FACTOR INVESTING, ESG, MDI STRATEGIES EXAMINED A Special Industry Event held by: Benefits and Pensions MONITOR
Factor Investing, ESG, MDI Strategies Examined Pension investment strategy is playing an increasingly important role in plan management as sponsors look for ways to manage risk, increase returns, and meet their funding obligations. The Benefits and Pensions Monitor Meeting and Events Pension Investment Strategies session brought together a collection of experts who shared current thinking on factor investing and determining ESG (environmental, social, and governance) criteria that is financially material to individual assets in a portfolio. Joining Vincent de Martel, factor investing specialist with Invesco s Global Investment Solutions team; and Adam Hornung, Associate Director, Investment Strategy, for Russell Investments Canada, RICL Institutional Business; was Kevin Zhu, Managing Director and Head of Portfolio Construction at OPTrust; who described its shift to a member-driven investment strategy. In our work with institutional investors, we find three potential situations regarding factor investments, said Vincent de Martel, factor investing specialist with Invesco s Global Investment Solutions team. Investors may have no or a balanced factor exposure. Investors may also have a balanced factor exposure due to deliberate tilts such as an active stance into momentum or value to deliberately create an unbalance. In large organizations, this could be the result of different teams having different tilts. Finally, there is the case of unknown factor exposure where an investor has not yet looked at factor exposures they hold or their managers, knowingly or not, have been using but haven t told their investors or have realized themselves that they are. This why building a solid foundation for factor investing starts with an analysis of what is being invested in exactly, he said. The returns of any strategies can be attributed to three major factors macro, Vincent de Martel, a factor investing specialistt with Invesco s Global Investment Solutions team; and Adam Hornung, Associate Director, Investment Strategy, for Russell Investments Canada, RICL Institutional Business; and Kevin Zhu, Managing Director and Head of Portfolio Construction at OPTrust; shared some of the current thinking on Pension Investment Strategies at a Benefits and Pensions Monitor Meetings & Events session. style, and alpha. A factor is a quantifiable characteristic of any security that helps determine the risk and return of that particular asset. To distinguish between these factors, de Martel used a music analogy. Macro factors are what kind of music you re listening to classical, pop. That determines the baseline. The style factor determines the particular style. Maybe it s pop, maybe it s disco, reggae, or techno. The third one the alpha is the genius. Being in Canada, it could be Neil Young who was actually born here or pick your own favourite artist, but it s really what s special and makes a difference, said de Martel. Once these three exposures have been unbundled, they can be analyzed and in- 1 BENEFITS AND PENSIONS MONITOR May 2018
Number One Trend According to a survey from the PRI (Principles for Responsible Investing), the number one trend asset owners are acting on is climate change. In terms of incorporating climate change considerations into portfolios, however, the solution set is evolving. There are much clearer directives now than several years ago. As well, a report by the Taskforce on Climate-related Financial Disclosures (TCFD) made a number of recommendations with the most prominent being that climate change presents global markets with both risks and opportunities that cannot be ignored. This is a key consideration when thinking about climate change and carbon risk and how to incorporate it in portfolios, he said. How ESG factors are measured is also changing. First-generation metrics used a risk-management lens such as looking at the carbon footprint of a company. Many realize that carbon reserves can be a fairly significant financial risk, said Hornung. However, as the TCFD pointed out, we not only want to focus on the risk side, but also the opportunities. One way is to identify opportunities with companies in the industries that are most at risk such as utilities or powervestment decisions made on how much to invest in each. Which factor to use depends on what the investor is looking for. If you re looking for returns in the long run, that s going to be macro factors. The benefit is that over the last 150 years, they have been unconditionally rewarded so you don t need specific skill. Style factors are a little more appealing in that we re moving from having just asset classes to owning these styles which can give you an additional return uncorrelated to the market and it can last for decades. Alpha is, of course, the one that s harder to find and to keep over time, he said. This makes the biggest challenge determining which factors to use within these. The problem is there s no official list. PCA (principle component analysis) is a statistical analysis which reveals that four macro factors explain 90 per cent of the returns of any asset class. For example, corporate bonds give exposure to two factors interest rates and credit. Other factors include growth, real rates, and emerging markets. By and large, what you find is there are only a limited number of factors that can help you replicate the performance of any asset class, said de Martel. One can also use a more qualitative approach moving from macro to style factors since human biases are one of the main reasons for the existence of style factor premiums. Researchers have discovered about 200 biases investors tend to favour although there is a smaller number of major categories. These biases create price dislocations investors can benefit from as prices revert back to fundamentals. One worth focusing on is momentum. Momentum is the tendency to extrapolate price movements. By the way, some managers don t believe in momentum, so if you look at the Norway pension fund as an example, they decided that they didn t want to invest in momentum because they believed there s no premium there. The reality is that it has actually delivered good results over time, he said. Value Another is value. The tendency of investors is to focus too much on the glamorous stocks which tends to make them overpriced in the long run. Identifying assets that really can be determined to have good value through time requires a more con- trarian approach. This is the value approach found in the earnings yield or price-tobook calculations. With implementation, the details are important because there are some very different methodologies for ranking stocks. When building a factor portfolio, a score is put on each security. However, managers have different methodologies, so it s important to understand how each index is constructed because the details can have a large difference in performance. Adoption has been primarily focused on the larger institutions to begin with, but we see it starting to trickle down and now become available to