Returns are a secondary consideration to the ethical values of members when framing the socially responsible investment policy of Swedish fund AP7.

AP7’s head of communications, Johan Floren, says that the fund is less concerned with socially responsible investment (SRI) as a driver of returns rather than as a reflection of the values and ethics of members and the broader community.

The comments come as AP7 released research reviewing 21 SRI performance studies from 2008 to 2010 that show no link between responsible investment and returns.

“The findings in the report strengthen our belief that there is no ‘easy alpha’ to find here,” Floren says.

“The primary driver behind environment, social and corporate governance (ESG) simply isn’t yield. It’s values – both on behalf of the people in the industry and societies around it.”

The approach of AP7 continues a broader debate in the industry about how far fiduciary duty extends for pension fund trustees.

At a UN-backed investor summit in January, CalPERS chief executive Ann Stausboll called for funds to look beyond just returns to members and push for broader environmental and social action on such issues as climate change.

According to Floren, the AP7-commisioned study has given fresh impetus to the fund’s SRI efforts, with research finding there was no automatic drag on returns from applying SRI investment strategies.

“The findings are important in several perspectives. The report confirms that SRI doesn’t come with an automatic penalty on performance, which is important to establish in itself,” he says.

“But it is also interesting since it turns the whole debate upside down – if it doesn’t cost anything, why isn’t everybody doing it? We now can go on developing our work without second thoughts.”

AP7 bases its asset management and SRI strategy on academic research.

Frustration about the contradictory messages being received by both academics and practitioners around the effectiveness of SRI resulted in the fund commissioning this latest study.

The Performance of Socially Responsible Investments by Dr Emma Sjostrom from Stockholm School of Economics, is also a timely caution to SRI investors not to overestimate the effectiveness of responsible investing.

“Another perspective is that there is no evidence that SRI (ESG) improves performance,” Floren says,

“Our impression is that a lot of people, both among practitioners and academia, would like responsible investing to have better returns, so much so that they abandon demands for evidence. Apart from being more faith than facts, it also might backfire when fantastic figures are missing and disappointment follows. To us, the conclusion is: don’t make promises you are unlikely to keep.”

Sjostrom discussed her findings at a recent UN-backed Principles for Responsible Investment (PRI) webinar looking at the latest developments in SRI research.

The report reviewed the available studies over three years that investigated the link between performance and SRI but excluded studies that focused exclusively on governance.

 

SRI performance a “mixed bag”

It found that two-thirds of the studies found no obvious connection between responsible investing and performance.

Of the remaining third, five studies suggested a positive correlation and three a negative correlation between SRI and performance.

“SRI as far as we can see does not automatically generate higher or lower or similar returns,” Sjostrom says.

“There is nothing to say that SRI always underperforms or outperforms – it is a mixed bag.”

Sjostrom and Florens highlighted the need for more comprehensive research into performance and SRI, with it not a matter of merely counting the studies to provide evidence either way of the link between SRI and performance.

The studies investigated used widely differing methodologies and looked at funds in various locations, under different market conditions and those employing different investment strategies.

Sjostrom says the findings highlight the need for more in-depth research into what is driving the performance of these SRI funds when compared to funds that do not consider SRI factors.

“What are the underlying factors for these results? What is going on in the market at this time? Does this performance have anything to do with the skillsets of the managers,” she suggests.

“Whatever the case may be, we would hope for studies that take the next step in measuring performance.”

Index construction is pushing the boundaries of active management, with index providers launching products such as high beta to take advantage of market movements.

S&P Indices is the latest to add to its family of high-beta indexes, recently launching two indexes of developed and emerging markets.

Alka Banerjee, S&P Indices’ vice president of strategy and global equity indices, says index construction is pushing into areas of strategy that have previously been the domain of active managers.

S&P, along with other index providers, has been moving aggressively in recent years into what it describes as “strategy indexes”.

“There is definitely a lot of innovation in the indexing world, moving into things that have been in the domain of active managers so far, of trying to extract value other than market value by developing new strategies,” she explains.

“We find, if we have clear, transparent and easy-to-understand rules that can be implemented in a consistent and regular manner, over time those strategies can be indexed and it is a huge cost advantage to the investor.”

In S&P research conducted last year that tracked the performance of alternative beta strategies researchers found that some strategies had outperformed compared to active management.

The report Evaluating Alternative Beta Strategies by Xiaowei Kang, S&P’s index research and design director, finds that over a 10-year period from 2001 to 2011, simple equally weighted and low-volatility strategies significantly outperformed the S&P 500.

Specific objectives

By comparison, the average US large-cap manager has lagged behind the S&P 500 over the same period.

Kang finds that although alternative beta strategies aim to achieve better risk-adjusted performance than cap-weighted portfolios, they are often constructed with more specific objectives in mind.

“These objectives include achieving a systematic value tilt, lowering portfolio volatility or reducing stock-specific risks, and may define the essence and main applications of different strategies,” the report finds.

