EDHEC-Risk Institute research associate Hilary Till looks at the risk management of commodity derivatives trading and the lessons that can be learned from recent high profile trading debacles.

Till, a principal, at Premia Capital Management, LLC, analysed several case studies and looks at risk management at large institutions, proprietary trading firms and at hedge funds. The research is a chapter dealing with commodity derivatives trading risk management in Risk Management in Commodity Markets: From Shipping to Agriculturals and Energy.

View this research here: Case Studies and Risk Management Lessons in Commodity Derivatives Trading

Advocating the use of financial models a six-year-old could understand and warning that the dogmatic belief in overly complex and unrealistic models contributed to the financial crisis were some of the challenging views put to the attendees of the recent CFA Institute’s annual conference.

Throwing down the gauntlet was GMO asset-allocation team member James Montier, who outlined what he saw as the key flaws of finance to members of the institute.

The fallout from the financial crisis was a point debated throughout the recent 65th Annual CFA Institute Conference in Chicago. Opinion was divided on whether the key building blocks of financial theory remained intact or had been fundamentally undermined by the events of 2008.

Montier told delegates that the four bads – bad behaviour, bad models, bad policies and bad incentives – explained the causes of the financial crisis and warned that the many of these key failings remained.

Montier honed in on the widespread use of risk measured by value-at-risk as an example of where investors were lulled into a false sense of security and/or ignored clear signs of growing risk due to an overdependence on finance modelling and theory.

“Using VaR is like buying a car with an airbag that is guaranteed to fail just when you need it, or relying on body armour that you know keeps out 95 per cent of the bullets,” Montier says.

“VaR cuts off the very part of the distribution of returns we should be worried about: the tails.”

He points to systemic problems if VaR is widely adhered to, with investors locked into pro-cyclical behaviour.

This would occur when the commonly used trailing correlation and volatility inputs to the model indicate lower risk or lower VaR, encouraging investors to increase leverage. Similarly, when VaR rises, investors are likely to collectively deleverage, further amplifying the market cycle.

The adoption of VaR by regulators encouraged bad incentives, according to Montier.

On the back of intense lobbying from powerful banking interests, VaR was extensively used as a means to determine capital adequacy and drove a surge in leverage in the banking sector.

Montier says volatility was a poor measure of risk, and pointed out the build-up of leverage in the financial system was also one indication of increasing risk.

In finding solutions to the causes of the financial crisis, Montier calls for investors to abandon their obsession with the concept of optimality. Rather than trying to construct optimal portfolios, investors should instead aim for robust portfolios.

He advised investors to treat financial innovation with suspicion and be mindful of the limits of financial models.

“All financial-model underpinnings and assumptions should be rigorously reviewed to find their weakest links or the elements they deliberately ignore, as these are the most likely source of a model’s failure,” he says.

To watch  Montier’s presentation to the the recent 65th Annual CFA Institute Conference in Chicago, click here.

In its most simple form, CalPERS defines sustainability as the “ability to continue”. This year CalPERS turns 80 and clearly “continuing” is something it wants to do.

The strategy paper, presented to and endorsed by the board, explains the fiduciary framework the fund has adopted to integrate sustainability across the entire fund and sets out the themes and visions for the future.

Anne Simpson, director of corporate governance at the fund, says one of the interesting questions for a fund as big and complex as CalPERS is “how do you actually get this done?”

“This is a new strategy for a total-fund approach with practical impact. It has been a two-year project, it takes time, so be patient,” she says.

In developing a total-fund approach, it was essential to get buy-in from all aspects of the fund at the outset.

The fund’s corporate-governance program has been overseen by a working group that has representatives from all the key constituents in the business, including the chief executive, the president of the board, the chief operational officer and head of external affairs.

“This allows the fiduciary, investment and all aspects of the business to be across it. This is critical to develop this new strategy,” she says.

“There is a question in the industry about whether the governance people sit in the investment team, legal or in a separate division, the answer is yes, in all of them.”