a larger number of investors, he said. Stakeholder pressure and regulatory shifts are just two of the reasons the incorporation of ESG (environmental, social and governance) considerations into portfolios is growing, said Adam Hornung, Associate Director, Investment Strategy, for Russell Investments Canada. Both internal and external stakeholders are getting more vocal on this topic and want to explore what incorporating these factors specifically carbon reduction means to the performance of their portfolios. Regulatory and political shifts are taking place throughout the globe. Countries like France are instituting regulations around disclosing how climate change considerations are being incorporated into investment decision-making, so going beyond general ESG integration he said. Difference Between Views In terms of the relative importance of environmental issues versus social or governance considerations, there is a difference between the views of asset owners and asset managers. One survey shows asset owners overwhelmingly believe that issues related to the environment are more than double the importance of both social and governance issues. Asset managers, on the other hand, ranked governance as the most important issue. Historically, asset managers have found it easier to align themselves with governance issues in researching a company s sustainability. May 2018 BENEFITS AND PENSIONS MONITOR 2
generation and identifying those companies in these sectors that are most progressive and investing in renewable sources of energy, he said. Marrying the underlying metrics of carbon footprint and carbon reserves with a metric of renewable energy creates a broader lens that accounts for both the risk and the opportunities and gives a better understanding on how companies are incorporating ESG into their initiatives. In the past, investment managers used a third-party provider for ESG scoring. Scores for individual institutions were based on 150 different considerations. However, these scores were very much centred around the median. Aggregating the scores made it hard to really find meaning behind different companies in different sectors, he said. Financial Materiality Looking for a better method, Russell Investments conducted research into how to identify those ESG factors that are financially material to a company and its profitability. Recognizing that not all considerations are relevant from industry to industry, company to company, the firm created a materiality map for different sectors and industries. We then weighted it based on the materiality of those issues to those sectors and effectively created a new custom ESG score for every single one of the companies in the global universe, he said. The results of the research and analysis are promising. Companies that tended to score high on material factors outperformed companies that scored high on immaterial factors. So, understanding which ESG factors are financially material to an organization may help drive performance. Although there is a strong link between performance and financial materiality of these ESG factors, our data set is still a little narrow. It s only a market cycle. We think there s a lot of evidence there that we are on the right track. We will continue to foster evolution in how we, as an industry, measure and report on the impact ESG factors have on investment portfolios, said Hornung. The top priority at OPTrust is ensuring we can deliver our pension promises in the long run, said Kevin Zhu, its Manag- ing Director and Head of Portfolio Construction. With net assets of over $20 billion, OP- Trust invests and manages one of Canada s largest pension funds and administers the OPSEU Pension Plan, a defined benefit plan with over 92,000 members and retirees. Using a diversified global portfolio with balanced risk factor exposures, the plan is fully-funded on a going-concern basis and its investment performance has been robust and consistent with a nine per cent annualized rate of return on average since its inception in 1995. Maturity Challenge However, Zhu noted that OPTrust is a maturing plan. The active-to-retiree ratio as of December 31, 2017 was 1.2 to 1, and this ratio is expected to decline further to less than one in the next five years. This is going to be a big challenge because we are going to face a net cash outflow in an increasing fashion going forward, said Zhu. As a true pension manager, our mandate is to ensure pension certainty to our members. As such, we measure our success fully based on the funded status of the plan, said Zhu. Our investment objective is to maintain our fully funded status by taking the lowest risk possible. He noted that many pension funds have struggled with properly aligning their goals and their operations, incentivizing investment teams to focus on generating extra returns to outperform the benchmark. Total portfolio return and risk are what really matter in the end, said Zhu. Under the MDI strategy, OPTrust has transformed to become a pension management organization by fully aligning our investment strategy with our mandate to keep our promise to our pensioners. We look at investments on a riskadjusted basis. For each investment we make, we want to make sure that the risk is aligned with our goals. Zhu explained that OPTrust s total portfolio management framework has two principal pillars: using a total fund-oriented mindset and approach in portfolio construction and dynamically managing risk factors through a total portfolio overlay structure. Its portfolio construction uses a risk factor-based framework and takes into consideration real world constraints such as risk, capital, and liquidity, and it then weighs the different trade-offs to strike the right balance in the portfolio. We don t operate in an ideal world and our portfolio construction exercise is challenging, like solving a puzzle with many different constraints, said Zhu. In its portfolio construction process, OPTrust separates the liquid and illiquid portions of its portfolio to account for different investment time horizons and liquidity profiles. Once illiquid exposures are known, the portfolio construction focus shifts to the completion portfolio where desired total fund risk and risk factor exposures can be managed more dynamically and effectively. Risk/Reward Profile A total portfolio overlay structure is created internally with the mandate to more dynamically manage the major risk factor exposures of the fund. The overlay committee constantly monitors and assesses external macro opportunities and risks and, within its allocated risk budget, the committee makes decisions to adjust major risk factor exposures with the goal to improve the risk/reward profile of the plan s funded status. Our experience and performance over the past two years prove that our strategy is working, and we have delivered what we promised to our members, said Zhu. We have reduced our funding risk profile, while succeeding in our ultimate goal of improving the funded status of the plan. BPM BENEFITS AND PENSIONS MONITOR WOULD LIKE TO THANK THE SPONSORS OF THIS EVENT 3 BENEFITS AND PENSIONS MONITOR May 2018