In this issue:
IMPROVING ACTIVE RISK BUDGETING
Strategies providing strong risk-adjusted returns can better position investors for outperformance and also target other, unrelated objectives. Investors recently have begun rethinking how they take and manage risk in their portfolios, and many have reduced allocations to managers using high levels of active risk, instead favoring index strategies. Many investors clearly do not believe they are appropriately compensated for the risks their active managers are taking, leading them to limit or eliminate active risk from their portfolios. This approach reflects the misconception that overall portfolio risk can be managed best by allocating a significant portion of the portfolio to index strategies and that using managers with a high level of active risk is the primary way to generate outperformance. In reality, taking a different approach will better position investors to generate consistent outperformance and target objectives that are not performance-related. How? Use strategies that provide strong risk-adjusted returns by focusing on compensated risk factors such as value, low volatility and momentum. In fact, strategies that take on high levels of active risk tend to be relatively inefficient and often result in low risk-adjusted performance. We explore this topic further in our paper Improving Active Risk Budgeting.
FACTOR-BASED INVESTING CASE STUDY: PENSION RISK MANAGEMENT
Many plans that need equity exposure to close funding gaps turn to low-volatility equity strategies to manage portfolio risk. In 2013, we saw not only a strong year for global equities, with the MSCI ACWI up nearly 24%, but also an upward shift in the term structure of U.S. bond yields. As a result of last year’s dynamic transformation in capital markets, many defined benefit plans now enjoy improved funding ratios and have turned their attention to preserving funding levels by de-risking plan assets. In such an environment, plan sponsors will typically reduce their exposure to risk assets such as global equities in favor of securities such as long-duration bonds that have characteristics matching the returns of their liabilities. These practices are common in traditional liability-driven investment strategies designed to protect pension plans from adverse changes in funding ratios by matching the duration of plan assets with that of liabilities. However, many plans may still need equities exposure to close funding gaps. To fill that need, plan sponsors have turned to low-volatility equity strategies to manage risk within their portfolios. In our paper, “Quality Low-Volatility and Pension Risk Management,” we show that the use of a low-volatility strategy can help a plan manage surplus volatility by increasing the correlation of plan assets to benefit obligations, while allowing for efficient, risk-controlled participation in global equities.
GOOGLE SHARE SPLIT: IMPACT ON U.S. INDEX SERIES
In recent years, U.S. corporations increasingly have implemented multiple share class struct-ures as a way to increase availability and liquidity with other motivations from founders or early investors wanting to maintain control in voting rights. Google Inc. recently issued a new class of shares (Class C) and distributed them in the form of a mandatory stock dividend to all current holders of Google Inc. This new non-voting class of stock officially commenced trading on April 3, 2014. Given the size of Google’s market capitalization in large-cap indexes (approximately 1.9% in the Standard & Poor’s (S&P) 500 index), this distribution prompted index providers to closely examine current methodologies around the treatment of multiple share classes.
Index providers such as S&P Dow Jones and Russell historically handled securities with multiple share class structures by including only the most-liquid share class as the primary representation in the index. To account for a company's entire float-adjusted market capitali-zation, the share count was composed of a combination of all share classes. When the Google distribution was announced, S&P Dow Jones and other index providers said the existing methodology would apply and only one line of Google would be represented in the index.
Both Google Class A and Class C shares will become members of the S&P 500 index, resulting in a current index security count exceeding 500 names. Investment managers and asset owners questioned the proposed treatment of the Google distribution because of the trading size, market impact, potential tax implications and loss of voting rights associated with liquidating Google Class A and buying additional Google Class C in order to replicate the index. Passive investors argued that to minimize the trading impact, index providers should either re-examine current methodologies or make an exception for Google Inc.
