The Californian pension funds, CalPERS and CalSTRS, have taken a leadership role in promoting corporate board diversity, demonstrated in the launch at the NYSE this week of 3D with GMI Ratings, and membership in the Thirty Percent Coalition.

3D, which stands for Diverse Director DataSource, is a databank of pre-approved board candidates with an emphasis on highlighting people with fresh ideas and new perspectives.

The initiative is consistent with the funds’ focus on long-term shareowner value.

Anne Sheehan, director of corporate governance at the $150-billion CalSTRS, says 3D is a market solution to a supply-and-demand problem.

“As promoters of long-term shareowner value, we’ve been demanding greater diversity on the corporate boards of our portfolio companies for some time. Now we’re prepared to provide a tool to supply corporate-search firms and nominating committees with a deep breadth of quality board candidates. These professionals can not only do the job, but approach issues from diverse perspectives forged by a wide variety of backgrounds and experience, as well as by gender or ethnicity.”

Anne Simpson, CalPERS senior portfolio manager and director of global governance, says 3D is an innovative resource that opens the door to finding candidates whose fresh ideas and new perspectives can help companies generate lasting value and provide a check against the kind of ‘group think’ that played a significant role in the financial crisis.

Chair of GMI Ratings, Richard Bennett, says corporate boards work best when they reflect a diversity of perspective and experience.

“With 3D, we created an accessible resource to help companies and recruiting firms identify and recruit candidates sometimes overlooked under traditional search processes. We encourage candidates to continue submitting their credentials for review.”

GMI Ratings is an independent provider of global corporate-governance ratings and research.

It makes business sense to embrace more women

Separately the funds, as part of the Thirty Percent Coalition, sent a letter urging change to the 41 S&P500 companies that do not have any women on their boards.

The Thirty Percent Coalition is a group of pension funds, state officials, fund managers and women’s groups that is pressing for gender diversity on corporate boards.

According to reports by Catalyst, ION and Governance Metrics International, women only hold between 12 and 16 per cent of corporate board seats.

Studies have shown there is a correlation between greater gender diversity among corporate boards and management, good corporate governance and long-term financial performance.

The Thirty Percent Coalition project leader, Charlotte Laurent-Ottomane, says substantial research underscores the correlation between gender diversity, good governance and positive long-term corporate performance.

“We are urging the business community to embrace this elemental truth.”

The letter references quotas being adopted in numerous countries around the world to increase the number of women on corporate boards but proposes instead that companies in the US voluntarily embrace more ambitious diversity goals because it makes business sense.

The group has set a three-year time line by which it would like to see 30 per cent of corporate board seats held by women.

CalSTRS’ Sheehan says the group intends to follow up and engage with each of the 41 companies, asking them to “welcome women to their boards”.

“Whether it’s in dialogue with management, through shareholder resolutions or related strategies, we intend to press for change. And then we’ll move beyond the S&P500 to other companies as well. Our goal is to continue engaging companies until women hold at least 30 per cent of corporate board seats across the United States.”

Of nine board members at CalSTRS, women hold three positions, including the chair, Dana Dillon.

At CalPERS there are only two women on the board.

 

Consultants are recommending investors have as much as 10 per cent of their fixed-income portfolio in emerging markets debt with endowments, public pension funds and even some corporate clients using liability driven investment strategies showing increasing interest in the asset class.

Top1000funds.com spoke to consultants from Callan Associates, Hewitt EnnisKnupp, Cambridge Associates and Russell Investments who universally advocated investors actively manage emerging-markets-debt allocations.

Karen Harris, vice president for Callan Associates’ capital markets research group, says they are seeing increasing interest in the asset class from public pension funds, which have to achieve return targets of around the 8 per cent mark, as well as insurance companies.

The higher yields on offer in emerging markets debt are attractive to these investors, according to Harris. Callan’s analysis shows that the asset class generally has a low correlation to US fixed income and a higher correlation to US equity.

Harris notes that most new investors to the asset class have looked to go into US dollar-denominated sovereign debt as an introduction to the asset class, with the JP Morgan EMBI Global Diversified index the most popular benchmark.

