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Topics Included Emerging Markets, the Credit Market, Actuarial Matters, and Governance

PRB Investment Committee Meets Online Sept. 29

The Pension Review Board Investment Committee meeting will be 

streamed online on its YouTube channel

Image by Alexandra_Koch from Pixabay 

Staff Report 

The Texas Pension Review Board will host its Investment Committee meeting by teleconference at 10 a.m. CST on Tuesday, Sept. 29, 2020.

Click here for the meeting agenda.

The committee meeting will be streamed online on the PRB’s YouTube channel. That link will be available on the PRB homepage, www.prb.texas.gov, before the session begins.

The PRB encourages anyone who wants to provide public comment to pre-register with the PRB’s Office Manager, Lindsay Seymour, by Sept. 29, 2020, at 8 a.m. CT. To pre-register, call 512-463-1736 or 800-213-9425. Or, send an email to prb@prb.texas.gov.

Risk Mitigation Opportunities: Taking Time to Re-evaluate Portfolio Strategies and Board Governance

Image by Michal Jarmoluk from Pixabay 

By FLOYD SIMPSON III & MALLORY SAMPSON/PFM Asset Management

The traditional 60% S&P 500 - 40% Aggregate Bond index investment portfolio has been the benchmark for portfolio construction for decades due to the inverse return relationship between equities and fixed income and higher historical bond yields. This simplistic mix had provided returns for pensions that allowed them to meet their actuary assumed returns. The S&P 500 index posted an approximate annualized average return of 11.3% for the past 10 years (ending 2019)[1], while the current yield on the Aggregate Bond Index less than 1.5% (coupon rate of hovering around 3%). The correlation between the two indexes has been slightly negative for the past ten years, and bonds have not provided a consistent offset for drawdowns within the S&P 500 index. Over the next five years, earning a 5% annualized return will be tough. Based on recent comments from the Federal Reserve (the Fed), the expectation for higher interest rates in the intermediate term is minimal. While investors cannot control what the Fed is doing, we can recalibrate current positioning and take a serious look at the risk within the portfolio and its governance.

Investment Strategy

The first question that most investors have started to ask themselves is how to replace the missing yield from the fixed income market. When seeking a replacement, many forget to fully vet the additional risks associated with finding an alternative. While there might be other public and private options, each one brings a different type of risk profile to the portfolio, which must be considered. Hence, swapping one investment for another is a naïve approach that could have detrimental effects if the understanding of current and potential strategies is vague. This is an important area to focus on, and what an investment advisor is paid to do. You might have a relationship with an advisory firm in which they present you with options or a fiduciary that does the decision-making and portfolio construction for you. In either case, this is the time for an investment committee to focus on oversight elements that are usually glazed over. From an investment perspective, members should take this time to:

• Re-evaluate their Strategic Allocation
• Update their Investment Policy
• Refresh their Objectives
• Evaluate their tactics around allocation of assets and assessment of those decisions
• Revisiting their Spending Policy

This is also an appropriate time to rethink how the committee gauges success of their portfolio. Instead of looking exclusively at the traditional aspects of asset classes and benchmark performance, committees should start to consider:

• Gauging the overall risk of their exposure
• Homing in on their underlying market exposures to events that could be detrimental to returns
• Measuring the volatility of returns for each fund and portfolio as a whole
• Considering drawdown of the portfolio

Governance Structure

Understanding and addressing the potential holes within the governance of a board is equally important to understanding current market conditions. Unfortunately, this rarely gets the same attention as the latest news from the stock market does.

As investment professionals, we spend far too much time talking about the markets, but clients’ governance structure usually has glaring holes and creates just as much risk for plans. The adoption of good governance starts with:

• Addressing educational needs within the board
• Introduction of term limits
• Staggering board terms
• Independent, third-party reviews of board investment process
• Proactively minimizing conflicts of interest
• Re-evaluate current investment advisor beyond investment performance
• Utilizing board assessments

While most boards would say they follow a couple of these best practices, very few that take time to adopt many of these items because they can be tedious and cumbersome to carry out. The board assessment can help in numerous areas. It can inform a board about members that are not contributing, bring up potential conflicts or educational gaps in knowledge and could even help in determining term-limits based on board needs. Pinpointing weak areas within the governance structure can help prevent surprises during times of distress.

It is crucial for boards to maintain discipline in their governance and review processes; while it may not seem as exciting as stock and fixed income movements, it is equally as important of an exercise for more efficient portfolio management.

