A report finding Norway’s $582.7-billion sovereign wealth fund could face significant losses in a range of climate-change scenarios is unlikely to result in changes to the fund’s investment strategy, Norway’s state secretary Hilde Singsaas says.

Norway’s Ministry of Finance released the report into the Government Pension Fund Global’s (GPFG) that it commissioned from Mercer and which recommends the fund make it a priority to increase allocations to low-carbon intensive infrastructure, environmentally friendly real estate and green-investment opportunities in private equity.

Currently, the fund has no allocation to infrastructure, private equity, timberland agricultural land or other alternatives.

Under its current strict investment mandate, GPFG is limited to financial instruments (mainly listed equity) fixed-income real estate and cash.

Singsaas, who heads the Ministry of Finance, which is responsible for management oversight of the fund, believes GPFG is diversified enough to deal with a range of risks, including climate change.

“The fund’s investments are spread across asset classes and sectors all over the world. This reduces its vulnerability to different types of risk, including climate change,” Singsaas says in a written response to Top1000funds.com questions.

“Mercer analyses the potential effects of climate change on returns and risk in the GPFG. Major uncertainty means that it is not possible, based on Mercer’s calculations, to draw concrete conclusions about the consequences for the fund’s future returns. Nevertheless, the analyses are a useful contribution to efforts to improve the understanding of how climate change may affect the fund’s risk and return.”

The fund has an investment mandate that came into effect on January 1 and Singsaas says there is currently no move to revisit the mandate to provide for the types of climate hedges recommended in the report.

This is despite Mercer’s modelling showing that under the two most likely scenarios – delayed action and regionally divergent approaches to tackling climate change – the portfolio would experience cumulative losses of between 8 per cent and 1 to 2 per cent, respectively.

Singsaas says that the uncertainty around climate change and potential risks caused by it mean that the fund should not give too much weight to quantitative analyses on the effect of climate change.

She notes that the fund already manages climate risk as a priority area within active ownership, which is noted in the report.

Water risk is one of the fund’s key focus areas.

In addition, Singsaas points to other long-term risks that could also have substantive effects on capital markets and GPFG’s portfolio.

“The report also emphasises that the analysis is limited to potential isolated (sic) effects of climate change. Other long- term trends, such as demographics and the emergence of new economies and markets, may have other effects on risk and return in the capital markets,” she says.

The report forms part of the ongoing efforts of the ministry to support research into risk factors that may affect long-term investors.

“There is obviously a need for further research on the impact of structural, environmental and societal trends on long-term asset returns. Research is one of the main elements of the ministry’s responsible investment strategy,” she says.

“As a large owner and international investor, the ministry can influence the research agenda on ESG-issues. Participation in research projects will therefore continue to be a priority for the ministry. “

To read the Mercer report into Norway’s sovereign wealth fund’s exposure to climate risk click here.

 

Beta-driven equity investors may currently be taking far greater risks than they are getting paid for when seeking broad market exposure, British risk expert Nick Bullman warns.

Bullman, the founder of specialist risk consultancy CheckRisk, has developed a methodology using macroeconomic research along with econometric and behavioural risk inputs to identify what he describes as risk clusters.

The risk-monitoring process attempts to understand both human perception of risk and how that relates to the actual risk environment.

Monitoring the rate of change in a variety of market variables and, most importantly, correlations is a key driver of the firm’s approach, Bullman says.

 

Post VaR
The result of CheckRisk’s analysis is at odds with the view that investors should get back into the market after the volatility experienced in the later part of 2011, Bullman argues.

“These are not beta-driven markets, and the things that equity markets are addicted to are quantitative easing (QE) and LTRO (the European Central Bank’s Long-term Refinancing Operation), and both these have diminishing-return values because the bond market is taking a different view,” he says.

“Given it is the bond market that has to eventually finance QE and LTRO, they are beginning to ask where the growth is going to come from.”

Bullman reckons investors need new ways of thinking about risk, as traditional risk models – such as value-at-risk (VaR) – have failed to account for outlier events, which can have a devastating effect on portfolios.