The outcome of the report is that implementing environmental, social and corporate governance (ESG) is now a strategic goal for the investment office, and it is a board commitment, she says.

“This won’t work if we can’t get the F into ESG,” she says. “It sounds like I’m swearing.”

Until Christmas, Simpson’s corporate-governance group of around 20 people sat within the global equities asset class. That has now changed and they work across asset classes.

“Previously we were in global equities, but that didn’t allow us to connect on issues across other asset classes, such as private equity. This move was made just before Christmas, and it is one of the moves we’ve made internally to implement the sustainability plan.”

At the same time the sustainability plan was being formed, the fund conducted its triennial asset-liability-modelling review.

 

External matters

It now manages assets in three buckets: growth, which includes public and private assets; income; and inflation hedges. The management of ESG is done within these different buckets and the appropriateness of the strategy assessed on each.

“The working group across asset classes had a representative from each, and the commitment of each asset class and a critique of the vision was done on economic grounds. They assessed the vision and how to link that on to an investment strategy,” she says.

“We have an economic view that wealth creation is through financial, human and physical capital and that became the intellectual framework for ESG.”

Each of these three elements – financial, human and physical capital – was then assessed in each asset class.

CalPERS still faced the enormity of how to prioritise these forms of capital in ESG implementation, and for clarity it benchmarked the fund through an international group of peers.

It communicated directly with 11 funds, all of which had more than $200 billion, including Norges Bank, Government Employees of South Africa, Previ, Ontario, PGGM and BT.

From that process clarity of how to implement a strategy became clearer, it prioritised one mission for each of the different areas.

Climate change became the theme for the environmental consideration. The reasoning was it affects all asset classes and CalPERS believes as a mega-fund with long-term liabilities, it will be impacted by climate change.

For social issues, priorities and human capital, talent management and rewards, human rights and fair labour practices across the entire supply chain will be a focus.

And for governance, alignment of interest is the key focus.

“It’s not everything, but we can’t do everything. We had to do something that speaks to our size, global exposure and the long-term nature of our liabilities,” Simpson says.

“Each asset class developed a couple of specific things before now and the end of the financial year.”

 

Internal considerations

In addition, another project is underway, a “manager’s expectation” document across the total fund.

“We have a complicated structure with internal management of public assets as well as external managers. If we think ESG has the potential to effect risk then we need to be consistent with expectations of internal and external experts. An expectations document is the next project to start next week.”

“CalPERS is in a leadership role. Rather than small portions of capital to the space, we want managers to look at risks and opportunities,” Simpson says.

CalPERS will also issue a request for proposals next month to review the “evidence” of the effect of ESG on risk and return. This will set the scene to commission new research, which ultimately will identify data and create a matrix to integrate into financials.

The fourth project, in what Simpson describes as a “mighty amount of work to do”, is to review the more than 110 initiatives and statements across the CalPERS portfolio.

This will be developed into a unified statement of principles for the entire portfolio.

“We have been doing a lot of rethinking about the long term, the fear of sustainability of returns, and the fundamental ability to pay pensions,” Simpson says.

Simpson says CalPERS has been proactive in leading by example internally.

It has cut its own greenhouse gases by 30 per cent between 2008 and 2010, more than 90 per cent of its printing and writing paper come from recycled sources, and it has conducted a governance overhaul, which includes in an external-board evaluation this July.

“We are willing to take those things on,” she says. “Asset owners need to act and engage intelligently on market level reforms. We need a broader vision.”

More than 1000 asset owners and service providers have signed up to the United Nations Principles for Responsible Investment, and yet the question on everyone’s lips remains how to actually integrate sustainability into the investment process and ultimately add alpha. Bill Mills, managing partner of Highland Good Steward Management, has an idea and a platform for such a solution.

As with any integration process, empowerment is crucial; for integrating environmental, social and corporate governance (ESG) into investment processes it is no different.

Mills is working on the premise that ESG information can be turned into alpha and it rests with empowering the investment decision-makers.