PFM is an Associate Member of TEXPERS. The views expressed in this article are those of the authors and not necessarily PFM nor TEXPERS. 

Sources

[1] Bloomberg

About the Authors

Floyd Simpson III, CFA, CFP, is Senior Managing Consultant with PFM Asset Management LLC. As part of PFM’s OCIO business, Simpson works with clients across the country to develop and implement multi-asset class strategies for their portfolios. He also serves on the Multi-Asset Strategies Group and the Multi-Asset Class Investment Committee.

Mallory Sampson, CFP, is Senior Managing Consultant with PFM Asset Management LLC. Sampson manages PFM’s institutional multi-asset class relationships in Texas, with a focus on higher education, endowments, foundations and OPEB trusts.

Has COVID-19 Made Sustainable Investing More – or Less – Important?

Photo courtesy of Macquarie Group LTD.

By BARRY GLADSTEIN/Macquarie Investment Management

Environmental, social, and governance (ESG) investing has drawn considerable investor attention in recent years. Morningstar[1] reported that 2019 represented a record year of flows into ESG-related funds in both Europe and the United States. Along with this increased interest, Macquarie Investment Management has continued its commitment to sustainability such as through new ESG analytical and performance measurement tools for investment teams to integrate into their process. Yet, as the world continues to seek effective ways to deal with the COVID-19 pandemic, investors have questioned if there has been a shift in the relative importance of ESG issues when assessing investments. In other words, has ESG lost some of its relevance during the pandemic – or does the crisis make it even more important.

There are currently two schools of thoughts on this subject. One is that with the considerable toll that the pandemic has taken from both a societal and economic standpoint, seemingly more distant and lower priority issues such as climate change will take a back seat, especially as financial assets needed to make changes appear more scarce.

The other thought is that people have been ignoring warnings about a global pandemic for quite some time and the resulting lack of preparedness is a critical problem the world now faces. The same logic can be applied to longer-tail issues such as climate risk, where a potential crisis may similarly be lessened with nearer-term action.

An eye to the long term 

Macquarie Investment Management’s view on the relative importance of ESG in the investment process has not changed as the result of the pandemic. As Lotte Beck, ESG manager for Macquarie’s Luxembourg-based ValueInvest team, put it, “Our approach to ESG has always been to look at it as a stamp of quality. Stable, quality companies usually also have a higher level of ESG management and vice versa.”

The majority of our investment teams employ a fundamental approach toward identifying and assessing securities. Inherent to their investment process is an in-depth analysis of economic, competitive, and other factors that may influence future revenues and earnings of the issuer of the securities, including factors that have been identified as material from an ESG perspective.

Parsing out “E,” “S,” and “G”

This emphasis on materiality may result in a shift in focus regarding ESG factor consideration when evaluating potential investments. In the past few years, the “E” in ESG – environmental – has taken on ever increasing importance as investors have assessed the risks of climate change and its potential effect on a company’s future revenue and expenses. An example of this is the impact of global warming on the future crop supply for food processors and other industries that rely on these vital raw materials. In a 2019 report, the US Department of Agriculture’s Economic Research Service found that if greenhouse gasses are allowed to continue to increase, US production of corn and soybeans could decline as much as 80% over the next 60 years.

Of a more immediate nature are the dramatic increase in wildfires in recent years that many attribute to climate change. Barry Klein, utilities analyst on Macquarie’s Global Listed Infrastructure team, has regularly traveled to California to gain insights into the impact of utility-caused wildfires, assess the response of utilities, and meet with legislators, regulators, and management teams. “It’s important, from both an investment and an environmental responsibility perspective, that we gain a full understanding of the response of the different parties, and how seriously they are taking this growing issue,” Klein said.

While environmental factors remain important risks to consider, “S”, or social factors, are also taking on increasing importance as investors assess the risks of COVID-19 on individual companies. Workplace health and safety is a social factor that the Sustainability Accounting Standards Board (SASB) has identified as being important to many industries. Adrian David, senior credit analyst on Macquarie’s Fixed Income Global Credit Research team, pointed out that workplace safety has historically been a big focus for riskier industries such as mining or energy, Now, challenged by the rapid spread of the virus, more companies outside these sectors are considering how they can operate while providing a safe environment for their staff.

The “G”, or governance aspect of ESG, has always been an important area of focus for investors and will continue to be in the current environment. Steven Catricks, senior portfolio manager on Macquarie’s US Small Mid Cap Value Equity team, noted “how companies address governance issues such as executive compensation will be an important determinant of management quality. Share buyback and dividend policy will also take on greater relevance as stakeholders assess managements’ ability to be effective stewards of capital.”

