Return

A return is the gain or loss on a pension fund's portfolio or investment value in a particular period. The return consists of the income from the investment such as coupons paid, dividend and rent; and the change in price. This sum is also referred to as the “total return.” In investment management theory and practice, returns are viewed as “mark-to-market” returns, meaning that the return is based on the market price of the investment at the beginning and the end of the measurement period. The reliability of this market pricing can vary enormously from investment to investment. In very liquid markets, such as the large cap stock market, this provides a good indication. In many other markets, however, such as in corporate credits, a price will often simply be set because there is no recent transaction. Essentially, in illiquid assets, there is no pricing information between the points at which the investment is made and realized. It is important to be aware of this when trying to draw conclusions from detailed and short-horizon performance reports. Two points are important:

1. Net returns. What matters to your beneficiaries is the net return, the return after all costs;
2. Real returns. Real returns are the returns after deducting inflation. Pensions are meant to provide people with decent living standards during their retirement. Real return takes the cost of living into account, thereby providing a metric that returns real capital increase/decrease. This is important because inflation decreases the real value of money. For example, a continuous inflation of 5% for 10 years reduces the purchasing power by 40%.

Expectations

An investment solution or portfolio is always constructed by looking ahead. Therefore, in board and committee meetings about investing, the orientation should always be forward-looking, with the right horizon. This seems easy, but in practice it is difficult. The past provides a nice collection of very exact facts and data. These can be wonderful tools for accountants and performance measurers. But the future is risky at best and, more often than not, uncertain. In investing, what has happened in the past—even in the recent past—is usually an extremely poor guide as to what will happen in the future. For example, at the time of writing, there has been a continuous decline in both interest rates and bond yields. In many parts of the world, they have moved close to zero. It would be very dangerous to extrapolate the past in order to predict the future. Similarly, for example, the historical performance of managers is a very poor guide to their future performance. This does not mean that we cannot learn from history. There are always patterns, and there are always lessons to be learned.

Looking ahead at expected returns, the average investment consultant will present you with an expectation that is based on one or more of the following points:

1. The concept of “risk premiums.” The differential in returns between equities and bonds is calculated over long periods, and on the grounds that there is no reason to assume that returns in the future will be any different than in the past, this is then projected into future risk premiums;
2. An assessment of the current valuation of an investment plus a long-term “reasonable” valuation. The underlying investment belief is that values revert to a long-term average. It would be more profitable to buy undervalued assets and the board should hesitate to buy overvalued assets, as these might over time converge to their long-term “reasonable” valuation. This is not an uncontested approach. Between 1998 and 2018, consultants and strategists consistently predicted that the interest rate level would revert to its higher long-term average. It did not, and the resulting bad hedging decisions clearly cost funds worldwide;
3. Understanding the components of the underlying economic processes that generate the returns, such as expected profit, profit growth, rent, etc. This approach expands on the current valuation approach and assumes that asset returns are driven in the long term by fundamental long-term economic factors.

What helps in working out expectations is the use of aggregation. If you look at an individual company, it is almost impossible to know whether it will still be around 10 years from now, let alone what its returns will be. If you look at the aggregate stock market, you can make statements with a lot less uncertainty, much in the same way as it is easier to predict the average height of everyone in a certain country than the height of a single individual. So, predictions should be based on the major asset classes at an aggregated level.

Forecasts make for interesting reading and discussion for a board, but many boards interpret and use forecasts wrongly. Most predictions will fail to materialize, time and time again. There is abundant evidence that, at best, they predict the short-term trend, but fail consistently when it comes to major changes in financial markets or economies. Therefore, the board should not spend too much time on a detailed discussion or tweaking of these expectations. The way to use them is by comparison: if we compare changes in the return/risk expectation for equities versus corporate bonds, are we compensated sufficiently for the relative differences in return/risk, and how does this translate into portfolio construction?