His solution is a labyrinth of players which are involved in a continuous multi-directional loop of information. But the secret, he says, is to leave the responsibility for decision making, with the fund manager.

The Highland Good Steward Global Bond Fund, which uses Pimco as the sub-advisor, has an emphasis on changing the behaviour of borrowers in a long-term sustainable way, but also to remain flexible enough to maximise short-term opportunities.

The key, Mills says, is to provide ESG signalling to the underlying manager in order to guide its long-term decision-making in sustainable companies without limiting its shorter term investment discretion.

The philosophy is that the outcome will be achieved by collaborating with the manager rather than replacing the manager’s judgement.

“Philosophically, we do want a sub-advisory based on traditional asset management with a track record. But we want to stimulate their thinking, not change their thinking, for ESG, but ask them to think deeper,” Mills says.

“What underpins all of this is that you don’t tell managers what to do. You hire the best managers, listen to them and work with them.”

There are a number of differences in this approach that distinguish it from simply overlaying a process with ESG information on a company.

 

How data signalling and engagement work
Highland Good Steward Management (HSGM) has developed a consortium of research firms that provide company ESG and socially responsible investment (SRI) information. This is fed to the manager as additional information for securities selection, of which the manager retains ownership.

The research consortium includes ECPI, Eco-Frontier, MSCI, CAER, EIRIS, and SocioVestix Labs, and produces a grading on 7000 companies for the individual elements of environment, social and governance, as well as a consolidated ESG rating.

“The data from these providers acts as a signal for the portfolio managers to use, alongside financial and other data used for analysis.”

“Highland will not limit Pimco’s investment choices by negative screening. Instead the aim is to collaborate with the manager in their search for additional alpha by integrating ESG considerations into their investment analysis.”

But it doesn’t stop there. Another element of the process is the use of a service, provided by Hermes EOS, to engage with corporations before and after the investment decision.

Colin Melvin, managing director of Hermes EOS, says engagement is a way of looking at longer term decisions and aligning the client.

“We have an engagement indicator that measures the quality of the company and its responsiveness to engagement. If you are considering it as part of the normal decision-making, then you want fund managers to do it as they do other things. But you can also use it to challenge managers on their decisions,” he says.

“For many, these issues have been taboo for funds managers. They have been overly impressed for too long by short-term decisions.”

Hermes engages this way with about 500 companies globally.

For this relationship, the engagement starts with investors suggesting themes. These currently include climate change, access to and utilisation of water, operations in troubled regions, supply chain, and access to medicines.

Hermes then suggests to HGSM certain companies that may have potential for engagement breakthroughs. This list is then taken to Pimco for the manager to analyse as possible portfolio holdings on the basis of their investment thesis.

If Pimco invests in these companies, which is at their discretion, then Hermes engages in focused impact engagement in order to accelerate the corporate and potential changes in share value.

It also works the other way: if Pimco invests in companies outside the HGSM research-consortium database, then HGSM can request that a research report on the company be performed by one of the research companies, and Hermes may also engage with that company.

“It is incorporating the manager in the process. We can take all the holdings in the fund and download them into research,” he says. “Over time we can see how the portfolio is moving towards E,S,G or not.”

 

Case studies on the HGSM platform
Mills points to the example of two companies as to how the process may work. On a corporate level, the companies would be analysed on a theme and how they engage with Hermes, and then ranked.

Say, for example, company A has improved its water management, which will be reflected in a good environmental score, but it has a tight yield spread. Compare this to company B, which historically hasn’t taken Hermes seriously on water engagement and has a low environment grade, but its yield spread is higher.

In recent times when Hermes engages with company B, it now wants its senior management to be involved, which is sending a different signal about how it is approaching the issue. HGSM sends the information to Pimco, instructing that it is a signal to be fed into the analyst’s process.

“They love that,” he says. “Everyone wants to prove ESG works. It entirely depends on the time frames, the same way for example value and growth does. We have been attaching the wagon to the wrong thing and setting ourselves up. The ideal way is corporate engagement – it is the only way to determine a company’s DNA.”

