With hundreds of indexes, portfolio and risk analytics, and a growing emerging-markets and environmental, social and governance (ESG) focus, MSCI is a business in constant evolution, but chief executive and chairman, Henry Fernandez, says institutional investors are demanding further development, such as private-equity indexes.

Fernandez has been chief executive of MSCI since 1996, when the company’s revenue was $9 million. Last year it had $900 million in revenue and employed 2500 staff in 20 countries. The firm has grown organically and through acquisition, and Fernandez says he is on the lookout for suitable companies once more.

The last acquisition saw RiskMetrics assimilated into the MSCI fold within nine months of purchase, and each part of that business is now performing well, he says.

He admits he was perhaps too quick to call Institutional Shareholder Services (ISS), the proxy-voting firm that formed part of RiskMetrics’ stable, a “non-core” business.

“The risk business is why we bought the company. I had been pursuing them for five years and a year into the pursuit they bought ISS, and Morgan Stanley owned MSCI,” he says. “When two years ago I bought RiskMetrics, maybe I was too quick to say ISS is non-core and implying it would be sold.”

Now he says the proxy-voting business and a product that checks companies on non-financial factors could be huge successes.

Proof of that is MSCI’s ESG business, an offshoot of the ISS business, which has doubled in the past two years.

“It is a business with a lot of potential,” he says.

Last summer MSCI also launched an executive-compensation data-analytics offshoot of ISS.

“We looked at data in-house but didn’t make it available. It’s been a home run, especially from the issuers, the companies themselves. We’ve done that in the US, and will extend to all countries in Europe and eventually Asia,” he says.

The next cab off the rank in the ESG business will be the rating of sovereign debt on those criteria.

“We’re very brave,” he says.

While typically MSCI has had an equities focus, the recent relationship formed with Barclays to form an ESG fixed-income index is an example of the company looking to expand into other asset classes as investors and other clients demand.

“I have a sense that fixed income will grow a little bit organically or some by sort of acquisition,” he says.

“Institutional investors, asset owners, are extremely interested in creating transparency so their decisions are clear about what they’re buying – the purpose, benefit and measurement of that. We’re in the business of providing that transparency. We provide clarity. They want us to advance the state of the art in what we do. They want us to go in areas we’re not in yet, like private-equity indexes, risk models and fixed-income portfolio management.”

 

Tooling up
Fernandez says MSCI is very focused on creating the tools that help people make investment decisions.

“The broader investment industry attracts a lot of very smart people. We’ve found it attracts talent but the tools to help them navigate are not efficient. We are very focused on creating and maintaining and enhancing and investing in those decision-making tools,” he says.

“We are not in the business of indices per se, or data per se; they are a means to an end.

For example, an index is a performance tool for us, not just an index. The way we build our tools is we look at investment problems then at how to build the tools to fix the problem. It comes of out research.”

An example of that, he says, is the evolution of small caps as a global asset class.

“In the world of high correlations, people want ways to diversify. We make it more transparent,” he says.

The company continues to focus on equity investments as one of its core competencies, with an emphasis on providing equity-portfolio managers the tools they need including performance tools, by way of indexes, performance attribution, in Barra, portfolio construction, market-impact models and the ability to invest according to Sharia compliance or ESG.

But it also continues to evolve into other areas, such as multi-asset-class portfolio analytics, strategy indexes such as volatility or risk premium.

“For a long time indices were about slicing and dicing with market beta, what’s now happening is an evolution in the index world; it’s strategy beta.”

This evolution includes equities long/short, merger arbitrage, momentum (such as fundamental weighted indexes) and will change according to market cycles, for example, inflation-protected equities indexes are on the horizon.

 

 

EDHEC-Risk Institute has released a study highlighting the need to reform retirement systems and pension funds.

The study Shifting Towards Hybrid Pension Systems: A European Perspective also looks at the need to adopt professional management structures and to considerably improve the product offering of defined-contribution funds.

