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The complexity of sustainable investing could be a step too far for many asset owners with current governance not up to the complexity of embedding environmental, social and governance (ESG) factors into decision-making, according to head of Towers Watson Roger Urwin.

The comments come as the global asset consultant is set to release the results of Project Telos, a collaborative project spearheaded by Urwin and done in conjunction with Oxford University.

Also partnering on the project were 22 investment management partners and eight chief investment officers. The global CIO group included Mohammed El Erian of Pimco, Jim O’Neil from Goldman Sachs Asset Management, Adrian Orr from New Zealand Super and Jaap van Dam from PGGM Investments.

Streamlining complexity

Urwin says that the Project Telos aims to provide a road map to sustainable investing as a way of streamlining the challenging complexity of integrating sustainability considerations into asset owner decision-making.

“Telos is trying to help organisations to take on a new strategy when often the governance they would have to move to that new approach would be super-stretched by this type of change,” Urwin says.

“The governance of asset owners across the world is not strong. I didn’t say weak and that is important. Because in some respects to be too negative about asset-owner governance is to lose track of the difficulties that asset owners have in managing complex funds in the fast-moving financial markets of today.”

Having been at the coal face of fund governance, working with some of the world’s biggest asset owners on improving their decision-making processes, Urwin says that sustainability demands funds ask big questions beyond traditional investment approaches.

It also brings into the spotlight what he describes as the “governance gap” between the existing levels of fund governance and the demands of managing an increasingly complex investment landscape.

Clarifying a “worldview” and a set of beliefs around investment at the board level is crucial to starting down the path of sustainable investment.

Urwin says that sustainable investing has become more justifiable than ever from a “finance first” point of view.

For Towers Watson this involves a definition of sustainable investing that encompasses long-term investing that is efficient – as measured by return per unit of risk.

Sustainable investing also entails intergenerational fairness: “We measure that by the terms of the deal for present, current participants being as good as the returns enjoyed by future participants of a fund,” Urwin notes.

While the detailed findings of Project Telos have not yet been released publically, Urwin says the project aims to provide road map covering key areas from drawing up sustainable investing mandates to managing risk exposures to ESG factors.

“It is a cute phrase, but funds don’t have the bandwidth to deal with sustainable investing at the moment,” he says.

“That is why Towers Watson is helping funds to embed sustainable investing within the investment process, and a change management process around road maps is the best shot at the task.”

Transformational change

The work done in Project Telos involves thinking about “transformational changes” and positioning portfolios with a view to how these changes will affect investment performance over the medium to long term.

Towers Watson identifies three transformational changes involving slowing growth in developing economies; the changing demography and the declining work force in developed countries and China; and resource scarcity and the pressure it will put on natural capital.

According to Urwin, traditional investment approaches look to gradually plan for the future on a year-by-year basis, while sustainable investing demands fiduciaries form a view that takes into consideration some of the key risks that can have a material effect on portfolios.

It is an approach that attempts to position a portfolio both for today’s conditions and simultaneously for what the future may hold, Urwin explains.

Starting with a clearly defined set of investment beliefs and worldview, a fund could take the step of committing to the UN-backed Principles of Responsible Investment (PRI) as part of starting the process of embracing sustainability.

Urwin describes this process as “emblematic” and “only one piece of the whole”. Asset owners also have to roll up their sleeves and get down to the nitty gritty of looking at their manager line-up and how to construct mandates that reward a long-term focus.

This would involve an integrated assessment to look at sustainability practices.

“Sustainability encompasses ESG exposures, it’s a portfolio assessment, it’s a process assessment but it also encompasses the economics of the relationship, the fees in the relationship, the benchmarks used,” Urwin says.

Part of this process is a “de-emphasis” on the role of cap-weighted benchmarks as a measure of performance, with a greater focus put on absolute returns over long periods of time.

Using the navigation principle of triangulation as an analogy, Urwin says that an emphasis on outcomes is a way of “getting a fix on a manager from two lines of sight”.

Moving from a relative benchmark to incorporating absolute-return objectives requires substantial governance work, according to Urwin.

“Benchmarks drive portfolios; bad benchmarks drive bad portfolios. This principle is being applied here. So the driving force behind portfolio construction is an outcome more than a relative-to-benchmark position – that type of point is a key part of the sustainability conversation,” he says.