“You can be more explicit in engagement than data providers can be on performance. But the engagement partners are selected not with an eye to embarrassment but effective engagement.”

“We would go back to Hermes and say that water engagement is important to my client and Pimco bought 500 bonds on that basis. We will also share with the company we’re engaging with.”

“This is a long-term monitoring process that makes sense, it’s better than trying to prove alpha exists,” he says.

Mills is now transferring all the data from this platform to Microsoft Cloud, which makes it immediately customisable.

Institutional investors are clearly behind in risk management compared to the innovative techniques implemented in treasury departments of corporate America, chief investment officer of Wurts and Associates, Jeff Scott says.

Scott, who spent his career managing the balance sheet at Microsoft, Dow Chemical, the Alaska Permanent Fund and now investment consultant Wurts, says institutional investors want to manage returns, which is impossible.

“Returns are a function of animal spirits. They swing between fear and greed. Do companies really change in long-term valuation over the weekend?” he asks.

And while he points to investors such as Warren Buffet who “thinks about risk constantly with his capital”, Scott says many institutions are not thinking about risk.

“There is poor governance, and poor risk management. A lot of losses experienced by funds throughout the financial crisis were a function of missing simple risk-management concepts like custody of collateral and liquidity. You didn’t need fancy mathematical risk models instead of common sense you can get in Omaha.”

Scott says that institutional investors are behind in their risk-management practices.

“Many asset-management firms and hedge funds have far superior approaches to risk management than institutional investors. There are steps to take and it has to start with governance, and then understanding the risks you are taking.

Change of hats
As chief investment officer of Alaska, Scott managed a number of strategic partnerships with service providers, and now has flipped to the other side of the table to be providing those strategic partnerships.

“It is the same hat and we have switched it around,” he says.

Scott says he works with funds at an organisational level discussing a new approach to asset allocation, that is really risk allocation, but before that there needs to be a discussion around knowing the funds’ risk tolerance, which is a lot more than standard deviation.

“Two different funds could have the same investment objective but the exposure for each is different because of what it “means” to them in the overall context.”

“We take the objective and liability of a total enterprise and manage a diversified portfolio relative to that,” he says. “We show them how we manage that, take an active risk budget around that and how we manage that risk budget and how investments change.”

While a few managers may have similar propositions, what Wurts does is have a service agreement alongside the investment-management agreement, whereby that knowledge will be applied at the portfolio level.

In other words, Wurts is transparent about the risk of the discretionary portfolio it manages, but it also communicates that thinking at the organisational level, feeding back advice on organisational and governance change management.

“We have an investment-management agreement and a service-level agreement, which defines in writing what the strategic partnership program is designed to accomplish and how it will operate.”

The key to good governance, Scott says, is a clear delineation between who has authority, responsibility and accountability.

Scott says some concepts applied during his tenure at Alaska were concepts and methods developed in treasury management learnt at Microsoft and Dow Chemical.

Resourcing was an obstacle to applying more than about 60 per cent of the concepts.

The current chair of the Microsoft investment-advisory committee chair is Mohamed El Erian, co-chief investment officer of Pimco, demonstrating the complexity in the portfolio.

 

 

The Canadian Pension Plan Investment Board (CPPIB) is shunning European sovereign bonds, with the $152.8-billion fund’s head of investment saying European infrastructure offers far more attractive risk/return opportunities.

Mark Wiseman, CPPIB’s executive vice-president of investments, told delegates at last week’s Milken Institute Global Conference 2012 in Los Angeles that the fund had chosen not to invest in the bonds of European governments.

“If we buy a German bund all we are really getting is the full faith and credit of the German government and we have all learnt that that isn’t worth much,” Wiseman says.

“On the other hand what we have is a hard asset, for example we will buy the gas distribution in Germany and we will make a substantial spread on a regulated asset that is essential to the operation of the German economy.”

Wiseman says that the fund can achieve a return of upwards of 500 basis points above German bunds.