A common misconception is that total return is proportional to risk. For example, that an investment with an expected 10% annual standard deviation should have twice the total expected return of an investment with an expected 5% annual standard deviation.² While it is true that there is an upward slope in returns that correlates with risk, this is far from a mechanistic relationship. Exhibit 3.1 demonstrates this relationship. Just because investors generally get paid to carry risk does not mean that the pension fund will want to do so. The difference can be substantial. If one assumes a cash return of 4% in the above-mentioned example, the investment with a 5% annual standard deviation would have an expected return of 6% and the investment with a 10% annual standard deviation would have an expected return of 8%, not 12%. Another question for a trustee is then: which risk premiums are out there and which ones are relevant for them?

Risk Is not Volatility

Risk is the possibility of loss: the chance that the return on a portfolio or an investment will be lower than the expected or targeted return. In everyday investment language, “high risk” often means “high (short-term) volatility.” However, risk and volatility are different things, and it is actually dangerous to reduce risk to volatility. In pension investments, we feel there are two central meanings of “risk.” The most important one in our view is: can the pension fund reasonably expect to deliver the benefits explicitly or implicitly promised over the relevant horizon? The probability of delivering less than this is called the shortfall risk. The other risk is the shorter-term degree of variability that occurs while working towards the long-term objective. This is the daily meaning that trustees and regulators tend to give to risk. The two concepts can lead to very different conclusions. For example: government bonds are commonly seen as “risk free,” meaning they will pay what they promised. At the moment of writing, the expected return on a 20-year German government bond is around 1% nominal. You can be very sure that this promise will be realized, hence, low risk. Meanwhile, expected inflation over the next 20 years is in the order of magnitude of at least 1.5%, but it might end up a lot higher. In other words, you would be buying something that certainly will not contribute to generating a reasonable pension—a very high-risk asset in terms of shortfall risk.

Risk Premium

A risk premium is the return that an investment is expected to yield in excess of the risk-free rate; an asset's risk premium is a form of compensation for investors for tolerating the extra risk in a given investment, as compared to a risk-free asset. For example, high-quality corporate bonds issued by established corporations earning large profits carry very little risk of default. Therefore, such bonds pay a lower interest rate than bonds issued by less-established companies with uncertain profitability and relatively higher debt levels. Investment consultants and researchers are keen to identify new risk premiums.

In Exhibit 3.2 you will find the most widely accepted risk premiums, as well as an idea of the currently accepted order of magnitude. Usually, cash or short-term liquidity at a high-quality debtor (the state or central bank) is seen as the lowest risk asset, and therefore constitutes the basis for comparison.

The risk premiums in Exhibit 3.2 provide the bulk of the rationale for constructing portfolios. If the board understands these risk premiums, then 80% of the expected long-term return/risk outcome of the portfolio is covered.

The risk premiums are based on the assumption that risk and return are proportional, i.e. that an additional unit of expected risk results in an additional unit of expected return. More specifically, we assume that “excess return” is proportional to risk. Excess return is the return in excess of a risk-free return such as a return on cash. The measure of risk is the annual standard deviation of returns. So if an investment with an expected 5% annual standard deviation would be expected to return, for instance, 2% more than cash, an investment with an expected 10% annual standard deviation would be expected to return 4% more than cash.

A misconception is that risk-taking is automatically rewarded. Taking risk is not in itself a rewarding activity, which is why it needs a risk premium as a reward—it actually works the other way around. The real questions are: Which risks are on average rewarded, and which are not? Second, is the expected rewarded risk in proportion to the expected extra return, and if not, can the risk be avoided altogether? This leads to strategic choices in investment plans, for example to mitigate currency or interest rate risks.

Getting Risk Measures Right

The goal for trustees is to find applicable measures for the different risks. Aggregating the risks into a few handy, comparable measures with which trustees can influence the outcome would be very helpful. Stochastic risk analysis is widely used for estimating errors and small probabilities when the observables are averages of a large quantity of independently acting agents or extremes of such observations. Risk measures have been developed and applied successfully in actuary science and management analysis.

Typical measures of risk are the standard deviation, Value at Risk (VaR), or drawdown frequencies. In reports and risk management systems, these are often measured retrospectively, but purporting to describe the situation looking ahead. A trustee should be aware of this, because the assumption to be challenged is that the information from the past period provides guidance for the future period. In fact, if the current volatility of the stock market is low, for example, this does not say anything about its future volatility.

