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.”

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.