Asset owners remain understandably challenged to incorporate sustainability factors into global equity allocations. Global macro trends make clear that sustainability considerations will be increasingly essential for consideration, but often less clear is how to factor this into portfolio decisions in a sophisticated manner.

Dwindling natural resources and the world’s related ‘carrying capacity’ is translated by the Global Footprint Network into the concept of “global overshoot”. This year, apparently, the world will consume 1.5 times the amount we should do in order to remain relatively sustainable as a planetary whole. Reaching this point earlier in the year on an ongoing basis pretty much ensures that natural resources will become scarcer over time, with demand/supply dynamics likely to impact corporate profit levels and related portfolio valuations. That is unless companies increase value-chain efficiency or otherwise can pass on increased costs to ever-budget conscious global consumers.

The likes of Jeremy Grantham and Jason Schenker of Prestige Economics talk at length of this coming inevitability, as well as related effects from overpopulation, extreme weather linked to climate change, ongoing challenges to biodiversity and more, all of which may seem daunting, not only from a fund management perspective.

Outperformance

The good news is that outperformance has already been seen by forward-looking mostly large-cap companies, and so the opportunity to weight portfolios towards sustainable innovation and best practice on sustainability has emerged as a vital strategy for asset owners to consider.

Examples of this outperformance abound. In classes I teach at the University of Maryland’s Smith School of Business and Columbia University’s Earth Institute, we have constructed what have gone on to become outperforming portfolios using just this sort of methodology.

One challenge has been that while sustainability-driven companies outperform, predominating negative approaches to the field do not and have not performed well. So, asset owners remain unconvinced. It is critical to parse out positive ESG approaches from negative ones, and the difference in performance has been dramatic.

Sustainability: many things to many people

The definition of sustainable investing can vary, but it calls for future-oriented investment with sustainability risks and opportunities firmly in mind, measured in a sophisticated manner, including keeping one eye firmly on the viability of the business as a whole and another on the quality of management, including factors such as trust and culture. Culture has emerged as a key indicator of success from a sustainability standpoint.

Companies that are both innovative and can manage their sustainability risks successfully belong in such portfolios. Apple, for example, has managed well its lengthy environmental and social challenges.

Prior to this, in Sustainable Investing: the Art of Long-Term Performance, my co-authors and I demonstrated outperformance from positively focused sustainability mutual funds for the one, three and five years leading up to the end of 2007, while negative approaches at best met market returns. And so I understand the widely held belief that asset owners cannot outperform through socially responsible investing (SRI), however this is a direct function of the sophistication of existing and available strategies. Other examples abound. In April 2012, a sustainable innovation portfolio focused largely on US companies had performed over 50 per cent better over the previous five years versus the S&P 500.

The S&P 500 over the last five years – less coal, oil and financial services and double weight tech – has done much better than the plain vanilla S&P 500. The top 100 of the Newsweek Green Rankings companies over the first two years outperformed the S&P 500 by 4.8 per cent. These may come across as a series of correlations, but larger trends may also be afoot.

As pointed out in Evolutions in Sustainable Investing, over 90 per cent of SRI portfolios in the US remain largely focused on negative approaches such as taking a benchmark and subtracting alcohol, tobacco and firearms. Environmental considerations in such portfolios tend to be retrospective views of past violations, rather than seeking companies finding revenue streams from solutions to sustainability challenges going forward, and hence are not indicative of finding opportunity.

From a fiduciary duty standpoint, all asset owners need to attempt to maximise returns, and so it is exciting that a focus on sustainability trends can help with this, so long as a positive, well considered iteration of sustainable investing is applied. Negative approaches have understandably not convinced fiduciaries. Positive opportunities focused strategies may one day be the definition of fiduciary duty itself, and these strategies retain the potential to create a dynamic, which if applied by enough of the market, could drive the sort of change which would benefit all categories of stakeholder.

Are broad emerging-markets allocations still appropriate?

By analysing the trend of mandate configuration, this paper by MSCI looks at whether the emerging-markets concept is dated and whether broad-based emerging-markets investing remains an appealing way to capture economic growth premium.

Read the report here.