A bigger problem than whether the data are correct is that trustees are not trained to deal with stochastic measures and probability. Kritzman⁵ provides a painful example of how “loss” depends on how you frame the question. Suppose that the investment committee has to decide on the strategic asset allocation, and it has the following information: the expected average yearly return is 10%, and the standard deviation is 20%. How safe is the portfolio? Based on this information, Kritzman comes up with five variants for calculating the likelihood of loss:

• Likelihood single year loss: 14%
• Likelihood average annual loss: 0.03%
• Likelihood cumulative loss: 3%
• Likelihood loss in >1 year: 77%
• Likelihood cumulative loss at some point: 54%

Which number will you use in a discussion with trustees? At this point, trustees may increasingly be feeling that they are at a loss to know what to do. They may be given all the information, in neat tables with percentages, but how can they determine whether the likelihood of a 4% loss is worse than a 2% loss, and if it is, should it be assumed that 4% is twice as bad?⁶ Without a firm grounding in statistics, trustees will give widely differing answers, which is not helpful and in some cases downright misleading for decision-making.

The message is clear: it pays for a committee or board to agree on one or more risk measures that guide the investment process and implement them throughout the monitoring and evaluation. Trustees should not work with abstract figures alone, but instead should be trained to cope with real life situations—especially the bad ones. In other words, how can risk measures be put into practice?

There may be underlying or additional beliefs that have to be made explicit, such as the emotional loss-aversion characteristic of trustees, alongside the rational loss-avoiding function of a pension fund embodied in Asset-Liability Management (ALM). What will your actions be when the cover ratio is 150%, 105% or 90%? How will stakeholders react? Will you still rebalance, or not? These are the kind of situations trustees should become familiar with. This type of mental training with scenarios will help a fund cope with future crises and is especially helpful in an unstable environment where the time span between financial and economic crises keeps decreasing.⁷ Preparation and training is not new. “We expect firemen and ambulance crews to practice regularly for unexpected situations, so why not the trustees to whom participants have delegated the task of providing for their income once they reach 65?,” the prospective pensioner could justifiably ask.

Having determined how to interpret the risk measures, it is also important to consider where to use which risk measure in the investment process. This is visualized in Exhibit 3.3.

Risk Is about Behavior

Trustees have little difficulty making hundreds of decisions every day. This is because the best course of action is often obvious, and because many decisions are not worth spending much time on as the potential outcome has little impact. For pension funds, however, many potential decision paths diverge in outcome, and the correct path may be unclear. There is ample research that provides insights into the psychology of the decision maker or trustee. A central theme is that the natural manner of reacting and thinking, if not tackled effectively, can regularly and unintentionally lead to decisions with unintended and even undesirable outcomes. Portfolio theory and management are based on the following “rational” basic principles:

• The sum is different from the parts;
• Diversification in risky investments can increase the stability of the overall portfolio;
• Returns are not the only thing that matter—risk and obligation aspects must also be taken into consideration;
• Long-term trends can be overshadowed in the short term by temporary things like market dips, exchange rate issues, and uncertainties that cloud the horizon;
• The desire for short-term certainty and stability of return can significantly harm long-term aims, for example in protecting capital against inflation.

Trustees, investment committees and advisors must therefore avoid three pitfalls: oversimplifying problems, ignoring personal preferences when forming judgments, and short-cut information processing. It is worthwhile training the investment committee to recognize and avoid behavioral pitfalls. The trick is to make sure that, when deciding, you are collectively in “thinking slow” mode; that is, slow, rational and well-thought-out, and not in “thinking fast,” intuitive, emotional, “let's make a mental shortcut” mode.⁸ Chapter 14 elaborates on these behavioral biases.

Benchmarks

In an investment plan, a benchmark often represents an asset class on which the pension fund wants to earn its risk premium. So, for example, if a fund wants to earn the risk premium on equities, it will make an allocation to one or more equity benchmarks, such as the S&P 500-index or the MSCI-All World Index. At the same time, a benchmark is a standard against which the performance of a security, mutual fund or investment manager can be measured. Generally, broad market and market-segment stock and bond indexes are used for this purpose. So what is a sensible benchmark to set? We can think of the following desirable features:⁹

• The combination of benchmarks should aggregate to the overall benchmark that the pension fund has set;
• The benchmark and resulting investment style should not trigger procyclical behavior;
• The benchmark should not be tweaked towards exploiting or concealing regulatory loopholes;
• The investment style and benchmark should be congruent with sound investment principles (such as the period required to earn equity risk premium, etc.);
• The composition and maintenance of the benchmark should be simple and easy to understand.