To read the paper click here


A decision by two of Missouri’s public pension plans to adopt a straightforward risk-based approach to asset allocation garnered their best result in two decades last year, while also providing investment staff with the autonomy to react quickly to changing market conditions.

The board overseeing the Public School Retirement System of Missouri (PSRS) and the Public Education Employee Retirement System of Missouri (PEERS) adopted an asset-allocation approach in 2009 that divides the portfolio into three simple buckets: safe assets, public risk and private risk. Both funds are managed by one investment team and overseen by a single board.

Chief investment officer of PSRS and PEERS, Craig Husting, explains that the approach gives clarity to the board by providing a clear, easily understood focus on a set of risks that are to be managed across the portfolio.

“We divided the portfolio into three buckets to try to identify how much money we could lock up in long-term illiquid investments where we could expect a higher rate of return,” Husting says.
The system is one of the best funded public-pension funds in the United States, with PSRS and PEERS enjoying more than 85-per-cent actuarial rates of funding.

This is on the back of a bumper year in 2011, where the combined assets of the two funds topped $31 billion. PSRS and PEERS earned returns of 21.8 per cent and 21.4 per cent respectively.

Husting explains that PSRS and PEERS use what he describes as an “intuitive risk-based approach” that focuses on liquidity, volatility, tail risk and the ability to meet the system’s assumed rate of return of 8 per cent per annum and a real-return target of at least 5.5 per cent per year.

“Sometimes people in our industry get caught up in terms of the value-at-risk in the portfolio or the standard deviation or the tracking error and other quantitative measures,” Husting says.

“What we mean when we take an intuitive approach to risk is that it’s a fairly simple concept to understand because our primary risk is liquidity or illiquidity, the ability to get 8 per cent, which we need to get, and tail risk, which is are we going to get killed by a left-tail event?”

The focus on risk is bearing fruit not only in terms of building a more robust portfolio but also in providing for more efficient returns relative to risk.

The system used Trust Universe Comparison Services (TUCS) analysis to show that the while the PSRS/PEERS total returns over three and five year time periods were marginally below the public-fund median return, they had taken less risk than 70 per cent of other comparable funds in the TUCS universe. Safe assets consist of mainly US treasuries and Treasury Inflation Protected Securities (TIPS). Private-risk assets are essentially illiquid and include private real estate, private equity and private credit assets.

Husting says the public-risk asset is broadly defined as any asset that is primarily liquid and has a risk component to it with this portfolio consisting of both US and non-US stocks, most types of credit, hedged assets and currency plays.

The 8-per-cent-return target, in the upper range for a US public-pension fund, means the investment staff cannot simply take risk off the table if they still want to meet the return objectives.

The public-risk portfolio, with its broad focus on liquidity, gives the investment staff flexibility, Husting explains.

“That [public risk] is a relatively broad bucket, with the intention of giving staff more flexibility to move assets around,” he says.
“For example, if equities seem expensive, instead of taking all the risk off the table by going from equities to bonds, we can lower the beta of that portfolio or bucket by going from full equities to credit or something like that,” he says.

 

Hedging your risk/return
Hedge funds play a vital role for the system, both from a returns perspective and as part of their strategy to manage volatility across the portfolio.

Hedge funds now make up 15 per cent of the total portfolio, with managers focused on providing lower volatility returns compared to the system’s broader equity portfolio, Husting explains.

This aspect of the hedge-fund program was funded out of allocations from equities and typically aims to have a beta much lower than the broader equity market of around 0.4.

“It is really there to lower the overall beta and volatility of the total fund, but still have some ability to capture upside,” he says.

Complimenting this hedge fund strategy are several low-volatility mandates the fund has adopted in its broader equity portfolio. Its private-equity investments also provide a lower volatility source of returns compared to public markets, Husting says.

The focus on low volatility means the investment team can also look to take on more risk in the remainder of the equity portfolio, he notes.

In addition, the system also uses hedge funds to provide an alpha overlay.