ESG only a subset of fundamental analysis

The above-mentioned issues are some of the many on which our investment teams focus and reinforce our ongoing message – that ESG analysis and integration present just a subset of overall thorough fundamental analysis. Investors appear to agree that ESG issues remain paramount even in the face of the global pandemic. Morningstar reported that sustainable funds globally attracted an estimated $45.7 billion in net flows during the first quarter of 2020 even as the overall fund universe suffered $384.7 billion in outflows.[2] Summarizing the impact of the pandemic on ESG, Åsa Annerstedt, a portfolio manager on the International Value Equity team, said, “COVID-19 shone the light on the importance of ESG. It will change industries for good, if humanity is wise enough to learn and adapt.”

Macquarie Investment Management is an Associate Member of TEXPERS.The views expressed in this article are those of the author and not necessarily Macquarie Investment Management nor TEXPERS.

Sources

[1] Morningstar, Jan. 10, 2020, “Sustainable Fund Flows in 2019 Smash Previous Records.”
[2] Morningstar, May 14, 2020, “There’s Ample Room for Sustainable Investing to Grow in the U.S.”

About the Author

Barry Gladstein, CFA, leads Macquarie Investment Management’s Environmental, Social, and Governance (ESG) efforts.

New report sheds light on retirement security and financial decision making

Photo: Karolina Grabowska from Pexels.

TEXPERS STAFF REPORT

The Consumer Financial Protection Bureau issued a new report, Retirement Security and Financial Decision Making, that finds a growing number of retirees are not experiencing the expected gradual reduction in spending after they retire.

The report, published by the Consumer Financial Protection Bureau, finds that nearly half of Americans who retired between 1992 and 2014 were unable to keep the same spending level for five years following retirement. The Bureau’s findings indicate that certain financial decisions may enhance or diminish retirees’ ability to maintain the same level of spending, according to an email from NIRS announcing the webinar. For example, for homeowners, entering retirement without mortgage debt, for those with a pension, choosing a monthly annuity rather than in a lump-sum payout, are positively associated with retirees’ ability to maintain the same spending level for five years.

The study helps identify ways to protect retirees from overspending their savings in early retirement.

> REPORT:  Access a copy of the research brief.

Key Findings

• The study found that about half of people who retired between 1992 and 2014 had income, savings, and/or non-housing assets to maintain the same spending level for five consecutive years after retiring.  
• Bureau found that the ability to maintain the same spending level in the first five years in retirement was associated with large spending cuts in later years. 

The Consumer Protection Bureau is a federal agency responsible for consumer protection in the financial sector.

Governor's disaster declaration extension includes Open Meetings Act provisions; tips to safeguard public access

By TEXPERS Staff

UPDATE 8/14/20 -- Texas Gov. Greg Abbott on Aug. 8 issued a proclamation extending the state's Disaster Declaration in response to the COVID-19 pandemic. The declaration includes all Texas counties and includes a provision that allows governmental bodies such as state and local pension boards to continue hosting remote meetings.

"Renewing this Disaster Declaration will provide communities with the resources they need to respond to COVID-19," Abbott stated in a news release. "I urge Texans to remain vigilant in our fight against this virus. Everyone must do their part to slow the spread of COVID-19 by wearing a mask, practicing social distancing, and washing your hands frequently and thoroughly. We will overcome this challenge by working together." 

The state's disaster declaration includes Texas Open Meetings Act suspensions allowing governmental bodies to host public meetings remotely to reduce in-person meetings of large groups of people. 

Abbott initially issued the disaster declaration on March 13. On March 16, the governor granted the office of the attorney general's request for temporary suspension of certain open meeting statutes. The suspension allows for telephonic or videoconference meetings of governmental bodies as long as they remain accessible to the public. 

      > LEARN MORE: Open Meeting Act suspensions

State and local public pension systems should be aware that this temporary suspension leaves significant open-meeting protections in place. According to the governor's March 16 news release:

• Members of the public will be entitled to participate and address the governmental body during any telephonic or video conference meeting.
• To hold a telephonic or video conference meeting, a governmental body must post a written notice that gives the public a way to participate remotely, such as a toll-free dial-in number, and that includes an electronic copy of any agenda packet that officials will consider at the meeting.
• A governmental body must provide the public with access to a recording of any telephonic or video conference meeting.