Trustees choose a market index, or a combination of indexes, to serve as the portfolio benchmark. An index tracks the performance of a broad asset class. Because indexes track returns on a buy-and-hold basis and make no attempt to determine which securities are the most attractive, they represent a “passive” investment approach and can provide a good benchmark against which to compare the performance of a portfolio that is actively managed.

When implementation is delegated to an asset manager or investment management organization, the investment management agreement will describe the choice of and deviation around the benchmark in great detail. The amount of “room” that an investment manager is entitled to between the performance, or investment return, of an individual mandate and its benchmark is known as the relative risk budget. This is often specified as a (annualized) standard deviation percentage of the realized returns versus the benchmark returns, in this context called the “tracking error.” The lower the tracking error, the more the outcome of the mandate will resemble that of the benchmark, in other words, the more “passive” the investment style. When a portfolio is actively managed, the tracking error may reflect the investment choices made by the active manager in an attempt to improve performance. Exhibit 3.4 shows different risk budgets accompanied with their characteristics. Important here are the reasons behind these investment choices: the investment style and investment beliefs of the manager. However, this is information that cannot be obtained from a benchmark, but requires a quality conversation.

Diversification

Diversification is a risk management technique that mixes a variety of investments to minimize the potential downfall in adverse times within a portfolio. The rationale behind this technique is that a portfolio constructed out of different kinds of investments will, on average, yield higher returns and pose a lower risk than any individual investment found within the portfolio.

Diversification aims to smooth out unsystematic risk events in a portfolio such that the positive performance of some investments offsets the negative performance of others. Diversification, therefore, only works—on average—if the assets in the portfolio are not perfectly correlated. However, during crises the correlation between assets increases dramatically, eroding the value of diversification—perhaps the sole exception being the lack of correlation between equities and bonds.¹⁰ In other words, diversification ‘works’ best when it is not needed, but works poorly when financial markets are in crisis. Trustees should allow for these different circumstances (regular business, crisis) in their investment policy. The existence or absence of correlation is the driving force behind diversification. Investment theory teaches that diversifying over different assets makes sense when there is low correlation among asset classes. An investment portfolio with multiple asset classes that have low or negative correlations can deliver a portfolio with more attractive risk/reward characteristics than any one of the asset classes alone.

In recent years, more insights have been gained into why assets are imperfectly correlated. Securities returns could move together by chance, or they might be correlated with a single common factor, such as oil. The financial crisis in 2008–2009 showed that many assets and securities have more in common than previously assumed. When the crisis is serious enough, just about anything is sold in the short term. So, when trustees discuss diversification, they should ask themselves whether the pension fund's goals will still be met when diversification works only partially during stress, or whether other measures—such as a solvency strategy—might be needed to manage the amount and type of risks on the balance sheets, which change when the solvency ratio of the pension fund changes.

Conventional vs. Alternative Assets

Diversification does not tell a trustee which assets to include in the diversification. What is the investment universe that the trustees would like to consider? Trustees can basically make a choice from two options, which will mainly reflect their appetite for complexity and innovative new instruments. The first is to select traditional assets such as bonds and equities to construct a portfolio. These are perfectly adequate for realizing a pension fund's goals, but do not leverage their potential long-term strengths. At the other extreme, trustees could add alternative assets such as private equity and infrastructure, which leverage a pension fund's strengths, but come with a “product warning:” complexity and higher costs that might detract from long-term goals.