Callan is also seeing increasing interest in local-currency offerings. However, emerging markets corporate debt is generally viewed as more of a tactical allocation, typically accessed through active management.

Harris says investors can also gain from active managers who can provide broader exposure given the index universe doesn’t currently represent the available opportunity set.

“Callan recommends up to 10 per cent of the fixed-income portfolio could go into emerging markets. If you took the market-cap weight of all the emerging market opportunities in the benchmarks, it is probably 3 to 7 per cent of all global fixed income” Harris says.

“Then, if you said ‘what about all the other bonds not included in these indexes?’, managers are putting out numbers that say the universe of EMD is up to 25 per cent of the global-bond-market cap, then we think somewhere between index-market cap and potential global opportunity sounds like a reasonable strategic allocation.”

A good fit for insurance funds

This 10 per cent allocation was also seen as an advisable level of exposure by consultants from Russell and Hewitt EnnisKnupp.

While Harris says Callan is seeing limited interest from corporate pension funds in emerging markets debt, insurance companies with large fixed-income allocations see attractive diversification opportunities in emerging markets debt.

In addition to the potentially higher yields on offer relative to most developed market debt, emerging markets debt is also a good fit for the overall investment objectives and regulatory requirements of insurance funds.

“Due to the statutory requirements, insurance companies do not carry bonds at market value; they carry them at book or amortised cost so book yields to some degree are as important to insurance companies,” Harris explains.

She is typically seeing allocations to emerging markets debt of between 5 and 10 per cent of a fixed-income portfolio from large institutional investors.

Emerging markets debt does not have a role to play in a fixed-income portfolio for Cambridge Associates, says the consultant’s Singapore-based managing director Aaron Costello.

Cambridge believes that the role of fixed income should be extremely defensive, providing a source of liquidity in times of market stress.

Accordingly, Cambridge advises that fixed-income holdings should generally be high quality bonds in the investor’s home country.

“The idea of combining EM debt into your fixed-income portfolio, if you view it as a source of safety, is suboptimal to us,” Costello says.

The role of emerging markets debt for Cambridge, therefore, is as a diversifying asset.

“While emerging markets debt will tend to be risk-on, they are certainly less volatile and less correlated to global equities than, say, emerging market equity for example,” he says.

“So in the current environment, it is a way of increasing returns over a fixed-income portfolio without taking full equity risk.”

 Emerging-markets-debt exposure on the rise

This diversifying characteristic for emerging markets debt makes the asset class interesting today from a risk-adjusted return perspective, along with high-yield developed-market bonds and certain hedge fund strategies, according to Costello.

T. Rowe Price portfolio manager for emerging markets debt strategy, Mike Conelius, says that, despite flows into emerging markets debt having grown strongly over the past decade, it is just the start of a global shift to emerging market assets.

While acknowledging that some investors will have exposure to emerging markets debt through globally focused bond indexes, he says that this still represents a considerable underweight relative to the opportunity set.

“The flows coming from the developed world are really now just kicking in and clearly they are leaving the developed world,” Conelius says.

“The numbers we have seen are around 3 per cent of fixed-income allocations and it has to be the biggest underweight in a global context, especially when adjusted for fundamentals.”

Costello notes that in 1999 only 15 per cent of their surveyed endowment-client base had an exposure to emerging markets debt, with the average size just 1 per cent of the total portfolio.

This allocation remained fairly static through most of the subsequent decade until the last couple of years.

Cambridge figures show by the first quarter of this year almost 40 per cent of its clients reporting an exposure to emerging markets debt.

The average allocation was 2 per cent of an overall portfolio, with allocations above 4 per cent generally considered large.

Attractive duration diversity

In contrast with Callan, Hewitt Ennis Knupp’s Chicago-based senior consultant Francois Otieno says they are seeing burgeoning interest among US corporate clients looking to include small allocations of emerging markets debt into their portfolios.

While noting that this is currently at the “discussion phase”, Otieno says that emerging markets debt can offer attractive duration diversity for some liability-driven investments (LDI).

“I won’t say these discussions are at are at the general level, but we are starting to talk with some clients about emerging markets debt as part of a broader LDI-type allocation,” he says.