“The alpha overlay is essentially buying S&P swaps. We get exposure to the equity market through swaps and then we take the money and buy market-neutral-style hedge funds and overlay those hedge-fund returns over those S&P 500 swaps,” he explains.

Husting says the objective of the 10-manager program is to get alpha over and above the index, which in this case is the S&P 500.

“This program has been very successful providing alpha in excess of 400 basis points a year for the past several years,” he says.

When it came to managing tail risk, Husting notes the fund did consider tail-risk insurance but eventually decided to look to the safe-asset bucket to take on this role within the portfolio.

The fund has about 15 per cent in US treasuries and TIPS, which Husting notes acts as a buffer to potential risk events.

However, the fund is underweight safe assets compared to a policy target of 20 per cent.
“We are underweight because it is such a low-yield environment and we are searching for yield in other places so we have been moving some money out of safe assets into a little more risk-seeking assets,” he says.

The system is also underweight private equity as it gradually builds out its program. Private equity currently makes up 7 per cent of the portfolio with the board setting a long-range target of 10 per cent.

 

Autonomy with accountability
The autonomy enjoyed by the investment team also comes with accountability: the board established a process of benchmarks to hone in on the attribution of performance.

The board has set a long-term asset-allocation target for public-risk assets of 60 per cent, safe assets of 20 per cent and private assets of 20 per cent.

The investment team is given broad policy ranges for each of the underlying asset classes in these buckets.

Actual allocation vs target allocation

Public risk assets Safe assets Private risk assets
US
equity		 Credit
bonds		 Hedged
assets		 Global
equity		 US
Treasuries		 US
TIPS		 Private
equity		 Real
estate		 Private
credit		 Cash &
equivalents
Target
allocation*		 27.0% 12.0% 6.0% 15.0% 16.0% 4.0% 10.5% 7.5% 2.0% 0.0%
Actual
allocation		 30.8% 8.6% 14.9% 15.5% 13.5% 1.7% 6.7% 6.8% 1.3% 0.2%

SOURCE: PSRS/PEERS Asset Allocation

 

The board then annually reviews the internal team’s performance by referencing a policy benchmark consisting of a broad set of market indexes, essentially a passive benchmark against a strategic one.

This benchmark is set monthly and aims to reveal whether the investment team’s decision to overweight or underweight certain asset classes added value to the fund.

In an additional step, the fund compares this strategic benchmark to actual performance of the fund to evaluate whether manager selection has made a positive contribution to performance.

Along with strategic asset-allocation decisions, the 11-person internal investment team has the responsibility, with advice from consultancy Towers Watson, to select managers.

PSRS and PEERS use external managers for all its asset classes.

As a final check and balance, any major moves in asset allocation must be signed off by Husting, the executive director and the consultant.

 

Getting what you pay for
When it comes to selecting managers, Husting says the investment team is focused on only paying for active management in asset classes in which it believes alpha can be consistently achieved over the long-term.

“We are moving more to the view that there are fewer asset classes where you can add alpha in,” he says.
“Definitely [in] private markets and hedge funds, we are fully active and think we can add alpha in those areas. But in large caps and straight bonds, we think it is very difficult to add alpha, so we have gone more passive in those areas. Emerging markets and small caps we are also more active in.”

Fund performance to March 31, 2012

Fiscal year to date* 1 year 3 years 5 years 7 years 10 years
PSRS 2.9% 4.7% 15.3% 2.6% 5.2% 5.7%
PEERS 2.7% 4.4% 15.0% 2.5% 5.2% 5.6%
Policy benchmark** 4.7% 5.9% 16.4% 2.6% 5.1% 5.6%

* The Retirement Systems’ 2012 Fiscal Year began on July 1, 2011.
**The Policy benchmark is comprised of 40.5% Russell 3000 Index, 16% Barclays Capital Treasury Blend, 15% MSCI All Country World ex-US Free Index, 15% Barclays Capital Intermediate Credit Index, 7.5% NCREIF Property Index, 4% Barclays Capital US TIPS 1-10 Year Index and 2% Merrill Lynch High Yield Master II Index.
SOURCE: PSRS, Total Fund Investment Returns

At least one state in the US is acting on the need for epic reform of its pension system, but the political difficulty associated with such reform – something all states are wary of – was demonstrated in the violent outburst by Illinois representative, Mike Bost, last week (see video) and the inability of representatives to agree to the reform package before the state assembly broke last week for summer.