Based on feedback from the passive investment community and an internal review of the current methodology, S&P Dow Jones decided to change the treatment of multiple shares class companies in their U.S. indexes. S&P Dow Jones will implement a multiple class structure to current index constituents in September 2015. This change will require a revision to certain guidelines such as liquidity and float-adjusted market capitalization to coincide with multiple share class inclusion. Companies issuing similar mandatory share class distributions between now and September 2015 will be considered for inclusion in the index. As a result of this announcement, both Google share classes will be members of the S&P 500 index, resulting in a current security count of more than 500 names. Going forward, the S&P 500 index still will represent 500 companies but will contain more than that number of securities (Exhibit 1). These guideline changes will also apply to other indexes such as S&P 100, S&P MidCap 400, and S&P 600 that historically have had a fixed number of securities.
Russell ultimately decided to keep both Google share classes as index constituents, but it has not announced any broad methodology changes for the treatment of multiple share class securities going forward. Index providers will continue to monitor and enhance methodolo-gies, given trends in the marketplace and feedback from investment managers and investors.
EMERGING MARKET ESG – CORPORATE GOVERNANCE AND LOW-CARBON DISCUSSION
The rise of environmental, social and governance (ESG) investments is well documented. At least 22% of assets invested globally incorporate ESG criteria1, and 22 of the top 30 largest pension plans in Europe signed the United Nations Principles for Responsible Investing2 (UNPRI) initiative, declaring themselves responsible investors. Furthermore, a recent Ernst and Young survey noted that 89% of 163 global investors polled said that non-financial performance information was a key consideration in their decision-making with the last 12 months3.The effect of falling returns and increased ESG scrutiny from investors, especially concerning corporate governance and carbon emissions, has triggered demand for appropriate investment solutions. Numerous high-profile scandals in emerging markets (EM), including ones where Satyam Computer Services in India, Gome Electrical Appliances in China and Sibir in Russia all failed to act in the best interests of shareholders, has re-doubled focus on corporate governance.
Developing countries will generate 70% of projected global emissions by 2050. Governance matters within the EM universe, where a high proportion of companies are owned or controlled by governments, powerful families or industrial groups. Most significantly, 70% of total earnings generated by the MSCI Emerging Market constituents come from companies in concentrated control4. Too often, controlling shareholders have the opportunity to engage in abusive behavior, especially in jurisdictions where transparency is relatively poor.
To help mitigate the issues seen in emerging markets, we developed the MSCI Emerging Markets Custom ESG index in collaboration with MSCI and using input from our clients. This index aims to apply carefully selected screens to the MSCI EM universe. The first screen excludes companies that breach the UN Global Compact Principles. The second screen bars manufacturers and suppliers of controversial weapons such as cluster bombs. Third, tobacco manufacturers and distributers are excluded. Finally, a governance screen cross checks majority ownership with the independence of board membership and the functioning of various board committees is applied. The result: 73 companies are excluded from MSCI EM index5.
Investors also are focused on limiting the carbon exposure within their portfolios. Following the Kyoto Protocol (2005) and the United Nations Copenhagen Accord (2009), countries are signing legally binding agreements to limit or reduce emissions of greenhouse gases. The commitments are substantial, as industrialized countries must reduce emissions by 25% to 40% below 1990 levels by 2020 and cut them by 80% to 95% by 2050. This will affect profits, locations and investment decisions for carbon resource-intensive companies.
The assessment on carbon exposure is becoming key when discussing EM investments, and investors should consider the attendant risks and opportunities. Developing countries will generate 70% of projected global emissions by 2050, and a large portion of their assets are allocated to resource- and carbon-intensive companies where “low-carbon” policies may disproportionally affect costs.
Again, in collaboration with MSCI, we’ve developed the MSCI Custom Emerging Markets Optimized Low Carbon Index that applies a carbon screen to the broader MSCI EM index before optimizing, subject to several constraints. The carbon screen excludes issuers that contribute 50% of the total carbon reserves and issuers contributing 25% of absolute total emissions of the MSCI EM. As a result, 149 companies are excluded6 from the MSCI EM index.
1 MSCI data as at November 30, 2013
4 Northern Trust and MSCI, November 2013
5 Data as at March 31, 2014
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