“As you are building out an LDI framework, clearly it is long duration-focused, but as you are building that glide path you do allocate to a number of different materials across the yield curve. So, emerging markets debt is not generally issued at the long end and it generally plays a role in the intermediary part of the curve. It is really a yield play.”

Otieno is seeing allocations among some public pension funds of as much as 30 per cent of their fixed-income portfolio in emerging markets debt.

Russell Investments UK-based portfolio manager, James Mitchell, says that emerging markets debt generally forms part of the growth component of investors’ fixed-income portfolio.

“Investors are typically looking to build out an emerging-market sovereign-debt component with a 50/50 split between hard and local currency,” Mitchell says.

 

Swedish buffer fund AP2 is investigating a move from traditional market cap-weighted benchmarks for its fixed-income portfolio to using other metrics, such as fiscal sustainability or GDP weights, the fund’s chief investment strategist Tomas Franzen says.

The 216.6-billion Swedish krona ($30.9 billion) fund has more than 36 per cent of its portfolio in investment-grade fixed income, with Franzen saying that the approach could also extend to the fund’s actively managed emerging-markets-debt holdings.

AP2 uses four external managers for its emerging-markets-debt exposure.

If the fund was to adopt such an approach, it would be in line with the strategy already adopted in AP2’s equity holdings, in which the use of non-market-cap weightings is already well established.

Franzen says that the fund is currently researching this approach as there is an increasing consensus that market-cap weighting for debt securities results in investors having a concentrated exposure to the biggest debt issuers.

For sovereign debt this generally means an exposure to more heavily indebted and slower growing developed-market countries.

AP2 reported in its most recent annual report that its biggest exposure to fixed-income securities is in its home country of Sweden.

This makes up 17 per cent of its overall portfolio, followed by North American fixed-income securities, European at 9 per cent and emerging markets 4 per cent.

“We have been using non-market-cap weightings for the past six or seven years and we are looking to do a similar thing with our fixed-income portfolios and not use the debt footprint, so to say, but rather use other metrics such as fiscal sustainability measures; GDP weights are also a very simple approach,” Franzen says.

“If you look at the credit market, for example, you can also see that fundamental weights could improve your portfolio significantly. So, rather than taking bets on regions, maybe we are trying to use other metrics for other allocations.”

“Rather than taking bets on regions, maybe we are trying to use other metrics for other allocations,” AP2 chief investment strategist Tomas Franzen says.

Liquidity constraints
Franzen says that the need for liquidity constrains how broadly the fund can adopt non-market-cap weight approaches, particularly in the emerging-markets segment of its fixed-income portfolio, where there are already inherent liquidity constraints.
“Maybe you cannot deviate very much from the market or debt footprint, but on the margin it can improve your portfolio quite significantly,” he says.
The need for liquidity at the buffer fund was put into sharp focus when AP2 experienced its first net outflows in 2009.
The fund has continued to pay out more in benefits than it has received in contributions in the past two years. Projections of high levels of new retirees in the coming years are predicted to cause net outflows to continue for some time to come.

Deeper into emerging markets debt
In keeping with their established mandate to seek higher returns, the AP funds are expected to take on more controlled risk compared to the risk exposure of the remaining 90 per cent of assets in the Swedish system.
Part of managing this risk is through increasing the diversification of the fund.
In 2011 the fund took the decision to comprehensively reallocate its long-term strategic portfolio from Swedish equities and fixed income towards emerging markets equities and government bonds.
While the fund has had some exposure to emerging markets debt since 2002, the decision to tilt towards emerging markets took its holdings of that market’s debt from 1 per cent to 4 per cent.
Last year, as AP2 wanted to finance the new allocation to EMD local currency from its developed-market sovereign bond portfolio, the fund essentially had to restrict the investments to investment-grade bonds. Currently AP2 has allocations in emerging markets debt to both hard-currency and local-currency sovereign debt. The allocation ratio is three to one favouring local-currency debt, which is essentially a reflection of the overall market structure.