“Value-at-risk is a very dangerous tool and using it is like driving down the highway very fast looking into your rear view mirror. You will have an accident, it is just how badly and when,” he says.

VaR underestimates both the scale and frequency of outlier events or what Bullman describes as the quantum of risk. CheckRisk wants to look at these tail risks and see if they are random events or, in fact, related to each other.

It is what the firm is seeing in its analysis of correlations that has resulted in this cautionary note to investors seeking market beta.

The firm monitors 160 risk factors weekly, looking for correlations between these factors and, most importantly, sudden changes in them.

The result is a monthly dispersal index that endeavours to measure how much each of these correlations are “listening” to each other – whether, in effect, markets are behaving in a rational manner.

 

Correlations are key
When markets become highly dispersed, there are two ways CheckRisk believes they can re-correlate.

The first is through a benign re-correlation, a so-called type A re-correlation, which is easily spotted because it is slow and is driven by positive economic data and steady investment flows.

The second or type B re-correlation occurs through a negative-event risk.

“When the correlation matrices are highly dispersed and event risk is high as it is today, we believe that depending on beta is risky because you are likely to be exposed to these type B correlations that occur when markets fall,” Bullman says.

This approach is driven by the view that risk clusters, or that risk can, in fact, create more risk in special circumstances.

Bullman notes that this is counter-intuitive because in benign risk periods, bond and equity markets absorb risk and investors have a tendency to become complacent to new risk events, assuming that risk absorption will continue.

“We are in a long-risk cluster with a potential elongated duration of seven to 12 years. So those depending on market beta to drive returns are taking excess risk, assuming that markets will return to a more normal risk pattern,” he explains.

“What you need to buy is dividend yield, corporate debt, infrastructure and property. Because those things are certain and the cash flows are more dependable and generate a larger portion of total investment return than the previous 20 years.”

While some have argued that investing for income-generating assets is already a crowded trade, Bullman has a different view.

“Saying the income story is a crowded trade is assuming a reversion to mean and the good old days. That is a premature assumption that is not supported by the risk backdrop,” he points out.

Informed by research looking at the daily returns of the S&P from 1928 to 2011, Bullman argues that risk forms clusters, which may become chains of risk, in which one event triggers others along the chain.

These risk clusters can then spread around the system or can “bridge” across the system rapidly – sometimes in previously unexpected ways. Market crashes such as the global financial crisis are described by Bullman as super correlations, as all parts of the risk environment are affected.

“Far from being noise, it [changes in correlation] is actually really interesting information,” Bullman says.

“People struggle when they see correlations changing rapidly because they want to know what to do. What you do is you stand back and say this is unusual, this is not normal, therefore, risk must have increased.”

Along with these correlations, CheckRisk’s analysis also examines the acceleration, deceleration or sudden reversals in direction of risk factors, the absolute level of which also forms part of the overall risk-measurement framework.

 

Revelations of risk
According to CheckRisk’s analysis, markets are currently in a period of increased risk.

Its historical analysis of daily S&P returns reveals that these risk clusters of increased market volatility and risk usually last between three to five years. They are then followed by benign periods that tend to average around 14 years, in which GDP growth is constant and there is a low risk of shock events.

Bullman predicts that this time we are in for an extended period in which risk is elevated and the potential for a large market shock continues to loom in investors’ thinking.

“We think the generation of liquidity by central banks that have expanded their balance sheets from $5 trillion to $15 trillion over the last six years is elongating this risk cluster. It could be as long as 10 to 12 years,” he says.

“That really makes a huge difference to your risk appetite and the kinds of assets you go for.”

While it is perhaps no surprise that a risk consultant would have a bearish outlook, Bullman says that this risk analysis is also a way for investors achieving a more objective view of where they might be in a particular market cycle.

 

Bubble trouble
Along with its work on risk-factor correlations, Bullman says CheckRisk has spent a lot of time thinking about price bubbles and their relation to investors’ perception of risk.

He notes that at the beginning of a potential market bubble, namely after a market shock, investor perception of risk may be quite high, when in fact real risk is low.