Received financial wisdom holds that the price of virtue for ethical investors is lower returns. It all depends on the time frame, argues Tom Joy, director of investment for Britain’s Church Commissioners, who manage the Church of England’s £5.2-billion ($8.38 billion) pension fund.

The Church Commissioners, as fund managers who are ultimately accountable to God, abide by strict ethical guidelines. They cannot invest in a range of sectors, from tobacco and alcohol to defence and pornography. In the short term, the guidelines make the fund more vulnerable to market “headwinds”, says Joy, but they also create a “liberating” long-term investing horizon, “especially in terms of taking on much more illiquidity in assets like property, timber and private equity.”

The Church Commissioners’ accounts provide some support for Joy’s theory. Over the past 20 years, the fund’s assets have grown in value by an average 9.5 per cent per year, compared with average annual UK inflation of 2.9 per cent. From this relatively long-term perspective, the fund has comfortably beaten its strategic target of a return at least 5 per cent higher than inflation. In the past decade, Joy estimates that ethical exclusions have on average clipped about 0.5 per cent per year off the fund’s returns, which makes the performance even more respectable. However,  since the 2008–9 financial crisis, exclusions have cost the fund far more in lost investment opportunities, because – put crudely – cigarettes, drink and other addictive human vices are strong defensive stocks in a downturn. In 2011, the commissioners reported that exclusions reduced the return from the global equity portfolio by 1 per cent, and the return from UK stocks (where the fund is more exposed) by 2 per cent. Set in that context, the fund did well to make a total return of 2.9 per cent last year.

An income defined by history

A few lean years are not going to deter the commissioners from their mission to observe exemplary ethical investing standards while distributing about $322 million annually to help fund clerical pensions and support other church needs, such as the upkeep of cathedrals.

“Our added value is that we are not just another ESG fund that generally raises issues on sustainability or governance grounds,’’ says Edward Mason, secretary of the church’s Ethical Investment Advisory Group (EIAG). “We take a distinctively ethical approach when we engage with companies, and focus on what is right and wrong.”

Given this approach, it is ironic that history, far more than Christian morality, has defined the overall shape of the fund today. When Henry VIII broke with Rome in the 1530s, the English Crown seized clerical taxes previously paid to the Pope. In 1704 Queen Anne transferred this income to a charity to relieve clerical poverty, which forms one of the modern fund’s inherited income streams. Another source of income is real estate, with the fund exploiting freeholds and leaseholds that in some cases have been owned by the church since before the Reformation.

Property has in fact been the fund’s saving grace in recent years. The real estate portfolio accounts for about 30 per cent of its total value and ranges from historic church estates such as the Old Bishop’s Palace at Ely, near Cambridge, through about 1800 residential and commercial properties close to Hyde Park in London, to more recent investments like the Metrocentre in northeast England, Europe’s largest shopping mall. In addition, the commissioners own about 105,000 acres of mostly prime English farmland and more than 40 mineral-extraction leases.

In total, property assets delivered a 13.1-per-cent return in 2011, boosted by substantial international demand for the fund’s upmarket residential properties in central London.

… and theology  

Meanwhile, equity investments, representing about one-third of the fund’s total value, provide the main testing ground for the Church Commissioner’s ethical guidelines. The EIAG’s exclusion check list for equities, which is reviewed four times a year, is both wide-ranging and specific.

Arms manufacturers are always excluded if they produce “indiscriminate” weapons liable to kill civilians, from landmines to nuclear bombs. Yet the fund is allowed to buy stakes in companies that make conventional weapons, provided military sales do not amount to more than 10 per cent of  turnover.

“As Christians, we recognise that the world is imperfect and that war may be justified in certain circumstances, according to the theology of a just war,” says Mason, whose group also advises two smaller Church of England investment funds.

The fund cannot invest in companies that publish or distribute pornography, defined as material “with the primary, proximate aim, and reasonable hope, of eliciting significant sexual arousal on the part of the consumer.” This blanket interdiction covers everything from Playboy to hard-core material that cannot be described in a family-friendly publication like top1000funds.com. Any company “substantially involved” in alcohol, tobacco or gambling is out, and the fund has given advance notice that it will never invest in a bioscience firm that researches or develops human embryonic cloning.