Sticking to benchmarks
The fund uses what Franzen describes as a bespoke JP Morgan index as its benchmark for its local-market exposures.
This benchmark is based on the JP Morgan Government Bond Index – Emerging Market, but has been adjusted to only include investment-grade fixed-income securities.
In keeping with its investment approach to emerging markets equities, the emerging markets debt portfolio also has a tilt toward Asia.
The combined position of the four external managers results in an exposure for the fund that is evenly spread across regions.
This results in a slightly higher allocation to Asia than the benchmark and less of an exposure to Latin America and emerging markets in Eastern Europe.
However, Franzen notes it is up to external managers to select country weightings but that its managers are limited to how far they can stray from the fund’s benchmarks to ensure accurate performance attribution.
“There are a few off-benchmark opportunities they can make and we try to stick to our own benchmarks as much as possible,” he says.
“If not for other reasons, then to not make it too easy for managers to take systematic risk above the benchmark and report that back as alpha. So, there is some leeway but we try and keep that to a minimum.”
AP2 does not have a specific allocation to emerging markets corporate debt, although it does have some exposure to emerging markets corporates through global credit mandates.
“It [emerging markets corporate debt] is not on our research radar, to be honest, at the moment but it could be a natural extension of what we are doing,” Franzen says.

A modest shortfall
However, the fund does not have the capacity to manage emerging markets debt in house.
“We use only global managers and expect them to play both in the security selection and country selection arena,” Franzen explains.
AP2 also externally manages its emerging markets equities holdings. However, it is currently looking at how this might be bought in-house.
“Basically, what our external-manager team is doing is to search for superior external managers and, within a framework of active risk budgeting, allocate the investment capital between them. Of course, they are looking to select managers that are somewhat dissimilar among themselves in order to have diversification and low correlations,” he says.
“But you know it isn’t really the way it works all the time. When something hits the fan, it seems to be all over the place. Against that, a lot of managers have similar exposures to different themes but of course we try to find managers who can diversify among themselves.”
Franzen says the fund’s emerging markets debt has outperformed its developed-market sovereign-debt portfolio.
Over the past two years developed-market sovereign debt has achieved 6.4 per cent in annual returns compared to 11.1 per cent for the emerging-markets-debt portfolio.
Over the past three years the difference has been even greater, with developed-market sovereign debt achieving 5.8 per cent compared with 13.7 per cent for emerging markets debt.
The last year has been a difficult investment environment for emerging markets debt, says Franzen, with currency volatility a drag on returns.
“Where active returns are concerned, it is really a mixed bag over the past 12 months. It has been quite a tough market climate with a lot of currency volatility,” he says.
“On average, however, the managers have not been able to beat their benchmarks, but the shortfall is very modest compared to the benefit of having the asset class as such in the strategic portfolio.”

Not content to sit back and wait for the market to move, PGGM decided to learn by doing and launched its own responsible-equity portfolio three years ago. In line with its belief that sustainability pays, PGGM’s portfolio has a long-term investment horizon that integrates financial and environmental, social and governance (ESG) factors with active ownership.

The belief that sustainability pays translates, in philosophy and implementation, to an appreciation of investing over the long term, the need to integrate financial and ESG considerations, and the culture required to achieve positive investment results consistent with that ideology.

Head of responsible-equity strategies at PGGM, Alex van der Velden, says in the past few years there have been perceived positive moves in the market regarding ESG awareness, but in reality little uptake.

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

“At PGGM we decided the only way to do it was to learn by doing – not sitting back and waiting for the market.”

Van der Velden says evolutionary behavioural change can take a generation, so PGGM took on the role of acting as a catalyst for change.

“If you look back over history, then change only occurs when people are forced to change,” he says. “A catalyst for change is needed in this area. ESG is all about what hasn’t happened yet [in terms of portfolio impact].”

One unified strategy

PGGM’s Responsible Equity Portfolio makes up 3 per cent of the overall assets of €125 billion, or 10 per cent of the equities allocation. It began life in January 2009 with €1 billion and since then has grown to €3 billion.

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

This has resulted in a three-pronged analytical approach involving fundamental financial analysis, ESG integration and active ownership.

There is also recognition that ESG analysis takes a substantial amount of time, not just to understand the specific facts, but more importantly to understand their financial relevance. This has meant that the approach by PGGM is active and concentrated.