Likewise, when a bubble is close to bursting, market exuberance may be high, indicating low perceived risk in the face of heightened underlying risk in the market.

 

Perception versus reality
Another of CheckRisk’s methodologies compares a range of behavioural inputs to broader economic data and attempts to provide insight into the level of perceived risk versus real risk.

The rate of change in a variety of behavioural inputs – such as insider selling, adviser-sentiment surveys, confidence surveys and credit-default-swap pricing or volatility – are monitored.

These are then compared to economic or statistical inputs, such as money supply, velocity of money, bond pricing, TED Spread (the difference between interest rates on interbank loans and on short-term US government debt) and others. The result is a perceived-risk-to-real-risk ratio that can provide an indication of potentially heightened risk.

CheckRisk’s approach has seen it develop strong academic-research relationships with the University of Bath School of Management in the UK. It has recently launched a four-year risk-development program sponsored by the UK government and partnering with Bath and Bristol Universities.

As well as providing a general overview of the risk environment, CheckRisk provides bespoke risk analysis to clients.

Bullman says the consultancy can monitor up to 98 per cent of the risk exposures in a client’s portfolio, providing correlation analysis for a sample portfolio and comparing it to correlation changes in the broader market.

For clients needing to use VaR, the consultancy can also provide what it calls a confidence overlay, which allows for the potential for outlier events that may not appear in the VaR analysis, to be factored in.

“This kind of risk analysis is dynamic and focused on the present,” he says.

“It generates risk discussions around long-term portfolio allocations, about risk appetite and the critical question all investors should ask: ‘Are we being paid to take the risk our portfolios are currently exposed to?’ Just having a risk tool to drive that question can significantly reduce risk.”

 

Funds are looking to increase their allocations to property, with direct ownership of unlisted pooled-property funds the most popular way of gaining exposure, a Top1000funds.com global property survey reveals.

The survey shows funds have an average exposure to property of 9.5 per cent of their overall portfolios and would most likely move funds from equities and bonds to increase exposure to the asset class.

Most of the funds surveyed indicated their allocation to property would either stay the same or increase. While they had long-term plans to increase allocations to non-domestic property, funds still demonstrated strong home bias when it came to property.

Funds that indicated they would increase allocations to property on average would do so by 10 per cent to domestic property, compared to an average increase to non-domestic property of 5.6 per cent.

When it came to investing in property, funds were looking for like-minded investors with long-term time horizons.

“The ideal way to invest in non-domestic property for us as a pension fund would be a non-listed leveraged or very low leveraged fund with a limited number of participants, preferably other long-term investors,” one senior investment staff member told Top1000funds.com.

Conducted in the later part of 2011, the survey garnered responses from 54 funds in 14 different countries representing almost $1 trillion in combined assets under management.

Respondents included Canada’s Alberta Investment Corporation, sovereign wealth funds the Korean Investment Corporation, Ireland’s National Pensions Reserve Fund and Pensioenfonds Vervoer from the Netherlands.

More than 70 per cent of respondents say they plan to diversify into non-domestic property, with the majority seeing little difference in the global approach they take to equities and bonds and the strategy they are adopting in property.

Despite this, property portfolios still have some way to go before they match these diversification goals as the median allocation of property assets was 85 per cent domestic and 15 per cent non-domestic.

The continuing home bias towards domestic property can be seen in the context of last year’s risk-off environment.

The majority of funds consider non-domestic property to be higher risk than the domestic variety. But they also indicated that the rewards were potentially higher in non-domestic property.

Funds also seem more confident about investing in their own backyards. When asked if they had strong knowledge about non-domestic property, the most popular response was “somewhat/neutral”

The vast majority of funds saw the main benefits of investing in non-domestic property as increased diversification followed by increased risk/adjusted returns.

There was also a number of ways funds were choosing to access the asset class. The most popular was direct ownership of unlisted pooled-property funds, with 20 per cent of investors indicating they used or would use this method. This was followed by a fund of listed-property securities or real-estate investment trusts (REITs), with about 14 per cent of investors preferring this method, 11 per cent each going for direct ownership of listed-property securities or REITs and exposure through property debt.