With missionary zeal, the EIAG – whose members range from theologians to lay Anglicans with business expertise – tries to convert invested companies to the Church’s ethical position. In 2011, the EIAG held 35 “engagement meetings” with companies, focused on the fund’s 20 largest holdings, mostly in Britain. They included BP, which the EIAG took to task for safety and risk management failures in the Deepwater Horizon oil spill, and News Corp, which the EIAG castigated for lax corporate governance during the phone hacking scandal. In News Corp’s case (but not BP’s), the fund sold its $3.1-billion stake because the EIAG felt the company had not responded adequately to its criticisms.

Omnipresent influence

There is, in short, hardly a corner of the investment universe that is not subjected to the EIAG’s moral scrutiny. For instance, the EIAG disapproves of hedge funds that engage in overly aggressive short-selling, mineral companies that operate dangerous or dirty mines, “payday” loan businesses that charge steep borrowing rates and any firm that pays its executives too much. (In the UK last year, the commissioners voted for barely one-third of all remuneration reports at invested companies.)

It is arguable, though, that the fund’s ethical lobbying and exclusion is wasted effort for two reasons. Firstly, the fund, while substantial, is hardly a global investing giant. So why would companies pay much attention to what it does or says? Mason counters that the fund punches (ethically) above its weight because it represents the church, and furthermore, often acts in concert with other ethical investors like Norway’s sovereign wealth fund and the US Interfaith Center on Corporate Responsibility.

A second, more profound objection is that the fund cannot truly be ethical if it embraces “big capital”  – for example, by investing in the same banks that precipitated the worldwide financial meltdown in 2008. “The Church Commissioners should start taking their money out of big international banks and consider placing it with alternative banks that make small loans for the greater social good,” argues Jonathan Bartley, co-founder of Ekklesia, a Christian think tank in London. Bartley, who co-wrote a recent paper criticising the fund, adds that the commissioners need a “complete rethink” of their strategy.

Mason responds that the EIAG “puts an awful amount of thought into what it means to be an ethical investor, with a view to coming up with a distinctly Christian approach to the issue.”

Like the Bible itself, that approach also appears open to widely varying Christian interpretations.

Delegation is a fundamental obstacle to the alignment of asset-owner and asset-manager goals. However, Sebastien Pouget, professor of finance at the University of Toulouse, believes a combination of customised performance benchmarks and a dual short and long-term fee incentive can help overcome the problems of the principal/agent relationship.

Pouget, who spoke at the recent United Nations-backed Principles for Responsible Investment Academic Conference in Canada, discussed whether aligning the interests of asset owners and asset managers is actually possible.

He believes the motivation shouldn’t be a problem in meeting long-term expectations, as the investors and the assets in which they want to invest both have.

Asset owners, with long-duration liabilities, should be long term and the companies they invest have projects and assets that are also the long term.

“It’s tricky when between the companies and investors you have asset managers who report on quarterly a basis, are evaluated on a yearly basis and after a few years face the risk of being fired,” he says.

Correcting short sight

This “long fight against short sight” has been well documented academically, most recently by the Kay Review, and the industry itself has also tried to come up with solutions, such as the CFA’s report, Breaking the short-term cycle.

One proposal has been to lengthen mandates in terms of management and compensation, but Pouget believes that’s largely futile – there is still an end date that alters behaviour.

“Asset owners face a trade-off between compensating asset managers in the long run, once investment outcomes are known, and offering bonuses based on a short-run performance, so that asset managers do not have to wait too long,” he says. “These different horizons are of a profound nature. There is a long chain of delegation in this industry, so it’s the nature of the relationship in the entire industry that’s at stake.

“Asset owners don’t want to give the keys to the car to a manager for 20 years, it’s a question of talent (or is it trust) that you want to allow yourself room to replace that manager in case they’re not up to it. This is very fundamental, even if you have funds management inhouse, you still need to think about pay, performance and time lines.”