The portfolio combines fundamental financial analysis, ESG analysis and active ownership into one unified strategy with the overarching aim of identifying companies that are financially attractive, responsible and open to engagement.

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

“You still need a finance background, but you really need that one-in-a-hundred person who is open-minded enough to make up their mind after analysis,” Alex van der Velden says.

In a Rotman International Journal of Pension Management article, van der Velden outlines a set of eight Responsible Equity Portfolio (REP) Investment Principles, which define what it thinks companies that will thrive over the long term look like.

“They have strong management and ESG disciplines and offer good value/growth prospects at low inherent level of financial risk including low leverage, low capital requirements and sustainable margins.

“Management’s proactivity on ESG issues and strong financial metrics provide an important proxy for assessing company stability and management quality, as do openness, transparency and honesty.

“We are aware there are limits to the depth of this analysis when we approach a company as an outside investor, and that management access is essential to truly understanding a business and creating the opportunity to exercise good oversight. To achieve this access, REP always aims to be a top-20 investor to investee companies, with the corollary that companies can be candidates for investment only if senior management team meets with members of REP on a regular basis.”

In addition, REP will invest in a company only if its business model and balance sheet can be understood.

The insistence on thorough and deep financial and ESG due diligence, combined with the desire to maintain an active corporate oversight, requires a concentrated portfolio.

REP targets 15 to 20 holdings and at the moment it only looks at developed-European and North American companies. The emphasis on the long term implies that the average holding period of each investment can be expected to be many years.

Performance issues

The success of the portfolio remains to be seen over the long term, but in the three-year period since inception it has performed well.

Van der Velden says it is premature to report on the portfolio’s performance as it focuses on the long term, but he says one of the more enduring aspects of its success is the culture of investing at PGGM.

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

“Any organisation starts at the top. One factor that slows progress is the extent to which pension funds are risk-based culture – as opposed to an investment focus. Investing €1 billion in an unproven strategy takes courage, and few people have the mindset to take that risk. However, our experience across other asset classes has shown us that there is a substantial early-mover advantage,” he says.

Overcoming entrenched opposition

Fellow Dutch investor APG is also taking on this approach and also has a team and a portfolio dedicated to ESG. But across the industry van der Velden says there is little pressure to change.

“There is an innovation dilemma when you do something new. Our leadership in the start-up phase was what kept us protected. When you do something different from the norm within any large organisation, there is a risk that the vested interests work against it.”

He points to a recent article in Vanity Fair magazine that demonstrates why new initiatives at Microsoft have failed over the years.

“Don’t underestimate the innovation dynamics that are at play in large organisations. There is generally an entrenched opposition to change, it is important that the top leadership is behind it.”

Daring to differ

Consistent with a long-term focus, PGGM’s portfolio had a three-year lock-up period and this allowed the manager to make mistakes without fear of repercussion.

“It takes away the short-term pressure to prove yourself. In fact the first two companies we invested in were complete basket cases,” van der Velden says. “One was a bad financial decision and the other was very poor on ESG despite our analysis. During the start-up phase we made quite a few mistakes, but overall still had a good first year. And we learned a lot and continue to do so.”

PGGM has a 10-person team dedicated to this portfolio. It also takes input from the company-wide responsible investment team, but it was important for the portfolio managers themselves to be engaged and not use overlays by another team.

“This empowers the analysts, they decide ESG is valuable or not as the case may be,” he says.

With regard to assembling the right team, PGGM’s experience points to finding the right skill set that combines a traditional finance background with an open-mindedness to look at other considerations.

“You still need a finance background, but you really need that one-in-a-hundred person who is open-minded enough to make up their mind after analysis. We have quite a young team, they have the daring to do something different.”

Go figure

Van der Velden says the REP process results in a portfolio with collectively lower financial and ESG risks.

The portfolio had a tracking error of 5.9 per cent in the fourth quarter of 2011.

Because of the concentrated nature of the portfolio, most of the absolute risk can be explained by stock-specific risk. It believes the higher stock risk can be balanced by the ESG risk analysis.

PGGM has developed its own toolbox and looks at more than 80 relevant ESG data factors which reflected an absolute, not relative, measure of ESG risk.