The first approach constructs a portfolio with the minimum number of different asset classes to achieve the return/risk objectives. Conventional investment classes such as equities, bonds and cash could fill the bill. The asset allocation of the Norway Fund consists of just that—bonds and equities. However, if the board feels that further diversification benefits could be gained, they can consider alternative investments. Funds with more extensive assets under management and those that feel they have an experienced board and/or staff tend to consider adding alternative assets. Alternative assets are those that are not among the conventional classes of equities, bonds and cash. They include private equity, hedge funds, infrastructure, real estate, commodities and derivatives. Alternative investments also include highly specialized exotica, such as wine, stamps, antiques and art. However, for most funds this is beyond their scope, and very few in fact invest in these areas; these markets are not that well developed and questions may be raised by regulators and participants. Alternative investments share certain characteristics:

• Low liquidity. Difficult to buy or sell quickly or at certain, possibly critical, times. As they are not listed on exchanges, it may be difficult or impossible to find a buyer when you want to terminate the investment;
• Difficult to value. Sometimes the theoretical price is vastly different from the price (if any) offered by the market. This is otherwise known as the difference between the “mark to model” and “mark to market” prices;
• Higher degree of due diligence needed. The regulatory environment for alternative investments is not as strong as for traditional investments. Therefore, a deeper and broader range of enquiry is needed as to by whom, how and where the investment is being managed. Transparency is not something the alternative classes are usually known for.

Alternative investments also claim a large portion of the governance budget of trustees. Transparency is limited, and trustees have to think through the consequences of limited liquidity. These assets cannot be sold in periods of strong market movements, so the other core assets must provide all the liquidity needed for pension payments, derivatives, etc. Furthermore, for many alternative investments the academic debate on diversification is far from settled. For example, does private equity really provide a complementary risk premium compared to equities, or is the investor paying a hefty fee for returns that are similar to, but lagging behind equities?

Active vs. Passive Investing

Trustees are by far the most important principals awarding active managed mandates worldwide in the investment industry, and they therefore support the income model of asset managers to a large extent. The debate on active management started in the late 1960s, when investors started to incorporate the latest ideas about portfolio management into actual investment practices, and benchmarks were developed to measure the relative results of managers. While actively managed investments contribute a small portion of the overall realized performance of the pension fund portfolio, fees for active management form a large slice of the income of the asset management industry that is providing strategies and services to the pension funds.

Active management is a broad brush. Any investment decision that intentionally or unintentionally creates a portfolio that deviates from an agreed reference framework is a form of active management. The aim is to generate returns exceeding those of the reference framework, on a risk-adjusted basis. So, the idea of active management is a strange one from the outset. Most service providers would be content if they delivered what they had promised. Active managers start out by promising that they will over-deliver.

Basically, most studies confirm that managers have a difficult time beating benchmarks, raising questions about the worth of active management for a pension fund. The reasons for this could be summed up as follows:

1. Fees have a high impact, in absolute and relative terms;
2. There are too many smart investment managers chasing the same strategy, collectively lowering returns;
3. Managers have their ups and downs—it is difficult to predict when these will be;
4. Extra returns are not based on skill, but on expensively leveraging cheap benchmark returns.

We will now provide the reader with some more detailed explanations of these reasons:

• Reason (a). Trustees are increasingly taking a second look at the one variable that, for a long time, most assumed was too small to matter: fees. The logic is simple: higher costs lower any form of returns, and for the better part of the 1990s and 2000s, costs have been rising, either directly or indirectly. Fees for active management are usually described as “only” as in “only 1%.” But that really means 1% of the assets that the investor already has. So what the manager offers to deliver is a return on those assets. If equity returns average 7% going forward, that 1% fee is really—if correctly calculated—much higher: roughly 15% of returns. But since index funds deliver the market return at no more than the market level of risk, any economist would say the true fee for active management is the incremental fee over and above the very low fee for indexing, as a percentage of the incremental risk-adjusted returns. Defined in this rational way, fees for active management are not low. They are actually very high and, surprisingly—until examined closely—average over 100% of the potential additional active returns. The combination of repeated disappointing results and the gradual recognition of the very high incremental cost of active management is prompting an increasing number of investors to shift increasing proportions of their assets into low-cost index funds and exchange-traded funds.
• Reason (b). The number of players has increased dramatically. According to the renowned investment writer Charles Ellis, active management is not failing because of bad managers, but because too many similarly trained good managers enter the market,¹¹ searching for similar strategies and, therefore, on aggregate, reducing the chances of making a decent living.
• Reason (c). There is evidence that managers themselves are mean-reverting over a longer period. This is investment jargon for stating that no investment manager is always good. He or she tends to have up and downs.
• Reason (d). The final reason for the overall disappointing results is a technical one. If we take a closer look at the extra return, research tends to show that it is highly correlated with the underlying benchmark, which gives rise to another suspicion: alpha is not so much correlated with the skill that the manager has in identifying market-independent opportunities, but rather with the risk of the underlying benchmark. In other words, managers leverage their own positions. Is this all bad news for active management? No. There are studies showing potential for outperformance. For example, recent studies suggest that highly concentrated portfolios deliver better results. This means choosing a limited number of stocks, in contrast to investing in all the stock of the benchmark and only changing its weightings a bit. However, it must be kept in mind that these are academically driven studies, in the sense that they identify corner solutions that require a very specific breed of investors. Either the investment horizon must be very long, or the type of securities must have a specific characteristic that requires some stamina (deeply undervalued securities, for example).

