This paper presents two simple algorithms to calculate the portfolio weights for a risk parity strategy, where asset class covariance information is appropriately taken into consideration to achieve “true” equal risk contribution.

Previous implementations of risk parity either (1) used a naïve 1/vol solution, which ignores asset class correlations, or (2) computed “true” risk parity weights using relatively complicated optimizations to solve a quadratic minimization program with non-linear constraints.

The two iterative algorithms presented here require only simple computations and quickly converge to the optimal solution.

In addition to the technical contribution, we also compute the parity in portfolio “risk allocation” using the Gini coefficient. The researchers confirmed that portfolio strategies with parity in “asset class allocation” can actually have high concentration in its “risk allocation”.

To read the paper click here

Anyone who thought ESG was a passing fad can think again.

The announcement this week that Mercer, which has led the consulting industry on standalone ESG ratings, will now integrate those factors across its ratings process has cemented ESG as an important investment risk and return consideration.

The consultant rates more than 20,000 investment strategies globally, oversees more than $5 trillion in assets under advice and has $60 billion of assets in its multi-manager products.

The move will mainstream ESG in the investment manager community, whether the managers are ready for it or not.

The Mercer researchers will look at ESG factors alongside their other research considerations, and the expectation is that managers should do the same.

It reflects the powerful position that consultants maintain in influencing manager behaviour and investment trends. It will only be a matter of time before other consulting firms follow Mercer’s lead.

Mercer looks at ESG ratings across the generation of investment ideas, construction of portfolios, implementation of active ownership practices through voting and engagement, and the demonstration of a firm-wide commitment to ESG issues.

It now rates 5,000 investment strategies on ESG factors, with only 9 per cent of those receiving the top ESG rating.

Of its entire universe of 20,000 strategies about 10 per cent receive an A rating, or recommendation status. Of these 80 per cent have an ESG rating, and it won’t be long before that figure is 100 per cent.

In this fourth part of an OECD working paper, researchers look at the potential that portfolio rebalancing by financial investors can contribute to spreading financial turmoil in a major market event such as the global financial crisis or ensuing sovereign debt crisis in Europe.

In International Capital Mobility and Financial Fragility – Part 4: Which Structural Policies Stabilise Capital Flows When Investors Suddenly Change Their Mind, researchers test for the change in sentiment that contributes to financial contagion.

The paper used bilateral bank data and an instrumental-variables technique that allows for focusing on changes in investors’ country assessments that are unrelated to fundamentals. Changes in investor sentiment are found to drive capital flows.

Sentiment-driven capital flows are found to be smaller in countries with a tougher regulatory stance, such as stricter banking supervision or enhanced financial transparency.

To read the paper, click here.

Mercer will integrate its proprietary environmental, social and governance (ESG) ratings across all of its manager-search and performance data, cementing ESG as a key investment consideration.

The consultant rates more than 20,000 strategies, oversees more than $5 trillion of assets under advice and has $60 billion in its multi-manager products.

Mercer has led the consulting industry on standalone ESG ratings and will now integrate those factors across its ratings process.

About 10 per cent of the strategies rated by the consultant receive an A rating, or recommendation status. Of these, 80 per cent have an ESG rating.

Separately it rates 5000 investment strategies on ESG factors, with 9 per cent receiving the top ESG rating.

Rich Nuzum, president and global business leader for Mercer Investment Management, says the move is a response to client demands, particularly from sovereign wealth funds, which want an objective approach to comparing strategies and asset classes over time.

“For managers, it encourages reporting on ESG but that is an indirect outcome. The main thing was we wanted an objective approach that applies across strategies,” he says. “This creates an incentive and dynamic around that.”

By providing the ESG research as part of its client communication, Nuzum says Mercer is enabling smaller clients – who may not be able to afford the dedicated resources necessary for ESG – to benefit.

 

Universal ownership
Mercer has spent time and money on training its research analysts on ESG factors. While the consultant has a separate ESG research team that focuses primarily on policy and strategy, the ESG ratings are incorporated in the research process conducted by all analysts.

“The manager-research team integrates ESG into its research process, and we expect managers to do the same,” Nuzum says.

“ESG factors are different from financial-statement analysis but most analysts would also look at other things as well and many have been considering corporate governance factors for years. I don’t buy the argument for a second that a manager needs different skills to analyse ESG.”

He says many analysts have been considering ESG factors, such as political and regulatory risk, in their risk and return considerations for many years.

“There are lots of things that are not in financial statements that process needs to look at.”

Nuzum believes there is ESG alpha at the individual strategy level, but is also focused on a more universal ownership argument.

“Most clients own a proportion of the global economy. A focus on ESG factors can get management teams to take these externalities, such as treatment of employees or child labour, into account. If there is improvement at individual companies, the compounded effect is felt across overall GDP growth,” he says. “There is alpha at the individual strategy level but there will also be higher expected returns to most asset classes if universal owners get company management teams to behave better, everyone’s returns will go up. There will be a higher beta.”