There has been much economic theory studying this delegation and Pouget’s theoretical solution is for asset managers to be paid in the short and long term, and critically for their performance to be measured against a benchmark specifically constructed to be skewed against the long term.

“You can design a performance benchmark that is appropriate. This might mean overweighting assets that are sensitive to long-term issues such as value assets, resource and development-intensive assets, and ESG. Smooth out the short-term asset-price movements.”

In this way, Pouget says short-term incentives can be useful for promoting long-term goals.

“If the manager has overweighted an industry where there’s a bubble, then you won’t compensate them in the short term because you know in the long term the bubble will burst, so there is no long and short-term alignment.

Liquid enough?

“Short-term incentives are effective to promote long-term goals when the market is liquid enough, so for large caps and mature industries, and when there is a good coordination between long-term investors and subsequent speculators,” he says, noting that short termism is more prevalent when long-term information acquisition is more costly, and more difficult to monitor, for example, in intangible items and ESG issues.

“You can satisfy them in the short term and satisfy you in the long term. But crucial for this mechanism is to know what the level of efficiency in the market is. For example, if you have information of the long-term prospect of a company, then you can pay more of their fee now because it’s priced in the long term anyway,” he says.

He does say that rewarding managers only in the long-term may be detrimental to both asset owners and market efficiency.

Ironically, he says that in the absence of long-term incentives, asset owners may refrain from collecting long-term information, which is short-termism.

Determining market efficiency

A mix of short and long-term compensation may be optimal. If financial markets are perfectly efficient, prices reflect long-term information and short-term incentives are effective.

“Conceptual analysis tells you that you can use short-term bonuses only if the efficiency of the market is good. So as an asset owner, you should do work on the current level of efficiency.”

The big question, then, for asset owners becomes how you determine the level of efficiency of the market.

Pouget says the level of liquidity of market can be a determinant of efficiency, but also that asset owners should use resources similar to traders and invest in research such as microstructure theory, which looks at how specific trading mechanisms affect the price-formation process.

“By studying the behaviour of asset prices, you can determine whether there is asymmetric information or whether there’s information that the market doesn’t know,” he says. “Asset owners could invest in more inhouse research to better monitor managers.

“I am a professor and as an academic you have to be humble. Maybe if it’s not done in practice, there’s a reason why there are limitations.”

 

Pouget’s paper, Fund managers’ contracts and financial markets’ short-termism, can be accessed here.

Denmark has blitzed the pension-system competition, being awarded the first Mercer Global Pension Index A grading. In the process, it has relegated the Dutch and Australian systems to second and third places, respectively, after four years.

Mercer senior partner and report author, David Knox, says the reasons for awarding Denmark the top grade were clear.

More than 80 per cent of the working-age population is covered by the nation’s pension system, the contribution rate is 12 per cent and assets put aside for the system are 150 per cent of GDP.

In addition, Knox says the Danes have relatively few funds so they can reap the cost benefits of economies of scale through administration and also through participating in large-scale investment deals.

The Danish darling

While the Mercer index rates countries on their systems – not the individual funds within the country – it is worth pointing out that the $98.4-billion Danish ATP fund is widely recognised as one of the best funds in the world.

It has a mission of matching assets and liabilities, and is managed in two distinct portfolios: hedging and investment or return-seeking. It’s the hedging portfolio, which hedges as closely as possible the interest-rate exposure of the fund’s pension liabilities, that allows the fund to sustainably pay its beneficiaries. See article here.

Lars Rohde, chief executive of the fund for 14 years, has been appointed the new governor of the country’s central bank. Replacing him at ATP remains a challenge for the board.

Raising the Netherlands

While it moved to second place, the Dutch system improved its rating from 78.9 to 79.9 this year, with improvements in both the adequacy and sustainability ratings. The Dutch system is in the middle of major reform discussions, with a likely move away from its current defined-benefit structure to a “defined-ambition” one. See article here.

Equities for Australia

The Australian system improved its score slightly from 75 to 75.7, primarily because assets as a percentage of GDP improved and, with the slated guaranteed contribution increase of 9 to 12 per cent, Knox says he expects the Australian score to gradually improve.

However, he said that regulatory reform, particularly as it applies to the provision of an income stream, will be needed in order to improve the rating further.