When it came to selecting a manager, funds indicated that they on average ranked investment process as the most important feature followed by experience and performance.

The size of the fund and a consultant’s ranking were the least important criteria for manager selection.

Academics collide on the relationship between environmental, social and corporate governance (ESG), and alpha. One view is there is a clear link that can be uncovered by a deep dive into the underlying factors using a sophisticated operating engine. The other perspective is that the market will price in environmental and social factors, the way it has done with governance. Amanda White speaks to academics with different points of view.

Andreas Hoepner, lecturer in banking and finance at the University of St Andrews in Scotland, says alpha requires a sophisticated investment operating engine to find ESG.

The simple step of taking the ESG data, especially if it is sold to everyone, is usually not adequate to find alpha, he says. But if extra steps are built in, then alpha becomes evident.

“The extra steps are, for example, to look at industry or other types of classifications. ESG factors have a profoundly varying impact on firms, depending on their business model. Environmental management, for instance, has a very different meaning for banks than for oil companies. When you start to build extra steps, you quickly come to some alphas.”

The more competition in the area, according to Hoepner, the higher the level of operating engine needed to identify alpha.

“For example, analysing conventional fundamental accounting information, there is a lot of competition so the engine needs to be highly sophisticated,” he says, referring to the level of information portfolio managers assess in order to find alpha.

Within the field of ESG, Hoepner thinks there isn’t as much need for an engine that is quite as complicated, because there is not as much competition.

“From an investor point of view, when searching for alpha, ESG is a style similar to value investing: you are convinced of a certain type of asset and try to understand where and when it performs best. In the value-investing case, you are convinced by firms with low price-to-book rations, while in the ESG-investing case, you are convinced of firms with more sustainable business processes and a longer term management perspective,” he says. “From an investment-style perspective, at St Andrews we are optimistic that ESG information is not fully efficient as in our research we find many alpha opportunities that cannot be fully explained by transaction costs.”

 

When it comes to the relationship between ESG and alpha, Hoepner highlights the impact of specialist skills, pointing to the 2010 Journal of Business Ethics paper, The performance of socially responsible mutual funds: the role of fees and management companies by Javier Gil-Bazo, Pablo Ruiz-Verdu and Andre Santos.

The study found that in the period from 1997 to 2005, US socially responsible investing (SRI) funds had better before-fee and after-fee performance than conventional funds with similar characteristics, and the differences were driven exclusively by SRI funds run by managers who specialised in SRI.

Further, funds run by companies not specialised in SRI underperformed their matched conventional funds.

“The research found some very interesting outcomes. Specialist funds are clearly better than conventional funds, and non-specialist are worse than conventional funds,” he says.

Hoepner says this highlights a key failing of current investment thinking in that there is a clear mismatch between ESG skill and finance training.

This is also something that asset owners are discovering in their own approach to ESG integration.

 

The CalPERS case
The investment office of CalPERS, for instance, now has set implementing ESG as a strategic goal and its board is committed to this.

But Anne Simpson, director of corporate governance at CalPERS, recently said that it won’t work unless it can get the F – as in finance – into ESG.

Hoepner believes there are inadequacies in using only financial accounting data in financial analysis, as corporate accounts are conceptually an estimation and they are more relevant in the valuation of some companies, such as Fedex, than other companies that trade at large multiples of their book value, such as Amazon.

He believes it is also important to assess non-tangible factors, such as management quality, and this is an opportunity for assessing whether alpha exists.

“There is an enormous opportunity to incorporate intangible factors in a responsible way in financial markets,” he says. “You speak to people in other industries such as engineers or computer scientists and they say it is obvious that intangible factors affect consumer decision making and so performance. Just financial economists have possibly believed their own theories of the hyper-rational homo economicus in the consumer and also the analyst a little too much.

“We are very optimistic ESG alpha exists, but you can’t get ESG from one nice, level approach. But if you combine ESG metrics with very sharp statistics you can find alpha.”

One of the faults, according to Hoepner, is that analysts either look at financials and then ESG, or ESG and then financials.