“We will make a substantial spread over German bunds and, quite frankly, I would rather own the gas pipes than a promise from Angela Merkel. I think this is a better risk and we are getting paid 400 to 500 basis points over bunds.”

Make-up of the maple
Fixed income makes up 36.1 per cent of the overall portfolio, and includes marketable and non-marketable Canadian government bonds, corporate bonds, other debt, absolute-return strategies, money-market securities and debt-financing liabilities.

Infrastructure makes up around a third of CPPIB’s inflation-sensitive asset bucket, which also includes inflation-linked bonds and real estate.

Inflation-sensitive assets make up 17.7 per cent of the overall portfolio.

 

The long-term view
Wiseman told delegates CPPIB was a long-term investor that tried to formulate investment strategies around a 25-year time horizon but also framed decisions in terms of a 75-year outlook.

In keeping with its long-term outlook, Wiseman told the conference that the fund was much more concerned about the risk of inflation than deflation in the world economy.

To do this, the fund has extensive real estate and infrastructure holdings that act as a hedge against inflation and is also looking to innovative ways to invest in commodities.

“Being a Canadian fund, we are naturally long commodities, and are increasingly buying commodities in the ground and thinking about an investment program where we are actually buying reserves, literally in the ground, that will be extracted in decades to come.”

Sharing the stage with Wiseman was Joseph Dear, chief investment officer of CalPERS.

Both Dear and Wiseman pointed to a movement away from traditional asset allocation models, with investors increasingly looking use a risk-based approach.

“It amazes me that people still are talking about asset allocation. If there is one thing we have learned from the financial crisis, it is that assets – when you least expect it – all tend to behave the same way or all tend to behave differently. But when you care about it the most, they don’t behave the way you expect in normal circumstances,” Wiseman says.

“What we have done and been thinking about for quite some time – and others are beginning to follow – is trying to get away from asset labels.”

 

CalPERS goes the Canadian way
CalPERS’ Dear told the conference that Canadian funds had been leaders in adopting a risk-based approach, and noted CalPERS was not as far down the road as its Canadian counterparts but was heading in the same direction.

The $233.6-billion fund has implemented an alternative-asset classification that attempts to address major risks the fund could face and protect against significant capital loss as a result of a major market event.

The restructure of asset classes resulted in assets being classified in five main groupings: growth, income, inflation, real assets and liquidity.

The fund also has an absolute-return strategy component of the overall portfolio.

The new structure allows the fund to allocate according to how these particular assets perform in low and high-growth markets, and the prevailing inflation environment.

Both the liquidity and inflation-hedging portfolios have a 4-per-cent target allocation.

Dear says that CalPERS risk-management processes are now aimed at protecting capital during major market events and providing a framework for assessing the portfolio in its entirety.

“We are shifting the whole approach to our capital allocation from asset class, such as this much equity, this much fixed income and so forth, to really a risk-factor based approach,” he says.

“Now, our friends in Canada have been pioneering this and showing the way in how to move away from the classic approach of the past 30 years and trying to figure out how you construct a portfolio in an environment that is going to be much tougher than we have had before, and how to get a better understanding and management of risk to protect yourself against a big drawdown.”

Wiseman told the conference that traditional asset labels bunched different assets such as government and corporate bonds together, despite the fact that they may have very different underlying risks.

“A bond could be a US government bond or a corporate distressed bond, which is, essentially, equity waiting to happen. But you would put both of those in your fixed-income portfolio and you then used to say I have this much allocation to bonds. It is nonsensical.”

Likewise, Wiseman says that CPPIB does not make a distinction between private and public equities.

“We allocate 65 per cent of our portfolio to equities regardless of whether it is public or private and look through these asset labels. I think this has got to catch on, not just for institutional investors, because this isn’t a particularly complicated way of looking at the world.”

CPPIB typically thinks of private equity as having a 1.3 beta, according to Wiseman. Dear says that CalPERS looks for a return of about 300 basis points above its public market benchmarks as the premium for the illiquidity of private equity.