"As we continue to respond to the COVID-19 pandemic, our top priority remains the health and safety of all Texans," Abbott stated in a news release announcing a previous extension of the Disaster Declaration. "By extending the disaster declaration, we are ensuring that Texas has the resources and capabilities in place to safely and strategically open the state while containing the spread of this virus. As we move forward in our response, I urge all Texans to continue following the health and safety guidelines laid out by the CDC and Texas' team of medical experts."

The History of Texas' COVID-19 Emergency Declaration

On March 13, the governor announced actions the state is taking to mitigate the spread of the novel coronavirus, which causes the COVD-19 disease, including declaring a State of Disaster in all Texas counties.

 

The governor extended the March 13 declaration on April 12. 

The governor extended the April 12 declaration for another 30 days on May 12. 

BY STEFFEN REICHOLD, Stone Harbor Investment Partners

Sustainable investment assets globally reached $30.7 trillion at the start of 2018, an increase of nearly 35% in two years, according to the Global Sustainable Investment Alliance. And while the majority of these assets are invested in equity strategies, bond investors are actively participating in the growth of environmental, social and corporate governance, or ESG, investing through various approaches, including purchasing green, social and/or sustainable bonds, launching ESG funds, benchmarking against ESG indices, and embedding ESG factors into the overall investment framework. 

In our view, integration of ESG factors into the fixed income investment process is complementary with fundamental credit analysis and engagement activities with sovereign and corporate issuers. Importantly, active investor involvement can drive change and positively affect sovereign and corporate issuers by creating incentives for them to improve ESG performance and by supporting economic development through fixed income investments.

Of the primary ESG factors, governance is particularly important to bondholders due to the impact it can have on improving institutions and on the rule of law that supports economic development. From a bondholder’s view, the sovereign’s commitment to political stability and security, and the strength of the institutional framework that supports the financial sector are strong indicators for improving creditworthiness. Considerations that are particularly relevant with corporate issuers include management incentives to ensure that their actions do not disadvantage bondholders in favor of stockholders, the structure of the board of directors, and the nature of the shareholding structure, among other factors.

Social issues and environmental factors, while still relevant and important, are somewhat more narrowly applicable compared to the governance factor. For a bondholder, the ability to influence social issues (e.g., worker rights, fair pay and adequate living standards, etc.) is limited. However, where these social issues are inequitable, concerns about the stability of the country are raised, along with questions about the sovereign’s ability to service its debt. Environmental factors are crucial for sectors such as the extractive industries. Again, from a credit perspective, the ability to effectively manage environmental risks (e.g., lapses and accidents) is a key concern as the company’s approach could have significant economic implications for the company, thereby affecting its debt servicing capabilities, as well as causing potential fatalities.

Click graphic to enlarge.

Improvements in ESG scores, particularly as they apply to governance, are often connected to better returns as the market prices in the improved fundamental (and thus lower risk premium). Therefore, the incentives for both issuers and investors to take actions to positively impact ESG scores are clear: improved ESG factors tend to be associated with lower spreads and thus better returns, benefitting bondholders; and countries and corporations that experience improving ESG scores also tend to undergo economic development and reduce their borrowing costs.

Click graph to enlarge.

The increasing demand for fixed income ESG products have also led to the development of tools for investors. Morningstar introduced their Sustainability Rating, which measures how well the holdings in a portfolio are performing on ESG factors relative to a portfolio’s peer group. Fixed income ESG indices have also been developed to provide a comprehensive and efficient coverage of the investable universe. For the JP Morgan ESG index suite, weights are set by scalar as determined by ESG score. For fixed income asset managers, tools that aid in analysis of ESG factors and provide better transparency are critical in managing ESG strategies.

Click graphic to enlarge.

The views expressed herein do not constitute research, investment advice or trade recommendations, do not necessarily represent the views of Stone Harbor Investment Partners nor TEXPERS, and are subject to revision over time.

About the Author:

BY BLAKE S. PONTIUS, William Blair Investment Management

The January 2019 collapse of a Brazilian mine tailings dam—which released 11.7 million cubic meters of toxic mud, killed at least 150 people, and led to a corruption probe—underscores the critical but underappreciated value of environmental, social, and governance (ESG) considerations in emerging markets.

ESG: More Important in Emerging Markets?

The majority of ESG-aware asset managers surveyed by Citi Research in October 2018 expressed the view that ESG factors are more important in emerging markets than developed markets, particularly from a corporate governance risk perspective.