  Overall, the previously mentioned reasons still do not explain why current day active management persists. A possible explanation could be the marketing budget of the financial industry, in addition to a matter of perception—the idea that if these managers are highly paid, they must be successful. Alternatively, while investment managers retain their job for decades, trustees only last for a couple of years. This introduces a sort of managerial call-option: “I know that active management fails overall, but if it does, I am not alone. If on the other hand it succeeds, it will be something that I can add to my achievements.” Shefrin¹² identifies another possible downside element: investment committees may be perfectly well aware that active management is a zero-sum game. However, when the fund has a lot of active mandates, if they fail, management can fire these mandates, demonstrating resolute action. With only passive mandates and asset allocation choices to show, the investment committee would be far more accountable—and vulnerable. Finally, investment committees tend to choose external advisors perceived to have been successful in investment management. These generally tend to be in the field of active management.

Better Beta: Styles and Factors

Over the past decade, there has been a strong take-up of “smart beta,” style and factor investing within public equity markets. This form of implementation lies somewhere between passive and active investing. In investment lingo, “beta” is the part of the return that is to be ascribed to the market or benchmark invested in, and “alpha” is the part that is gained or lost by taking specific positions vis-à-vis the benchmark, or in other words, active management. So, in a passive strategy, beta is one and alpha is—by definition—zero. You can also look at it like this: the beta returns are earned because of the policy and strategy of the plan; the alpha is the part where the degrees of freedom that are allowed to the investment manager contribute.

Typically, at the fund level and for most funds, beta will contribute at least 90% of the net return over time … and too often more than 100%, if the alpha after cost turns out to be negative. So, for trustees it makes sense to concentrate on generating strong beta returns.

Within the returns of portfolios, specific characteristics can be found, which in the longer term can earn a “systematic” additional risk premium as compared to the market, which may pay out as a higher return or as a lower risk in times of trouble. These are called “styles” or “factors.” To mention the most prominent ones: Value (overweight cheap stocks) and Small Cap (overweight small companies) have been around for a long time, and Momentum (overweight stocks that have done well recently) was an important third. Typically, three more will be taken into consideration nowadays: Quality (overweight companies with strong and resilient earnings and growth potential), High income (overweight companies which generate high dividend yields), and Low Volatility (overweight stocks with a low market volatility). For most of these factors, there is a good to reasonably good storyline underpinning the logic of their existence and at least some empirical evidence that they may produce added value over the longer term, such as the course of an investment cycle, although slippage in the form of implementation cost may be high.

These styles and factors explain a large part of the returns that were used to call alpha historically. This is why some people say “alpha is beta waiting to be discovered.” The big advantage is that the returns to these factors can be systematically packed into benchmarks and strategy, thereby replacing the artisanal character of alpha by something that is more systematic and controllable by the board, and typically also cheaper than active management. This approach often goes by the term “smart beta investing” or, preferably, “better beta.” This approach typically is becoming part of the standard building blocks of equity investing for pension funds. Nowadays, funds will often allocate 20%–40% of their public equity market investments to better beta strategies.

Responsible Investing

Responsible Investing or environmental, social, and governance (ESG) investing is built on two thoughts. First, risk and return on investments are impacted by more than just the financial factors that come into play when evaluating them; more specifically by ESG factors. Thus, investors have a clear interest in taking these into account. Second, investors and asset owners do have an influence on their investments, which goes further than just being financially literate. This potentially makes for better outcomes with regards to governance, the environment, and the society.