“Except for the most egregious engagement situations, generally share prices don’t reflect ESG risks. People say it is priced in but there is still a long way to go before that is the case,” he says. “As an investor, I ask whether I am being compensated for that risk, we need to compare companies on an absolute level.”

On the ESG risk side PGGM is developing better tools to measure ESG, but one proxy for ESG risk – CO2 emissions – show REP companies emit 150 tons of carbon per €1 million of sales, while the S&P500 companies emit 473 tons of carbon per €1 million of sales.

 

 

The idea of accessing risk premia through the use of index-based funds and ETFs has been gaining momentum in recent years. Risk premia indexes aim to reflect the equity premia of stock characteristics such as value, size or momentum.

Among the risk premia indexes, equally weighted indexes are some of the oldest and most well known. This MSCI Research Insight paper revisits the rationale behind equal weighting and profiles the recent performance of these indexes.

Click here to read Demystifying Equal Weighting.

A line in the sand has been drawn on the short-term behaviour of all participants in capital markets – including companies, brokers, funds managers and investors – with the formal commitment of five stock exchanges to promote long-term, sustainable investment and improved environmental, social, and governance disclosure and performance among listed companies.

With a combined 4600 listed companies in developed and emerging markets, the five stock exchanges – NASDAQ in the US, the Brazilian BM&FBOVESPA, the Johannesburg Stock Exchange (JSE), the Istanbul Stock Exchange and the Egyptian Exchange – have voluntarily committed to work with investors, companies and regulators to promote long-term sustainable investment and improved environmental, social and corporate governance (ESG) disclosure and performance among companies listed on their exchanges.

The endorsements came during the Sustainable Stock Exchanges (SSE) 2012 Global Dialogue, held at the Corporate Sustainability Forum in Rio de Janeiro, an initiative co-organised by the Global Compact, the United Nations Conference on Trade and Development (UNCTAD), UN-backed Principles for Responsible Investment (PRI) and the UN Environment Program Finance Initiative UNEP FI).

Institutional investors can take some credit for the enrolment of exchanges in the take-up of ESG reporting (see table below).

Prime movers for good governance

The JSE, which was part of the commitment, was the world’s first exchange to require listed companies to disclose financial and sustainability performance in single integrated reports.

In a committed and bold move, from March 2010 the JSE requires companies to submit integrated reports or list elsewhere.

South African professor and corporate-governance advocate, Mervyn King, was instrumental in the exchange moving to integrated reporting, with the King Report on Governance for South Africa 2009 (King III) outlining many of the arguments.

King is also the chair of the International Integrated Reporting Council (IIRC), which comprises a cross section of international leaders from the corporate, investment, accounting, securities, regulatory, academic and standard-setting sectors.

The IIRC will publish the world’s first Integrated Reporting Framework by the end of 2013.

It believes that by reinforcing the linkages between an organisation’s strategy, governance and financial performance and the social, environmental and economic context within which it operates, integrated reporting can help business to take more sustainable decisions and enable investors and other stakeholders to understand how an organisation is really performing.

It says the integrated reporting framework will underpin and accelerate the global evolution of corporate reporting, enabling organisations to communicate the full range of factors that contribute to the creation of value and ensure they are embedded within an organisation’s strategy.

There is an Integrated Reporting Pilot Program, made up of 70 reporting organisations and the IIRC investor network of 20 investors chaired by Colin Melvin of Hermes EOS, which is providing feedback on the framework.

 

ESG disclosure call
In January last year a group of 25 PRI investors sent letters to 30 stock-exchange chief executives and listing authorities around the world asking them to support their call for improved ESG disclosure. Here’s what investors wanted stock exchanges to consider:
Encouraging better internal corporate governance within companies, such as improving structure, independence and quality of boards of directors and disclosing how sustainability issues are addressed at the board level.
Consulting with companies on how they should be integrating sustainability into long-term strategic decision-making – such as highlighting risks and opportunities within the existing business model on their website and in their financial report. This includes encouraging companies to undertake integrated reporting.
Distributing guidance for listed companies on material sustainability issues, global initiatives and other opportunities that encourage ESG disclosure.
Mandating that listed companies have a non-binding shareholder vote on the sustainability report or sustainability strategy to be put to the AGM.