Pension reform is the reform of our lifetime, according to Illinois governor, Pat Quinn, who is determined to fundamentally change the system.

“We must enact bold reform that eliminates the unfunded liability,” he says.

The state is facing $83 billion in unfunded liabilities and Quinn is worried about ratings-agency suggestions they will lower the state’s credit rating if the state assembly doesn’t take action.

The reform agenda includes increasing employer contributions so the funding ratio will reach 100 per cent in 2042. It also proposes that members increase their retirement age to 67.

The eruption of Mike Bost in the Springfield assembly last week is indicative of the frustration that policy makers, fund trustees and staff are experiencing with regard to the dire pension situation in the US.

Bost, who reacted strongly to the amount of time he had to discuss a pension-policy reform agenda, launched into a soliloquy about the adverse control of the state speaker and the inability to effect reform.

“I feel like someone escaping from Egypt: let my people go,” he yelled in the assembly last week. “I’m trapped by the rules being forced down my throat. We live in a democracy, but not here. The speaker has too much control.”

A few days after his outburst, the Illinois House of Representatives broke for the summer but pension reform was not passed due to disagreement on a provision to shift the pension costs from state to local school districts.

Now the governor is calling for a special legislative session in the summer to deal with the reform.

“We are racing the clock,” he said.

The Illinois State Board of Investments manages the $11.5 billion in assets of the pension funds and has a fairly aggressive allocation: US equities 30 per cent, international equities 20 per cent, fixed income and cash 20 per cent, private equity 5 per cent, real estate 10 per cent, infrastructure 5 per cent, hedge funds 10 per cent.

While the state politicians could not agree on the “reform of our lifetime”, they did pass a law called the “skin tax”, which will charge strip-club patrons $3 each – the money going to sexual-assault-prevention services.

Who would be a politician?

The Ann F Kaplan professor of business at Columbia Business School, Andrew Ang will teach a case study on the Canadian Pension Plan Investment Board’s (CPPIB) reference portfolio in the fall. While for the most part complimentary of the approach and process, he challenges the Canadian fund to consider a more dynamic reference portfolio.

The CPPIB is respected by investment practitioners and academics alike for its approach to investment implementation, using what it calls a total portfolio approach. The strategy, which looks through asset class labels and considers each asset in terms of its underlying factors, is the result of a clearly defined governance structure that sets clear responsibilities for the board and management.

At its core is the reference portfolio, which is set by the board, and which management uses as a benchmark for making active decisions.

The reference portfolio is a passive mix that could reasonably be expected to produce the long-term average-annual real return of 4 per cent that is necessary to sustain the CPPIB at its current 9-per-cent-contribution rate. The current composition of the reference portfolio benchmark is 55 per cent global equities, 30 per cent Canadian nominal bonds, 10 per cent Canadian equities, and 5 per cent foreign sovereign bonds.

Active investment decisions are made against this reference portfolio, with every investment decision needing to be justified, or funded, against the reference portfolio.

The concept is simplistic and clean, but the implementation is quite complicated.

“The CPPIB reference portfolio is a low cost, tradeable, implementable portfolio that will meet their requirements. That is hard to beat,” Ang says. “If they did that alone then they would be top quartile because it is so hard to outperform because of costs. That thinking permeates their entire organisation and those that would normally operate in silos, according to asset classes, forces them to think across the entire portfolio.”

While the CPPIB approach is complicated to execute, Ang says from a top-down trustee level, it is simple and intuitive.

“The board has said buy anything you want but here’s the benchmark,” he says.

“Implementing it requires discipline, technical expertise, competence and independence that few investors have.”

He describes CPPIB as a professional organisation built in a structure that allows a manager a great degree of independence.