“I think there’s way too little of both together. If you focus on one, then you miss the other. Bringing the two drivers together can be powerful,” he says.

“It is important to compare ESG investment to other styles when you want to do financial analysis, otherwise it is treated like a step child.”

Hoepner points out that when it comes to portfolio and strategic decisions, there is more to it than just alpha – client loyalty and the universal owner hypothesis come into play, and trust becomes very important.

 

What is relevant will be priced
Unlike Hoepner, Rob Bauer, professor of finance at Maastricht University School of Business and Economics and director of the European Centre for Corporate Engagement, thinks that markets have already priced in some of the relevant ESG information.

“By simply buying good ESG companies, you do not necessarily make good returns in the long run,” he says. “Especially, information on G (governance) is properly priced to a large extent. It might not be at that stage yet for E and S, but I strongly believe that market participants are gradually pricing the relevant information pieces, and they certainly will in the next decade. So there will be no information advantage.”

Bauer points to the study by Harvard academics, Lucian Bebchuk, Alma Cohen and Charles Wang: Learning and the disappearing association between governance and returns.

The study looks at the relationship between returns and a governance index, constructed on the basis of 24 governance provisions that weaken shareholder rights. During the 1990s there was a clear governance-returns correlation, which then disappeared in subsequent years.

The paper provides evidence that the existence and disappearance of that correlation were due to market participants’ learning to appreciate the difference between well and poorly governed firms.

It found that the disappearance of the governance-return correlation was associated with an increase in the attention to governance by a wide range of market participants; and until the beginning of the 2000s, but not subsequently, stock-market reactions to earning announcements reflected the markets being more positively surprised by the earning announcements of good-governance firms than by those of poor-governance firms.

“The Bebchuk study confirmed the results of the Paul Gompers study in 2003, which found that in the 1990s well governed firms performed better than poorly governed firms. The Bebchuk team redid that report and now finds that good governance (especially information on takeover defences) is fully priced into stocks.

Probably, the same will happen with E and S, but it will take some time to figure out which information is relevant for cash flows and the volatility of cash flows of firms,” Bauer says. “I think it is not clear yet, but it is becoming clearer. In the end, what is relevant will be priced; what’s not relevant is simply not relevant.”

 

Engagement also starts with E
Bauer believes engagement is the only sustainable way of responsible investing.

“There is a need for a collaborative investor community to engage and change practice on relevant issues in both the financial dimension and the ESG dimension. This will then change the valuation of these companies and lead to higher returns.

Both Bauer and Hoepner are previous winners of the French Responsible Investment Forum, which supports promising research and significant academic achievements and is endorsed by PRI.

Jean-Philippe Desmartin, who created the awards in 2004 and who is the head of ESG research at Oddo Securities, says ESG research is scant.

The awards aim to promote in the long-term academic research with finance and ESG in Europe, he explains.

The genesis of the award came in September 2003, when he saw Harvard’s Michael Porter speak at Copenhagen Business School and identify ESG as a key subject for companies.

“He said it was a top-10 issue for the following decade… and there needed to be more professionalism, to deliver academic research not just to show convictions.”

Desmartin believes that in practice integrating ESG is not completely different from other fundamental analysis.

“Analysts want to understand management, products and services as well as financial statements and fundamentals,” he says. “At Oddo, we are convinced from ESG research you can get alpha.”

There are a number of awards, and this year the winners will be announced at the PIR-CBERN Academic Conference 2012, Evolution of Responsible Investment: Navigating Complexity, to be held from October 1 to 3 at York University in Toronto.

Korean corporate pension funds have grown more conservative in their investments, increasing already high allocations to guaranteed-insurance contracts (GICs) and term savings, the Towers Watson Korea Pension Report shows.

The annual snapshot of the Korean pension market found that 93 per cent of corporate pension-plan assets are allocated to principal-guaranteed products, of which nearly 58 per cent is invested in cash instruments.

Guaranteed-insurance contracts are insurance policies that promise a fixed or floating interest rate during the policy period.

