire for transparency from investors is a restoration in trust from providers, markets and regulators.

Despite the seemingly dull future, Duncan says the research is optimistic because the industry is responding to the challenges.

“We have seen denial, then awareness, and now the industry is starting to be experimental in how we go about doing this,” she says.

The Center for Applied Research was launched in June 2011 to provide strategic insights into the issues that will shape the investment management industry.

The results of a year-long research project by State Street’s Center for Applied Research will be showcased at the Fiduciary Investors’ Symposium in Santa Monica. Click here for more details.