In an indication that investors are increasingly looking to hedge for a market upswing, S&P Indices’ latest additions to its high beta family of indexes cover stocks in both developed and emerging markets.

The indexes measure the performance of 200 stocks in their respective markets that are most sensitive to changes in market returns.

The most sensitive stocks receive the highest weights. The indexes: The S&P BMI International Developed High Beta Index and the S&P BMI Emerging Market High Beta Index have been licensed to a third party which plans to launch exchange-traded funds based on them.

“Of course, you have your basic market beta investment, but then you have allocation to high beta and an allocation to low volatility and you cover yourself for both bull and bear market scenarios so you are not completely at the mercy of the markets,” Banerjee says.

The developed market index tracks the 200 most market-sensitive stocks within the S&P Ex US-Korea LargeMidCap Index. Countries it covers include Canada in North America, Germany, France, Ireland and Italy in Europe and Australia, Japan and New Zealand in the Pacific, and Israel.

The emerging market index covers stocks in Eastern Europe, Russia and Turkey as well as countries throughout Asia, Latin America, the Middle East and Europe.

It is possible for the best elements of defined benefit (DB) schemes to be applied to defined contribution (DC) schemes, by replicating real deferred annuities to produce superior pension outcomes for members, according to a new paper by APG.

The paper, How to mimic DB-like benefits in a DC product, does what it says.

It demonstrates through simulation that by using derivatives there is a way to combine the best of both worlds into an individual pension product that has clearly defined ownership  while delivering a DB-like pension.

In the paper, its author, APG-intern Jens van Egmond, says while there is a clear global trend towards defined contribution, the solution is sub-optimal because of the disconnect between the accumulation and decumulation phases of the schemes.

“Defined benefit is a fully integrated product,” van Egmond says. “Defined contribution is a pension savings scheme, a wealth management strategy. It doesn’t tell you what you can do with that money at retirement.”

Van Egmond says the study rests on the premise that people want income over  their whole life.

“A real annuity is the best way to achieve that, and you can only get that in a defined benefit scheme,” he says.

Stefan Lundbergh, one of van Egmond’s supervisors and head of the innovation centre at APG, says defined contribution funds are essentially wealth management or active management solutions.

“That makes it easy to communicate that your wealth is growing,” Lundbergh says.

“A real pension solution delivers future cash flows, of which the net present value is much more volatile than just wealth accumulation. That’s a very difficult thing to communicate.”

Because defined contribution funds don’t have a pension payout mechanism, the member is subject to “conversion” risk when converting the pension wealth into an annuity at retirement.

The paper proposes a solution where interest rate and inflation derivatives protect the purchasing power of the defined contribution investment over time, making the conversion risk a non-factor.

Essentially, the paper describes a way to match long-term future benefits with investments now.

Van Egmond describes it as using a traditional lifecycle solution, with an allocation consisting of a safe and a risky asset. But instead of using bonds as the safe asset, an asset mix replicating a real deferred annuity is used.

“You know the price of the annuity will change as interest rates and expected inflation vary.,” he says.

“When you invest into the safe asset, the investment amount is translated into future real monthly pension payments, or at least into a very close approximation of these cash flows. The safe asset can be converted into a real annuity at retirement day since it uses an investment strategy that moves the same way as the real deferred annuity moves when market variables change.”

Van Egmond says that replicating a real deferred annuity is dependent on three factors: the interest rate; the inflation rate; and mortality rates. It uses financial instruments to hedge the first two, while explicitly saving more to pay for longevity increases.

Interest rate swaps are used to hedge inflation. The hedging model uses an insurance mindset, and moves away from the asset management mindset of hedging by looking for correlations with certain asset classes. The break-even inflation quoted for inflation swaps is identified as the inflation measure. This provides a cost-efficient hedging method, but it relies on liquidity in the inflation derivative market.

Lundbergh says that while APG is not necessarily producing a solution from this research, it is committed to a different way of looking at the pension payout problem in DC funds.

“There is a gap in the market between standard defined benefit and the more traditional defined contribution models,” he says.

“In the long run, it would be great to have a hybrid product that combines the best from DB and DC for those who only have access to the current DC models. As a mission-driven organisation we are going back to our roots when looking at this problem.”

Ruben Laros, another APG supervisor, says Netspar, the national network of pension practitioners and pension scientists, offers a master’s degree in the economics of finance of aging. Part of this degree is an internship at one of Netspar’s partners, such as APG.

APG has offered more than 30 students the opportunity to do in-depth research into pension related topics. Jens van Egmond is the most recent graduate.

Towers Watson’s negative outlook for bonds and its advice to increase allocations to high quality credit is being reflected in portfolio shifts by institutional investors. (more…)

Source: EPFR Global.

This MSCI research note looks at the historical behaviour of two risk-based investment strategies and investigates their potential application in an institutional equity portfolio.

 

Does risk-based strategy diversification work?