Generally, weaker corporate governance practices in emerging markets relative to developed markets have played a role in shaping this opinion. More seasoned, quality-focused investors have long appreciated the need to be sharp on governance considerations when investing in frontier countries such as Kenya and Argentina, as well as the more mainstream countries such as China, India, and Brazil.

We’ve seen a variety of environmental and social issues become increasingly relevant to investors.

Emerging markets have more state-owned enterprises, necessitating a higher level of scrutiny of governance practices by prospective investors. While varying across different countries, there is generally a greater prevalence of family founders with majority stakes within emerging markets. Lower rates of board director independence and weaker corporate transparency are other realities contributing to the elevated governance risk profile.

Beyond these more obvious considerations related to governance and business culture, we’ve seen a variety of environmental and social issues become increasingly relevant to investors. From an environmental perspective, combating air, soil, and water pollution is becoming a more significant focus of government policy in China and India. And from a social perspective, investors are increasingly scrutinizing how companies are managing broader stakeholder relationships that can materially impact financial performance.

Back to the Brazilian Dam Disaster

The latter point takes us back to the Brazilian dam disaster.

The resource-intensive energy and materials sectors continue to play an important role in the socioeconomic welfare of many emerging and frontier economies, with concomitant ESG risk factors that can have severe consequences beyond share price performance.

For example, mining companies that operate in environmentally sensitive areas where indigenous populations live have to be thoughtful about how they develop resources. They must also ensure the safety of their employees through ongoing capital investments and training.

Brazil’s Vale SA, which owns the dam that collapsed in Brumadinho, knows that all too well. The company has since announced that it will close all 10 of its dams in the country with a similar design. 

Ratings Reflect Greater Risks, but also Opportunities

These risks can be seen in the ESG ratings distributions of emerging versus developed markets. Conventional ratings distributions, such as the one shown below from MSCI, reflect a negative skew in emerging markets relative to developed markets. (Applying MSCI’s ratings methodology, CCC is the lowest ESG rating assigned to companies on an industry-relative basis and AAA is the best.)

Click graph to enlarge.

This negative skew in ESG ratings reflects some of the risks I discussed above, with a consistent overhang being weaker governance structures for companies across different sectors within emerging markets. Companies lacking a majority independent board, for example, are systematically penalized. The existence of a combined chairman and CEO or dual share classes with unequal voting rights are also detrimental to the rating.

Over time, we expect ESG ratings for emerging market companies to broadly improve as more capital flows into ESG-focused equity and fixed-income strategies, and as more asset managers integrate ESG considerations in traditional strategies.

Emerging market ESG funds now account for nearly 10% of global emerging markets funds, up from just 2% a decade ago, as illustrated below.

Growth of ESG Assets in Emerging Markets

We’ve already seen tremendous growth in ESG-focused emerging markets fund assets, from less than $1 billion in 2008 to $20 billion in 2018, as measured by EPFR and Citi Research. Emerging market ESG funds now account for nearly 10% of global emerging markets funds, up from just 2% a decade ago, as illustrated below.

Asia ex-Japan represents a significant percentage of ESG-focused assets in emerging markets based on data collected by the Global Sustainable Investment Alliance (GSIA), with the largest markets for sustainable investing being Malaysia (30% of total professionally managed assets), Hong Kong (26%), South Korea (14%), and China (14%).

Malaysia’s prominence may come as a surprise considering the high-profile scandal involving its state-owned investment fund, 1MDB. Similarly, China’s inclusion on the list of prominent ESG markets contradicts the conventional perception of weaker governance given the role of state-owned enterprises (SOEs) and environmental mismanagement (ambient air pollution kills hundreds of thousands of citizens every year, according to the Chinese Ministry of Health).

But, perhaps surprisingly, according to a recent biannual review of corporate governance practices in Asia by research firm CLSA, Malaysia was the “biggest mover in 2018,” climbing to 4th place in Asia’s corporate governance market ranking.

And China was the fastest-growing market for sustainable investing from 2014 to 2016, according to the GSIA. Sustainable assets there were up 105%, followed closely by India (up 104%).

Much of that growth was driven by investment opportunities arising from public policy initiatives to clean up the environment, including China’s efforts to improve air quality by working to transition away from coal toward natural gas and renewables.

The views expressed herein do not constitute research, investment advice or trade recommendations, do not necessarily represent the views of William Blair Investment Management nor TEXPERS, and are subject to revision over time.

About the Author: