MSCI looks at how equity investors can find European stocks that offer some protection against the current volatility buffering markets.

Zoltán Nagy and Oleg Ruban examine how the Barra Europe Equity model (EUE3) can be used to help identify stocks that are less sensitive to the unfavorable movements in troubled countries.

Using the covariance matrix of the EUE3 model, the researchers calculate the predicted betas of European stocks with respect to a given country. After repeating this separately for the five most troubled countries (Ireland, Portugal, Spain, Italy, and Greece), Nagy and Ruban look for common characteristics of the lowest beta stocks.

The results show important regional, sector and style commonalities among these securities.

To read the research click here

 

Co-head of responsible investment at the £32 billion Universities Superannuation Scheme, David Russell, says asset manager engagement with companies should move away from its “almost myopic focus on remuneration” to other issues that impact value and strategy.

His comments come on the back of the final report of the Kay Review of the UK equity markets and long-term decision making. One of the recommendations in the report was to improve the quality of engagement by investors with companies.

Russell says the challenge for the industry is in the implementation of the recommendations.

“Whilst we welcome the general thrust of Kay’s recommendations, the challenge is going to be with the implementation of the recommendations and the steps necessary to kick-start the changes needed which Kay has highlighted.

Across the board asset owners and asset managers in the UK have largely welcomed the recommendations.

Martin Gilbert, chief executive of Aberdeen Asset Management, one of the biggest managers in the UK with £182.7 billion in assets under management, said he was “very supportive of John Kay’s findings”.

“As an asset manager, we have very low turnover of about 10 per cent annually because we believe it is best to buy a good company and hold on to it as long as we can,” he said. “By being a long-term investor, it helps with engagement and corporate governance. We can engage with companies and act as proper and responsible owners of their stock.”

There were many recommendations that would have a material effect on the structure and habits of funds managers including disclosure of fees, re-thinking remuneration and a move away from quarterly reporting.

“I’m sure UK companies would like to move away from quarterly reporting but I think it would be difficult. US investors which many UK companies wish to attract to diversify their shareholder register view quarterly reporting as standard.”

The overall conclusion of the report is that short-termism is a problem in UK equity markets caused primarily by the decline of trust and the misalignment of incentives through the equity investment chain.

The review sets out principles that are designed to provide a foundation for a long-term perspective in UK equity markets and describe the directions in which regulatory policy and market practice should move.

“The epic story of Ulysses tying himself to the mast to resist the call of the sirens demonstrates the length of the history of attempts to construct devices and institutions to combat our instinctive short-termism. The central question for this review is whether capital markets in Britain today dissuade or stimulate the search for instant gratification in the corporate sector,” John Kay says in the final review report.

Some of the key recommendations of the review include:

  • Improving the quality of engagement by investors with companies
  • Increasing incentives to such engagement by encouraging asset managers to hold more concentrated portfolios judged on the basis of long-term absolute performance
  • Tackling misaligned incentives in the remuneration practices of company executives and asset managers, the disclosure of investment costs and in stock lending practices
  • Reducing the pressures for short-term decision making that arise from excessively frequent reporting of financial and investment performance, including quarterly reporting by companies and from excessive reliance on particular metrics and models for measuring performance, assessing risk and valuing assets
  • Companies should consult their major long-term investors over major board appointments
  • Asset managers should make full disclosure of all costs, including actual or estimated transactions costs, and performance fees charged to the fund
  • The Government and relevant regulators should commission an independent review of metrics and models employed in the investment chain to highlight their uses and limitations.

The review also recommends the establishment of an investors’ forum for institutional investors in UK companies.

USS’ Russell says ideas such as the investors’ forum are not new and it is uncertain of their impact.

“It remains to be seen if they will lead to this year’s increased voting and engagement activity becoming an established feature of the investment landscape,” he says.

“There also needs to be recognition that pension funds are broadening their holdings away from equities, particularly as defined benefit schemes mature. A consideration of what long term investment means for non-public equity holdings is essential in this context.”

Joanne Segars, chief executive of the National Association of Pension Funds whose members represent £800 billion says the report offers some useful, practical advances.

“Equity markets must work more effectively in the long-term interests of investors and savers, who need to be able to see that they are getting value for money.

“The NAPF is pleased to see Kay say that transaction costs and stock lending income should be set out more clearly. Boardroom pay must also become more transparent and more strongly linked to long-term performance.

“Most pension funds delegate responsibility for company engagement to an investment manager, and Kay is right that this relationship needs to be reshaped if good corporate governance is to develop further.

“Pension funds need to hold their managers accountable for delivering long-term returns, and quality stewardship should be a key factor when picking or reviewing investment managers. However, at present there are many competing priorities for trustees, and managers’ capabilities are difficult to assess.

“Our members regularly engage with companies on routine and more serious matters. This approach fits well with Kay’s suggestion of a forum to encourage collaboration among domestic and overseas investors, and it’s something funds will be keen to get involved in.

“We strongly support the FRC’s Stewardship Code and welcome the new best practice statements for asset owners. These could encourage pension funds to be more explicit in their expectations of their asset managers and more rigorous in holding them to account. We plan to incorporate the relevant parts of the statements into our Corporate Governance and Voting Policy and Guidance on the application of the Stewardship Code.”

 

 

A Columbia Business School case study on CalPERS has criticised the fund for being “opaquely transparent”, with a computation of investment expenses revealing the fund pays three-to-four times its peers in fees.

Written by Columbia professor of business Andrew Ang and Columbia CaseWorks fellow, Jeremy Abrams, Californian dreamin’: The mess at CalPERS examines the political, governance, staff and funding obstacles that the fund has faced.

One of the enduring aspects of the fund, according to Ang, is the lack of true transparency of reporting. While there is a lot of publicly available documentation, CalPERS does not report any meaningful numbers, he says. For example, the fund does not report a single management expense ratio (MER) figure.

“CalPERS does not directly report its expense ratios, or even its proportion of internally or externally managed funds,” the report says.

Ang and Abrams calculate total investment expenses by summarising investment expenses from several tables in the 2011 annual report, including the statement of changes in fiduciary net assets, schedule of fees and costs for private equity partners, schedule of fees and costs for absolute strategies program, and the schedule of commission and fees (see table).

According to the case study, in the fiscal year ending June 30, 2011 CalPERS’ expense ratio was 1.7 per cent for internally managed funds, 1.6 per cent for externally managed funds and 1.7 per cent overall.

This is significantly greater than CalPERS’ peers globally.

 Associated with transparency

A 2012 CEM Benchmarking study, which examined the organisational design of 19 of the world’s largest funds with average assets of $90 billion, found these funds spend an average of 46.2 basis points on external management, compared to 8.1 basis points on internal investment capabilities.

Ang, who describes the case study as “sad”, says not only is CalPERS paying significantly more than its peers in investment expenses, but because of its reporting it is difficult to see where value is added.

“The fund can start a reform process with transparency. They are transparent, everything is there, but they are opaquely transparent and need to report meaningful numbers,” he says. “For example, there is not one MER number recorded – the case study had to calculate both the total internal and external costs.”

Associated with transparency, Ang says, is the way the fund uses benchmarks.

“With more successful funds, the benchmarks are often simple, stable and easy to follow. They represent a
feasible alternative to the investment strategy in an indexed way, then you can see the added value.”

With CalPERS, he says, it is hard to see the costs and how much value is being added.

“For example, the fund has a huge cost for real estate but you can’t see what they’re spending it on,” he says.

“This is a clear symptom of management. You manage what you measure but you can’t see it directly at this fund. All this money is going out the door and you can’t see what it is for.”

The case study points to a number of political and governance issues the fund will need to overcome in order to position itself for success.

But on the investment side it also details the reactive nature of some of the decision-making, including the lack of a strict rebalancing policy before 2007.

Ang says lobbying for legislative change would be the best, but most difficult, way to make changes to the fund.

“It’s difficult because it requires political willingness, which is very difficult, but it could create something: a phoenix from the mess,” he says.

“But really working within the current structure of piecemeal reform is necessary. CalPERS could look to emulate best practice of funds within restrictive circumstances, for example, Alaska, which has done well on a shoestring budget.”

Ang, who will teach the case to his business class in the fall with an emphasis on the tremendous opportunities for change at the fund, says he deliberately didn’t speak with anyone at CalPERS “because I wouldn’t get approval”.

 

CalPERS investment expenses in 2011 (thousands of dollars) 
AUM Expenses Expense
ratio
Internal expenses
Consultants and professional services 87,337
Cost of lending securities 44,631
Real estate 1,893,044
Other 576,541
Brokerage costs 48,948
Total internal 155,781,798 2,650,501 1.7%
External expenses
Domestic equity 12,492,750 83,281 0.67%
Domestic fixed income 899,122 9,217 1.03%
Global equity 12,720,128 57,472 0.45%
Inflation linked 2,376,846 81,669 3.44%
Real estate 17,063,352 288,299 1.69%
Consultants 48,707
Attorneys, custodian and others 76,643
Alternative investments 34,398,914 658,879 1.92%
– private equity 28,908,879 516,858 1.79%
– absolute return strategies 5,490,035 142,022 2.59%
Total external 83,507,665 1,310,930 1.57%
Total AUM 239,289,463 3,961,431 1.66%

Source: “California Dreamin’: The Mess at CalPERS”, Columbia CaseWorks

Collated from the Comprehensive Annual Financial Report (CAR) 2011 and Annual Investment Report 2010 and 2011

Emerging markets debt is typically seen as an asset class in which investors can gain alpha through using active and usually external managers that charge for their niche access to segments of the market and on-the-ground local expertise.

However, two large institutional investors – Danish pension fund PFA and New Zealand Superannuation Fund – are taking a different approach.

PFA’s internal investment team has managed their emerging markets debt for more than a decade. Their holdings encompass the spectrum of available securities from US-denominated and local currency sovereigns to corporate debt.

New Zealand Super, the country’s sovereign wealth fund, approaches fixed income with the overriding aim of capturing the broadest exposure possible.

To achieve this goal the fund’s investment team have customised its own index, which attempts to capture the broad fixed-income universe, including emerging markets debt.

Both approaches are at odds with the approach advocated by top global consultants Top1000funds.com spoke to (click here to view story), who unanimously favoured investors seeking external, active managers for emerging markets debt.

PFA and tactical autonomy

PFA senior portfolio manager, Ulrik Roux Wolke, heads up the emerging-markets-debt team at the fund. He says that PFA generally favours internal management, and, despite the distance of the Danish fund from the markets it is investing in, emerging markets are no different.

“We believe in retaining knowledge internally; it adds quite a lot of value, also in terms of asset-allocation purposes and also for getting an overview of the market,” Wolke says.

“Every time you outsource, you lose a lot of knowledge. You can, to some extent, also argue that you cannot choose a manager if you don’t have a deep knowledge of the asset class.”

Emerging markets debt makes up 25 per cent of the fund’s strategic allocation to its credit bucket. The remaining credit allocation is split between 50 per cent investment-grade, developed-market corporate credit and 25 per cent US high-yield.

Of this 25 per cent strategic allocation to emerging markets debt, 85 per cent goes to hard-currency sovereign, with the remaining 15 per cent assigned to local-currency sovereign.

Wolke and his team are given autonomy to make tactical allocations to emerging market corporate debt.

Having the freedom to act tactically without pre-determined limits, which for external managers are often around such things as credit quality, is one of the advantages of internally management, according to Wolke.

“We prefer not to limit ourselves to very mechanical rules such as investment grade only. Rules such as credit quality are not a good substitute for risk management with in depth knowledge of the credit risk,” he says.

“I understand if you have an external manager but it is one of the positive sides of internal management that you can have a dialogue instead of having to impose rigid and not very workable rules.”

Wolke rejects the notion that external managers benefit from being close to the markets they are investing in, saying that being in Copenhagen and investing in emerging markets is no different to bond traders in London managing global portfolios.

“I also travel a lot and I am regularly visiting the markets in which we invest,” he says.

The internal team has the capacity to invest in ways that are essentially the same as an external manager, according to Wolke.

 On and off benchmarks

PFA benchmarks its internal emerging-market performance on the JP Morgan EMBI Global Diversified index.

The internal team then takes a number of off-benchmark positions. While he was not prepared to disclose the current positioning of the fund’s emerging markets debt portfolio, Wolke did say the fund takes off-benchmark positions, including in euro-denominated bonds, emerging-markets corporate and local debt.

Wolke says the off-benchmark positions are generally aimed at gaining an average credit quality that is higher than the index.

JP Morgan’s EMBI Global Diversified index has an average credit quality of Baa3/BBB-.

“I don’t believe in a strong rally of anything at the moment, so I think it is better to provision a bit and have some buffers,” he says.

The team also uses derivatives for a small proportion of its emerging-markets-debt portfolio.

“The advantage of derivatives is that you get a cleaner exposure. If you want exposure to a give credit risk, you can do it a lot cleaner without liquidity premium or a special duration segment which could be influenced by a couple of big investors,” he says.

The strategic allocation is also unhedged with the internal team free to make tactical hedges on a currency-by-currency basis, Wolke says.

The current position of the emerging markets debt is underweight local debt and corporate debt due the internal team seeing more attractive opportunities in US high yield.

Wolke identifies strong fundamentals in US high: “For the moment there is fairly positive redemption and maturity profile for the debt.”

The strong balance sheets of US corporations and good spread also adds to the case for US high yield, according to Wolke, who says the shorter duration of US high yield also makes it easier to manage potential interest-rate risk.

However, while there is a fair amount of tactical autonomy, Wolke says there is a view that the strategic allocation provides a base level of diversification.

“The 50/25/25 split is probably the minimum it can get down to in order to retain the diversification effect… The new norm is a lot of things are correlated, but I still think there is a need for diversification, otherwise you expose yourself to a lot of credit risk,” he says.

Kiwi customisation

Diversification is a key advantage of New Zealand Superannuation Fund’s approach to the positioning of its fixed-income portfolio.

The fund’s head of asset allocation, David Iverson, says that the fund has chosen to index its fixed income. The internal investment team uses its own bespoke blend of global, high-yield and emerging-market indexes to capture the broadest exposure possible to the total fixed-income universe.

“There is no single index that gives us a suitably broad exposure, so we have customised our own benchmark to capture the fixed-income universe as best we can using existing well defined and well accepted benchmarks.”

The primary index is the Barclays Capital Global Aggregate Bond Index, with the investment team also using an emerging-market hard-currency-debt index and a global high-yield index from the same Barclays family of indices. In addition, the fund also adds into its customised benchmark a global inflation-linked bond index.

“When we put these together, the global high-yield index and the global aggregate index have underlying criteria that creates a small overlap, but they virtually more than 90 per cent of the emerging-markets-debt index,” Iverson says.

“This means that we have emerging markets debt securities already in our customised index, so we have already captured that segment of the market.”

Iverson explains that the internal investment team generally sees little value-add from traditional external managers in the fixed-income space.

“Have we gained a broad exposure to the fixed-income universe is the first question,” he says.

“The second question – to go active or passive – depends on whether we think the manager can outperform the benchmark. Based on our current assessment, there isn’t enough additional return that managers can add in order to make it worthwhile to go active.”

Weighty issues

The current exposure to emerging markets debt is limited to hard-currency exposures.

This exposure represents 1.8 per cent of the fund’s total fixed-income exposure. Because the fund has a more-than-80-per-cent allocation to equities, at the total fund level this represents a 0.4 per cent exposure to emerging markets debt in its benchmark portfolio and 0.2 per cent in its actual portfolio.

Two years ago the fund decided to diverge from allocating assets according to a long-term strategic asset allocation and now actively allocates assets away from a reference portfolio.

Iverson, who was formerly head of Russell Investment Consulting in New Zealand, says that the reference portfolio is comprised of low-cost, simple investments capable of achieving the fund’s objectives. It then becomes a basis against which active decisions are made and assessed

The reference portfolio acts as a measure of the performance of the investment team. In addition, it is also a real measure of the internal team’s decision-making and also acts as a governance benchmark.  A small internal team is only needed to operate the reference portfolio.

The approach the investment team takes to indexing its fixed income portfolio takes a lot of the complexity out of the decision-making process around how to maintain a relevant exposure to fixed income relative to increasing proportion of the total fixed income universe.

While the actual allocation to emerging markets is relatively small at this stage, the customised index has the capacity to increase exposure to emerging markets as they become a bigger slice of the fixed-income universe, Iverson explains.

“In the first instance, what we do is we try to capture the market in proportion to its market capitalisation and whatever size of the emerging-markets-debt universe. So, say if there is more issuance, then the market value increases and the weight automatically goes up,” he says. “We don’t have to think about how large the emerging-market universe is becoming and to reweight to it.”

The global trend in emerging markets debt (that sees the market for hard-currency sovereign debt shrinking as more emerging-market countries start issuing debt in their local currency) has provided food for thought for the investment team.

Maintaining breadth of the fixed-income portfolio means that the fund is investigating gaining exposure to local debt, Iverson says.

“There is a reasonable amount of emerging markets debt in local currency that is and has been issued, making it a significant part of the universe,” he says.

“That is something we have looked to investigate and, if there are sufficiently well defined indices, we will customise our index to include them as well.”

In the 1990s emerging markets-debt indexes were limited to external US-dollar-denominated sovereign debt but as interest in the asset class has increased so has the breadth and depth of available indexes.

The JP Morgan family of emerging market-bond indexes contains some of the most widely used by investors.

In the 2000s JP Morgan expanded its coverage of emerging markets debt and launched local-currency Government Bond Index Emerging Market Global. This was followed by an emerging-market corporate bond.

Both local and corporate bond markets have grown strongly in recent times.

JP Morgan reports that as of the start of this year the underlying market value of its Government Bond Index Emerging Market Global Diversified (GBI-EM Global Diversified) was $864 billion.

This compares to $276 billion for its long-established external hard currency benchmark Emerging Market Bond Index Global Diversified (EMBI Global Diversified). The most widely used of its corporate bond indexes, the Corporate Emerging Market Bond Index Broad Diversified, has a market value of $213 billion.

In the two government bond indexes, the hard-currency index is distinguished by the greater number of countries it covers.

The EMBI G Div covers 44 countries, while the GBI-EM Global Diversified covers just 14 countries issuing debt in their own currencies.

Relative weights

Securities must be accessible for foreign investors, resulting in both India and China not being included in JP Morgan’s local currency index due to restrictions on foreign investment.

JP Morgan’s Corporate Emerging Market Bond Index Broad Diversified contained 336 individual issuers as of the start of 2012.

Of the three indexes, the corporate index has the greatest exposure to Asia, with a 40-per-cent weight in the index to Asian corporate securities. This compares with 29 per cent and 19 per cent for the GBI-EM Global Diversified and the EMBI Global Diversified, respectively.

Of the two sovereign bond indexes, there is not a great deal of difference in terms of regional coverage. The local-currency index contains marginally more emerging market Asia and slightly less Latin America relative to the hard-currency index.

The indexes, while broad, capture a slice of the total fixed-income universe.

By 2011 there were more than 70 countries issuing US-dollar-denominated sovereign debt and more than 45 countries issuing debt in their own currency.

As more countries issue investable debt in both local and hard currency, the number of nations included in the index is expected to increase.

Similarly, the local-currency index may include other forms of debt beyond government bonds as companies start to issue debt in their own currency in reaction to a growing local-investor base.

The corporate bond index has also shown traits of increasing diversity.

There has been a marked increase in the regional diversity in the index with corporate issuers from emerging Europe, Africa and the Middle East now making up more than 32 per cent of CEM BI Broad Diversified as of December 31 2011.

While banks remain the largest sector of the index, energy and telecom companies have expanded their market share in recent years.

 

JP Morgan emerging market bond indexes

Yield Duration (years) Credit quality
EMBI Global Diversified 5.69% 7.1 Baa3/BBB-
Corporate EM Bond Index
Broad Diversified		 5.8% 5.2 Baa2/BBB
Government Bond Index EM
Global Diversified		 6.23% 4.6 Baa2/BBB

 

Source: JP Morgan, January 2012