Another clear signpost on the road map is funds thinking about their exposures to certain sustainability themes.

As part of this, traditional notions of asset allocation are expanded to include so-called smart-beta, in which investors use both specific mandates and asset-allocation decisions to capture exposures to a variety of ESG-related themes.

Urwin points to ESG-weighted indices as an example of a fast-growing selection of investment tools to measure and give exposure to ESG factors.

Finally, the road map also encourages an expanded role for the notion of ownership responsibility, encompassing asset owners as not just investors, but advocates for a broader range of issues.

“Asset owners and asset managers as their agents must have a much more developed view of their ownership responsibility, particularly in respect to the major causes of our time,” Urwin says.

“So, examples will include the oversight of the banking sector and their externalities, oversight of companies with environmental responsibilities and influence on important societal questions such as corporate pay.”

Urwin says that Project Telos has grappled with the question of fiduciary obligation, explaining that the road map is underpinned by an “enlightened view” of what constitutes fiduciary duty.

He says members now expect their fiduciaries to address issues such as executive compensation or environmental concerns.

With total portfolio costs of only 15.3 basis points, the $43-billion United Nations Joint Staff Pension Fund is one of the most efficiently run pension funds in the world – not bad for a fund that has investments in 41 countries and 23 currencies. This year it embarked on an operations overhaul to bring even more efficiency to its investment management.

The fund claims to be the world’s most globally diversified pension fund: not only are its investments in 41 countries and 23 currencies, it serves 23 different member organisations scattered all over the globe.

This year it joined the twenty-first century with an investment-operations overhaul designed to bring further stability to its investment approach as markets continue to be volatile.

“Underneath the mess in markets, we built an infrastructure we think every fund should have. Basically we retired our fax machine,” says Suzanne Bishopric, director of investments at the United Nations Joint Staff Pension Fund (UNJSPF).

Of the world and in the world

The fund now has an integrated trade-order-management system, which is fully integrated with SWIFT and matched with an independent master record keeper

In the past the fund followed its own UN-accounting standards – not those standards adhered to throughout the world.

“We are now using accounting standards, followed throughout the world, that are robust. This has allowed us to do a lot of other good stuff like monitor brokers. We know within a minute if a trade has been executed. It gives us great monitoring power and the risks of mistakes are less.”

The fund is monitoring any distinction in transaction-execution costs in a quarterly report and Bishopric says it’s starting to pay off.

United Nations Joint Staff Pension Fund: Ajit Singh, deputy director for risk; Suzanne Bishopric, director, investments; Toru Shindo, deputy director, investments.

“We have learnt that you don’t have to reinvent the wheel. There are standardised products out there and if you take a modular approach to it then you don’t disrupt your operations. We started with the payments side, then our trade-order-management system, so we can keep brokers honest. The trade-matching and affirmation software keeps settlements safer and this is important for us because we’re global,” she says.

It isn’t a joke that the fund has “retired its fax machine”; until this digital technology was introduced it was still using faxed orders.

“We would send a fax to Brazil and get a reply the next day. Now we are as close to the state of the art as any fund; we’ve leapfrogged some intermediate technology,” she says. “We went from a green field to state of the art. But there is an advantage to being a latecomer: we can see what is tried and true and what the industry standards are.”

Measuring up

Bishopric says the fund’s 58 staff recognised they needed these standards to improve their performance and put in a lot of effort to make it happen.

About 90 per cent of the fund’s assets are managed in-house, except for private equity and real estate.

It recently engaged CEM Benchmarking to do a cost-benchmarking study, which revealed its costs were “off the charts on the low side”, according to Bishopric.

The total investment costs of managing the portfolio were 15.7 basis points, which is an outlier in terms of global funds, it is “dangerously low”, she says.

The fund’s global peers typically operate within the range of 40 to 80 basis points.

Compared with other funds the UNJSPF saves money because of its internal trading and it also has a very low allocation to alternatives, currently less than 1 per cent, and similarly less than 5 per cent to real estate.

At the end of March 2012, the fund’s asset allocation was 60.7 per cent equities, 28.8 per cent bonds, 4.5 per cent real estate, 5.2 per cent short-term investments and 0.8 per cent alternatives.