Mercer looks at ESG ratings across the generation of investment ideas, construction of portfolios, implementation of active ownership practices through voting and engagement, and the demonstration of a firm-wide commitment to ESG issues.

It was only a few decades ago that trustees in many jurisdictions were restricted from investing in certain assets. Fiduciary duty has evolved as the thinking about investments has changed. This is true, then, of how trustees should be applying fiduciary duty to current day investment challenges, including systemic risk and climate change risk.

Ed Waitzer, professor and director of the Hennick Centre for Business and Law at the Osgoode Hall Law School in Toronto, has written extensively on trustee fiduciary duty and how the trustee duties in the pension context have evolved.

He will feature at the PRI-CBERN Academic Network Conference in Toronto this October, presenting a draft of the paper, The fiduciary duty – emerging themes in Canadian fiduciary law for pension trustees, which is the third in a series of research projects on the subject.

In it he says fiduciary duty is a dynamic concept – and while it is firmly rooted in clear and enduring legal principles, it has responded to changing contexts and worldviews.

“Events of the last decade have challenged the efficient market hypothesis, and the use of modern portfolio theory, as the basis for prudent investment and risk management practices (and, accordingly, the consequential legal framework governing pension fiduciaries),” he says.

He also says that pension fiduciaries are increasingly expected to consider questions of future value, rather than simply market price.

“Aside from the hazards of market volatility, they are expected to assess the impact of their investment decisions on others, including generations to come, with all the uncertainties so entailed. Accordingly, there is a growing recognition that risk management for pension funds extends well beyond that which is captured by market benchmarks, extending to market integrity, systemic risks, governance risks, advisor risks and the like.”

People out, returns in

Similarly an article by Jay Youngdahl, a partner at the Texas-based Youngdahl & Citti in the US and a visiting fellow at the Initiative for Responsible Investment in the Hasuer Center for Nonprofit Organisations at Harvard University, says many view modern portfolio theory (MPT) as the only way to comply with fiduciary duty in investment even though it is arguably incompatible with productive investment in the conditions that exist today.

In the article The time has come for a sustainable theory of fiduciary duty in investment, he says the foundation of the duties of fund trustees in the US began years ago in an environment of very different societal and investment expectations.

“Blind adherence to MPT no longer appears to be sufficient in fulfilling a trustee’s true investment duties to beneficiaries in the real… Current conceptions of fiduciary duty need to reflect this reality,” he says.

In the same article Youngdahl says the rigorous mandate to conform to the legal fiduciary duties has been a longstanding standard of trust law, while the definitional content of the investment function of this duty has been in constant evolution.

“…Adherence to fiduciary duty is ironclad, but the substance of the investment duty has always been malleable,” he says. “If you look at the history of fiduciary duty the basis has never changed, but what you do to fulfil that has to be dynamic.”

By way of example, he looks at the Restatement of Law in the US, an influential convention whereby experts in law convene, assess the law and make pronouncements about it.

He says the Restatement of the Law Second, Trusts, in place until 1992, said trustees could not purchase shares on margin or buy bonds selling at a great discount. They also could not buy shares in new companies, so no venture capital investments or investments in capitalisations, and it was considered improper to buy land.

“So, for example, distressed debt would be a per se violation,” he says.

“There is a growing recognition that risk management for pension funds extends well beyond that which is captured by market benchmarks…” says Ed Waitzer.

Youngdahl observes that people are no longer at the crux of the fiduciary duty.

“One thing that has happened to fiduciary duty is that people have fallen out of it. Now it is equated with a quarterly return. This is a distortion of what it’s about historically and what it should be about,” he says.

“Trustees have been looking at that wrong. The trustee fiduciary duty is all about protecting promises and pension promises are long term.”

In this context he says trustees have a duty to think long term, and to think about the factors that affect the long term.

“In the context of the fiduciary duty you have to think about long-term things. It is a violation to only think of quarterly returns.”

 Collective thinking to incentivise the long term

In the first of Waitzer’s series of articles, he argued pension funds take the lead on long-term thinking. The second article said if you weren’t convinced by the logic, then the law will get you, and he did sessions with trustees on what the lawsuit would look like. This third article looks at how, generically, the courts are likely to respond.

Waitzer argues that trustees have a duty to consult, a duty of obedience, a duty to collaborate, and a duty to comply with social norms.

“It is no longer legislatures defining law, but some social norms. All will be articulated in the law in short order,” he says. “But the article I haven’t written is OK, we hear you: what do we do?”

A key obstacle to thinking long term is that all of the incentives are short term, which he argues could be diffused by acting collectively.

“I’m the first to confess I don’t hold myself out as an expert in long-term thinking or how to balance competing interests. We need the ability to think long term when incentives are virtually all short term. But the duty to act collectively will change those incentive structures and we need to equip people to do it.”

He points to the PGGM PEP portfolio as an example. Click here

Waitzer says considering ESG factors when making investment decisions is compatible with trustees’ duty of care, as it allows them to evaluate sources of risk that would otherwise be overlooked.

“Climate change and impacting a systemic change is absolutely a fiduciary duty,” he says.