There is defined responsibility between the board and management and it is highly transparent.

 

The factor approach
Ang believes factor investing is what every investor should be aiming to do, but most investors haven’t embraced it.

In fact Ang advises investors to have a three-pronged investment approach which starts with a low-cost transparent portfolio.

He says then investors can benchmark to that and take on active management in a hopefully contrarian way.

Then ultimately asset owners can go to a third point of more discretion, with the rules giving you a conservative lower boundary.

“For example, in 2009 the rules would say buy, because markets were at a low, but a discretionary manager would buy more,” he says.

“The reference portfolio is the foundation stone. Most institutions don’t start with that, building a bridge without the foundation. CPPIB has a strong anchor.”

Chief investment strategist at CPPIB, Don Raymond, will join Ang at the New York City campus in the fall to discuss with students the complicated process of implementation that the fund has adopted.

 

Testing the hypothesis
Ang will challenge students on a number of aspects of the factor approach, including its applicability to funds such as US public-pension plans.

But he also has some suggestions in how to make improvements to the approach.

For one, he says the factors – the choices the board has made to include in the reference portfolio – are long only.

“There are many factors – usually the purvey of active managers – that are dynamic that involve long/short, that are systematic and can be done simply, and are hugely diversified.” He points to style-based factors, illiquidity premium, credit, and carry-on foreign exchange.

“This would make the reference portfolio more dynamic. Now it is a long-only reference portfolio done every three years. But some risk premiums can be accessed systematically.”

He does recognise that perhaps CPPIB investment staff are accessing these risk premiums in their active decisions, but believes they can be accessed more cheaply because they are systematic. It is essentially making active management harder.

If more dynamic factors were included in the reference portfolio, however, it raises governance questions as to where those dynamic factors sit, that is, with the board or the management team.

The other point Ang makes is that the reference portfolio doesn’t have any illiquid assets.

“Active management for CPPIB is collecting an illiquidity premium, and the board granted that decision to the manager. But it is a relevant question to ask what a fair hurdle rate for holding that liquidity premium would be. Whether the reference portfolio hold that is a question for the board.”

CalPERS is Ang’s next case study. And his reaction to the initial work on the case is shock. “You can’t even see an expense ratio,” he says. “It has taken us a lot of work to construct that number.”

Pension funds should disclose their governance arrangements using a methodology similar to a nutrition label, with members easily able to compare the transparency and accountability of fund standards, a leading corporate-governance expert from Yale says.

Dr Stephen Davis, the executive director of Yale School of Management’s Millstein Centre for Corporate Governance and Performance, has called for greater governance disclosure from both defined-benefit and defined-contribution plans.

Beneficiaries should be able to access and compare governance information through apps, in a similar way to the how consumers compare restaurants and other service providers, Davis told Top1000funds.com.

“It would be tempting for some advocates to be very prescriptive of the types of governance arrangements funds ought to have,” he says.

“But the trap there is that there are so many different types of funds and so many types of markets that it would be very hard to come up with a one-size-fits-all model. It makes some sense to have a bedrock of disclosure for funds. It is kind of a nutrition-label approach, where they would have to describe what governance arrangements are, and how they are designed to align with the interests of beneficiaries. If they don’t disclose this, they have to explain why.”

This approach to fund disclosure is detailed in Davis’ latest paper, Mobilising Ownership and an Agenda for Corporate Renewal, due to be published this month by the Brookings Institution.

Disclosure would also cover such things as the remuneration of internal investment staff and the fees extracted from funds by external managers. Davis advocates funds showing how this remuneration is aligned to the long-term interests of fund members.

“We now have apps on phones and tablets that can help individuals compare restaurants or doctors and all manner of services. There is no reason why we should not expect of our retirement systems disclose information that would allow a similarly easy comparison,” Davis says.

“I am not necessarily suggesting funds release information that is proprietary, but about their governance arrangements, about their accountability and transparency because that is a bedrock question. If you are a citizen saver, you really should have the right to know if a fund that wants your money has the capacity to align with your interests.”