However, there is a plan to increase the alternatives allocation, which Bishopric says is being done methodically and judiciously, adding about 1 per cent per year.

The fund’s biggest alternative investment is with the World Bank Group’s Intenational Finance Corporation’s African, Latin American and Caribbean Fund (IFC ALAC), which is a private equity investment.

“The philosophy is the investment has to resonate with our organisation,” she says. “We have a number of restrictions, such as tobacco and defence, reflecting the ethics of the UN.”

One reason the fund invested with the IFC fund is that it is managed consistently with principles of responsible investment (PRI).

“We can then learn private equity their way first, through a beneficial approach, before going to the private markets.”

The World Bank green bonds are another investment and an example of the fund investing according to PRI, she says. There are also other screens in their equity investments, such as worker safety.

The fund recently tested its new system in a disaster-recovery test, during which everyone in the investments team worked from home. Bishopric was in Montreal at the time and the deputy director for risk, Ajit Singh, was in Geneva.

“We managed to do our trades,” she says. “It was extremely beneficial and I highly recommend everyone do that. As Treasurer of the UN, I lived through 9/11 and having systems helped us enormously then.”

Operating reforms will save costs, she says but insists the point of pension investment management is to manage returns, not costs, the net return is the important place to focus

Having said that the fund did have a negative return last year partly due to a huge weight in Europe. It has investments in 41 countries, with North America dominating, followed by about 25 per cent of assets in Europe.

“There is uncertainty to what will happen in the eurozone,” she says.

“A set of irrevocable exchange rates poses some serious constraints. If you have an irrevocable exchange rate then greater flexibility will be required from other economic factors, such as labour or interest rates. There is a single currency but not the same creditworthiness.”

UNJSPF has liabilities in Europe, so “we do need to have some exposure there,” she says.

At the moment all the assets are managed in New York, but Bishopric says budgets not withstanding, it would be ideal to have an office in a different time zone.

However, she acknowledges that satellite offices are a risk and need to be well staffed, and have the same risk management and oversight as any office.

“You can’t start a second office on the cheap,” she says. “Operating infrastructure is a missing thing in fast-growing funds.”

UNJSPF also implemented RiskMetrics this year and now every portfolio manager has access to the risk parameters of portfolios.

“We analyse the portfolio risk at least weekly. Because we manage money in-house, the fund can benefit from delving deeper into the components of risk.

“We can look at every stock and it’s attribution to risk,” she says. “We can find outliers in every portfolio and remove them. We did that in the first quarter when we wanted to dial down risk.”

Bishopric is slightly optimistic: she says the value-oriented managers are seeing great valuations not seen since 2008.

How do the current economic risks facing developed economies such as the eurozone and the US impact your thinking regarding allocating assets to emerging markets (EM) debt?

On the back of a continuing shift in corporate pension plans away from defined benefit to defined contribution, Northwestern University’s Joshua Rauh and Indiana University’s Irina Stefanescu look at what causes the resultant freezing of these corporate plans.

The paper takes the further step of looking at the consequences for both employees and plan sponsors, investigating if the freeze results in savings to the companies as well as the impact on retirement-savings outcomes.

To read The Freezing of Corporate Pension Plans: Causes and Consequences, visit the Rotman School of Management’s International Centre for Pension Management.

US public-pension funds significantly underperform their global peers in real-estate portfolios due to a propensity to manage the assets externally, according to a new ICPM-sponsored research paper by three Maastricht University academics.

Value added from funds management in private markets: an examination of pension fund investments in real estate looks at real-estate investing among the 880 pension funds on the CEM database from 1990 to 2009. On average the allocation to real estate was 5.5 per cent, but fluctuates over time.

The paper by Aleksandar Andonov, Nils Kik and Piet Eichholtz examined the funds’ approach to investing in the asset class, costs and performance.

The paper found that US funds, both small and large, underperformed their self-reported benchmark by a whopping 127 basis points per year. Furthermore, their costs were twice as high as their global peers.

“I would be asking how it is possible that you do this and you keep on doing this,” Eichholtz says.

“This paper found that a fund’s approach, size and geography determine the cost and performance in real estate. You can’t choose to be a US or non-US fund, but you can learn from your peers.”

The paper found that while large pension funds overall are more likely to invest in real estate, they invest internally and have lower costs. They also have some exposure through real-estate-investment trusts (REITs) and few fund-of-fund investments.

Smaller funds are less likely to invest in real estate and more likely to invest in funds of funds.

Eichholtz said with regard to costs, the biggest driver is the approach decision, how a fund invests from internal management to funds of funds.

He said geographically there were some interesting results: US funds were more likely to invest externally, regardless of their size, and pay higher fees.

“It’s as if the real-estate-investment management industry in the US is able to charge higher fees,” he says. “The costs don’t lie in the pension funds but in the service industry, and in the US it is tens of basis points more. US funds pay far more for external managers and are more likely to retain managers. It’s double crazy.”

Eichholtz describes funds of funds as “way beyond expensive” and believes smaller funds would be better off getting real-estate exposure through REITs than funds of funds.

Another finding of the paper was that the more expensive the strategy, the worse the performance.

Internal management was the best performer across the board, both before and after fees. At the same time, Eichholtz says, funds of funds “destroy value in two ways” through costs and picking the wrong investments.

He has some practical advice stemming from the results of the paper: if a fund is big enough, it pays to manage real estate internally.

“There is a lot of low-hanging fruit, funds that are big enough and could go internal, especially in the US.”

If you’re small, he says, avoid funds of funds and invest in REITs, and if you don’t want listed exposure then he proposes investing in a syndicate.

An example of this is in The Netherlands, where there are three large real-estate funds established by pension funds, Amvest, Aldera and Vesteta, the latter started by ABP and now open to a large group of investors.

They key, Eichholtz says, is that the management organisation is owned by the shareholders of the fund (that is, the pension funds) so there is no conflict of interest.

“The owner pays the salaries. There is a 30-basis-point fee, no bonuses or incentives.”

Access Value added from funds management in private markets: an examination of pension fund investments in real estate here.

The Rotman International Centre for Pension Management (ICPM) has approved five research projects for funding this year, including a behavioural-finance project by Swedish academics, to investigate plan members’ views of the “extended” fiduciary duty of pension funds.

This project, to be conducted by Joakim Sandberg, Anders Biel and Magnus Jansson from the University of Gothenburg and Tommy Garling from Stockholm University, will develop and test a socio-pyschological model to explain differences in beneficiaries’ attitudes toward an extended fiduciary duty, including social and environmental issues.

Titled Attitudes toward extended fiduciary duty among beneficiaries of pension funds, it aims to help fund trustees gain a better understanding of their beneficiaries’ expectations with respect to fiduciary duty and environmental, social and governance (ESG) investment.

Chair of ICPM’s research committee and head of innovation at APG, Stefan Lundbergh, says this article is interesting because it looks a the issue from the beneficiaries’ perspective.

“As an industry we assume ESG is important, but we haven’t asked the member,” he says.

“This paper on fiduciary responsibility is interesting because it is a different type of research [that] we haven’t done before. Typically, we’ve done quant papers but this looks at behaviour and what drives people. Fiduciary duty has to be solved first. If you don’t solve this, then you can’t solve anything else.”

Lundbergh says the mission of ICPM is to drive knowledge and understanding as well as build an academic presence.

Since its inception in 1995, the organisation has funded more than 20 research projects across pension and governance design, investment beliefs and risk management.

Selected researchers are funded over a two-year period and usually invited to present their findings at ICPM discussion forums, and to write for the @@italics Rotman International Journal of Pension Management @@.

ICPM, which is chaired by chief investment strategist at CPPIB, Don Raymond, and has Keith Ambachtsheer as its president, held its annual June forum in Toronto this week.

The ICPM is supported by about 40 global research partners, which each make a financial commitment to support research, the organisation and execution of the twice-yearly discussion forums, the next of which is in London in October.

Other papers that were given funding for 2012–2013 include Pension fund asset allocation and liability discount rates: camouflage and reckless risk-taking by US public plans? by Aleksandar Andonov and Rob Bauer (who is also associate director of programs at ICPM) from Maastricht University, and Martijn Cremers from Yale School of Management.