Jayne Bok, Towers Watson Korea’s director of investment services, says the research indicates a 5-per-cent increase in allocations to principal-guaranteed products last year, indicating the high risk-aversion among both Korean pension-fund sponsors and members.

Much of this increase was caused by significant mandates, mostly invested in GICs, being awarded to two service providers from defined-benefit plans affiliated to them.

“Last year was a bit of a risk-off environment so the service providers who were doing the asset allocation were more conservative, and putting more into cash and bonds than they were into equities,” Bok says.

“There are restrictions that don’t allow you to invest that much in equities to begin with… But the problem is more the starting point, rather than anything that has happened in any particular year. Any kind of risky environment you could see will trigger the same response. The baseline level of risk tolerance in Korea is basically too low.”

Bok believes this conservative allocation is largely influenced by corporate sponsors’ “cash-reserving mentality”, which finds its roots in legacy severance schemes and recent fierce competition among service providers offering attractive or inflated interest rates to attract new clients.

“As a result, there is also an inappropriate focus on capital preservation rather than on income or return generation, which would be more suitable given allocations should be focused on the ability to pay pensions in the longer term,” she says.

 

Regulation and return-seeking assets
Further encouraging conservative investment approaches are government restrictions on defined contribution and individual retirement account (IRA) schemes limiting investments to return seeking assets such as equities.

This conservative approach is at odds with larger public pension funds, such as the National Pension Scheme of Korea, which is in the midst of a four-year program to double its holdings of international equities.

The country’s sovereign wealth fund, the Korean Investment Corporation, under former chief investment officer Scott Kalb, started a five-year plan to double its allocations to private markets, in particular looking at distressed-debt opportunities and real estate.

Corporate pension funds have, however, taken a safety-first approach, preferring principal-guaranteed products.

These GIC providers in the last year have offered interest rates on principal guaranteed products in a range of between 4.21 and 5.1 per cent, Bok says.

Bok points to wage inflation in 2011 as being around 5.5 per cent, based on Towers Watson’s annual compensation surveys, re-enforcing the need to seek better performance than the cash rate.

She expects a rationalisation in fixed-rate products and a gradual lowering of interest rates offered to drive a gradual push to more return-seeking assets.

The pool of $45 billion in Korean corporate pension plans includes both defined-benefit and defined-contribution plans.

 

Guarantees over growth
With funding levels for corporate defined-benefit plans typically around 70 to 80 per cent, funds adopting conservative investment approaches are unlikely to improve these, Bok notes.

Korea adopted a funded pension-plan system similar to those of developing countries in 2005. Bok says the relative infancy of the system also contributes to conservative investment approaches.

“Sponsors and members need time to increase their investment literacy before we can expect to see fundamental changes in their investment behaviour,” according to the report.

Plan sponsors have been focused on whether to adopt a plan and choosing a service provider, with little thought going into the ongoing investment strategy.

“From a chief financial officer’s perspective, if the pension plan costs are less than 1 per cent of your book, you don’t worry too much about how you are going to invest the assets. It is simple to write an insurance contract for a GIC because you then have no worries because someone else is guaranteeing your return,” Bok says.

“So, I can understand why at this early stage of the market we have this kind of behaviour, it is always easier to stick to the current practice than do something different.”

The report reveals that total pension assets grew by 71 per cent in 2011.

Bok says that as this recent exponential growth continues and pension plans loom larger on the balance sheets of companies, it could trigger changes in investment approaches as plan sponsors pay more attention to fees and performance.

Authors Christopher Armstrong from The Wharton School University of Pennsylvania, Ian Gow of Harvard Business School and David Larcker from the Graduate School of Business Rock Center for Corporate Governance, Stanford University, look at the efficacy of shareholder voting.

The study examines the effects of shareholder support for equity compensation plans on subsequent chief executive officer compensation.

Using cross-sectional regression, instrumental variable and regression-discontinuity research designs, the authors find little evidence that either lower shareholder voting support for, or outright rejection of, proposed equity-compensation plans leads to decreases in the level or composition of future CEO incentive compensation.

Click here to read The Efficacy of Shareholder Voting: Evidence from Equity Compensation Plans.