 

 Global governance database
A recent paper co-authored with Ben Heineman, senior fellow at Harvard University Law School and Kennedy School of Government, Davis calls for a global database on the governance of institutional investors.

After a subsequent roundtable in New York earlier in the year, Columbia Law School’s associate professor of law Robert Jackson Jr has taken the lead in developing such a database.

Davis says the the call for a database came out of the lack of information about fund governance and the increasingly important role ownership is given in the regulatory framework of markets.

Recent regulatory reforms such as the Dodd-Frank Act in the US and the Stewardship Code in the United Kingdom give shareholders increasing power relating to engagement with companies and the disclosure they can demand.

Davis says regulators have taken a chance that institutional investors, as large owners in the market, can take a key role in policing the market effectively.

In Are Institutional Investors Part of the Problem or Part of the Solution?, Davis and Heineman ask whether institutional investors are using these powers properly.

The authors also note that the level of disclosure required by corporations and demanded by institutional investors is much more onerous than those required for these same investors.

“We have made boards accountable, but accountable to whom? It looks like we have made them accountable to institutions. Even if their beneficiaries have long-term objectives, they act short-term. So the work of corporate governance needs to be matched with work on fund governance,” he says.

“The alternative to that is that corporations should actually reverse the process of making boards more accountable to investors and conclude that is a mistake because investors are inherently short-term. My view is that is not right, but the problem is that we have institutional investors that are out of alignment with their beneficiaries. If we bring them back into alignment, we can actually try ownership, we haven’t really tried it yet.”

Davis notes that institutional investors may require companies to provide extensive background information on directors, while beneficiaries may have little or no readily available information on who their fiduciaries are.

 

Equality of disclosure information
In the paper with Heineman, Davis notes that institutional investors – pension funds, insurance companies, endowments and their asset managers – now own more than 75 per cent of the largest 1000 companies in the US.

Despite this, little is known about these investors, with wide differences in the disclosure of governance arrangements at the institutions.

“Funds that are associated with asking corporations for generous disclosure are themselves rather opaque and would be hard pressed to meet the same kinds of disclosure requests they are asking from portfolio companies,” he says.

While Davis says some public pension funds like CalPERS have “looked in the mirror” and undertaken wide-ranging governance reforms, others still have a governance structure with a sole fiduciary

He singles out corporate pension plans as having particularly opaque governance arrangements, with beneficiaries commonly having little idea about the fiduciary of the fund.

“The information may be available but it is not easy to find. In most companies it is very difficult to get extensive background on the fiduciary and usually it is one fiduciary,” he says.

Warning that the definition of fiduciary duty is antiquated, Davis says it is better suited to an old defined-benefit-dominated retirement system.

The prevailing definition of fiduciary duty in many jurisdictions also curbs the capacity of investors to consider intangible factors such as environmental, social and corporate governance (ESG) considerations, Davis notes.

Along with questions around what fiduciary duty is, Davis says that it does not currently extend to a range of intermediaries.

Noting that there can be as many as 16 intermediaries between a beneficiary and an end investment, Davis says that in the US the Department of Labour and the Securities Exchange Commission are working though the question of whether fiduciary duty should cover intermediaries.

In the US the regulation of defined-contribution schemes, which accounts for an increasingly large slice of the funds in the retirement system, is also a vexed question for regulators.

Currently, the US Securities and Exchange Commission regulates 401K plans with a focus on protecting investors in the market generally, according to Davis. He questions if special protection should be given to investors in retirement schemes as they are effectively forced investors, and notes that there is little discussion around the governance issues specific to defined-contribution plans.

“With a defined-contribution scheme the issue is really the selection of funds. Which funds do you make available to scheme members, and how do you go about making that decision and who monitors those funds, and what are the contracts that define the relationship?” he says.

“Those are the main jobs for a board of a defined-contribution scheme. For a defined-benefit scheme it is different, there is more of a direct relationship and a more direct set of investment decisions.”