From an asset-allocation point of view, the main point of difference was the allocation to equities. Both Denmark and the Netherlands have less than 20 per cent in equities across the system. Australia has one of the highest allocations to equities of the OECD countries, with more than 45 per cent.

Annual additions

Each year since inception, the index has been tweaked slightly. This year an integrity question was added. Using the World Bank’s worldwide governance indicators, a “governance of governments” was measured.

“We want people to trust the long-term pension systems, and that means they have to trust the government to not change the system,” Knox says.

The global coverage has also expanded every year with the number of systems covered growing from 11 to 18 in the past four years.

Denmark and Korea were added this year, and last year it was Poland and India.

The index is calculated by assigning values to adequacy, sustainability and integrity. About half of the index questions are sourced from international groups, such as the IMF and the OECD, while the other half are sourced through Mercer.

It is produced by Mercer and the Australian Centre for Financial Studies and funded by the Victorian State Government.

The full report can be accessed below.

Mercer pension index 2012

 

For many years Japan has been an insurance-market behemoth and Japan Post Insurance Company is one of the giants with $1.13 trillion.

But the industry has not been immune to change. Between 1997 and 2001 seven life insurance companies became insolvent, and there is a question mark over whether it was a low interest-rate environment that caused this fallout.

Given that history and the current low interest-rate environment, investment risk manager at Japan Post Insurance Company Ryujiro Miki, who will speak at the Conexus Financial Fiduciary Investors Symposium, says it is worth exploring the potential effects on the insurance industry.

 

Mixed messages

The economic statistics in Japan are grim: the official government bond rate is 0.8 per cent, having peaked at about 8 per cent in 1980. Similarly, the Nikkei peaked at ¥39,000 in the 1990s and now it’s at ¥8000.

However, the bond market in Japan is unique in that 92 per cent of the nation’s debt is domestically owned. Furthermore, the Japanese government owns 40 per cent of the banking system directly, and about half of government bonds are held by government-owned institutions.

“Japan owns the bond market, external debt is very tiny; we are self sufficient,” Miki says.

“Since the peak of interest rates the Japanese industry has been trying to get rid of excess capacity so inflation has not been an issue but deflation has been… The debt-to-GDP ratio is 200 per cent – much worse than Greece – but the net-debt position is half that.”

The Japan Post Group is 100-per-cent owned by government. It is made up of two gigantic institutions, both of which are the largest in the world: Japan Post Insurance, which has $0.8 trillion of US-dollar-denominated Japanese government bonds (JGB), and Japan Post Bank, which has $1.8 trillion of them.

“We hold roughly 30 per cent of JGB,” Miki says.

The Japanese government is looking to sell the stock of a number of holdings in order to recapitalise after the earthquake, most recently the airline, and Japan Post Group is on its list.

 

Lesson from the 1980s

The potential listing has great consequences for the market more widely. If it lists and diversifies its asset allocation away from domestic bonds, it could have an effect on interest rates.

Back in the 1980s interest rates were deregulating but there were also a number of structural issues that contributed to the demise of the seven insurance companies, worth about $120 billion. These included financial deregulation and globalisation, a maturation of the death-coverage market and fierce competition for private insurers to raise assumed interest rates to struggle against public insurers.

In the 1980s insurance coverage was meeting its limit, according to Miki. While interest rates were deregulating, investment-style products were becoming more popular.

“Investors wanted high-return products and insurance companies were competing against the mutual-fund industry,” he says.

But really, Miki says, it was the absence of risk management, and asset-liability modelling, that led to the failures in the 1980s, not low interest rates per se.

“Under the circumstances, there was too much rapid expansion and concentration on risky assets, but there was a lack of corporate governance, an absence of risk culture and good management,” says Miki, who at the time was in the investment-planning department at one of Japan’s private insurance companies.

One of the main lessons from that time is that asset-liability modelling is the key to hedging interest-rate risk, Miki says, but he believed enterprise risk management, or lack of it, was the real cause of the insurance companies’ demise.

“It wasn’t the bubble bursting alone, but bad management also,” he says.