ESG has a strong global presence, especially since the launch of the Principles for Responsible Investment (PRI) by the UN in 2006. The PRI, which is signed by 1,800 asset owners and asset managers, represents some $60 trillion of investments. It is made up of six principles, the first two of which are the most important. Principle 1: We will incorporate ESG issues into investment analysis and decision-making processes; and Principle 2: We will be active owners and incorporate ESG issues into our ownership policies and practices. The genius of these principles is in the fact that they are so generically formulated that investors with very different motives and backgrounds fit in.

Motives or Mission

The motives for asset owners to take ESG issues into account vary from purely financial reasons, to having or taking on a certain responsibility for the outcomes their investments produce. We list potential motives here:

• Financial. If there is a material impact from ESG on investment outcomes, it is part of fiduciary duty to incorporate those into the investment process.
• Potential cost. Many investments generate external effects in the form of negative outcomes on society, such as carbon emissions. By owning these investments, implicitly you also generate this effect, which, in the longer term, may cost you.
• Enlightened self-interest. In the longer term, it is in the interest of asset owners (certainly collectively) to operate in a world in which the environment and governance are well taken care off, because they are crucial ingredients for producing long-term returns.
• License to operate. Beneficiaries and broader stakeholders will have changing demands from the asset owners that they entrust their pension savings to. Shouldn't the asset owner reflect the values of the beneficiary in the way it invests? Is the asset owner part of the solution, or part of the problem? If the fund is out of sync with its beneficiaries, its license to operate will come under pressure.
• Mission. It can be the mission of the asset owner or the wish of the beneficiaries to enhance ESG issues.

In practice, many pension funds will have a blend of the motives listed above. Investors and sometimes also boards start from the reasoning that taking care of ESG comes at a cost when it comes to investing; in other words, by investing more responsibly, you will earn lower returns, usually because the universe from which you can select your investments becomes smaller. However, this is a false belief, as, on average, this is not actually the case. There now is a large and growing body of evidence¹³ that by and large concludes that responsible investing as a bare minimum does not hurt in terms of return and risk, and even may enhance these. So, sound investing and responsible investing can come hand in hand. In other words, there is significant room to act, and given fiduciary duties around the world it may even become compulsory to take ESG issues into account. A word of caution, however. The generic evidence does not say “any responsible investment will pay off,” just as investment theory does not say “because diversification is good, including this stock in your portfolio will pay off.”

When formulating your mission, it is important to reflect on the pension fund's views on this, because it can have deep consequences for the way it presents itself to its participants and the other stakeholders, and in addition it lays the foundation for investment behavior.

Instruments

The set of instruments available for acting on responsible investing has rapidly evolved over the past decades. A first, rather blunt, instrument is exclusion, with which certain investments are excluded from investment portfolios because they do not live up to minimum standards. Often, human rights or controversial weapons will be subject to exclusions. More recent topics of exclusions are in the field of coal (unsustainable contribution to climate change in the longer term) and tobacco. A second instrument is voting on corporate issues, which is broadly implemented. It is often outsourced. A big advantage of voting is that is does not have to impact your portfolio composition. A third instrument is engagement, with which there will be a dialogue, oftentimes on a specific topic between investors and a company. For example, on carbon emissions or labor conditions. Often, this is done in the form of a cooperation or a coalition between investors, because this is more effective than acting alone.

Over the past few years, certainly in Europe, there has been a strong movement towards trying to have an impact on the real world or having a portfolio that reflects the mission and identity of the pension funds. There is a movement towards inclusion, meaning that funds only want to own companies and investments that reflect the qualities and behavior that fit into their mission and values. There also is a movement towards impact investing, in which asset owners are steering investments into areas and companies that will positively impact one or more topics or themes that are close to their mission, such as improving health care and food security, or avoiding global warming.

Recently, investors have started to think about how they can integrate the 17 Social Development Goals (SDGs) of the United Nations into their investment approach. In the next few years, it may prove to be the case that these will provide an effective common framework that helps classify investments, which makes it easier to allocate to them, delegate investment decision-making towards internal and external managers, and report on sustainability issues.