It’s sustainability, stupid

At the January United Nations Investor Summit on Climate Risk and Energy Solutions, the chief executives of California’s two largest pension funds, Ann Stausboll of CalPERS and Jack Ehnes of CalSTRS, were both vocal about the relationship between fiduciary duty and climate risk. The question of what fiduciary duty encompasses is a dynamic question that pension funds globally are pondering.

Stausboll, chief executive of the $235-billion CalPERS, says fiduciary duty of pension funds should extend to issues outside the parameters typically understood as being directly related to beneficiaries’ financial interests.

“As fiduciaries, it is our job to make sure investors, businesses and policymakers are responding aggressively and creatively to the risks and opportunities associated with climate change and other sustainability issues,” she says.

 

Other papers by Ed Waitzer in his recent series

Reclaiming fiduciary duty balance

Defeating Short-termism – why pension fnds must lead

 

 

 

The Government of Singapore Investment Corporation (GIC) is stockpiling cash as it positions itself to take advantage of any potential opportunities, lifting its cash allocation from 3 per cent at the start of 2011 to 11 per cent of its total portfolio by the earlier part of this year.

The sovereign wealth fund’s chief investment officer, Ng Kok Song, in his annual investment report says the fund’s investment team has been accumulating cash, and decreasing holdings of public equities and bonds.

“Due to the heightened uncertainty in global markets, we allowed the cash inflow from investment income and fund injection to accumulate during the year in preparation for better investment opportunities,” Ng reported.

Despite the turbulent times on world markets GIC also maintained its exposure to developed-world assets, including Europe.

GIC portfolio exposure by region in March 2012

REGION PERCENTAGE
The Americas 42
Asia 29
Europe 26
Australasia 3
*As of March 31 2012

Governance structure overhauled
In an effort to adapt to the volatility and uncertainty on global markets, the fund has also overhauled its governance structure, adding new committees and an international advisory board.

GIC has added new board committees aimed at improving its oversight capacity in both its investment and internal processes.

A new investment review committee will provide specialist oversight of all large investment decisions and will be chaired by Asian banking industry veteran Peter Seah.

GIC has had a focus on large direct investment in recent times. In research released this week, the Sovereign Wealth Institute ranks GIC as the largest direct investor by total transaction amounts.

This was followed by the Qatar Investment Authority and fellow Singaporean sovereign wealth fund, Temasek Holdings.

The institute reports that GIC’s assets under management are $247.5 billion. The fund does not disclose its total assets under management.

The new audit committee will aim to strengthen oversight of internal controls for complaints, financial reporting and disclosure, as well as looking at risk management processes at the fund.

In recognition of the increasingly complex macro environment funds must negotiate, GIC has also added a new international advisory board, chaired by former long-time prime minister Lee Kuan Yew.

“The advisory board provides perspective on the future, in particular global investment trends, emerging asset classes and new growth opportunities,” GIC president Lim Siong Ruan says.

When it comes to its portfolio, the fund has decreased allocation to equities from 49 per cent to 45 per cent over the course of the year.

This has mainly come from developed-market equities, with the fund maintaining its emerging-market equity holdings, which are primarily Asia-focused.

 

Long-term investment horizon
In a description of its long-term investing approach, GIC reported that it would maintain exposures to public markets as it was prepared to ride out short-term volatility.

“We can only enjoy the rewards of long-term investing if we are prepared to tolerate short-term losses or underperformance relative to market indices from time to time,” GIC states in its annual report.

It singles out its emerging-market equity holdings as an example of this. Emerging-market equities was one of the worst performing asset classes last year, swept up in the sell-off of risk assets.

However, GIC notes that its emerging-market-equity portfolio has achieved a 127-per-cent return since 2000, compared with a 22-per-cent return from developed-market equities over the same period.

In keeping with its long-term investment horizon, the fund reported that the almost 75 per cent of its investment mandates are for periods of more than three years, with almost 10 per cent of mandates stretching out for periods of more than a decade.

Approximately 20 per cent of the fund’s assets are externally managed.

The fund reported that more than 54 per cent of its mandates are in alternative asset classes, with 36 per cent allocated to equity managers and 10 per cent to fixed income managers.

 

Greater than inflation
In other investment decisions this year, the investment team also decreased its holdings of nominal bonds by 5 per cent over the course of the year, taking its fixed income holdings from 22 per cent to 17 per cent of the total portfolio.

It marginally increased its private equity and infrastructure holdings from 10 per cent of the total portfolio to 11 per cent.

All other asset classes have remained constant over the course of the year.

The fund reported that it had sliced 1 per cent off its exposure to the eurozone and increased it exposure to both Japan and North Asia (China, Hong Kong, South Korea and Taiwan) by the same amount.

The portfolio reported an annualised rolling 20-year real rate of return of 3.9 per cent, the same as the previous year’s performance.

Over five years the fund has achieved a 3.4 per cent nominal return in US-dollar terms and over 10 years it has achieved a 7.6 per cent return.

The Government of Singapore requires the GIC to achieve “a good, sustainable real rate of return over a 20-year time horizon” when investing the foreign reserves of the country over the long term.